How to Challenge an IRS Penalty Notice for Form 3520

How to Challenge an IRS Penalty Notice for Form 3520

Responding to a 3520 CP15 Penalty Notice

A more detailed analysis of CP15 Notice and Form 3520 Penalties can be found here in our 2/2022 article.

For several years now, the Internal Revenue Service has been significantly increasing enforcement of international information reporting penalties — and especially Form 3520 penalties for reporting foreign trusts and gifts. It is a bit peculiar that the IRS wants to take Taxpayers to task for 3520 gift/inheritance issues — because oftentimes the reason for having to file the form is simply because a US person with foreign national parents may have gifted the US person money or other gifts that may come by way of inheritance. Contrary to popular belief, it is not always because the foreign national just wants to give gobbles of money to a US person. As a new resident of the United States, it is very difficult for taxpayers to obtain any credit, mortgage, etc. –- so the foreign national parent just wants to help out a family member. Another common scenario is when a family member passes away and the US person inherited some money or assets (imagine receiving a 25% penalty on an inheritance from your sweet Grandma in Peru, right?)

What happens when a Taxpayer gets hit with a Form 3520 Penalty?

Unfortunately, the Internet is littered with fear-mongering websites, along with inaccurate information about how to proceed – here are 5 important facts.

Form 3520 is Not About Unreported Income

One of the most confusing aspects of a Form 3520 penalty for Taxpayers is that it does not require that there be any unreported income. When a US person receives a gift from a foreign person, it does not generate income tax issues or unreported income — which is why the penalties are so absurd. Stated another way, when a person files a tax return with incorrect income information and is audited — where it turns out they may have missed some income — it makes sense that the Taxpayer may be penalized (depending on the amount of unreported income they have and facts surrounding the audit). With a Form 3520 penalty, it does not involve missed income –– just missed reporting — so the penalty that the Taxpayer suffers for not filing the form has nothing to do with undisclosed income, and in most situations is completely unjust.

It is an “Assessable” Penalty

The Form 3520 penalties are assessable penalties. That means that a person does not receive notice that they may be subject to the penalty before it is issued — and are not provided the opportunity to dispute the penalty beforehand (unless possibly the potential penalty first arises during an audit, which is rare). Rather, when a Taxpayer has been assessed a Form 3520 penalty, the first notice of any potential penalty will be the actual CP 15 Penalty Notice – which notifies the Taxpayer that they are out of compliance; which IRC section they violated; what the penalty amount is, and how they can dispute the penalty.

The Reasonable Cause 30-Day Letter

Reasonable Cause is a Taxpayer’s first line of defense when it comes to a Form 3520 penalty. If a Taxpayer can show they acted with reasonable cause and not willful neglect – then the penalty should be removed. Oftentimes, Taxpayers can successfully abate or remove a penalty if they have sufficient facts to show Reasonable Cause. The problem is that the initial IRS agent may not want the burden of removing a six- or seven-figure Form 3520 penalty on their watch and/or they must first receive approval from a manager or supervisor – and if that does not happen timely, it leads to a form letter rejecting the initial reasonable cause submission and provides the option to appeal the penalty. It is important to note, that the Taxpayer usually has 30 days to respond to the CP 15 notice, but in case the IRS ever changes that time period, Taxpayers should always review the front and back of the letter.

To Appeal or Not to Appeal?

If the initial reasonable cause letter is rejected, the Taxpayer typically has the opportunity to file an appeal. If the Taxpayer files an appeal, then it may limit the ability to pursue a Collection Due Process Hearing (CDP) request on Form 12153 before a Settlement Officer (SO) instead of an Appeals Officer (AO) — which is usually preferred if a Taxpayer intends to dispute the penalty in tax court at a later date if necessary. There are many factors to consider when determining whether or not to pursue an appeal, as opposed to waiting for a Collection Due Process Hearing opportunity –– because with the CDP request, it is an “end-game opportunity” and the Taxpayer has to wait until they receive a notice of intent to levy or a Notice of Federal Tax Lien (NTFL) has already been issued. Oftentimes, less-experienced counsel fail to explain the “real-life implications of waiting for the CDP request.

And, while a CDP hearing before an SO may be preferable, it comes with the risk of the NTFL, which can impact a person’s credit; the ability to obtain a mortgage; the ability to sell their home with a lien on it; and overall life impact of being subject to an NTFL.

*Unlike a levy, which will not be issued (unless issued wrongfully) pending the opportunity for a CDP, the lien is issued before the opportunity for a CDP — but liens are not issued in every case, hence the risk of waiting it out for a CDP.

Form 3520 is Not Limited to One Penalty

Form 3520 not only refers to reporting gifts but also to reporting trusts. A recent appeal ruling in the case of US v Wilson shows just how bad the outcome can be for a Taxpayer who failed to file Form 3520/3520-A involving a foreign trust. In that case, while the District Court ruled the Taxpayer was limited to a 5% penalty based on the trust/distribution value, the Court of Appeals disagreed and held that the US government was not limited to just a 5% penalty — and that presumably the government can get multiple penalties against a Taxpayer who serves as both a trustor/grantor and beneficiary of the same foreign trust.

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 that 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

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.