District Court Addresses Form 3520 Penalties, Reasonable Cause, and IRS Authority in Huang v. United States: A TurboTax Defense Not Dismissed Out of Hand

As tax professionals, navigating the complexities of international information reporting can be challenging, both for us and our clients. A recent case in the Northern District of California, Jiaxing Huang v. United States of America, Case No. 24-cv-06298-RS, offers insights into how courts are addressing penalties related to foreign gift reporting, specifically Form 3520, and the defenses available to taxpayers. This article provides an overview of the case’s facts, the taxpayer’s claims, and the court’s analysis on the government’s motion to dismiss.

Background of the Case

The plaintiff, Ms. Jiaxing Huang, received substantial gifts from her non-resident foreign parents in 2015 and 2016 to facilitate her permanent relocation to the U.S. and purchase a home. When filing her taxes during these years, Ms. Huang used TurboTax, which, according to her complaint and evidence, advised users that recipients of foreign gifts do not need to report them, only the gift-giver does. Relying on this advice, she did not file Form 3520 for those years.

In April 2018, Ms. Huang learned of her obligation to file Form 3520 for gifts received from a foreign source. She promptly filed the required Forms 3520 for 2015 and 2016. The IRS responded by automatically assessing penalties: $62,496.25 for 2015 and $28,742.50 for 2016. Internal documents indicated an acting manager approved these initial assessments on October 16, 2018.

Ms. Huang submitted a reasonable cause letter requesting abatement, which the IRS denied on September 12, 2019, concluding she failed to show reasonable cause or due diligence. The IRS subsequently withheld portions of her 2019 ($280) and 2022 ($7,859) tax refunds to collect the penalties.

She appealed the denial to the IRS Appeals Division, arguing her "ignorance of the law relating to the reporting requirements resulting from the receipt of a gift from a foreign person" constituted reasonable cause, not willful neglect. During the appeal process, the penalty amount mysteriously increased to over $153,000, totaling nearly $190,000 with interest, which the plaintiff described as "significant errors" and arbitrarily inflated.

On August 4, 2023, the Appeals Division issued an Appeals Transmittal, abating $117,243.25 of the inflated penalty, noting the resolution was "based on ’Hazards of Litigation’". The remaining $36,495.50 in penalties was sustained due to lack of reasonable cause.

Plaintiff paid the remaining assessed penalties and interest in full on February 13, 2024. Less than two weeks later, she filed a Form 843, checking the box for "reasonable cause" as the basis for her claim and requesting immediate disallowance as instructed by the IRS Appeals Team Manager. She averred that over six months passed without an IRS response to her Form 843.

Notably, just before the hearing on the motion to dismiss, the IRS responded to her Form 843, revised the 2016 amount, and issued a refund check for $13,018.90 for 2016. Defense counsel indicated the check should not be deposited as the IRS planned to cancel it, and potentially issue a further check.

Taxpayer’s Claims for Relief

Plaintiff Jiaxing Huang sued the government seeking a refund of $35,573.43 for the assessed penalties, plus the $280 and $7,859 withheld refunds, attorney fees, costs, and expenses. Her complaint advanced four claims:

  1. Reasonable Cause: She had reasonable cause for the late filing of Form 3520s.
  2. Arbitrary and Capricious Action: The IRS acted arbitrarily and capriciously by (a) automatically assessing penalties and (b) randomly doubling the penalties.
  3. Lack of Statutory Authority: The IRS lacked statutory authority to assess and collect penalties under Section 6039F.
  4. Failure to Comply with Section 6751(b): The penalties were invalid because the IRS failed to obtain written supervisory approval as required.

The government moved to dismiss the complaint, arguing lack of jurisdiction and failure to state viable claims.

Court’s Analysis and Application of Law

The court analyzed each of Plaintiff’s claims in the context of the government’s motion to dismiss under Fed. R. Civ. P. 12(b)(1) (lack of jurisdiction) and 12(b)(6) (failure to state a claim). At the motion to dismiss stage, the court accepts all material allegations in the complaint as true and construes them favorably to the plaintiff, determining if the claim is plausible on its face.

  • Claim 1: Reasonable Cause Determination

    • Legal Standard: The court noted that a district court has jurisdiction over a tax refund suit only if a refund claim was duly filed with the agency prior to suing, providing sufficient detail of each ground for the claim. However, this jurisdictional requirement focuses on the grounds raised in the refund claim.
    • For the reasonable cause defense itself, taxpayers bear the burden of showing they "exercised ordinary business care and prudence [but were] unable to file the return within the prescribed time". Reliance on tax professionals can constitute reasonable cause, particularly under the three-prong test from Neonatology Assocs. v. Comm’r of Internal Revenue, 115 T.C. 43, 99 (2000), which requires the adviser to be competent, the taxpayer to provide accurate information, and the taxpayer to rely in good faith. Taxpayer education, sophistication, and business experience are also relevant.
    • Application: The court found the jurisdictional argument regarding the Form 843 did not apply to the reasonable cause claim. Plaintiff checked the "reasonable cause" box on her Form 843. Crucially, she had already detailed her reasonable cause arguments (ignorance of obscure law, inexperience, reliance on TurboTax) in her earlier appeal letter, providing the agency with sufficient detail. Moreover, she filed the Form 843 requesting immediate disallowance precisely as instructed by the IRS.
    • Regarding the plausibility of the claim, the court stated that while ignorance of the law alone is insufficient, other factors like inexperience and complexity of the law, when combined, could constitute reasonable cause. Relying on TurboTax advice, which affirmatively stated she didn’t need to report the gifts, is akin to relying on professional advice. Plaintiff alleges she inputted the proper data and relied on TurboTax’s advice, and that TurboTax is a "competent professional" for reliance purposes. The court noted that the Tax Court in Olsen v. Comm’r, 2011 WL 5885082 (T.C. 2011), found that reliance on tax software in good faith could support a reasonable cause defense.
    • The court distinguished Spottiswood v. United States, 2018 WL 1933521 (N.D. Cal. Apr. 24, 2018), cited by the Defendant, noting that the reasonable cause determination in Spottiswood was made on summary judgment, not at the motion to dismiss stage.
    • Plaintiff satisfied the requirements at the pleadings stage by alleging she acted with ordinary business care and prudence, relied on TurboTax’s incorrect advice, and acted promptly upon learning of the reporting requirement. The court emphasized that the most important factor is the taxpayer’s effort to report the proper tax liability.
    • Conclusion: The motion to dismiss was denied with respect to the reasonable cause claim, allowing it to proceed to the merits.

  • Claim 2: Arbitrary and Capricious Administration

    • Legal Standard: The court addressed the jurisdictional issue again, noting that this claim was not raised in the Form 843 refund claim. Further, judicial review under the Administrative Procedure Act (APA) is typically only available when there is no other adequate remedy in court. A tax refund suit under 26 U.S.C. § 7422 is considered an adequate remedy.
    • Application: The court found that the component of this claim arguing the denial of reasonable cause was arbitrary was barred because it duplicated her Section 7422 claim.
    • However, the court noted that the claim also alleged the IRS arbitrarily multiplied the penalty substantially and then removed a portion. This calculation error was distinct from the reasonable cause determination, and arguably had no alternative adequate remedy under Section 7422.
    • Nevertheless, the court found that the IRS had since rectified this error by abating the inflated portion of the penalty. Defense counsel confirmed at argument that a mistaken duplication of the 2015 penalty occurred and was resolved.
    • Conclusion: The court found the issue of the penalty inflation was moot because it had been rectified. The claim was dismissed without prejudice.

  • Claim 3: Lack of Authority to Assess and Collect Penalties

    • Legal Standard: Plaintiff’s argument was based on the placement of Section 6039F in Chapter 61 rather than Chapter 68, suggesting it shouldn’t be collected like other taxes under Section 6671(a). This argument drew on the Tax Court’s ruling in Farhy v. Comm’r of Internal Revenue, 160 T.C. 399 (2023), which held the IRS lacked explicit authority to collect Section 6038(b) penalties.
    • The court noted that the D.C. Circuit reversed the Tax Court in Farhy, finding such penalties are subject to IRS collection, reasoning that "Congress renders penalties assessable in more ways" than explicit reference, including by implication. The D.C. Circuit also pointed to the IRS’s decades-long practice of collecting such penalties and Congress’s failure to change the statute as persuasive evidence of intent. Additionally, the presence of a reasonable cause defense in Section 6039F (like Section 6038 analyzed in Farhy) suggests an assessable penalty with an administrative process.
    • Application: The court found the D.C. Circuit’s reasoning in Farhy persuasive. It stated it makes no sense to suggest a penalty within the tax code is outside the IRS’s power to assess and collect, particularly given longstanding practice and congressional acquiescence.
    • Furthermore, the court pointed out that Plaintiff failed to raise this argument with the agency in her refund claim.
    • Conclusion: The claim was dismissed due to failure to raise it with the agency.

  • Claim 4: Failure to Comply with Section 6751(b)

    • Legal Standard: Section 6751(b) requires written supervisory approval before a penalty may be assessed. However, the court noted that approval need not precede the first communication to the taxpayer imposing a penalty. It also doesn’t require a particular form of written approval, signature, or proof that the approval came from the immediate supervisor if a higher-level official designates it. The plain language requires only written approval by a manager.
    • Application: The court noted that the record, incorporated into the complaint, showed a manager approved the assessments for 2015 and 2016 on October 16, 2018.
    • Although Plaintiff contended the document didn’t prove approval by the immediate supervisor, the statute permits approval by the immediate supervisor "or such higher level official as the Secretary may designate".
    • Moreover, similar to the lack of authority claim, the court noted that Defendant’s waiver argument applied here as Plaintiff never raised this argument at the agency level.
    • Conclusion: The claim was dismissed due to failure to raise it with the agency.

Summary of Outcome

In conclusion, the court denied the government’s motion to dismiss only with respect to Plaintiff’s first claim, the reasonable cause determination for her late-filed Forms 3520. This claim, which includes the argument that reliance on tax software like TurboTax under these circumstances could constitute reasonable cause, will proceed to the merits. The court granted the motion to dismiss on the other three claims: arbitrary and capricious administration (found moot due to correction of the error), lack of statutory authority (not raised with the agency and contrary to persuasive D.C. Circuit precedent), and failure to comply with Section 6751(b) (evidence of approval exists and not raised with the agency).

This case highlights the importance for taxpayers (and their advisors) to carefully document their efforts to comply, including reliance on tax preparation software or other advice, and to be prepared to articulate all grounds for penalty abatement in the administrative process before pursuing litigation. It also underscores the court’s view, in line with the D.C. Circuit, that the IRS generally has the authority to assess and collect penalties codified within the Internal Revenue Code, even if not explicitly cross-referenced by collection provisions.

Prepared with assistance from NotebookLM.