Did You Receive a Foreign Inheritance or Gift? Here's What You Need to Know

The IRS has recently announced a major change in how it assesses penalties for late-filed Form 3520, "Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts." Previously, taxpayers faced automatic and substantial penalties for filing this form late, but the new policy emphasizes a reasonable cause approach before any penalties are imposed. This shift is particularly significant for taxpayers who do not qualify for the Streamlined Filing Compliance Procedures and need an alternative route to rectify late filings without incurring undue penalties.

Understanding Form 3520 and Its Penalties

Form 3520 is a critical filing requirement for U.S. persons who engage in certain transactions with foreign trusts or receive significant foreign gifts or inheritances. Failure to file on time previously resulted in severe penalties, creating financial hardship for many taxpayers who were unaware of the requirement.

Historically, the IRS imposed these penalties automatically, leaving taxpayers with the burden of proving reasonable cause after the fact. Between 2018 and 2021, nearly 67% of these penalties were abated upon appeal, demonstrating that many penalties were initially unjustified (Taxpayer Advocate Service).

Form 3520 Penalties

Failure to file Form 3520 on time or incorrectly reporting required transactions can result in substantial penalties, including:

• Failure to Report a Foreign Gift or Inheritance: A penalty of 5% of the gift amount per month, up to 25% of the total gift or inheritance value.

• Failure to Report Transactions with a Foreign Trust: A penalty of 35% of the gross reportable amount for transfers or distributions.

• Failure to File Form 3520-A (for Foreign Trust Owners): A penalty of 5% of the trust’s gross value per month, up to 25% of the total trust assets.

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These penalties apply even if no taxes are due, making timely filing crucial to avoid unnecessary financial burdens.

Why Clients Need to File Form 3520

U.S. taxpayers are required to file Form 3520 in various scenarios, primarily when they:

• Receive foreign gifts or inheritances exceeding $100,000 from a non-U.S. individual.

• Receive more than $16,111 (as of 2024) from foreign corporations or partnerships.

• Have transactions with a foreign trust, such as creating, transferring assets to, or receiving distributions from a trust.

• Own or control a foreign trust, which requires additional reporting through Form 3520-A.

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When a Foreign Gift or Inheritance Becomes Important

Not all foreign gifts and inheritances trigger tax consequences, but they must still be reported if they exceed the IRS thresholds. The key reasons why timely filing is important include:

1. Avoiding Hefty IRS Penalties – The IRS enforces steep penalties for failing to disclose foreign gifts, even if no taxes are due.

2. Ensuring Proper Tax Treatment – Certain foreign inheritances may require additional reporting or tax considerations, especially if they involve real estate or business interests abroad.

3. Preventing IRS Scrutiny – Large unexplained deposits into a U.S. taxpayer’s bank account could raise IRS red flags and lead to an audit.

   
   

What Has Changed?

As of late 2024, the IRS will no longer automatically impose penalties on late-filed Forms 3520 that report gifts or inheritances from foreign persons. Instead, taxpayers who submit a late return will have an opportunity to explain their reasonable cause before any penalty is assessed. This policy will also be extended to late-filed Form 3520-A, which is required for U.S. owners of foreign trusts.

Why This Approach is Beneficial

1. Eliminates Automatic Punishment: Previously, taxpayers faced penalties regardless of intent or circumstances. Now, those who can show reasonable cause may avoid penalties altogether.

   
   

2. Fairer Treatment for Taxpayers: Many taxpayers were penalized despite reasonable explanations, such as lack of awareness of the filing requirement or reliance on incorrect tax advice. The new approach prevents unnecessary financial hardship.

   
   

3. Reduces IRS Administrative Burden: By considering reasonable cause upfront, the IRS will likely see fewer appeals and penalty abatement requests, allowing for a more efficient resolution process.

   
   

Who Benefits Most?

This change is particularly valuable for taxpayers who:

• Were unaware of their filing obligations but acted in good faith once they learned about them.

  
  

• Do not qualify for the Streamlined Filing Compliance Procedures, which require non-willfulness and are only available to those who failed to report foreign assets but did not knowingly evade tax laws.

  
  

• Need to correct prior noncompliance without undergoing a lengthy and complex appeal process.

  
  

How to Establish Reasonable Cause

To take advantage of this policy, taxpayers must submit a detailed explanation with their late-filed Form 3520, demonstrating reasonable cause. Supporting documentation, such as correspondence with tax advisors or evidence of unforeseen circumstances, can strengthen the case (Forbes).

Conclusion

The IRS's decision to evaluate reasonable cause before imposing penalties on late-filed Form 3520 represents a significant improvement in tax administration. This shift ensures that penalties are applied only when justified, making the tax system fairer and less punitive for those who make honest mistakes. For taxpayers who do not qualify for streamlined procedures, this change offers a crucial alternative for compliance without facing automatic and excessive penalties.

For professional assistance in navigating foreign tax reporting requirements, contact MKHS Tax Group at www.mkhstaxgroup.com., or contact May Sunng may.sung@mkhstaxgroup.com.