The Form 3520 Penalties and Abatement Procedure Explained

Form 3520 Penalties and Abatement Procedure

Form 3520 refers to the IRS Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts in accordance with Internal Revenue Code 6677 and 6039F.  The filing of a Form 3520 is generally due at the same time a Taxpayer’s individual US tax return is due — and is required even if no tax return is filed. When Form 3520 is late-filed — it may result in fines and penalties. There are several scenarios in which IRS Form 3520 is required, such as:

• • • Received a Gift from a Foreign Person

    • Received an Inheritance from a Foreign Person

    • Received a Foreign Trust Distribution

    • Have Ownership over a Foreign Trust

    • Made Contributions to a Foreign Trust

The main problem with Form 3520 is the sheer magnitude of the penalties the IRS issues regarding non-compliance.  Adding insult to injury is the fact that many taxpayers who are penalized under Section 6039F do not have any tax liability with the United States and have no other FATCA or FBAR reporting requirements. Oftentimes, an individual may be a student or retiree who receives a gift from their parents or other relatives — or even an inheritance from overseas. Since the IRS has increased enforcement of Form 3520, it is important to stay in compliance with reporting – and to get into compliance if you have not already done so.

Original Publication Date by Golding & Golding: 11/2020.

26 U.S.C. 6039F: Notice of large gifts received from foreign persons

CP15 Notice of Form 3520, Example

Let’s look at a very common example: a U.S. Taxpayer receives a gift from his relatives in Taiwan for $900,000.

• At that time he hired a CPA who misunderstood the foreign gift and trust reporting rules and Form 3520 was not filed timely.

• The CPA realizes (after the fact) that Form 3520 should have been filed.

• 6-24 months later, Taxpayer receives a CP15 Notice for $225,000.

What happened?

The $225,000 penalty was issued based on the penalty is 5% (of the value of the gift) per month — for a maximum of 25%.  

The Attorney Files the Initial Protest

Before it is time to litigate a Form 3520 penalty, the IRS CP15 Notice provides an opportunity to dispute the penalty based on reasonable cause and the CP15 Notice gives the Taxpayer 30 days to respond.

Most CP15 Notices provide the following:

6039F Reasonable Cause

• • • “If you believe you have reasonable cause for your failure to comply, you may send us a written statement (include any documents that will support your position) within 30 days from the date of this notice.

    • The statement must list all the facts you’re claiming as reasonable cause for the failure, and it must contain a declaration that the statement is made under penalties of perjury.”

The CP15 Notice is from the IRS and the initial protest (pre-appeal) goes back to the IRS for the first round of Reasonable Cause penalty abatement review.

Form 3520 Reasonable Cause Letter Rejection and LTR 854C

If the Form 3520 protest letter is rejected, the Taxpayer will usually receive a follow-up Letter 854C. At this stage, the Taxpayer can submit a supplemental response to their initial protest letter that was sent to the IRS — if they have “additional information” to present to the IRS Office of Appeals.  Sometimes, before going to Appeals, the IRS will request additional information and the letter will first go back to the IRS and not the Office of Appeals — which can impact the overall strategy the Taxpayer seeks to pursue. 

If not, the IRS Office of Appeals will consider the request and may schedule a conference with Appeals — or not — depending on the specifics of the presentation and the officer assigned to the matter. The Form 3520 penalty may be abated (removed) based on the letter alone. When this type of abatement occurs, a 21C Letter is issued.  Taxpayers should work with their counsel to assess the different strategies and how to proceed on this issue before submitting the appeal letter.

Here are two examples of letters we received regarding the abatement of extensive Form 3520 Gift Penalties in the high-six, low-seven figures (each case is different and no outcome is guaranteed):

21C Letter Example Language 

• • • “We changed the civil penalty amount that we previously charged.                     

      • Our action is the result of your inquiry of

      • Account balance before this change: $xxx,xxx.xx

      • Decrease in Failure to File Form 3520 to Report Receipt of Certain Foreign Gifts or Bequests penalty -$xxx,xxx.xx

    • As a result you don’t owe us any money, nor are you due a refund.”

*This letter was the outcome of a protest letter only.

1278 Letter Example Language

• • • “I completed my review of your request to adjust the penalties assessed against you. Based on the information submitted, I am pleased to advise you the penalties will  be abated  (removed) in full. When this action has been completed, you will receive an adjustment notice from the Service Center, which originally assessed the penalty.

    • If you have any additional questions, please contact the person shown at the top of this letter.

Would an Appeals Conference Prevent a CDP?

If the Taxpayer may want to litigate Form 3520 penalties in the future, a proper strategy should be developed from the outset. If the Taxpayer submits the follow-up to the initial protest and has a conference with appeals — but is still rejected — and does not pay the penalty — they will at some point in the future receive a Notice of Lien or Intent to Levy — which opens the door to pursue a CDP. The IRS can then take the position that the prior conference with appeals was the bite at the apple and the CDP would be rejected. Therefore, before sending any post-protest letter to the IRS, Taxpayers and their counsel should review the pros and cons of each approach.

Collection Due Process Hearing

If the Taxpayer has not had the penalty removed and chooses not to prepay the penalty — at some point in the future they will receive either a Notice of Federal Tax Lien or Intent To Levy and Right To a Hearing. It is at that point that the Taxpayer will have the opportunity to submit a Collection Due Process (CDP) request using form 12153. The main benefit of a Form 12153 request is that the Taxpayer will have the opportunity to present the case to an Officer who has significant authority to resolve the matter. In addition, the Taxpayer has the chance to prove reasonable cause. Moreover, if the penalty abatement is rejected, the taxpayer will then still have the opportunity to bring the matter to the Tax Court — armed with multiple legal arguments. Still, there are potentially serious tax (and life) implications for a Taxpayer who waits for a CDP to become ripe instead of pursuing an appeal.

Litigating Form 3520 Penalty in Tax Court 

Most of the time, Tax Court cases involving Form 3520 penalties involve a significant amount of penalties. As a result, certain small case options are not available. Thus, Taxpayers should keep in mind that the Attorney’s Fees for an experienced Attorney are usually very high — and billed hourly — which may not be feasible for many Taxpayers. 

Federal Court for Litigating Form 3520 Penalties

Another option for the Taxpayer is to pay the penalty up front and then seek a refund from the IRS. If the refund request is denied — then the Taxpayer can sue in District Court. The idea behind having to pay upfront is the Flora Rule — which requires a Taxpayer to pay the debt at the IRS before moving forward in pursuing a federal claim. It is important to note that Form 3520 penalties are not the result of tax liability — but rather the result of a reporting penalty. Therefore, the Taxpayer may want to take the position that similar to a recent ruling in an FBAR case, prepayment is not required up-front.

More About the Reasonable Cause Defenses Against Form 3520 Penalties

The primary (and most cost-effective) defense against a Form 3520 Penalty is to show reasonable cause before the matter spirals into litigation. If the taxpayer can show they offer a sufficient explanation to convince the IRS agents that while they were non-compliant, they should not be penalized because they met the reasonable cause standard — then sometimes the IRS will avoid issuing a penalty, or abate a penalty that was already issued.

As provided by the IRM:

• • • “Reasonable cause is determined on a case by case basis considering all the facts and circumstances of your situation.

      • Reasons that qualify for relief due to reasonable cause depend on the type of penalty you owe and the laws in the Internal Revenue Code (IRC) for each penalty.

      • Reasonable cause doesn’t apply to certain penalties such as the estimated tax penalty.

      • For businesses, the reasons apply to the person with authority to submit the return, deposit, or tax.”

An important takeaway from the definition of Reasonable Cause is that it is based on each Taxpayer’s facts and circumstances – on a case-by-case basis. Thus, just because one Taxpayer qualifies for Reasonable Cause does not mean that a Taxpayer in a similar situation will also qualify for reasonable cause.

Information Return Penalty Relief

• • • “If you can show reasonable cause for failing to file accurate, timely information returns or payee statements, we may consider penalty relief if you prove:

      • • “You acted in a responsible manner both before and after the failure by having:

        • Requested extensions of time to file when possible

        • Tried to prevent a foreseeable failure to file on time

        • Fixed any issues causing the failure

        • Corrected the fail ure as quickly as possible

    • Along with acting in a responsible manner, you must also prove there were significant mitigating factors with respect to the failure or the failure happened due to events beyond your control such as:

      • • First time filer of the particular form or statement

        • Good compliance history

        • Actions by the IRS

        • Actions of an agent

        • Actions of another person

        • Access to relevant business records

        • Economic hardships that prevented electronic filing”

Since the failure to file international returns is a very common scenario that leads to IRS fines and penalties, the IRS provides several factors that can help bolster a Reasonable Cause submission. Factors such as a good compliance history and resolving the issue sooner than later may contribute to a successful reasonable cause submission package.

Other Factors to Consider for Reasonable Cause

• • “The following factors don’t generally qualify as valid reasons for failure to file or pay a tax on time:

    • “Reliance on a tax professional. You’re generally responsible for complying with tax law even if someone else handles your taxes. You should know what your tax preparer files and get proof that your return or payment is sent on time.

    • Lack of knowledge. You’re responsible for knowing or getting advice on how to file returns and pay or deposit taxes on time. This includes filing requirements, deadlines and amounts you owe.

    • Mistakes and oversights. You’re responsible for making sure your tax returns, payments and deposits are correct and on time. In certain cases, reasonable cause may apply to a mistake if additional facts and circumstances show that you tried to comply with tax law.

    • Lack of funds. By itself, lack of funds is not reasonable cause for failing to pay or deposit taxes due. However, you may qualify for relief based on other facts and circumstances that show you used reasonable care and tried to comply with tax law.”

It is important to note that the IRS is not stating these factors are not valid, but that generally they do not qualify.

This goes back to the concept of the ‘case-by-case basis,’ and that each Taxpayer must present their own story to the IRS based on all the factors to try to meet the reasonable cause exception to penalties. For example, while professional reliance will not always qualify for reasonable cause if the Taxpayer (in international tax matters) can meet certain requirements as set forth by the LB&I concept unit, then Reasonable Cause may still apply.

Mistake Was Made

While typically, making a mistake is not sufficient to avoid a Form 3520 penalty, sometimes if the taxpayer has specific facts and circumstances to support a penalty waiver of a late-filed Form 3520 Penalty for a mistake — especially when it was the first time the form was required to be filed.

As provided by the IRM:

• • • The taxpayer may try to establish reasonable cause by claiming a mistake was made. Generally, this is not in keeping with the ordinary business care and prudence standard and does not provide a basis for reasonable cause.

      • However, the reason for the mistake may be a supporting factor if additional facts and circumstances support the determination that the taxpayer exercised ordinary business care and prudence but nevertheless was unable to comply within the prescribed time.

      • Information to consider when evaluating a request for an abatement or non-assertion of a penalty based on a mistake or a claim of ignorance of the law includes, but is not limited to the following:

      • When and how the taxpayer became aware of the mistake.

      • The extent to which the taxpayer corrected the mistake.

      • The relationship between the taxpayer and the subordinate (if the taxpayer delegated the duty).

      • If the taxpayer took timely steps to correct the failure after it was discovered.

Erroneous Advice or Reliance

One very common way that taxpayers can try to avoid or abate a Form 3520 penalty for filing a late form is to show that they received erroneous advice from a tax professional who is experienced in these types of matters. Noting, it is not as simple as a taxpayer showing that they relied on a tax professional, but additional elements must be met.

As provided by the IRM:

• • • Each request for penalty relief should be reviewed thoroughly to determine the exact basis of the taxpayer’s request.

      • Is the taxpayer claiming they did not comply due to specific advice they received from someone, whether orally or in writing, or

      • Is the taxpayer claiming they relied on someone else to comply on their behalf?

    • Certain sections of the IRC and Treasury Regulations provide relief from certain penalties based on erroneous advice. See IRM 20.1.1.3.3.4, Advice, to first determine if a statutory exception or administrative waiver applies.

      • If the taxpayer states they relied on written or oral advice from the IRS but does not qualify for relief in accordance with the criteria in IRM 20.1.1.3.3.4.1, Written Advice From the IRS, or IRM 20.1.1.3.3.4.2, Oral Advice From the IRS, refer to IRM 20.1.1.3.2.2, Ordinary Business Care and Prudence, to determine if the taxpayer exercised ordinary business care and prudence in relying on the IRS’s advice.

      • The taxpayer may try to establish reasonable cause by claiming they relied on another party to comply on their behalf. Generally, this is not a basis for reasonable cause, particularly for filing or paying obligations, since the taxpayer is responsible for meeting their tax obligations and that responsibility cannot be delegated. However, other factors to consider include:

        • Was the taxpayer unable to comply because they did not have access to their own records? See IRM 20.1.1.3.2.2.3, Unable to Obtain Records.

        • Was the failure to comply due to a change in the tax law the taxpayer could not reasonably be expected to know? See IRM 20.1.1.3.2.2.6, Ignorance of the Law.

        • Consider all facts and circumstances presented by the taxpayer to determine if, despite the exercise of ordinary business care and prudence, the taxpayer nevertheless was unable to comply.

Ignorance of the Law

In some situations, if the taxpayer can show that there was an ignorance of the law, this too may qualify to avoid a late-filed Form 3520 penalty. In these types of situations, it is based primarily on the taxpayer’s education — along with other factors, such as whether or not the Taxpayer had been penalized for this type of violation in prior years.

• • • In some instances taxpayers may not be aware of specific obligations to file and/or pay taxes. The ordinary business care and prudence standard requires that taxpayers make reasonable efforts to determine their tax obligations. See IRM 20.1.1.3.2.2, Ordinary Business Care and Prudence.

    • Reasonable cause may be established if the taxpayer shows ignorance of the law in conjunction with other facts and circumstances. For example, consider the following:

      • The taxpayer’s education.

      • If the taxpayer has previously been subject to the tax.

      • If the taxpayer has been penalized before.

      • If there were recent changes in the tax forms or law which a taxpayer could not reasonably be expected to know.

      • The level of complexity of a tax or compliance issue.

    • Reasonable cause should never be presumed, even in cases where ignorance of the law is claimed.

    • The taxpayer may have reasonable cause for noncompliance due to ignorance of the law if the following are true:

      • A reasonable and good faith effort was made to comply with the law, or

      • The taxpayer was unaware of a requirement and could not reasonably be expected to know of the requirement.

Was the Gift directly made for Medical Purposes or Education?

Taxpayers need to be aware of what does NOT qualify as a gift as well —

As provided by the IRS:

• • • “A gift to a U.S. person does not include any amount paid for qualified tuition or medical payments made on behalf of the U.S. person.”

Offshore Disclosure Before a Penalty is Issued

Offshore Disclosure is not a defense, insomuch as it is an opportunity for a taxpayer to make a proactive submission to the Internal Revenue Service seeking to avoid penalties before they are issued. This way, the taxpayer can take the lead and make an offshore disclosure to the Internal Revenue Service using one of the international tax amnesty programs. Depending on which program the taxpayer qualifies for they may have a reduced penalty or their penalty may be avoided altogether.

Late Filing Form 3520-A Penalties May be Reduced or Avoided

For Taxpayers who did not timely file their Form 3520-A and other international information-related reporting forms, the IRS has developed many different offshore amnesty programs to assist taxpayers with safely getting into compliance. These programs may reduce or even eliminate international reporting penalties.

Current Year vs Prior Year Non-Compliance

Once a taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist who specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties. 

Need Help Finding an Experienced Offshore Tax Attorney?

When it comes to hiring an experienced international tax attorney to represent you for unreported foreign and offshore account reporting, it can become overwhelming for taxpayers trying to trek through all the false information and nonsense they will find in their online research. There are only a handful of attorneys worldwide who are Board-Certified Tax Specialists and who specialize exclusively in offshore disclosure and international tax amnesty reporting. 

This resource may help taxpayers seeking to hire offshore tax counsel: How to Hire an Offshore Disclosure Lawyer.

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure. 

Contact our firm today for assistance.