Does IRS Penalties For Failing to Timely File Form 3520 Violate the Eighth Amendment?

Section 1905 of the 1996 Tax Act created reporting requirements under Section 6039F of the Internal Revenue Code for U.S. persons (other than certain exempt organizations) that receive large gifts (including bequests) from foreign persons. The information reporting provisions require U.S. donees to provide information concerning the receipt of large amounts that the donees treat as foreign gifts, giving the IRS an opportunity to review the characterization of these payments and determine whether they are properly treated as gifts. U.S. donees are currently required to report certain information about such foreign gifts on Part IV of Form 3520. Section 6039F(b) generally defines the term “foreign gift” as any amount received from a person other than a U.S. person that the recipient treats as a gift or bequest.

Under Sections 6039F(a) and (b), reporting is required for aggregate foreign gifts in excess of $100,000 during a taxable year. Once the $100,000 threshold has been met, the U.S. donee is required to file a Form 3520 with the Internal Revenue Service (“IRS”). Section 6039F(c) provides that if a U.S. person fails, without reasonable cause, to report a foreign gift as requested by Section 6039F, the (1) the tax consequences of the receipt of the gift will be determined by the Secretary and (2) the U.S. person will be subject to a penalty equal to 5% of the amount for the gift for each month for the failure to report the foreign gift continues, with the total penalty not to exceed 25% of such amount. Originally, penalties associated with Form 3520 were assessed manually on individuals and entities who missed filing deadlines and were discovered during an audit.

Several years ago, the IRS began a systematic assessment of Section 6039F penalties associated with the late filing of Form 3520s. The systematic assessment of Section 6039F penalties is controversial. Many U.S. donees are unaware of their Form 3520 reporting obligation and learn of their filing obligation after the due date of the filing obligation has already passed. Many of these same U.S. donees often tried to comply with their Form 3520 filing requirement late. The IRS would typically rewards these U.S. donees “trying to do the right thing” by automatically assessing the maximum Section 6039F penalty against them. Recently, the IRS announced that it would no longer automatically assess Section 6039F penalties. But, the damage has been done. The IRS assessed millions of dollars of penalties against taxpayers that were attempting to do the “right thing” by filing a late Form 3520. This article discusses if the IRS assessment of Section 6039F penalties for late filed 3520s violates that Eighth Amendment of the U.S. Constitution.

What is the Eighth Amendment to the United States Constitution?

The Eighth Amendment provides that “Excessive bail shall not be required, nor excessive fines imposed, nor cruel and unusual punishments inflicts.” The prohibition of excessive fines is commonly referred to as the “Excessive Fines Clause.”  See Austin v. United States, 509 U.S. 602 (1993). The basis of the Excessive Fines Clause is traceable to the Magna Carta. See United States v. Bajakajian, 524 U.S. 321, 335-336 (1998). The principle is that fines should be proportional to the offense. A “fine” is a penalty which serves the purpose of punishment. Browning-Ferris Industries of Vermont Inc. v. Kelco Disposal, Inc, 492 U.S. 257, 265 (1989). In order for the Government to escape the Excessive Fines Clause, the penalty must solely be for remedial purposes. Austin v. United States, 509 U.S. 602, 610 (1993). A penalty is ‘remedial” only if it removes dangerous or illegal items from society or compensates the government for loss. Id. at 621. If any part of the penalty serves retributive or deterrent purposes, it is a punishment. Id. at 610.

A Section 6039F penalties assessed against taxpayers does not measure the size of the penalty by any reference to the government’s cost. Rather, the size of the penalty is instead related to the total months for the failure to report the foreign gift. See IRC Section 6039F(c) and as a result, the size of the penalty is related to an individual’s culpability. Since a Section 6039F does not reference the government’s cost and is related to an individual’s culpability, a Section 6039F Penalty is a fine subject to the “Excessive Fines Clause.”

The Legal Standard of the Eighth Amendment

The touchstone inquiry of the Excessive Fines Clause is proportionality. United States v. Bajakajian, 524 U.S. 321, 329 (1988). A fine violates the Excessive Fines Clause if it is grossly disproportional to the gravity of the offense. Id. at 334. If the amount is grossly disproportional to the offense, it is unconstitutional. Id. at 337. Four factors are considered in determining gross disproportionality: (1) the nature and extent of the underlying offense; (2) whether the underlying offense related to other illegal activities; (3) whether other penalties may be imposed for the offense; and (4) the extent of the harm caused by the offense. See Pimentel v. City of Los Angeles, 974 F.3d 917, 921 (9th Cir. app. 2020).

Nature & Extent of the Offense

The first factor courts look at in an Eighth Amendment Analysis is the nature and extent of the underlying offense. In assessing this factor, courts typically look to the violator’s culpability. Pimentel v. Los Angeles, 974 F.2d 917, 922 (9th Cir. App 2020). In a typical case involving a Section 6039F penalty involves an individual who did not know they were required to disclose a foreign gift or bequest on a Form 3520. Once these individuals find out about their reporting requirements, they file a late Form 3520 with the IRS. The gifts reported on Form 3520s are typically from legal non-taxable sources. Since the IRS suffers little if any losses as a result of late disclosure of foreign gifts, individuals being assessed Section 6039F penalties for late filed foreign gifts culpability if minimal.

Relation to Illegal Activities

The second factor is whether the underlying offense is related to other illegal activities. Pimental at 923. Typically, there is nothing connecting an individual disclosing a foreign gift or bequest on a Form 3520 to illegal activities.

Alternative Penalties

The third factor is whether other penalties may be imposed for the offense. Pimental at 923. Courts look to other penalties that the legislature has authorized and to the maximum penalties under sentencing guidelines. See United States v. $100,348 in United States Currency, 354. F.3d 1110, 1122 (9th Cir.App. 2004). The Federal sentencing guidelines do not provide for possible outcomes for  failing to timely disclose a foreign gift on a Form 3520. There is also typically no tax loss to the government for purposes of the sentencing guidelines. Consequently, the guidelines do not provide a minimum or maximum fine for purposes of alternative penalties.

Harm Caused by Offense

The fourth and final factor is the extent of the form caused by the violation. In cases involving the government, generally this factor focuses on the government’s economic loss. See Bajakajian at 338 (harm caused was minimum because “respondent caused no loss to the public fisc”); United States v. 3814 NW Thurman St., 164 F.3d 11191 (9th Cir. 1998) (no harm caused because “neither creditors nor the government suffered any actual loss”). In Section 6039F penalty cases, the government does not lose tax revenue. The only loss to the government in late 3520 filing cases is the timely filing of an information return.

Pattern of IRS Abuse

Section 1905 of the 1996 Tax Act created reporting requirements under Section 6039F for U.S. persons that receive large gifts from foreign persons to give the IRS an opportunity to review the characterization of these payments and determine whether they are properly treated as gifts. Congress has enacted steep penalties for failing to timely disclose foreign transactions such as foreign gifts on information returns to punish tax evaders and money launders. However, increasingly, severe penalties for the failure to report a foreign transaction on an information return such as foreign gifts are being assessed on unsophisticated, ordinary taxpayers.  See Taxpayer Advocate Report to Congress 2023. Instead of tax evaders and money launderers, penalties for failing to timely file an information return such as the Form 3520 is being assessed on middle and even low-income taxpayers with benign violations. Id. In its report to Congress, the Taxpayer Advocate warns of “potentially life-changing penalties for (a taxpayers” failure to meet (international) information filing requirements that are obscure and complex.” Id. pp. 102-107. The IRS’s draconian assessment of penalties for the failure to timely file Form 3520s has not gone unnoticed.

Conclusion

The IRS’s method of assessing penalties for late filed Form 3520s in the past has been disturbing. In many cases where the IRS assessed Section 6039F penalties all of the Bajakajian factors may indicate that these penalties are grossly disproportionate to the offense. In addition to a number of other defenses to Section 6039F penalties, anyone contesting a Section 6039F penalty should determine if the penalty assessment potentially violated the Eighth Amendment to the U.S. Constitution.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

Anthony has litigated Section 6039F penalty disputes before the United States Tax Court, United States Court of Federal Claims, and a number of United States district courts.

Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.