Opportunities Exist to Challenge Taxpayers’ Penalty Assessments for Failure to Report Large Foreign Gifts

U.S. citizens and residents who have received gifts (including bequests) exceeding certain thresholds from foreign persons must generally report such gifts to the IRS. Recipients of such gifts who do not report them in a timely fashion face penalties as high as 25% of the gifts’ value, plus interest, and the IRS has been quick to assert such penalties. Individuals may be able to challenge the IRS’s assertion of such penalties, but must tread carefully in doing so.

The Requirement to Report Foreign Gifts

In the case of gifts received from nonresident alien individuals or foreign estates, the threshold for reporting such gifts is currently an aggregate value of $100,000, and in the case of gifts received from foreign corporations or foreign partnerships, the threshold was $18,567 for 2023 (subject to adjustments for inflation). The form to be used to report such gifts is Form 3520, and in the case of a U.S. citizen or resident who is an individual, the form must generally be filed by April 15 (or October 15, if an extension has been obtained) of the year after the gift was received. The penalty for not disclosing reportable foreign gifts in a timely fashion equals 5% of the gifts’ aggregate value for each month the Form 3520 is late, up to a maximum of 25% of the gifts’ aggregate value, plus interest. See also, About Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts (Internal Revenue Service).

It is easy to miss the gift reporting requirement, because gifts from foreign persons generally have no impact on a recipient’s income taxes, tax preparation software often does not ask about such gifts, tax return preparers are sometimes not well versed in the rules for reporting such gifts, and the IRS has done little to make the public aware that such gifts must be reported. As a result, taxpayers who become subject to the 25% penalty are often individuals who were not aware of, and had no reason to even suspect, the existence of the requirement that large foreign gifts be reported.

There is an exception to the penalty for persons who had ​“reasonable cause” for the failure to timely report a foreign gift, and taxpayers may submit an explanation of why they had reasonable cause when filing a Form 3520 late. It is widely believed, however, that IRS personnel do not read such explanations, as the IRS does not hesitate to assert the maximum 25% penalty, regardless of the reason for the late filing.

Contesting the Penalties

After the IRS assesses a penalty for the failure to timely report a foreign gift, the IRS typically issues notices that demand payment of the penalty. If a taxpayer fails to respond to such notices, the IRS will eventually attempt to seize funds from the taxpayer’s financial accounts or otherwise seize the taxpayer’s property.

Some of the notices issued by the IRS may offer the taxpayer the right to file an administrative appeal. Taxpayers should pay attention to the content of such notices, as not all offers of an opportunity to file an administrative appeal are created equal. Some notices will offer the taxpayer the opportunity to request a ​“Collection Due Process” hearing. If the taxpayer requests such a hearing, the taxpayer will generally be given the opportunity to present his or her case to the IRS’s Appeals Division at a Collection Due Process hearing. Such an appeal will be heard by an IRS Appeals Division appeals officer or other hearing officer, who will have the authority to waive the penalty or settle the penalty for a lesser amount. If the taxpayer is unable to achieve a satisfactory result at the IRS’s Appeals Division, the taxpayer may generally appeal the penalty to the U.S. Tax Court without first paying the penalty.

Some notices offer the opportunity to file an appeal with the IRS’s Appeals Division, but do not specifically indicate that the taxpayer is being offered the opportunity to request a Collection Due Process hearing. If a taxpayer receives such a notice, the taxpayer may have a difficult choice to make. In the case of a penalty for the failure to timely report a foreign gift, if a taxpayer is offered the opportunity to appeal, but not the opportunity to request a Collection Due Process hearing, then if the taxpayer requests the appeal pursuant to the offer, but is not satisfied with the determination of the IRS’s Appeals Division, the taxpayer will generally not have the opportunity to appeal the adverse determination to the U.S. Tax Court. Instead, to further appeal the penalty assessment, the taxpayer would have to first pay the penalty, file a claim with the IRS for a refund of the penalty, then appeal any denial of that refund claim to a U.S. District Court or the U.S. Court of Federal Claims. Because a taxpayer may generally not appeal a penalty assessment to a U.S. District Court or the U.S. Court of Federal Claims without first paying the penalty, an administrative appeal that does not qualify as a Collection Due Process hearing can be less attractive to a taxpayer.

A taxpayer who has received a notice offering an appeal that is not described as a Collection Due Process hearing might be tempted to wait and see if he or she later receives a notice that does offer a Collection Due Process hearing. This approach carries some risk, however, as an IRS regulation provides that a taxpayer may not raise an issue (such as liability for a penalty) at a Collection Due Process hearing if the taxpayer had a prior ​“opportunity to dispute such tax liability” before the IRS’s Appeals Division. It is unclear whether, in the case of a penalty for the failure to timely report a foreign gift, the mere receipt of a notice that offers an administrative appeal, but not a Collection Due Process hearing, is considered to be an ​“opportunity to dispute” the penalty sufficient to preclude consideration of the penalty at a later Collection Due Process hearing. In the case of certain penalties, the IRS has taken the position, and the U.S. Tax Court has agreed, that the mere receipt of a notice that offers an administrative appeal (but not a Collection Due Process hearing) is an ​“opportunity to dispute” the penalty. Neither the IRS nor any court has yet indicated whether, in the case of a penalty for the failure to timely report a foreign gift, an offer of an administrative appeal that does not provide Collection Due Process rights and that is not acted upon by the taxpayer would preclude the taxpayer from challenging the penalty via a Collection Due Process proceeding in the future. Taxpayers who would prefer to be able to challenge penalties through the Collection Due Process procedure should consult with experienced tax counsel, who may be able to increase the likelihood that the Collection Due Process procedure becomes available.

A New Potential Argument

If and when a taxpayer does appeal the assessment of a penalty for failure to timely report a foreign gift, the taxpayer might have a new argument against the assessment of the penalty.

The IRS takes the position that penalties for the failure to timely report foreign gifts are what are known as ​“assessable penalties.” To collect such a penalty, the IRS first makes an internal bookkeeping entry, called an ​“assessment.” Once the penalty has been assessed, the IRS may collect the penalty, including by levying funds in the taxpayer’s financial accounts or by otherwise seizing the taxpayer’s property. A taxpayer does not necessarily have an opportunity to contest such a penalty in court until the penalty is first paid (either voluntarily, or as a result of the IRS’s seizure of the taxpayer’s property). The fact that the IRS may simply declare that the penalty is due, and then collect it without necessarily giving the recipient of the gift an opportunity to challenge the penalty in court, makes the penalty for the failure to report a foreign gift especially painful.

A recent U.S. Tax Court decision, Farhy v. Commissioner, 160 T.C. No. 6 (2023), has cast some doubt on the IRS’s ability to treat penalties for the failure to timely report foreign gifts as assessable penalties. The Farhy case did not specifically address the penalty on the failure to report foreign gifts, but it did address a similar penalty.

Under Section 6038(a) of the Internal Revenue Code, U.S. persons are required to report to the IRS certain information about foreign corporations that they control. IRS Form 5471 is used to report the information. Under Section 6038(b) of the Code, U.S. persons who fail to timely report the required information are subject to a penalty of $10,000 or more. While Code Section 6038(b) imposes a penalty, it does not say that the penalty is an assessable penalty.

Mr. Farhy had for several years owned 100% of the stock of one or more foreign corporations. As a result, Mr. Farhy was obligated to file Forms 5471, but did not do so, so the IRS assessed penalties against Mr. Farhy under Code Section 6038(b). Mr. Farhy contested the penalties before the U.S. Tax Court in a Collection Due Process proceeding, on the ground that the penalty was not an assessable penalty and that the IRS’s assessment was, therefore, invalid.

Because the statute imposing the penalty for the failure to timely report an ownership interest in a foreign corporation does not explicitly provide that the penalty is an assessable penalty, the IRS takes the position that the treatment of that penalty as an assessable penalty is implied – basically because no statutory provision provides that the penalty is not an assessable penalty. The Tax Court agreed with Mr. Farhy’s argument, however, and held that the IRS lacked the authority to treat the penalty as an assessable penalty.

The statute imposing penalties for the failure to timely report large foreign gifts is Code Section 6039F(c). Code Section 6039F(c) is not identical to the statute discussed in the Farhy case, but it shares some important features with Code Section 6038(b). In particular, neither provision contains language providing for the assessment or collection of the penalty. There is, therefore, an argument that the penalty under Code Section 6039F(c), for the failure to timely report foreign gifts, is also not an assessable penalty and may, therefore, only be collected by the IRS after the filing of a civil action. This argument has been made already. For example, in a complaint filed on March 15, 2024, with the U.S. District Court for the Northern District of California, Tomkinson v. U.S., a plaintiff made this argument in support of his claim for a refund of a penalty assessed under Code Section 6039F.

Use of the Farhy case to challenge a penalty for the failure to timely report a foreign gift is not a slam dunk, however. Not surprisingly, the government has appealed the Farhy decision, and there is no assurance that the Farhy decision will not be overturned. In addition, while Code Section 6039F(c) is similar to Code Section 6038(b), the two provisions are not identical, so even if the Farhy decision were to be upheld on appeal, it would be unclear whether the Farhy decision would apply to penalties for the failure to timely report foreign gifts. Moreover, even if one were successful in challenging a penalty with a Farhy argument, the government could still file a civil action to collect the penalty (but doing so would be more costly to the government than making a simple bookkeeping entry).

We will continue to monitor these developments. For assistance in determining if you will be subject to the reporting penalties and how to address them, please contact Kelley Drye Tax Partner, Andrew Lee.