As noted in our prior advisory, U.S. citizens and residents who receive gifts exceeding certain thresholds from foreign persons must generally report such gifts to the IRS on Form 3520, and the IRS does not hesitate to impose significant penalties on failures to timely report such gifts. The IRS imposes the penalty for the failure to report a foreign gift by “assessing” it – i.e., by making a bookkeeping entry stating that it is due – then collecting it (including, in some cases, by seizing the recipient’s assets). The penalty for the failure to report a foreign gift is one of several penalties under the Tax Code for the failure to report foreign assets or transactions with foreign persons.

In 2023, the U.S. Tax Court decided the case of Farhy v. Commissioner, 160 T.C. No. 6 (2023), in which the Tax Court ruled that the IRS could not treat a penalty for the petitioner’s failure to report information regarding a foreign corporation he controlled as a so-called “assessable penalty.” Since the penalty was not an assessable penalty under the Tax Court’s holding, the government could not simply assess the penalty, but rather would have to go to court before collecting the penalty. While the Farhy case did not specifically address the penalty for the failure to report a foreign gift, the type of penalty it did address was similar, and the case’s reasoning could have been applied to a penalty for the failure to report a foreign gift. Following the Tax Court’s Farhy decision, the IRS acknowledged in an internal memorandum that the case should be taken into account in determining the applicability of the penalty addressed by the Farhy case, and also similar penalties. Thus, the Farhy case created a new argument against the imposition of the penalty for failure to report a foreign gift.

Unfortunately, on May 3, 2024, the U.S. Court of Appeals for the District of Columbia Circuit issued a decision reversing the Tax Court’s Farhy decision and finding that the IRS did in fact have the authority to assess and collect the penalty at issue in that case. The D.C. Circuit’s reversal of the Farhy case is of course a setback for taxpayers, but taxpayers still have options for challenging penalties for the failure to report a foreign gift.

It is first important to note that the D.C. Circuit’s reversal of the Farhy decision is not the last word on that case. The Tax Court may continue to follow the Farhy decision in cases that are not appealable to the D.C. Circuit. Golsen v. Commissioner, 54 T.C. 742 (1970) and Peat Oil and Gas Associates v. Commissioner, 100 T.C. 271 (1993). Thus, the vast majority of taxpayers residing in the United States (and outside the District of Columbia) may continue to make arguments based upon the Tax Court’s Farhy decision. It is also possible that Mr. Farhy will appeal the D.C. Circuit’s decision. Furthermore, taxpayers may continue to argue that they had reasonable cause for any failure to timely report a foreign gift.

The D.C. Circuit’s decision might also have created a new opportunity for taxpayers against whom a penalty has been assessed for the failure to report a foreign gift. In our prior advisory, we noted that it is not clear that all taxpayers who have been subjected to a penalty for the failure to report a foreign gift can take advantage of a Collection Due Process proceeding to dispute the merits of the penalty. The D.C. Circuit’s Farhy decision, however, suggests more than once that all taxpayers who have been assessed penalties of the type at issue in the Farhy case are entitled to a Collection Due Process proceeding. At one point, for example, the D.C. Circuit stated that “[i]f penalties imposed under subsection (b) are likewise assessable, as the government contends, the taxpayer may opt for judicial review of those penalties, too, by requesting a CDP hearing and, if dissatisfied with its result, obtaining Tax Court review under I.R.C. § 6330(d)(1).” It is not clear that this sweeping statement is correct, and the penalty discussed in the Farhy decision was not a penalty for the failure to report a foreign gift, so taxpayers should still exercise caution upon receiving a notice from the IRS offering appeal rights in connection with the assessment of a penalty for failure to report a foreign gift.

We will continue to monitor these developments. For assistance in determining if you will be subject to the reporting penalties and how to address them, please contact Kelley Drye Tax Partner, Andrew Lee.

Court of Appeals Reverses Tax Court’s Farhy Decision, But Opportunities Remain to Challenge Penalties for Failures to Report Foreign Gifts