In very welcome news, the IRS Taxpayer Advocate has confirmed on its website that the IRS will end its practice of automatically assessing penalties for late-filed Forms 3520 and 3520-A.
In this blog, we analyze the ramifications of this policy change for U.S. citizens living abroad.
Background – Foreign Trust and Pension Reporting
In general, the following activities involving foreign trusts trigger reporting obligations:
U.S. persons treated as “owners” of a foreign trust must annually file a return confirming such status and must also ensure that the trust files a return providing a full and complete accounting of all trust activities and operations and provides an annual statement to the owner and any U.S. person who receives a distribution from the trust.
U.S. beneficiaries of a foreign trust who receive any distribution during a taxable year, whether or not taxable, must disclose such receipt.
Additionally, a “responsible party” (i.e., grantor, transferor or executor) must provide notice of (i) the creation of a foreign trust by a U.S. person, (ii) the transfer of money or property to a foreign trust, including by reason of death, and (iii) the death of a U.S. person treated as “owner” of a foreign trust under the grantor trust rules or if any portion of a foreign trust was included in the decedent’s estate.
The reporting of these transactions by grantors, transferors, owners and beneficiaries is done principally on the Form 3520, which if due from a taxpayer, is required to be filed on or before the due date (with extensions) for a taxpayer’s income tax return.
A trust’s return on Form 3520-A is required in the case of a foreign grantor trust with a U.S. owner. This form must be filed on or before March 15 of each year for the preceding year, unless a request for an extension is submitted by such date. The difference in the filing dates between the Form 3520 and Form 3520-A is confusing and a common trap for the unwary.
Foreign pensions often also have the status of a foreign trust for U.S. tax purposes, which can trigger both Form 3520 and 3520-A reporting obligations.
In addition to trusts, gifts and inheritance involving non-U.S. donors can trigger a Form 3520 reporting obligation.
A Policy of Automatic Penalties
On its website’s blog, the IRS Taxpayer Advocate notes that the policy to assess automatic penalties for late-filed Forms 3520 and 3520-A began quietly about ten years ago.
Prior to this, the IRS generally accepted late-filed forms under an amnesty program that would eliminate penalties if a reasonable cause statement was included with the late-filed form.
The blog states:
“Unfortunately, about a decade ago the IRS shifted its policy on IIR penalties and began automatically assessing penalties when taxpayers voluntarily filed late returns. No questions asked – just the imposition of potentially life-altering penalties. After the IRS automatically assessed large penalties against these taxpayers, the IRS started collection efforts against them. My office reviewed many of the IIR penalties assessed for the past decade, and contrary to what most people assumed these penalties were assessed against unsuspecting lower-income taxpayers, small businesses, and immigrants.”
Three Areas of Concern
The Taxpayer Advocate notes two areas of particular concern associated with automatic penalties – first, with respect to gifts and inheritance: “There are numerous examples of taxpayers who received a once-in-a-lifetime tax-free gift or inheritance and were unaware of their reporting requirement. Upon learning of the filing requirement, these taxpayers did the right thing and filed a late information return only to be greeted with substantial penalties, which were automatically assessed by the IRS upon the late filing of the Form 3520. Depending on how late it was filed, these taxpayers were penalized up to 25 percent of their gift or inheritance despite owing no actual tax. In the foreign gift context, the penalties can be huge; over the years 2018-2021, even taxpayers who reported $400,000 or less in income received an average penalty of over $235,000.”
The second area of concern involves foreign trusts: “To add insult to injury, while the IRS can waive the IRC [foreign trust reporting] penalty if taxpayers show that they had reasonable cause for filing the returns late, the IRS does not consider any reasonable cause statements or other information provided by taxpayers prior to assessing the penalties, even when attached to the returns. Many of these taxpayers file a protest with the Independent Office of Appeals (Appeals). Once reasonable cause is confirmed, the IRS abates a significant number of the penalties that were automatically assessed but were not justified. Over the four-year period from 2018-2021, the IRS abated IRC § 6677 penalties assessed with respect to Forms 3520 and 3520-A totaling more than $224 million. The abatement rate was 67 percent of the penalties assessed and 54 percent of the dollars assessed.”
In our experience, a third significant area involves foreign pensions, particularly because pensions do not operate on a calendar-year basis, and yet reporting must conform to certain calendar-year based deadlines. This has been a huge burden on taxpayers abroad (including lower-income individuals) with typical local pensions who are hit with enormous penalties, requiring months, if not years, of follow-up correspondence with the IRS, both initially with agents and then again with appeals, to have the penalties eventually abated. The IRS has made certain steps to improve this situation with respect to pensions, including Revenue Procedure 2020-17 (exempting certain foreign pensions from reporting) and proposed Treasury Regulations (designed to implementing the revenue procedure), but in our experience, the qualifying requirements in these procedures have proven too rigid, leaving many typical pensions outside their scope.
Welcome Change But More Can Be Done
As described in the Taxpayer Advocate’s blog, by the end of the year, the IRS will begin reviewing any reasonable cause statements that taxpayers attach to late-filed Forms 3520 and 3520-A before assessing penalties. This means, apparently, that penalties will continue to be assessed for late-filed forms, but the IRS will first consider a taxpayer's reasonable cause statement before assessing a penalty. The Taxpayer Advocate believes that this change should at least reduce unwarranted assessments and relieve some of the burden on taxpayers by giving them the opportunity to explain their situation before the IRS assesses a penalty. IRS Commissioner Danny Werfel also announced the change during a recent UCLA Extension Tax Controversy Conference.
While this is certainly welcome news, we believe more can be done to avoid overburdening well-meaning and good-faith taxpayers living abroad.
First, the IRS should consider lowering the penalty defense standard for foreign trust reporting from the stricter “reasonable cause” standard to the friendlier “non-willful” standard, in order to encourage disclosure and avoid unnecessary disputes that burden both the IRS and the taxpayers. The “non-willful” standard is used for the IRS Streamlined Procedures, which has been very successful in bringing hundreds of thousands of taxpayers living abroad back into overall compliance with the IRS.
Second, as others have pointed out, the policy change should apply not only to new cases, but also pending cases, particularly those that are stuck without any progress being made.
Third, the IRS should offer first-time abatements for taxpayers who are otherwise compliant. First-time abatements are allowed in many other penalty contexts, and would be effective in encouraging disclosures moving forward.
