IRS Announces Change in Penalty Policy for Forms 3520 and 3520-A

IRS Announces Change in Penalty Policy for Late Foreign Gift and Trust Reporting Forms

Summary of Policy Change

The IRS has announced a major change in penalties for late-filed IRS Forms 3520 and 3520-A, both of which are essential for U.S. taxpayers who transact with foreign trusts or receive large gifts from foreign individuals.

Until recently, the IRS automatically imposed penalties on late filers of these forms, creating significant burdens for taxpayers, who often found themselves penalized despite having reasonable cause for the delay. However, beginning in late 2024, the IRS will no longer impose automatic penalties on these late filings. Instead, it will review any reasonable cause statements included with the forms before determining whether to impose a penalty.

Background on Form 3520 and 3520-A Filing Requirements

Form 3520: This form must be filed by U.S. citizens or residents to report certain foreign transactions, including:

• Gifts or Bequests: Any U.S. person receiving foreign gifts or bequests in excess of $100,000 in any one year from foreign individuals or estates must report them.
• Distributions from Foreign Trusts: U.S. persons receiving distributions from a foreign trust must also file this form.
• Creation or Transfers to Foreign Trusts: When a U.S. person creates or transfers assets to a foreign trust, it is necessary to report it.
• Deceased Filers: Estates of deceased U.S. citizens or residents may also need to file Form 3520 if the decedent was involved with a foreign trust.

Form 3520-A: Trustees (whether U.S. or foreign) of foreign grantor trusts with U.S. grantors are required to file Form 3520-A. This form provides an annual report of the trust’s income, gains, losses, deductions, and credits, which pass through to the U.S. grantor and must be reported.

Key Points on Policy Change

1. 1. Elimination of Automatic Penalties for Late-Filed Forms: Previously, the IRS imposed automatic penalties on late-filed Forms 3520 and 3520-A. Now, if a taxpayer files a reasonable cause return with the late filing, the IRS will review it before deciding on penalties. Now, if a taxpayer files a reasonable cause return with the late filing, the IRS will review it before deciding on penalties.
   2. Historically High Penalty Waiver Rates: The IRS Taxpayer Advocate Service highlighted that automatic penalties often generated unfair burdens. Between 2018 and 2021, approximately 67% of penalties for Form 3520 were ultimately waived, meaning the IRS found sufficient cause to cancel them after being assessed.
   3. Increased Fairness and Reduced Burden on Taxpayers: The new policy eliminates automatic penalties, providing taxpayers with a fairer process and the opportunity to justify late filings. Previously, taxpayers often faced long waits for penalty resolution, even with reasonable cause statements attached to their filings.
   4. Substantial Penalties for Noncompliance: Late penalties on Forms 3520 and 3520-A have been substantial, sometimes reaching 25% of unreported gifts or bequests and 35% of unreported transactions with foreign trusts. With the new policy, taxpayers with valid reasons for the delays can avoid these substantial penalties.

Practical Implications and Next Steps for Taxpayers

The IRS announcement does not change the filing requirements, so U.S. taxpayers with gift, bequest or foreign transaction reporting obligations should keep an eye on these deadlines. Failure to file on time without good cause can still lead to significant penalties. Here are some points for taxpayers to keep in mind:

• Timely Filing to Avoid Penalties: Forms 3520 and 3520-A must be filed in April and March of the following year, respectively, with a possible six-month extension.
• Submit a Statement of Reasonable Cause if Late: If the delay is unavoidable, submit a clear explanation detailing the cause.
• Consult an Advisor: Given the complexity of foreign gift and trust reporting, consulting a tax professional can help in understanding and complying with the filing requirements, especially under this revised penalty system.

IRS Approach to Other Late-Filed Information Returns

While this policy is an advance, the IRS has not yet extended it to other forms subject to automatic penalties, such as Form 5471 (relating to foreign corporations) and Form 8938 (relating to foreign assets). Taxpayers who file these forms late should still anticipate automatic penalties, but this policy change for Forms 3520 and 3520-A may signal a broader movement toward penalty reform.

Considerations for Tax Professionals

This new IRS approach is a positive change for taxpayers and aligns with the Taxpayer Advocate Service’s focus on reducing burdensome penalties. While the penalty relief offers relief, it also underscores the importance of carefully complying with international tax reporting requirements. For individuals involved in transactions with foreign trusts or receiving large foreign gifts, timely and accurate filing remains the best strategy to avoid penalties.