Background. The law is well settled that the recipient of a gift or bequest is not required to pay income taxes when he or she receives the gift or bequest. For example, if John receives a gift of $200,000 from his good friend Jane, John will not owe any income taxes as a result of this gift. Depending on the source of the gift, however, John may be required to notify the IRS that he received it. Specifically, if Jane is not a U.S. citizen or resident, John will be required to report the receipt of this gift to the IRS (even though he will not owe any taxes). If John fails to timely report this gift, he may be liable for a penalty of up 25% of the value of the gift.
The Law. In 1996, the Small Business Job Protection Act added Section 6039F to the Internal Revenue Code. Section 6039F requires recipients of certain gifts from “non-U.S. persons” to report these gifts to the IRS (even though the gifts are not taxable to the recipient). Section 6039F also imposes an onerous penalty on persons who fail to comply with its requirements.
Despite the fact that this provision became law 17 years ago, many people (including many tax practitioners) are not aware of its reporting requirements. Because the consequences of failing to comply with the reporting requirements can be severe, we thought that it would be helpful to review these requirements to help ensure that they are not ignored.
Determining Which Gifts Must Be Reported. Certain gifts and bequests from “non-U.S. persons” that exceed a threshold amount are potentially subject to the Section 6039F reporting requirements.
Who is a Non-US Person? A non-U.S. person is any person other than a citizen or resident of the U.S. or a U.S. partnership or corporation. A non-U.S. person also includes a foreign estate.
For purposes of determining whether the receipt of a gift from a non-U.S. person is reportable, different reporting thresholds apply to gifts received from nonresident alien individuals and foreign estates and to gifts received from foreign partnerships and foreign corporations.
The IRS requires a U.S. person to report a gift from a nonresident alien or foreign estate if the total amount of gifts from these sources is more than $100,000 during the tax year. Once the $100,000 threshold has been met, the recipient must separately identify each gift that is more than $5,000, but is not required to identify the donor. For example, if a U.S. citizen receives a $1 million bequest from the estate of a deceased relative who was not a U.S. citizen or U.S. resident, even though the bequest will not result in an income tax liability to the beneficiary (who is a U.S. citizen), the beneficiary will be obligated to report the receipt of the bequest to the IRS.
A U.S. person must report the receipt of gifts from foreign corporations and foreign partnerships if the total amount of the gifts from all such entities during the year is more than $10,000, subject to cost-of-living adjustments. The cost-of-living adjustments make the reporting threshold $14,723 for 2012 and $15,102 for 2013. Once the threshold has been met, the gift recipient is required to separately identify all gifts from a foreign corporation or foreign partnership and provide the name of the donor.
Penalty for Failing to Comply With the Reporting Requirements. The penalty for not timely reporting a foreign gift on a Form 3520 can be severe. The penalty is measured by the value of the gift and is equal to 5% of its value for each month that the failure to report continues, up to a maximum of 25%. This means, for example, that if a U.S. person receives a gift from overseas with a value of $1 million and fails to file the Form 3520 for five months or more, he or she will be required to forfeit $250,000 of this gift (plus interest).
The IRS is authorized to abate the penalty if the recipient can show that the failure to report the gift is due to reasonable cause and not due to willful neglect.
Reasonable Cause
Under IRC sections 6677(d) and 6039F(c)(2), no penalties will be imposed if a taxpayer can demonstrate that failure to file a required Form 3520, or filing of an inaccurate or incomplete return, was due to reasonable cause and not willful neglect. It is difficult to have any tax penalty abated for reasonable cause. A taxpayer’s reliance on a professional for the “ministerial” act of filing a return is not reasonable cause [Boyle v. U.S., 469 U.S. 241, 252 (1985)]. But a few cases have held that a taxpayer may rely, after full disclosure, on a professional’s advice that a particular tax filing is not required [e.g., McMahon v. Comm’r, 114 F.3d 366, 369 (2d Cir. 1997); Estate of La Meres v. Comm’r, 98 T.C. 294, 316-17 (1992)].
Only two cases, however, have specifically addressed reasonable cause for failure to file Form 3520. In James v. U.S [110 A.F.T.R.2d 2012-5587, 2012 WL 3522610 (M.D. Fla. 2012)], the court refused to grant summary judgment to the government, which sought significant penalties for each of three years. The taxpayer, who owned a foreign trust, relied on his accountant to handle all trust matters and provided all trust information to the accountant, who nevertheless checked “no” on the taxpayer’s Form 1040, Schedule B, to the question: “Did you receive a distribution from, or were you the grantor of, or transferor to a foreign trust? If ‘yes,’ you may have to file Form 3520.” The court held that this could be construed as the accountant’s advice that the taxpayer need not file Form 3520, so there was a genuine issue of material fact as to whether the accountant provided the taxpayer with that advice and whether the taxpayer reasonably relied on the advice. At base, the court held that a taxpayer may rely exclusive on a tax advisor concerning whether to file Form 3520, so long as the taxpayer provides all necessary information to the advisor and the reliance is reasonable [see also Nance v. U.S., 111 A.F.T.R.2d 2013-1616, 2013 WL 1500987 (W.D. Tenn. 2013)].
It should be noted that a taxpayer’s inability to obtain information because of foreign bank secrecy laws is not reasonable cause [IRC section 6677(d)]. Moreover, under the IRM, a foreign trustee’s refusal to provide information for any reason, including difficulty in obtaining the information, or a provision in the trust instrument that prevents disclosure of the information, is not reasonable cause [IRM section 20.1.9.13.5(2)(b)]. There is no guidance, however, about what the owner or beneficiary of a foreign trust should do in these circumstances.
Leaving aside foreign secrecy issues, however, James and Nance merely denied summary judgment to the government and did not reach a final decision. In addition, these cases run counter to the IRS’s position, which is that “it is not reasonable or prudent for taxpayers to have no knowledge of, or to solely rely on others for, the tax treatment of international transactions” [IRM section 20.1.9.1.1(4) (10-24-2013) (emphasis added)]. Consequently, the likelihood that a taxpayer will succeed on a defense of reasonable cause is unclear, which makes filing a protective Form 3520 particularly appealing.
Satisfying the Reporting Requirements. A recipient subject to the reporting requirements must file IRS Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts). The Form 3520 is due on the same day that the recipient’s income tax return for that year is due (including any extensions obtained with respect to that return). The Form 3520 is not filed with the recipient’s income tax return. Instead, it must be separately filed with the IRS at the address shown on the instructions to the Form 3520 (at present, the Form 3520 must be filed with the IRS Service Center in Ogden, UT).
Exceptions to the Reporting Requirements. Certain gifts are exempt from these reporting rules. Specifically, qualified tuition payments that are made directly to an educational institution for the education or training of the gift recipient are exempt. Similarly, qualified medical payments that are made directly to a person who provides medical care to the gift recipient are exempt. In addition, certain gifts that are adequately disclosed on a tax return are exempt from the reporting requirements.
When in Doubt File a Protective Form 3520
A taxpayer and her preparer may reasonably believe that she is not required to file Form 3520, but they may not be 100% sure. It is often not readily apparent whether a foreign financial arrangement (such as an estate plan, retirement plan, or foreign foundation) constitutes a trust for U.S. tax purposes. A protective filing should then be considered.
Filing a protective Form 3520 has two primary benefits. The first is that, when reporting information related to a foreign trust, the applicable statute of limitations will begin to run. In such circumstances, the time for the IRS to assess “any tax imposed by this title with respect to any tax return, event, or period to which such information relates” is three years after the taxpayer furnishes the IRS with the Form 3520 information [IRC section 6501(c)(3)(8)]. Consequently, the statute of limitations on a taxpayer’s entire tax return never begins to run if the taxpayer should have filed Form 3520 in connection with a foreign trust. Filing a protective Form 3520 is therefore a means of avoiding a perpetually open statute of limitations.
IRC section 6501(c)(3)(8) does not mention IRC section 6039F, which requires the reporting of foreign gifts and bequests. Consequently, when Form 3520 should report receipt of a foreign gift or bequest (which is unlikely to affect the taxpayer’s income), the IRS treats Form 3520 as a separate return from the taxpayer’s income tax return, and takes the position that section 6501(c)(3) applies only to the Form 3520. Thus, a taxpayer’s failure to file Form 3520 reporting receipt of a foreign gift does not keep open the statute of limitations on the taxpayer’s income tax return, but the taxpayer will obviously be subject to the applicable Form 3520 penalties [see IRS CCA 201402010 (Jan. 10, 2014)], plus interest.
The second benefit of filing a protective Form 3520 is that doing so will generally avoid the stringent penalties discussed above.
There is no statute or regulation providing for a protective Form 3520. The IRS does anticipate such filings, however; see IRM section 3.21.19.14.6 (11-10-2015, which discusses the internal routing of Forms 3520 marked as “Protective Filing.” What a protective Form 3520 should include may, however, be gleaned from other areas. For example, a protective claim for a refund must, among other things, “be sufficiently clear and definite to alert the Service to the essential nature of the claim” [IRM section 25.6.1.10.2.6.5 (05-17-2004)].
In 2015, the IRS published a discussion of proposed regulations under IRC section 2801, which would have imposed a tax on the recipient of a gift or bequest from a person who expatriated in order to avoid U.S. taxes [Preamble to Proposed Regulations, Fed. Reg. Vol. 80, No. 175, p. 54447 (09/10/15)]. The regulations were never adopted, nor was a “Form 708,” intended to report such gifts or bequests, ever published. Nevertheless, the proposed regulations are informative; they specifically provide for a protective Form 708 “in order to start the period for assessment of tax” [Proposed Regulations section 28.6011-1(b)(i)]. A U.S. taxpayer who received a gift or bequest from an expatriate and “reasonably concluded” that the gift or bequest did not fall under section 2801, could file a protective Form 708, together with an affidavit signed under penalties of perjury, setting forth information relied on in concluding that the donor was not a “covered expatriate,” or that the transfer was not a “covered gift” or “covered bequest,” “as well as that person’s efforts to obtain other information that might be relevant to these determinations.” Absent fraud, a taxpayer who filed a proper protective Form 708 would not have been subject to any penalty for late filing, even if the IRS later determined that the gift was a “covered gift” from a “covered expatriate” [Proposed Regulations section 28.6011-1(b)(ii)].
Based on these authorities, a protective Form 3520 should do the following:
- State at the top, in large bold type, “Protective Filing”
- Be completed to the best of the taxpayer’s ability, but with the caveat, “Protective filing; see attached affidavit,” wherever substantive information is listed
- Attach the taxpayer’s affidavit, which should include the taxpayer’s name, address, TIN, and language that is “clear and definite” and straightforward about the “essential nature” of the taxpayer’s position
In addition, the affidavit should—
- make clear that, by filing the protective Form 3520, the taxpayer is not conceding that he is, in fact, required to file the form;
- state that the taxpayer has reasonably concluded that Form 3520 is not required, but that the form is being filed protectively;
- make it plain that the taxpayer has provided her tax advisor with all available information about the Form 3520 issue, with an eye to establishing reasonable cause if the IRS later asserts a penalty;
- list all available information that went into the determination that Form 3520 was not required, in as much detail as possible, with attached documentation;
- state that the taxpayer’s tax advisor, after reviewing the available information, has specifically advised the taxpayer that Form 3520 is not required, and that the form is nevertheless being filed in an excess of caution;
- discuss in detail all the efforts the taxpayer has made to obtain other relevant information, even if she was ultimately unsuccessful in doing so—especially if foreign bank secrecy laws are involved or a foreign trustee refuses to provide information, since those facts alone will not constitute reasonable cause; and
- if appropriate, state that the taxpayer has made reasonable estimates of reported dollar amounts, and what those estimates are based on.