2023 brings hope to the many individuals who have found themselves on the wrong side of IRS penalties applicable to international informational filing obligations. We are in the middle of a small wave of taxpayer favorable court outcomes for penalties that apply to the onerous information reporting obligations applicable to taxpayers with international accounts, assets, and business interests.
We’ve previously written an article on Bittner (you can find that article here). Bittner resulted in a huge amount of penalty relief for individuals with many foreign accounts who non-willfully failed to disclose their accounts on their FBARs annually, redefining the ‘violation’ to the failure to file the entire FBAR rather than a distinct violation for the failure to report each account. To demonstrate the significance of this change, consider a taxpayer who non-willfully failed to file an FBAR to report their 10 foreign accounts, the IRS would have imposed 10 separate $10,000 (scaled up for inflation) penalties, claiming the failure to report each account as a separate violation. In Bittner, the Supreme Court has said that rather than $100,000 in penalties for 10 $10,000 violations, the appropriate amount of the penalty should be $10,000, as failing to submit the entire FBAR is one violation.
Then, in March of 2023, we had WRZESINSKI v. United States, 2:22-cv-03568, (E.D. Pa.). In this case, the taxpayer received gifts from his foreign parents, and like most people, had no idea that gifts from foreign individuals in excess of $100,000 need to be disclosed to the IRS on Form 3520. In 2018, once the taxpayer learned that they should have filed Part IV of Form 3520 to disclose the gifts they received in 2010 and 2011, they proceeded to prepare the filings and submit them under the delinquent international information reporting submission procedures. The IRS rejected their reasonable cause and imposed a penalty of 25% of the amount of the gifts ($207,500). The taxpayer appealed the penalty using IRS appeals procedures, received a settlement offer, paid the settlement amount and proceeded to file a claim in federal court to have the amount paid returned. The tax division of the U.S. Department of Justice proceeded to ‘settle’ the case by fully reimbursing the taxpayer.
It’s my opinion that penalties for failure to report a gift received from a foreign person are some of the most outrageous penalties that the IRS can impose. It is common knowledge that in the U.S. you don’t pay tax on gifts you receive, and that the reporting obligations for gifts (and the potential gift tax) fall on the gift giver. It’s clear that the average person is entirely unaware that there is an informational reporting obligation for an individual that receives a large foreign gift, but in my experience, the average tax professional is also unaware of this obligation, which leaves individuals incredibly vulnerable to these penalties. In addition to this reporting obligation going against the common knowledge regarding tax reporting and gifts, you have the fact that there are no taxes associated with this reporting, and the IRS’ ability to effectively collect tax is in no way prejudiced by the failure to provide this information.
Now, I know that I ask my clients if they’ve received foreign gifts valued over $100,000, (and I’ve also included this in the training I’ve provided to all of the tax preparers that have worked for me over the years) and as you can imagine my domestic clients generally balk at the question, but with penalties of 25% of the amount of the gift, this has become a standard question that tax preparers should ALWAYS ask their clients. When was the last time your preparer asked if you received a foreign gift? The answer is probably never, or that it’s a question buried deeply into an excessively long tax organizer that they send you.
We’ve taken a bit of a detour through my outrage at these penalties in general, but cases like Wrzesinski give us reason to hope that there is some potential relief for individuals that get hit with these penalties. I have to believe that the government is motivated to settle these types of cases because they are afraid of losing the case and having an adverse precedent set. It’s just incredibly unfortunate that it requires spending the time and money to fight these penalties all the way through filing suit in federal court to recover these penalty amounts. The IRS is relying on people continuing to accept and pay these penalties without exercising every legal option to challenge the assessment.
The last encouraging case I’d like to discuss today is Alon Farhy v. Commissioner, 160 T.C. No. 6 (April 3, 2023). This case was decided by the tax court in April of 2023, and it could have a significant impact on the IRS’ ability to assess penalties on individuals who fail to file several types of informational filings. In this case, the taxpayer willfully failed to file Form 5471 to disclose his interest in a foreign corporation, the IRS assessed failure to file form 5471 penalties, and proceeded to propose a levy to directly collect the unpaid penalties, taxpayer challenged their ability to execute this levy, the IRS upheld the levy, and the taxpayer then petitioned the tax court. The tax court then proceeded to hold that the IRS lacks the statutory authority to assess these penalties. This is a wonderful outcome as it means the IRS will not have the ability to assess or administratively collect these penalties and if they want to pursue collection, they will have to obtain a court judgement, a non-negligible obstacle for the IRS to pursue these types of penalties. I don’t want to get too into the weeds, but the take home point here is that there isn’t a question as to the applicable penalties for failing to file these forms (and these penalties are clearly laid out in the applicable code sections, like 6038(b)) but rather the IRS’ ability to assess these penalties. This leaves the IRS having to jump through the additional hoops associated with the tax division of the department of justice bringing suit to assess these penalties, a much more time consuming and expensive proposition for the IRS who currently just systematically assesses most of these penalties without any meaningful human review.
We don’t know how the IRS is going to react to this decision. I can’t imagine that they intend to abandon all the penalties that they have already wrongly assessed (and this issue will clearly extend to quite a few other foreign informational filing penalties as well), and anyone in the process of challenging these types of penalties should be aware of this decision and their potential ability to challenge the assessments as the tax court has clearly stated that they are inappropriate. Additionally, anyone that has already paid this type of penalty may want to consider reaching out to a tax professional for assistance in filing a protective claim for refund. Note that the IRS could still pursue the assessment of these penalties, but at a certain point, one would hope they would conduct a cost benefit analysis before sinking significant resources into what in many cases will be relatively small penalties relative to the resources they’ll need to commit to pursue the penalties.
This brings me to the last topic for this article, the Taxpayer Advocate’s objectives report to congress which was just released this week. In this report the Taxpayer Advocate suggests that the IRS “Eliminate Systemic Assessments and Offer a First Time Abatement Waiver for International Information Return Penalties.” (you can find her full report here: https://www.taxpayeradvocate.irs.gov/reports/2024-objectives-report-to-congress/full-report/ ) Both of these suggestions would have saved many people considerable amounts of time, effort, and often money (because they are stuck hiring tax law firms, like mine, to fight to remove or reduce these penalties). Hopefully the IRS and Congress listen to the Taxpayer Advocate’s suggestions but for the time being, any individual that has had these types of penalties assessed against them should prepare to utilize these cases to fight those penalties.