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How the IRS can tax 'gifts' and impose big penalties

Are donations income that the IRS can tax? Fortunately, no, but the line between income and gift is sometimes blurred. Let's say you do a big favor for your employer and receive a $20,000 gift, is that really a gift? You can try to document it that way, but the IRS is unlikely to agree. The IRS would say it's a bonus, even if it doesn't run through regular payroll. What about the more usual family gifts, where your uncle or grandmother sends you money? That's safer and probably done with what the IRS calls unbiased and selfless generosity. Ideally, you don't just want the money to show up in your bank account, as the IRS might one day call it income if you can't explain that it isn't. Having a contemporary instrument as a gift or at least a letter from your relative saying it is a gift is a good idea. But assuming it's a gift.

Not so fast. It's true that in the US, gift tax falls on the giver, not the recipient. But these days, with a lifetime exemption of $12.6 million, most people don't have to pay gift taxes (although they may need to file gift tax returns reporting the gift). But as a recipient, before foreign gifts. With the IRS's keen eyes abroad and FATCA enforcement looming, foreign bank accounts are less secret than they used to be. Foreign income is subject to tax, and you must report your foreign bank accounts. It is more difficult to plead ignorance of these rules than in the past. But what about foreign donations and inheritances? These rules are not widely publicized, but the stakes are high. If you receive a gift or inheritance, it's not income, so you might think there's nothing to report. Also, if there is a gift or inheritance tax, the person who gives you the money or property pays it, not the recipient.

However, if you're worried about proving something was a gift or inheritance rather than income, you're better off filing IRS Form 3520. The same is true if you are concerned about avoiding penalties. IRS instructions are here. File a Form 3520 if you receive:

1. More than $100,000 from a nonresident alien individual or foreign estate (including foreign persons related to that nonresident alien individual or foreign estate) that you treated as gifts or bequests; or

2. More than $14,375 from foreign corporations or foreign partnerships (including foreign persons related to such foreign corporations or foreign partnerships) that you treated as gifts.

You must report bequests on Form 3520 when you actually or constructively receive them. Therefore, report a gift in the year you actually receive it or the year you could have acquired it, whichever comes first. The penalty for reporting a gift late is 5 percent of its value for each month the gift is not reported (limited to 25 percent). However, no penalty applies if the IRS is satisfied that the lack of information was due to reasonable cause and not willful neglect.

Model 3520. If you receive a gift from abroad or a distribution from a foreign trust, you may need to file Form 3520, Annual Return for Reporting Foreign Trust Transactions and Receipt of Certain Foreign Gifts. See How to Report Foreign Gifts and Bequests to the IRS. The penalties are severe, the greater of $10,000 or 35% of the gross reportable amount. For returns reporting gifts, the penalty is 5% of the gift per month, up to a maximum penalty of 25% of the gift.

Form 3520-A. Another irritating form is Form 3520-A, Information Return for Foreign Trust with a US Owner. Taxpayers must report property rights in foreign trusts. The penalty for failure to file or improper filing is $10,000 or 5% of the gross value of the trust assets determined to belong to the US person, whichever is greater.

As with offshore accounts and offshore assets, these rules are under closer scrutiny. And in recent years, the IRS has gone on a veritable penalty notice spree regarding these forms. Failure to appear may result in a penalty. Also, if you file late, the IRS can penalize you, making you wonder if you should have filed.

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