The (Foreign) Gift That Keeps On Giving – IRS Penalties

Gifting sounds nice in theory, but it can be complicated in practice, particularly when it comes to transfers by or to foreign persons. The Internal Revenue Service (“IRS”), suspecting wrongdoers at every turn, has been busy recently applying pressure in the international realm.

This has triggered several court decisions, two of which are discussed here, that should get the attention of all taxpayers with any level of global reach.

Receiving Gifts from Foreign Persons

Readers need a little backstory. Section 6039F of the Internal Revenue Code generally states that if a U.S. individual receives a gift totaling more than $100,000 during a year, then he or she must file a particular information return, a Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts), to tell the IRS all about it. The penalty for an unfiled Form 3520 is five percent of the gift for each month it is late, reaching a cap of 25 percent. For example, a $1 million gift from a generous European grandmother to her doting U.S. grandson could result in a fine of $250,000 if they are not careful.

The issue of missing Forms 3520 and corresponding penalties recently arose in a novel case, Wrzesinski v. United States.

The taxpayer was born and raised in Poland, he immigrated to the United States when he was young, and he later served his community as a police officer. In 2010, his mother, who was still a citizen and resident of Poland, won the lottery there and decided to gift the taxpayer $830,000 over a two-year period.

The taxpayer, trying to be responsible, called his U.S. tax advisor from Poland to inquire about any U.S. duties triggered by receipt of the gift. The advisor expressly and inaccurately told him that the gift did not cause any U.S. duties.

Years passed.

In 2018, the taxpayer wanted to send a portion of the earlier gift to his godson, who was still back in Poland.

Concerned about tax compliance, the taxpayer did some Internet searches for potential duties related to making, not receiving, foreign gifts. Only then did he discover that he should have filed Forms 3520 for 2010 and 2011 to report his mother’s generosity to the IRS.

The taxpayer contacted an attorney with international tax experience. The attorney explained to the taxpayer might still be able to fix matters, on a penalty-free basis, by approaching the IRS through the Delinquent International Information Return Submission Procedure.

The taxpayer did so, filing his late Forms 3520, along with a detailed statement of “reasonable cause” explaining why he should not be punished. Approximately one year later, the IRS sent the taxpayer two notices, indicating that he owed the highest possible penalties, or 25 percent of the gifts received in 2010 and 2011. They totaled $207,500.

The taxpayer challenged the penalties, filing a Protest Letter seeking review by the IRS Appeals Office. He strengthened his position by attaching a letter from his tax advisor, who admitted that he had given the taxpayer incorrect advice about his Form 3520 duties years ago. The IRS Appeals Officer eventually agreed to reduce the penalties to five percent of the amount of the gifts, or $41,500. The taxpayer disagreed with this partial victory, but paid the lower amount anyway and then filed a Suit for Refund in court.

The attorneys at the Department of Justice handling the case surely saw troubles ahead. Accordingly, they agreed to fully concede the case in favor of the taxpayer before they submitted any pleadings with the court, engaged in any discovery actions, or otherwise attempted to defend the IRS’s earlier position that the taxpayer should be stuck with penalties.

Making Gifts to Foreign Persons

Section 61 generally provides that U.S. persons face a worldwide tax system.

This means that they must declare to the IRS all income, regardless of whether it was earned, obtained, or accrued in the United States, a foreign country, or anywhere else. Many U.S. persons with foreign reach also must file various international information returns, including Forms 5471 (Information Return of U.S. Persons with Respect to Certain Foreign Corporations) for foreign corporations. Large penalties for non-compliance apply, as one would expect.

Under Section 2511, U.S. citizens and residents who make certain gifts are hit with gift taxes, which are determined based on the value of the property transferred.

Gifts are revealed to the IRS on Form 709 (U.S. Gift and Generation-Skipping Transfer Tax Return).

Importantly, the term U.S. resident only covers individuals who have a U.S. “domicile” at the time they make the gift.

The regulations clarify that one “acquires a domicile in a place by living there, for even a brief period of time, with no definite present intention of moving therefrom [but] residence without the requisite intention to remain indefinitely will not constitute domicile.”

International gift tax issues recently arose in an obscure Tax Court battle, Schlapfer v. Commissioner. The taxpayer in that case was born, raised, and educated in Switzerland. He also worked in his home country until he was transferred to the United States at the age of 30. He first possessed a work visa, then obtained a Greed Card, and finally became a U.S. citizen in 2008. The taxpayer started a few businesses along the way, including a foreign company through which he managed his investments (“Panama Entity”).

In 2006, the taxpayer applied for an insurance policy offered by a Swiss company, which he funded with cash and 100 shares of the Panama Entity. It appears that the objective of the policy was to financially benefit the taxpayer’s mother, aunt, uncle, and nephew, none of whom was a U.S. person. However, the taxpayer initially listed himself as the policyholder in 2006 but subsequently changed this to his foreign relatives in 2007.

Several years later, in 2012, the taxpayer entered into the Offshore Voluntary Disclosure Program (“OVDP”) to clean up past violations. It seems that the taxpayer had several compliance shortcomings, among them unreported income from foreign sources, unfiled Forms 5471 related to the Panama Entity, and an unfiled Form 709 for the gift to foreign relatives.

The taxpayer took the following positions with the IRS when submitting his OVDP materials.

First, he reported that he had gifted stock in the Panama Entity, not an insurance policy. Second, he claimed that he was exempt from gift taxes because he did not have a U.S. “domicile” when he made the gift in 2006, as he did not intend to permanently stay until he later became a U.S. citizen in 2008.

The IRS disagreed with the taxpayer about those two positions, yet it focused primarily on procedural matters. It mainly argued that the gift was made in 2007, as opposed to 2006, because it was not completed until then. Given that the taxpayer never filed a Form 3520 for 2007, continued the IRS, he owed gift taxes and penalties for that year. The IRS formalized its positions by issuing a Notice of Deficiency in late 2019.

After filing the initial pleadings with the Tax Court, both parties sought swift justice from the Tax Court, meaning a decision before trial based on so-called Motions for Summary Judgment. Much of the fighting centered on disclosure levels, by the taxpayer, and timing issues, by the IRS. These two concepts are interrelated. The IRS normally has three years from the time a taxpayer files a Form 709 to identify it, audit it, and assess additional amounts. The IRS can assess gift taxes at any time (i.e., indefinitely) if a taxpayer neglects to file a Form 709, but “adequate disclosure” of a gift by a taxpayer suffices to get the three-year clock ticking against the IRS.

The Tax Court held the taxpayer “strictly complied” or at least “substantially complied” with the relevant standards thanks to his filing of several documents as part of his OVDP application. These included the Form 709 for 2006, an explanatory statement, and the Form 5471 for the Panama Entity. Consequently, the Tax Court ruled that the taxpayer had “adequately disclosed” the gift to the IRS when he filed the application in 2013, and the IRS’s three-year period to assess additional amounts expired well before it issued the Notice of Deficiency in 2019. The IRS, in other words, was too slow; it lost the case before trial even began.

Celebration or Caution?

Did the taxpayers in Wrzesinski v. United States and Schlapfer v. Commissioner prevail on two different types of foreign gift penalty issues? Yes. Does this mean that all taxpayers receiving or making international transfers can rest easy now? No. If anything, these two cases show that U.S. tax and information-reporting duties are tricky, approaching the IRS through a voluntary disclosure program might not produce the expected results, the IRS can be aggressive in its enforcement actions involving global gifts, and the only route to justice for some unlucky taxpayers is litigation.