The IRS Ends Automatic Section 6039F Penalties for Late-Filed Form 3520s. Six Reasons Why the Announcement Was Inadequate

The Internal Revenue Service (“IRS”) will no longer automatically impose penalties on taxpayers who file late Forms 3520 (annual Return To Report Transactions With Foreign Trust and Receipt of Certain Foreign Gifts) reporting gifts or bequests from foreign persons, a change announced by IRS Commissioner Danny Werfel on October 24, 2024. Going forward, before assessing a Section 6039F for failing to timely report a foreign gift or bequests from a foreign person, the IRS will apparently review reasonable cause statements submitted with late filed Form 3520s. The IRS has come under intense scrutiny for automatically assessing penalties when taxpayers voluntarily file late Form 3520s, the appeals process to contest assessed for failing to timely file Form 3520s, and its application the reasonable cause defense to 3520 penalties. For reasons discussed in this article, the fact the IRS will no longer be automatically imposing Section 6039F penalties does not go nearly far enough.

Background: Section 6039F Penalties

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 foreign gifts on Part IV of Form 3520. Section 6039F(b) generally defines the term “foreign gifts” 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 IRS. Section 6039F(c) provides that if a U.S. person fails, without reasonable cause, to report a foreign gift on a Form 3520, 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. The IRS treats Section 6039F penalties as summarily assessable, as they are not subject to deficiency procedures, wherein taxpayers receive a notice of deficiency alerting them of the assessment and explaining the taxpayer’s options for contesting or complying with the penalty assessment.

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 filing obligations and learn of their filing obligations after the due date of the filing obligation has passed. Up until recently, the IRS would reward U.S. donees “trying to do the right thing” by automatically assessing the maximum Section 6039F penalty against them.

As discussed above, on October 24, 2024, the IRS stated it would no longer automatically impose Section 6039F penalties on taxpayers who file late Forms 3520.

This announcement came up well short of what the IRS should have announced on October 24th. Below are my top five reasons why the October 24th announcement was inadequate.

1. The IRS Should Provide Relief to Those Unfairly Assessed Section 6039F Penalties

The IRS announcement that it stopped automatically assessing Section 6039F penalties is a step in the right direction. The announcement does nothing to assist taxpayers that were negatively impacted by the automatic assessment of Section 6039F penalties.

Because gifts and inheritances are excludable from income, many taxpayers did not realize they had to report them on a Form 3520. The Taxpayer Advocate has stated that there are numerous examples of taxpayers who receive a once-in-a-lifetime tax-free gift or inheritance and were unaware of their 3520 reporting requirement. Upon learning of their 3520 filing requirement, these taxpayers did the right thing and filed a late Form 3520 only to be greeted with a substantial Section 6039F penalty, which was automatically assessed by the IRS upon the late filing of the Form 3520. See IRS HEARS Concerns from TAS and Practitioners, Makes Favorable Changes to Foreign Gifts and Inheritance Filing Penalties, NTA Blog National Taxpayer Advocate, October 24, 2024. The Taxpayer Advocate also implied that the IRS often erroneously assessed Section 6039F penalties. Assessing needlessly harsh and incorrect penalties against taxpayers trying to do the right thing has caused undue hardship and burdens.

The IRS has clearly acknowledged that its automatic Section 6039F penalties are flawed. The IRS should at least offer some sort of abatement to taxpayers that were wrongfully assessed Section 6039F penalties. That is unlikely to happen anytime soon. As a matter of fact, the IRS Office of Chief Counsel and the Department of Justice are still aggressively defending Section 6039F that were automatically assessed against taxpayers trying to do the right-thing.

2. IRS Should Immediately Adopt the Boyle Standard of Reasonable Cause for Purposes of the Section 6038F Penalty

In its October 24th the IRS appears to be inviting taxpayers that have failed to timely discuss a foreign gift or bequest on a Form 3520 to file the return along with a “reasonable cause statement.” The problem with making such a submission is that the IRS has not defined the term “reasonable cause” for purposes of the Section 6039F penalty.

The IRS has authority to waive a Section 6039F of the Internal Revenue Code for failing to timely disclose a foreign gift on a Form 3520. “Reasonable cause” is nowhere defined in Section 6039F or in the regulations interpreting it. That phrase, however, appears repeatedly in statutes governing the IRS’s tax assessment role. For example, Section 6664(c)(1) prohibits penalties for any portion of an underpayment of tax “if it is shown that there was reasonable cause for such portion and that the taxpayer acted in good faith with respect in such portion.” Another statute, applicable to foreign trusts, prohibits penalties for “any failure which is shown to be due to reasonable cause and not due to willful neglect.” See IRC Section 6677(d). The statute which is analogous to Section 6039F is Section 6651(a)(1). In that statute, Congress prohibited monthly penalties for failing to file tax returns where “such failure is due to reasonable cause and not due to willful neglect.”

In 1985, the Supreme Court noted that the meaning of the terms “reasonable cause” and “willful neglect” ‘ha[d] become clear over the near-70 years of their presence in the statute.” See United States v. Boyle, 469 U.S. 241, 246 (1985). It also noted that the regulation defined “reasonable cause” for purposes of Section 6651(a)(1). The relevant Treasury Regulations calls on the taxpayer to demonstrate that he or she exercised “ordinary business care and prudence” but nevertheless was “unable to file the return within the prescribed time.” There is no reason to believe that Congress intended the meaning of “reasonable cause” in a Section 6039F penalty to differ from the meaning ascribed to it in tax statutes.

Reliance on the advice of a tax professional may constitute reasonable cause and good faith, if under all the facts and circumstances, the reliance is reasonable and in good faith. The United States Supreme Court has stated “When an accountant .. advises a taxpayer on a matter of tax law, such as whether liability exists, it is reasonable for the taxpayer to rely on that advice. Most taxpayers are not competent to discern error in the substantive advice of an accountant…To require the taxpayer to challenge [or] seek a ‘second opinion,’ or to try to monitor [the accountant] on the provisions of the [Internal Revenue] Code himself would nullify the very purpose of seeking the advice of a presumed expert in the first place…’Ordinary business care and prudence’ do not demand such actions.” See United States v. Boyle, 469 U.S. at 251.

Both sophisticated and unsophisticated taxpayers consult with tax professionals to determine their IRS filing requirements such as a Form 3520. It has been a common problem that many tax professionals have failed to advise their clients regarding a 3520 filing requirement. Under Boyle and the regulation promulgated under Section 6651, reliance on a tax professional should have provided a reasonable cause defense to a Section 6039F penalty. Many taxpayers have filed protest letters with IRS Appeals challenging a Section 6039F penalties claiming a reasonable cause defense based on reliance of a tax professional. The IRS (or IRS Appeals) response to Boyle reliance arguments have been as follows: “ordinary business care and prudence require taxpayers to make themselves aware of their duties and that ignorance of tax laws could not serve as a basis for reasonable cause.” The IRS has essentially been ignoring the Supreme Court and its own regulations when responding to requests to remove or abate Section 6039F penalties. If the IRS is going to invite the public to submit late Form 3520s with reasonable cause statements, the IRS should define the term “reasonable cause” for purposes of the Section 6039F penalty. The failure to provide a definition of the term “reasonable cause” or making up the definition of “reasonable cause” for purposes of the Section 6039F only discourages compliance.

3. IRS Needs to Properly Train its Employees and Appeals Officers

After hearing horror stories in regards to the Section 6039F penalty abatement process, in 2022, a major publication made a Freedom of Information Act (“FOIA”) request to the IRS to obtain certain information regarding Section 6038F penalty assessments. As part of the response to the FOIA, the IRS provided “training materials” to IRS Appeals Officers for purposes of the Section 6039F penalty. The “training materials” included examples and Internal Revenue Manual (“IRM”) cites. The “training materials” provided to Appeals Officers stressed that Section 6039F penalty mitigation should be used sparingly and only when hazards of litigation are low and extenuating circumstances exist. See IRS Appeals Training Materials on Reasonable Cause Worry Practitioners, Tax Notes Int’l, Oct. 10, 2022, pp. 144-47. The “training materials” are contrary to Boyle and Treasury Regulations promulgated for Section 6651(a)(1) that require ordinary business care and prudence to establish reasonable cause to remove a penalty. If the IRS is going to expect taxpayers to file late 3520 with an attached “reasonable cause” statement, it must properly train its employees and appeals officers to properly apply the reasonable cause standard to late filed Form 3520s.

4. IRS First-Time Penalty Abatement Procedures Need to be Updated

In 2001, the IRS established the first-time penalty abatement procedures to help administer the abatement of penalties consistently and fairly, reward past compliance, and promote future compliance. This administrative program allows a first-time noncompliant taxpayer to request abatement of certain penalties for a single period. For some unknown reason, the IRS specifically excludes Section 6038F penalties from relief under the first-time penalty abatement procedures. The first-time penalty abatement procedures should immediately be updated to include Section 6039F penalties. An amendment to the first-time penalty abatement procedures will encourage taxpayer compliance for reporting foreign gifts and bequests.

5. The IRS’s Current Penalty Review Procedures Likely Violates the APA and Should be Changed

When a taxpayer is assessed a Section 6039F penalty, he or she is given 30 days to file a written protest with the IRS Appeals Division. Regardless of the reasons in the written protest, IRS Appeals often responds to protest letters with the following statement: “ordinary business care and prudence require taxpayers to make themselves aware of their duties and that ignorance of tax laws could not serve as a basis for reasonable cause.” These short terse responses to often very well drafted protest letters implies that IRS Appeals has not properly trained its agents to review these letters. These types of responses from a federal agency may violate the Administrative Procedure Act (“APA”). The APA speaks directly to certain kinds of federal agency decisionmaking. 5 U.S.C.A. Section 555(e) requires prompt notice “of the denial” and “a brief statement for the grounds for denial.” Courts have held that an agency’s statement of grounds for denial should be specific and contain reasons for the conclusion. See Trailways of New England, Inc. v. CAB, 412 F.2d (1st Cir.1969); Meadville Master Antenna, Inc. v. FCC, 443 F.2d 282 (3d Cir. 1971). It is not difficult to imagine a scenario in which a federal court determines that the very short terse and unresponsive answers to Section 6039F penalty protest letter violates Section 555(e). Moreover, the due process clause of the Fifth Amendment to the Constitute may also be violated.

Section 706 of the APA authorizes individuals to bring a lawsuit against the IRS if the denial of a request to remove a penalty was arbitrary and capricious. In order to avoid litigation, it is very much in the IRS’s best interest to at least general reasons (specifically tailored to the facts of that case) for a denial of a request to abate the Section 6039F penalty at issue. There was nothing in the October 24th IRS statement which indicated that the IRS will provide at least general reasons for denial of Section 6039F penalty relief.

6. The Penalty Review Processing Time is Ridiculous

Anyone that has submitted a request to remove a Section 6039F penalty has witnessed that it can take the IRS more than two years to determine whether or not to remove or abate a Section 6039F. There is no reason why it should take the IRS months or years to complete the penalty review process. If the IRS wants to encourage taxpayer compliance of the Form 3520 and other international information returns, it must figure out how to provide a fair and timely penalty review process.

Conclusion

The recent IRS announcement that it will stop the automatic penalty assessment for individuals who are late reporting a gift or inheritance they received from a foreign individual is a step in the right direction. But it does not go nearly far enough. The IRS needs to focus on establishing a fair and efficient Section 6039F penalty review process.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony has litigated Section 6039F penalty disputes before the United States Tax Court, Federal Court of Claims, and Federal District Courts throughout the United States. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. 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.