As people increasingly interact with individuals and businesses in other countries, tax preparers in the United States are undoubtedly becoming better acquainted with international tax issues.
For example, most are aware that individuals who have a financial interest in or signature authority over a foreign financial account must comply with the Report of Foreign Bank and Financial Accounts (FBAR). But international issues go beyond FBAR. Sometimes, as in the case of gifts and inheritances received from individuals or entities outside the U.S., they might challenge common perceptions.
Generally, it’s understood that the value of gifts or inheritances given to a taxpayer don’t need to be reported on his or her income tax returns. IRS §102 appears quite clear that the value of property that a taxpayer acquires by gift, bequest, device, or inheritance isn’t included in gross income for U.S. income tax purposes. As most tax practitioners would point out, it isn’t the recipient of a gift or inheritance who is liable, but rather the tax is paid by the donor who gave the gift (IRC §2503) or the decedent who transfers the taxable estate (IRC §2001).
But that isn’t necessarily the case if the gift or bequest came from a foreign individual, corporation, partnership, or estate. Except for tax-exempt organizations, U.S. taxpayers who receive a foreign gift or bequest that exceeds certain threshold amounts may have to report it to the IRS. This reporting requirement was created by the Small Business Job Protection Act of 1996 (P.L. 104-188, H.R. 3448) and can be found at IRC §6039F. The Treasury and the IRS determined that different reporting thresholds are warranted for gifts received from nonresident alien individuals, foreign estates, foreign partnerships and foreign corporations in its guidance for this new law in IRS Notice 97-34 (1997-1 CB 422, June 2, 1997). The threshold amounts are more than $100,000 (per IRS Notice 97-34 and not modified by cost-of-living adjustments) from a nonresident alien individual or a foreign estate and more than $15,671 for taxable years beginning in 2016 (as modified from $10,000 by cost-of-living adjustments per IRS Rev. Proc. 2015-53, IRB 2015-44, October 21, 2015) from foreign corporations or foreign partnerships. Any transfers to a U.S. person for either tuition to a qualified educational organization or to any person who provides medical care on behalf of a U.S. person don’t need to be reported.
What was the purpose of this new reporting requirement since there’s no tax liability directly attached? As with all required reporting by the IRS, the likeliest explanation for the requirement is so the IRS can scrutinize the taxpayer’s transactions to see if the transfers are properly classified as a gift or if they should be classified as income. Of course, if the IRS finds the transfer isn’t a gift or bequest, it will be considered gross income per IRC §61 and consequently taxed.
Treasury hasn’t issued regulations for IRC §6039F, but the Conference Report of H.R. 3448 clearly spells out the authority of the Secretary of the Treasury to penalize the failure to report these foreign transfers – while also including an added twist to encourage compliance. First, the U.S. taxpayer is subject to a penalty equal to 5% of the amount of the transfer for each month that he or she fails to comply (total penalty not to exceed 25%). Second, if the individual fails without reasonable cause to report the foreign transfer as required, the Secretary of the Treasury is authorized to determine the tax treatment of the unreported gifts.
The Conference Report points out that the Treasury Secretary’s exercise of its authority to make such a determination will be subject to judicial review under an arbitrary or capricious standard, which provides a high degree of deference to such determination. In other words, if the taxpayer fails to report the transfer, Treasury (and, therefore, the IRS) is given greater discretion over the determination of whether the transfer is a gift/bequest or income.
The IRS could still challenge the transfer if it’s reported, but with less discretionary authority. Thus, be sure to report any foreign transfer that must be reported. With the ease of tracking money transfers in this day and age, along with the IRS’s usual routine of requesting or issuing a subpoena/summons for bank statements, any large monies a taxpayer received from foreign persons or entities will most likely be a topic of discussion during an audit.
Therefore, if a U.S. taxpayer received a foreign gift or bequest during the current tax year that exceeds the threshold amounts, Form 3520 must be filed with IRS when the individual’s income tax return or estate tax return is due. To calculate the threshold amounts of $100,000 and $15,671 for taxable years beginning in 2016, transfers from related foreign individuals and estates or foreign corporations and foreign partnerships must be aggregated if the taxpayer knows or has reason to know that the transfers are coming from related parties. A related foreign individual generally includes but is not limited to a member of a person’s family such as a person’s brothers and sisters, half-brothers and half-sisters, spouse, ancestors (parents, grandparents, etc.), lineal descendants (children, grandchildren, etc.), and the spouses of any of these persons. Report them in Part IV of Form 3520. Treat gifts from foreign trusts as trust distributions you report in Part III of Form 3520. A person is related to a foreign trust if such person, without regard to the transfer at issue, is a grantor of the trust, a beneficiary of the trust, or is related to any grantor or beneficiary of the trust.
So the next time when someone quickly says that gifts or bequests aren’t taxable income for the recipient, it’s better to say that this is generally true. Foreign gifts and bequests over a threshold amount are reportable and could be considered taxable income, especially if those transfers aren’t reported on Form 3520.
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Anthony P. Curatola, Ph.D., is the Joseph F. Ford Professor of Accounting at Drexel University in Philadelphia, PA., a tax columnist, and an author of the EA Exam Review for Surgent Professional Education. Tony can be reached at email@example.com.
The author herby authorizes the use of this article by TaxACT in their upcoming e-newsletter while Tony Curatola retains all rights and privileges to the article.
James W. Rinier, CPA, EA, is the Vertex Fellow at Drexel University. He can be reached at firstname.lastname@example.org.
©2016 A.P. Curatola