The Tax Times

Tuesday, May 12, 2026

Federal Court Upholds IRS Penalty Power On Foreign Wedding Gifts: Zhang v. IRS

A recent decision from the U.S. District Court for the Northern District of California adds a major new chapter to the running fight over international information‑return penalties. In Zhang v. Internal Revenue Service et al., No. 24‑cv‑8210 (N.D. Cal. May 4, 2026), the court held that the IRS does have statutory authority to assess penalties under Internal Revenue Code section 6039F for failure to report large foreign gifts—dealing a setback to efforts to extend Farhy‑style arguments to foreign gift penalties.

The story: a foreign wedding, late reporting, and a big bill

The plaintiff, Jinming Zhang, is a U.S. person who received about $287,100 in wedding gifts from family members in China. Those gifts were not taxable income, but they did trigger a reporting obligation under section 6039F, which requires U.S. recipients of large foreign gifts to file Form 3520.

Zhang filed the required reporting form late. The IRS responded by asserting a section 6039F(c) penalty of roughly $68,000—about 25% of the gift value—consistent with the statutory regime that allows a 5% per‑month penalty up to a 25% cap for late or non‑filed disclosures. After paying, Zhang sued for a refund, arguing that the IRS lacked authority to assess the penalty and therefore could not collect it administratively.

The legal theory: importing Farhy into the foreign gift world

Zhang’s complaint tried to build on the Tax Court’s 2023 decision in Farhy v. Commissioner, 160 T.C. No. 6, which held that the IRS had no statutory authority to assess penalties under section 6038(b) for certain information‑return failures. In Farhy, the Tax Court reasoned that because Congress had not expressly made those penalties “assessable,” the IRS could not simply post them on its books and collect them administratively; instead, the government would have to bring a civil suit under 28 U.S.C. section 2461(a).

Zhang argued that section 6039F(c) penalties for late‑filed foreign gift reports sit in a similar posture. The statute imposes a penalty, but does not spell out assessment procedures or clearly designate the penalty as assessable. According to the complaint, that silence meant the IRS could not treat section 6039F penalties like other assessable penalties under section 6201(a) and could not use standard collection tools such as offsets, liens, and levies.

The court’s holding: yes, the IRS can assess section 6039F penalties

In its May 4, 2026 decision—reported at 2026 WL 1210079—the Northern District of California rejected Zhang’s challenge and upheld the IRS’s authority to assess the section 6039F penalty. Coverage indicates that the court concluded that:

· The general assessment authority in section 6201(a) is broad enough to encompass section 6039F penalties, even though 6039F does not use the word “assessable.”

· Congress’s structure and cross‑references for international information‑return penalties support the view that section 6039F penalties are meant to be assessed and administratively collected, not pursued only through stand‑alone civil lawsuits.

· As a result, Zhang’s refund challenge based on lack of assessment authority failed, and her ability to contest the penalty is limited to the usual grounds (reasonable cause, computation issues, etc.), not a broad attack on the IRS’s power to assess.

In practical terms, the court refused to extend Farhy beyond its specific statutory context and signaled that, at least in the foreign‑gift setting, the IRS’s existing penalty assessment practices pass muster.

Why this matters: limits on Farhy‑based refund strategies

Ever since Farhy, taxpayers and practitioners have explored whether other international information‑return penalties—Forms 3520, 3520‑A, 5471, 5472, 8865, 8938, and others—are vulnerable to similar statutory‑authority challenges. Commentators have warned that the reasoning could extend beyond the specific penalty at issue in Farhy, potentially undermining large swaths of the IRS’s international penalty regime.

Zhang is a clear signal that at least one federal district court is unwilling to take that leap for section 6039F. Combined with the IRS’s recent procedural changes and ongoing commentary criticizing “draconian” foreign gift penalties, it suggests a landscape where:

· Courts may enforce the penalties as legally assessable while still scrutinizing how the IRS exercises its discretion in imposing them.

· Pure “no assessment authority” refund suits under section 6039F will face an uphill battle in the Northern District of California and potentially beyond.

· Taxpayers may be better served focusing on reasonable cause, reliance on professional advice, and proportionality arguments, rather than betting the case on a Farhy‑style structural attack.

Practical takeaways for taxpayers and advisors

For U.S. persons with foreign family wealth, Zhang underscores a few key points.

· Late foreign gift reporting is expensive. The statute allows penalties up to 25% of the gift value, and courts are showing increasing willingness to uphold the IRS’s ability to assess them.

· Early, accurate filing is the best defense. If there is any possibility that foreign cash transfers or gifts exceed the section 6039F threshold, advisors should raise the Form 3520 issue proactively—especially in life‑events settings like weddings, house purchases, or relocations.

· If you’re already late, fix it thoughtfully. Several recent cases and commentaries highlight situations where taxpayers tried to clean up past non‑compliance and still faced large penalties, sometimes after receiving bad advice. A carefully documented reasonable‑cause narrative, anchored in contemporaneous facts and professional guidance, remains critical.

· Farhy is not a magic wand. While Farhy remains important for certain categories of penalties, Zhang shows that courts can distinguish foreign gift penalties and uphold the IRS’s assessment power, limiting how far Farhy will travel.

Looking ahead

Zhang will not be the final word on foreign gift penalties. Other refund suits and potential appeals may raise different statutory and procedural arguments, and scholarship is already questioning the structure and policy rationale behind section 6039F. At the same time, the IRS has begun to tweak its procedures for late‑filed foreign gift and trust forms, suggesting at least some recognition of how harsh current practices can be in real‑world cases.

For now, though, the message from Zhang is straightforward: section 6039F penalties are very real, and the IRS can assess them. For taxpayers with foreign family support, that makes careful planning, early advice, and meticulous documentation more important than ever.

Need To Successfully Contest Form 5471,
5472, 8938, & 3520 Late Filing Penalties?

Contact the Tax Lawyers at

Marini & Associates, P.A.

for a FREE Tax HELP Contact us at:
www.TaxAid.com or www.OVDPLaw.com
or Toll Free at 888 8TAXAID (888-882-9243)

Sources:

1. https://www.law360.com/cases/673e6277b614d30e2e29e1df/dockets

2. https://dockets.justia.com/docket/california/candce/3:2024cv08210/439751

3. https://law.justia.com/cases/federal/district-courts/california/caedce/1:2024cv00667/447756/15/

4. https://cdn.ca9.uscourts.gov/datastore/memoranda/2022/10/24/21-17093.pdf

5. https://www.ballardspahr.com/insights/alerts-and-articles/2025/04/supreme-court-no-strong-arming-the-federal-government-with-state-law-fraudulent-transfer-claims

6. https://www.casemine.com/judgement/us/5914af6eadd7b0493474ccc6

7. https://natlawreview.com/article/irs-lacks-statutory-authority-to-assess-international-information-return-penalties

8. https://news.bloombergtax.com/daily-tax-report/foreign-wedding-gift-recipient-challenges-disclosure-tax-penalty

9. https://www.finnegan.com/en/insights/articles/court-denies-discovery-of-evidence-regarding-irs-views-on.html

10. https://www.law360.com/tax-authority/articles/2474317/irs-gets-protest-of-wedding-gift-penalties-narrowed

11. https://news.bloomberglaw.com/daily-tax-report/u-s-district-court-upholds-irs-authority-to-assess-foreign-gift-penalty-dismisses-apa-excessive-fines-claims

12. https://news.bloombergtax.com/daily-tax-report/foreign-wedding-gift-recipient-challenges-disclosure-tax-penalty

13. https://news.bloombergtax.com/tax-insights-and-commentary/draconian-irs-foreign-gift-penalties-serve-no-practical-purpose

14. https://kostelanetz.com/publications/draconian-irs-foreign-gift-penalties-serve-no-practical-purpose

15. https://natlawreview.com/article/irs-lacks-statutory-authority-to-assess-international-information-return-penalties

16. https://www.grantthornton.com/insights/newsletters/tax/2024/hot-topics/nov-26/irs-changes-late-foreign-gift-reporting-penalties

17. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=6378838

18. https://news.bloombergtax.com/tax-insights-and-commentary/irss-penalty-policy-for-foreign-gifts-discourages-compliance

19. https://www.facebook.com/wpxi/posts/recently-a-federal-court-ruled-that-the-government-should-not-have-assessed-pena/1380924250738368/

20. https://www.taxcontroversy360.com/tag/zhang-v-united-states/

21. https://www.jdsupra.com/legalnews/fifth-circuit-rejects-tax-court-s-2135617/

22. https://www.scribd.com/document/795137112/the-Washington-Post-12-10-19

23. https://anyflip.com/xizbi/qtna/basic

24. https://www.linkedin.com/posts/michael-j-miller-3201175_irss-penalty-policy-for-foreign-gifts-discourages-activity-7350843051604361217-3wdV

Monday, May 11, 2026

Kadau Case Alert: How “Insurance” Planning Turned Into a 40% Tax Disaster

The Tax Court’s memorandum decision in Kadau v. Commissioner, T.C. Memo. 2026-37 (May 4, 2026) is the latest warning shot at taxpayers using microcaptive insurance structures that do not hold up as real insurance arrangements with genuine economic substance. For practitioners, Kadau is useful not just as another “bad microcaptive” case, but as a clear illustration of how courts are applying the economic substance doctrine and the 40% penalty under section 6662(i) in this context.

The Structure: Microcaptive + Life Insurance

In Kadau, the taxpayers owned and operated a metal alloy coating business. To manage their risks—and, as the IRS argued, primarily to manage their taxes—they participated in a microcaptive insurance arrangement using a Nevis-based captive insurer, Risk & Asset. The business paid premiums to this captive, which purported to insure various business risks. Those premium payments then helped fund life insurance investments and other related-party benefits that largely inured back to the insured owners.

On paper, this looked like an insurance program qualifying for favorable tax treatment under the small insurance company regime. In practice, the court concluded it was nothing of the sort. Premiums were set at levels roughly 2.5 to 3.5 times prevailing commercial rates, and the flow of funds resembled a circular financing arrangement more than an arm’s-length insurance relationship with real risk transfer.

Economic Substance: Failing Both Prongs of § 7701(o)

The Tax Court evaluated the transaction under section 7701(o) and the economic substance doctrine, which requires:

1. A meaningful change in the taxpayer’s economic position (objective component), and

2. A substantial non-tax purpose (subjective component).

Kadau failed both tests.

On the objective side, the court found that the microcaptive structure did not materially change the taxpayers’ economic position. Premiums were grossly inflated relative to commercial market rates, and the captive’s assets and activities were effectively under the taxpayers’ control. The supposed insurance risk was largely illusory because the arrangement was designed so that funds could be recycled to benefit the owners (including through life insurance), with little genuine risk distribution or exposure to third-party claims.

On the subjective side, the court was not persuaded that the taxpayers had a substantial, non-tax business purpose. While they cited risk management and estate planning goals, the evidence showed that the dominant driver was tax reduction: large deductions for premiums paid to a related insurer that would be taxed lightly (if at all) within the captive, followed by access to those funds through other channels. The disparity between premium levels and commercial coverage also undermined any claim of bona fide insurance pricing.

Against the backdrop of cases like Avrahami, Reserve Mechanical, and a prior Kadau-related opinion (T.C. Memo. 2025-81), the court treated this as part of a familiar pattern of microcaptive structures that nominally follow the form of insurance but lack real substance.

The 40% Accuracy-Related Penalty

Perhaps the most painful aspect of Kadau for taxpayers is the 40% accuracy-related penalty under section 6662(i) for transactions lacking economic substance. Once the court concluded the arrangement failed under section 7701(o), it applied the heightened 40% penalty (rather than the usual 20% under section 6662(b)) because there was no adequate disclosure and no reasonable cause.

Key penalty points from the opinion:

· The microcaptive was treated as a transaction lacking economic substance, triggering the potential for the 40% penalty.

· The taxpayers did not adequately disclose the transaction (for example, through Form 8275 or other robust disclosure), which foreclosed the reduced penalty rate.

· The court found no substantial authority and no reasonable cause/good faith defense. Reliance on promoters or on opinions that merely accepted the taxpayer’s assumptions about risk, pricing, and structure was insufficient.

For advisors, Kadau reinforces that once the court characterizes a transaction as lacking economic substance, the default expectation is a 40% penalty unless the taxpayer has very strong disclosure and reasonable cause facts.

Practical Lessons for Microcaptive and Estate Planning Work

Kadau is another data point in the IRS’s continuing campaign against abusive microcaptive arrangements, but it also offers practical takeaways for structuring legitimate risk management and estate planning strategies.

Some key lessons:

· Risk transfer and distribution must be real. Courts will look closely at whether the captive is truly bearing risk, whether risks are pooled or diversified, and whether claims experience is consistent with genuine insurance.

· Premiums must be at arm’s length. Overpriced policies (multiples of commercial coverage) scream tax-motivated structuring and undermine both economic substance and insurance characterization.

· Avoid circular cash flows. If money effectively goes from the operating company to the captive and then back to the owners via loans, life insurance, or thinly disguised distributions, expect scrutiny.

· Document non-tax purposes rigorously. If there are real, quantifiable business reasons—unique risks, gaps in commercial coverage, regulatory requirements—those should be substantiated with contemporaneous analysis and third-party input.

· Take disclosure seriously. Kadau illustrates the cost of inadequate disclosure in a post-§ 7701(o) world: the difference between a 20% and a 40% penalty can be enormous.

For estate and business succession planning, the opinion also underscores that using insurance and captive structures to support wealth transfer is not inherently problematic, but when those structures are driven primarily by tax arbitrage and lack real insurance economics, they are highly vulnerable in litigation.

Have an Micro Captive Tax Problem?