By Anthony Diosdi
Chapter 61 of the Internal Revenue Code contains countless reporting requirements regarding foreign information filing obligations. Many of the sections under Chapter 61 impose significant penalties for the failure to comply with its reporting requirements. A well-known provision in Chapter 61 by tax attorneys is Section 6039F. Section 1905 of the 1996 Tax Act created new reporting requirements under Section 6039F for U.S. persons (United states person means United States citizens, United States residents, corporations, partnerships, or limited liability companies created or organized in the United States) 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 Internal Revenue Service (“IRS”) an opportunity to review the characterization of these payments and determine whether they are properly treated as gifts. Donees are currently required to report certain information about such foreign gifts on Part IV of Form 3520.
Section 6039F(d) 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. Section 6039F(c) provides that if a U.S. person fails, without reasonable cause, to report a foreign gift as required by Section 6039F, then (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 percent of the amount for the gift for each month the failure to report the gift for each month the failure to report the foreign gift continues, with the total penalty not to exceed 25 percent of such amount.
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.
Internal Revenue Code Section 6677 assesses a separate penalty in connection with failing to timely file a Form 3520 to disclose a foreign trust. Section 6677 imposes a statutory penalty equal to the greater of $10,000 or 35 percent of the value of a foreign grantor trust or 35 percent of all amounts received by a United States person from a foreign person who has not filed an information return on Form 3520. Internal Revenue Section 6677(d) provides in part that, “no penalty shall be imposed by this section on any failure which is shown to be due to reasonable cause and not due to willful neglect.”
Originally, penalties associated with Form 3520 (hereinafter 3520 penalties) were assessed manually on individuals and entities whose missing filings were discovered during an audit. The IRS is still assessing 3520 penalties during audits. However, several years ago the IRS began systemic assessment of 3520 penalties associated with the late filing of these returns. The systemic assessment of 3520 penalties is controversial. Many taxpayers are unaware of their 3520 reporting obligations and learn of their filing obligations after the due date of the filing obligation has already passed.
Many of these same taxpayers often try to comply with their Form 3520 filing obligations by filing Form 3520 returns late. The IRS typically rewards these same taxpayers “trying to do the right thing” by automatically assessing 3520 penalties against them. These penalties can range from a minimum of $10,000 to several million dollars. Below, this article will discuss a number of factors to consider when developing a strategy to contest a 3520 penalty.
How IRS Treats 3520 Penalties
The IRS treats 3520 penalties as summarily assessable, as they are not subject to deficiency procedures. Under the deficiency procedures, taxpayers receive a notice of deficiency permitting them to petition the United States Tax Court and request judicial review of the proposed assessment. In other words, the IRS takes the position that it can assess a 3520 penalty and collect a 3520 penalty without providing the individual or entity assessed a 3520 penalty prepayment judicial review.
IRS Appeals’ View of Reasonable Cause
Many individuals assessed a 3520 penalty appeal penalty assessment to the IRS Appeals Division. As discussed above, Sections 6039F and 6677 provide that no penalty shall be imposed on any failure to file that is shown to be due to reasonable cause and not due to willful neglect. Probably the most common position taken is reasonable cause. The problem is IRS Appeals has applied mitigation of 3520 penalties sparingly for taxpayers utilizing a reasonable cause defense.
Many tax practitioners have expressed concern about recently obtained training materials from IRS Appeals regarding information return penalties and relief offered by the IRS Appeals Division. The information was obtained through a Freedom of Information Act (“FOIA”) request and contains a lot of information, including: slides concerning foreign trust penalties, foreign gift penalties, case authorities, examples, and Internal Revenue Manual or (“IRM”) cites. See IRS Appeals Training Materials on Reasonable Cause Worry Practitioners, Tax Notes Int’l, October 10, 2022, pp. 144-47.
One major area of concern is how Appeals interprets the applicability of United States v. Boyle to 3520 penalty cases. The United States Supreme Court stated in Boyle that:
“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 errors in the substantive advice of an accountant. To require the taxpayer to challenge, to seek a ‘second opinion,’ or to try to monitor [the accountant] on the provisions of the 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.” The Supreme Court also held in Boyle that failure to file a tax return was not excused by delegating the task to a tax professional. See United States v. Boyle, 269 U.S. 241, 246 (1985).
The blurred line when it comes to applying Boyle to 3520 penalty cases is delegation of the duty to file a return compared to a tax professional advising an individual whether or not they have an obligation to file a Form 3520.
According to training materials obtained from the FOIA request, Appeals officers are being trained to apply penalty mitigation only in extenuating circumstances when it comes to reasonable cause defenses. The most troubling aspect of IRS Appeals application of Boyle is taxpayers face a double-edge sword utilizing a reasonable cause argument. In a case where a taxpayer was unaware of the 3520 requirements and used a tax preparation software program such as TurboTax, Appeals would determine a 3520 penalty should not be abated because the taxpayer did not hire a tax professional. On the other hand, in a case where a taxpayer hired a tax professional who did not advise the taxpayer of a 3520 filing requirement, IRS Appeals would typically determine that a 3520 penalty cannot be removed because of a strict interpretation of Boyle, in that a taxpayer cannot delegate the filing of a Form 3520 to a tax professional.
The IRS’s strict interpretation of Boyle is resulting in valid reasonable cause defenses being ignored. Krzysztof Wrzesinski v. United States, No. 2:22-cv-03568 (E.D. Pa. Mar. 7, 2023) is an example of IRS Appeals misapplication of Boyle. In Wrzesinski, a Philadelphia police officer was gifted $830,000 by his mother after she won the Polish lottery. The officer filed a refund suit in U.S. District Court for the Eastern District of Pennsylvania attempting to recover a penalty assessed by the IRS for failure to file Form 3520 to report receipt of the gift.
In the case, the taxpayer consulted his accountant prior to receiving the gift, and the accountant advised him he did not have to comply with any U.S. reporting requirements. Wrzensinski only learned of the gift reporting requirements after contacting a tax attorney when he planned to make a gift to his godson. The attorney advised him to file delinquent information returns and attach statements of reasonable cause based on the erroneous advice of his first tax professional.
The IRS penalty notice stated the ignorance of tax laws is not a basis for penalty abatement under the reasonable cause standard, which requires ordinary business care and prudence. While the IRS ultimately abated 80 percent of the penalty, the taxpayer still claimed he should be subject to zero penalty based on reasonable cause. The Tax Division of the Department of Justice conceded the 3520 penalties assessed against the officer.
IRS Appeals’ Position Regarding Section 6751
In addition to the reasonable cause, the IRS Appeals training materials obtained through a FOIA request also offered insight into Appeals’ understanding of the Section 6751(b) penalty approval process. Internal Revenue Code Section 6751(b)(1) requires personal, written supervisory approval of the initial determination “of [a penalty] assessment.” That section applies to all Title 26 penalties, except for penalties under Sections 6651 (penalties for the failure to file a tax return or to pay a tax), 6654 (penalty for the failure by an individual to pay estimated income tax), and 6655 (penalty for the failure by a corporation to pay an estimated tax).
Although the IRS uses the term “systematically” assessed in reference to 3520 penalties, 3520 penalties are not automatically calculated and are subject to the Section 6751(b) penalty approval process. The guidance obtained from the IRS through the FOIA request indicates that there may be a number of cases where there is no opportunity for managerial approval of penalties assessed for the failure to timely an international information return. Appeals seems to believe that certain international penalty cases do not fall under the scope of Section 6751(b).
Anyone contesting a 3520 penalty should question whether the IRS satisfied the supervisory approval process requirement under Section 6751(b). Preparation is key when raising a Section 6751(b) argument. As soon as a 3520 penalty dispute arises, the individual contesting the 3520 penalty should send to the IRS a FOIA in order to obtain documents necessary to determine if there was written supervisory approval of a 3520 penalty. At a minimum, the FOIA request should demand the following documentation and information from the IRS:
1. All documents, including but not limited to workpapers, notes, case activity records relating to the 3520 penalty.
2. All documents relating to written supervisory approval of the penalty determination.
3. All documents and information identifying the person who made the “initial determination” of the penalty assessment.
4. All documents and information establishing that the person who approved the penalty assessment for the tax year in question was a supervisor.
Does Farhy Apply to 6038(b) Penalty Assessments?
Taxpayers developing a strategy to contest a 3520 penalty should consider the arguments made in Farhy v. Commissioner of Internal Revenue, 160 T.C. 6 (2023) in developing an overall strategy to contest a 3520 penalty. In Farhy, the petitioner was required to file Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, but he did not. The penalty for failure to file, or for delinquent, incomplete, or materially incorrect filing is a reduction of foreign tax credits by 10 percent and a penalty of $10,000. An additional $10,000 continuation penalty may be assessed for each 30-day period that noncompliance continues to $50,000 per return. The IRS assessed penalties against the petitioner under Section 6038(b) of the Internal Revenue Code. The Tax Court determined that there is no law giving the IRS authority to assess penalties under Section 6038(b).
We will now discuss if a Farhy type argument can be made in connection with Section 6038(b) penalty. By way of background, the IRS believes it has a grant of authority to assess international penalties (such as 3520 penalties) under Section 6201(a) of the Internal Revenue Code. This provision of the Internal Revenue Code permits the IRS to assess tax as well as interest and penalties. In NFIB v. Sebelius, 567 U.S. 519, 546 (2012), the Supreme Court agreed that the plain language of Section 6201 places assessable penalties within the definition of a tax for purposes of granting the IRS the authority to assess those penalties. As a result, the IRS has taken the position that NFIB v. Sebelius authorized it to summarily assess and collect international penalties such as Section 6039F penalties found in Chapter 61 of the Internal Revenue Code.
The Supreme Court in Sebelius analyzed whether the Anti-Injunction Act applied to the Affordable Act penalty. The Anti-Injunction Act provides that “no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person.” See IRC Section 7421(a). The question in that case, therefore, was whether the Affordable Care Act penalty was a “tax” for purposes of the Anti-Injunction Act. Neither the holding nor reasoning in Sebelius addresses the issue as to whether the IRS has the statutory authority to assess and collect under Section 6039F. The Court’s analysis in Sebelius is limited to the specific language in the Anti-Injunction Act and its interplay with the Affordable Care Act mandate. The IRS somehow reaches the conclusion that based on the Supreme Court’s reasoning in Sebelius, that it has the authority to assess and collect all international penalties such as Section 6039F penalties.
The IRS incorrectly takes the position that it has the authority to assess Section 6039F penalties under Section 6201(a). In order for the IRS to have the authority to assess and collect a Section 6039F penalty, the penalty must be paid upon notice and demand and assessed and collected in the same manner as taxes. See Smith v. Commissioner, 133 T.C. 424, 428 (2009). While the express language of Internal Revenue Code Section 6039F(c)(1)(B) states that the penalty is payable “upon notice and demand by the Secretary and in the same manner as tax.” However, this express language is missing the key phrase “assessed and collected” required by the Supreme Court in Sebelius. The absence of the key phrase “assessed and collected” from the language of Internal Revenue Code Section 6039F(c)(1)(B) may be fatal to the IRS’s argument that it has authority under Section 6201 to assess and collect a Section 6039F penalty.
Anyone considering contesting the Section 6039F penalty should consider if the express language of the statute authorizes the IRS to use its administrative powers to collect a Section 6039F penalty as part of an overall strategy.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi 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.