Form 3520 Penalty: Exemption & Relief Procedures

Form 3520 Penalty: Exemption & Relief Procedures

Form 3520 Penalty

Form 3520 Penalty: Exemptions & Relief Procedures:Each year, certain US persons are required to file a form 3520 with the IRS if certain transactions occur involving large foreign gifts and/or trust transactions. The main types of foreign transactions include ownership, transfer, or distribution to and from a foreign trust, and the receipt of certain large gifts from foreign persons ignite the reporting rules. Gifts from foreign Persons are not limited to individuals — it includes individuals and entities — but the threshold for reporting gifts from entities and individuals varies extensively. When the form is not filed timely, the taxpayer may be penalized.

If the taxpayer qualifies for Revenue Procedure 2020-17 or is able to show reasonable cause, they may avoid penalties. Otherwise, the taxpayer may be subject to significant fines and penalties. In recent years, the IRS has taken to automatically assessing these types of penalties so if you are not compliant it is important to speak with experienced board-certified tax specialist that specializes in offshore matters to get the lay of the land.

Let’s review form 3520 penalty and relief provisions:

Large Gift from Foreign Persons & Form 3520 Penalties

Ever since the IRS began cracking down on offshore tax havens and foreign trusts in general, the majority of people filing form 3520 are US persons who received a gift from a foreign person. As noted above, the definition of US person is not limited to US Citizen. Rather, it includes US citizens, legal permanent residents, and foreign national who meets the substantial presence test.

The applicable code section for penalties involving large foreign gifts is section 6039F.

    • Section 6039F. In the case of a failure to timely report foreign gifts described in section 6039F, the IRS may determine the income tax consequences of the receipt of such gift, and a penalty equal to 5% of the amount of such foreign gifts applies for each month for which the failure to report continues (not to exceed a total of 25%). No penalty will be imposed if the taxpayer can demonstrate that the failure to comply was due to reasonable cause and not willful neglect.”

What does this mean?

It means that for each month the filer has not filed form 3520 the IRS will hit them with a 5% penalty on the value of the gift — up to a maximum value of 25%. For example, if you receive a gift in the amount of $900,000 and you filed the form 3520 8-months late, your penalty will be $225,000.

Form 3520 Penalties for Foreign Trusts

Just as foreign trust reporting is complicated, so is the IRS penalty scheme associated with it. The applicable code section is Internal Revenue Code section 6677, as follows:

  • A penalty applies if Form 3520 is not timely filed or if the information is incomplete or incorrect (see below for an exception if there is reasonable cause). Generally, the initial penalty is equal to the greater of $10,000 or the following (as applicable).
    • 35% of the gross value of any property transferred to a foreign trust for failure by a U.S. transferor to report the creation of or transfer to a foreign trust in Part I.
    • 35% of the gross value of the distributions received from a foreign trust for failure by a U.S. person to report receipt of the distribution in Part III.
    • 5% of the gross value of the portion of the foreign trust’s assets treated as owned by a U.S. person under the grantor trust rules (sections 671 through 679), if the foreign trust
      • (a) fails to file a timely Form 3520-A and furnish the required annual statements to its U.S. owners and U.S. beneficiaries, or
      • (b) does not furnish all of the information required by section 6048(b) or includes incorrect information.
    • If a foreign trust fails to file Form 3520-A, the U.S. owner must complete and attach a substitute Form 3520-A to the U.S. owner’s Form 3520 by the due date of the U.S. owner’s Form 3520 (and not the due date for the Form 3520-A, which is otherwise due by the 15th day of the 3rd month after the end of the trust’s tax year) in order to avoid being subject to the penalty for the foreign trust’s failure to timely file Form 3520-A.
    • For example, a substitute Form 3520-A that, to the best of the U.S. owner’s ability, is completed and attached to the U.S. owner’s Form 3520 by the due date for the Form 3520 (such as April 15 for U.S. owners who are individuals), is considered to be timely filed.
    • See section 6677(a) through (c) and the instructions for Part II of this form and Form 3520-A. Additional penalties will be imposed if the noncompliance continues for more than 90 days after the IRS mails a notice of failure to comply with the required reporting.
    • If the IRS can determine the gross reportable amount (defined later), then the penalties will be reduced as necessary to assure that the aggregate amount of such penalties does not exceed the gross reportable amount. For more information, see section 6677.
    • Reasonable cause. No penalties will be imposed if the taxpayer can demonstrate that the failure to comply was due to reasonable cause and not willful neglect.
    • Note. The fact that a foreign country would impose penalties for disclosing the required information is not reasonable cause. Similarly, reluctance on the part of a foreign fiduciary or provisions in the trust instrument that prevent the disclosure of required information is not reasonable cause. See section 6677(d) for additional information.

What does this mean?

This is more complicated than the foreign gift penalty, so let’s break it down into parts:

$10,000 Penalty vs. Trust or Income Value

With foreign trust penalties, the starting penalty amount is $10,000. The $10,000 is in comparison to other trust transactions that may have occurred during the tax year. If these other transactions result in values that are higher than the $10,000, then the penalty is the greater of the values (unless and exception, exclusion, or limitations applies).

These other values may include:

  • 35% of the gross value of any property transferred to a foreign trust (Part I)
  • 35% of the gross value of the distributions received from a foreign trust (Part III)
  • 5% of the gross value of the portion of the foreign trust’s assets treated as owned by a U.S. person under the grantor trust rules (sections 671 through 679), if the foreign trust
    • (a) fails to file a timely Form 3520-A and furnish the required annual statements to its U.S. owners and U.S. beneficiaries, or
    • (b) does not furnish all of the information required by section 6048(b) or includes incorrect information.

Depending on the value of the trust, and/or contributions and distributions made to the trust — it may result in significant penalties exceeding $10,000.

What if Trust Does Not File Form 3520?

If the trust does not file the necessary forms, the U.S. owner must file or else they become subject to the penalty. The owner does not need to file it perfectly – just the best they can using due diligence.

Also, if there are distributions, it may impact the overall penalty.

IRC 6662

Internal Revenue Code section 6662 which deals with underreporting penalties has an additional section that refers specifically to foreign trust owners and how the penalty may be increased based on certain underpayments attributed to transactions that should have been included on form 3520-A.

As provided by the IRS:

    • “Section 6662(j). If a U.S. owner of a foreign trust is subject to a penalty imposed under section 6662 for an underpayment of tax required to be shown on a return, then such penalty may be increased under section 6662(j) for any portion of an underpayment which is attributable to any transaction involving any asset with respect to which information was required to be provided on Form 3520-A. For more information about undisclosed foreign financial asset understatements, see section 6662(j).

      No penalty will be imposed with respect to any portion of an underpayment if the taxpayer can demonstrate that the failure to comply was due to reasonable cause with respect to such portion of the underpayment and the taxpayer acted in good faith with respect to such portion of the underpayment. See section 6662 and section 6664(c) for additional information.”

Reasonable Cause & Form 3520 Penalty

If a taxpayer is going to be penalized but is able to show reasonable cause — and that the failure to file timely, properly, or accurately was not due to willful neglect, then they may be able to avoid the penalty. Reasonable cause is based on the totality of the circumstance and will vary from taxpayer to taxpayer.

Rev Proc. 2020-17

In 2020, the IRS released revenue procedure 2020-17. It is intended to limit the reporting on forms 3520 and 3520-A for tax deferred retirement and non-retirement trusts. There are very specific rules and requirements that must be met.

In conclusion, the penalties surrounding form 3520 noncompliance can be pretty rough. The penalties are sparked by the non-reporting of certain large gifts from foreign persons and foreign trusts. If you file the form late, you may be penalized, but you may be able to avoid, reduce, or abate the penalties with reasonable cause or revenue procedure 2020-17 if applicable.

International Tax Law Specialist Team: Golding & Golding

Our firm specializes exclusively in international tax, and specifically IRS offshore disclosure, including help clients with late reporting of Forms 3520 and 3520-A and Form 3520 Penalty & Relief Procedures.

Contact our firm today for assistance.