Foreign gifts: A common example of undisclosed foreign transactions

Here’s what may happen when a foreign gift has not been disclosed. The story involves a nonresident alien foreign couple whose two children went to school in the United States and ultimately stayed in the United States to live and work. Both children have become U.S. residents. The parents have been working hard overseas for their whole life, and they want to support their children Two years ago, the parents transferred $200,000 to each child’s foreign bank account that they opened as children.

Your practice has prepared returns for each child for a few years. The children did not tell you about these transfers in the prior year organizers, but in the current year the organizer shows they jointly purchased a condominium on the beach. After asking further questions, you learn that they were able to purchase the condominium because of the foreign transfer.

Even though the foreign parents made the deposit into the foreign bank account, this constitutes a “gift” that triggers U.S informational reporting requirements that can have severe penalty consequences if the required filings are not made timely.

Specifically, the receipt of a foreign gift of over $100,000 triggers a requirement to file a Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts. Form 3520 is due the fourth month following the end of the person’s tax year, typically April 15. This due date gets extended only if the taxpayer files a timely extension for the Form 1040 tax return on Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return.

The penalty for failing to file Form 3520 is 5% of the value of the gift per month, not to exceed 25% for each person who received a gift with a minimum fine of $10,000. Here, since you, the preparer, did not learn about the $200,000 gifts until a subsequent year, the penalty that each child is facing is $50,000.

Steps to take

What should you, the tax preparer, do? First, have a more detailed discussion with the clients to understand the full scope of any international footprint of the family that can affect the children’s informational reporting requirements. Also make sure that there are no further transfers in the current year so no further forms need to be filed.

Then, discuss the penalty exposure with the clients to meet your ethical requirements under Circular 230, Regulations Governing Practice Before the Internal Revenue Service, Section 10.21, Knowledge of Client’s Omission, and help them understand their options for mitigating penalty exposure. Similarly, the AICPA’s Statements on Standards for Tax Services No. 6, Knowledge of Error: Return Preparation and Administrative Proceedings, has a similar requirement, including advising the client of the potential consequences of the error and corrective measures to be taken.  

The children may be able to file delinquent Form 3520 returns, with a reasonable cause statement. The clients may also pursue the delinquent international information return submission procedures that apply to these late Forms 3520, which might result in reducing or eliminating the penalties. 

Here, there is no unreported income in the prior years to address with the clients, but if there had been any unreported income the clients should have been referred to an attorney to discuss their options.

Additionally, as there are overseas transfers, do not forget to inquire whether any foreign bank accounts or ownership in foreign entities need to be disclosed.

Foreign accounts should have been reported on FinCEN Form 114, Report of Foreign Bank and Financial Accounts, for a year in which the balance exceeded $10,000 at any time during the year, as occurred in this scenario. Commonly referred to as FBAR, this form is filed electronically through the Financial Crimes Enforcement Network and is required under the Bank Secrecy Act. It is not an IRS form although the IRS administers the program.

Foreign assets also may have to be reported on Form 8938, Statement of Specified Foreign Financial Assets, which should be filed attached to the federal income tax return. The filing requirement is triggered if the taxpayer’s assets exceed certain thresholds. Separate filing requirements may also exist for each foreign entity.    

Also, keep in mind that the statute of limitation under Sec. 6501(c)(8) does not expire until three years after any delinquent Forms 3520 or certain other international informational returns are filed. This means in this case that the children’s Form 1040 returns remain open for three years after all of these delinquent returns are filed. If the taxpayers could establish reasonable cause, the statute remains open only to the extent that the delinquent information had an effect on the tax results.

— Mark Heroux, J.D., is a principal in the Tax Services group at Baker Tilly Virchow Krause LLP. Byron Shinn is a partner at Carr Riggs & Ingram, CPAs and Advisors. Cory Stigile, CPA, J.D. LL.M., is an attorney at Hochman Salkin Toscher Perez, P.C. Dan Wise, CPA is the head of Tax Risk at CohnReznick LLP. All four authors are current members of the AICPA’s Tax Practice and Procedures Technical Resource Panel. For comments on this article or suggestions of other topics, contact senior editor Sally Schreiber at Sally.Schreiber@aicpa-cima.com.