Corrected, July 18, 2024: This article has been updated to fix a typo in the fifth paragraph and clarify a reference to a tax preparer missing a deadline.
Generally, U.S. persons must file an IRS Form 3520 if they: (i) make transfers to or receive distributions from a foreign trust, or (ii) receive gifts or inheritances from foreign persons over a threshold amount. To ensure compliance with the IRS Form 3520 filing requirements, Congress granted the IRS authority to assess significant civil penalties for late filings. If the late filing relates to a foreign trust, the penalty equals the greater of $10,000 or 35% of the amount of the trust contribution or distribution. If the late filing relates to a foreign gift or inheritance, the penalty can be up to 25% of the amount of the gift or inheritance.
These late-filing penalties can be steep, especially if the amounts at issue are high. Fortunately, there are viable penalty defenses for taxpayers. Often, the trick in obtaining penalty relief is to properly raise these penalty defenses in a strong and persuasive reasonable cause statement. This article discusses some of the nuances associated with penalty defenses associated with the IRS Form 3520.
Reasonable Cause
Reasonable cause is perhaps the most common penalty defense for late-filing penalties, including IRS Form 3520. Generally, taxpayers have reasonable cause if they can show that they acted with ordinary business care and prudence but nevertheless missed the filing deadline.
There are several subcategories of reasonable cause. For example, individuals who rely on the guidance of tax professionals in preparing their income tax returns can often argue reasonable cause if the advice turns out wrong. To qualify for reasonable cause here, the taxpayer must show: (i) the professional was competent and had sufficient experience to render the advice; (ii) the taxpayer provided the professional with sufficient information for the professional to provide advice; and (iii) the taxpayer actually relied in good faith on the advice. These are referred to as the Neonatology factors.
In many cases, taxpayers stumble on the second Neonatology requirement, particularly with respect to the IRS Form 3520. This usually occurs where the taxpayer fails to inform the tax preparer of the existence of the foreign trust or the receipt of a foreign gift or inheritance until after the filing deadline. In addition, taxpayers should be careful of an important distinction regarding reliance on a tax professional. Specifically, there is no reasonable cause reliance on a professional to simply file the return. Thus, taxpayers remain liable for the late-filing penalty in instances where the taxpayer was aware of the IRS Form 3520 filing requirement, authorized the preparer to file it, and the preparer missed the deadline.
Individuals who self-prepare their returns without the aid of a paid preparer also have reasonable cause defenses. For example, courts have recognized that an honest and reasonable misunderstanding of the law (here, the filing requirement) can constitute reasonable cause. In determining whether reasonable cause applies in this context, courts look at the experience and education of the taxpayer in conjunction with other relevant factors, such as whether the taxpayer has been penalized before for the information return.
Of course, traditional reasonable cause defenses may also apply, including death or severe illness of the taxpayer or the taxpayer's immediate family. In these instances, a good timeline is critical. Indeed, although the IRS will often agree that reasonable cause existed for the late filing under these circumstances, the agency will challenge the duration of reasonable cause if the taxpayer was able to perform other functions, such as work, prior to the eventual filing of the IRS Form 3520.
Section 6751(b)
Section 6751(b) of the Code provides that "[n]o penalty . . . shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination[.]" Because the IRS Form 3520 late-filing penalty falls under section 6751(b), this defense can apply in certain circumstances. But taxpayers should be aware that the IRS usually argues an exception applies, particularly if the IRS Form 3520 penalty was automatically assessed through a computer. See I.R.C. sec. 6751(b)(2) (exempting from written managerial approval penalties that are "automatically calculated through electronic means").
First-Time Penalty Abatement
The IRS sometimes abates penalties under its first-time penalty abatement (FTA FTA 0.0%) program. To qualify, taxpayers must have clean filing and penalty histories. If FTA applies, taxpayers do not have to show reasonable cause for abatement of the penalty.
Unfortunately, FTA does not apply to all penalties, including those associated with "event-based" filings. Under IRS guidance, FTA specifically does not apply to the IRS Form 3520 late-filing penalty. See IRM pt. 20.1.1.3.3.2.1(8) (3-29-23).
But that does not mean that taxpayers with clean compliance histories should not raise that point with the IRS. In many cases, the IRS views compliance history as an important factor in determining whether to sustain the penalty or reduce it.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.