Foreign Trust Information Reporting – Filings, Penalties, and Relief
- Taxpayers with ownership interests in foreign trusts are being increasingly scrutinized.
- The U.S. tax treatment and reporting requirements for foreign trusts are different for grantor and non-grantor trusts.
- Rules are complex and penalties for non-compliance can be steep—starting at $10,000 and up to 35 percent of the value of unreported amounts.
- That said, recent court rulings should help taxpayers who are late filing their Form 3520s.
With the pandemic, recession, and delayed filing deadlines until July 15th, it may be easy for taxpayers to overlook the Form 3520 filing requirement. Given the significant penalties for late filings and IRS scrutiny of the form, that would be a mistake.
Overview and Background
In May 2018 the IRS announced a compliance campaign targeting Forms 3520 and 3520-A. Since its inception, the goal of the campaign has been to take a “multifaceted approach to improve compliance with respect to the timely and accurate filing of information returns reporting ownership of and transactions with foreign trusts.”
The campaign is titled “Forms 3520/3520-A Non-Compliance and Campus Assessed Penalties,” and is focused on the reporting required when U.S. persons have transactions with foreign trusts. One prong of that approach seems to be sending the letter 6076 out to taxpayers that may have received an EIN for a trust.
The IRS has scrutinized offshore holdings and international information reporting for a number of years. To that effect, we have seen programs such as the Offshore Voluntary Disclosure Program (OVDP) and the introduction of the foreign account tax compliance act (FATCA).
Comments from the IRS demonstrate a skeptical view of foreign trusts. The commentary also implies a punitive approach to taxpayers who miss filings. The IRS website providing guidance on foreign trusts states:
“Although there are legitimate reasons why a U.S. person might create a foreign trust, or have transactions with a foreign trust, they can have tax consequences and result in filing responsibilities as well. Regardless of your motivation, failure to meet these reporting and filing requirements can result in very significant penalties.”
Those significant penalties that the IRS mentions start at $10,000 and can go up to 35 percent of the value of unreported amounts. Given the significance of the penalties, it is critical for taxpayers and their advisors to understand the information reporting requirements that apply to foreign trusts with U.S. beneficiaries or grantors. Fortunately, for taxpayers, a recent court ruling may limit the penalties that the IRS may impose in a case of a missed filing.
Recent Court Case May Limit Penalties
If a taxpayer is late in filing a Form 3520 then we do have some encouraging news in the form of a recent court ruling.
In Wilson, Emily S. v. the U.S., (2019, DC NY) the IRS attempted to assert a 35 percent penalty on the amount that Joseph Wilson failed to timely report as a distribution on Form 3520. The total amount of the IRS assessed penalty was over $3.2 million.
The 35 percent penalty applies in the case where a beneficiary fails to report a distribution from a foreign trust. The taxpayer in this case was also the grantor of that same foreign trust. There is a separate 5 percent penalty that applies where a grantor fails to timely file a Form 3520 to report ownership of a trust.
In this case, the IRS tried to assert the 35 percent penalty and argued that both the 35 percent and 5 percent penalties could apply. The taxpayer (and later his estate) argued that because he was a grantor only the separate 5 percent penalty should apply. The court ruled in favor of the taxpayer’s estate stating that the IRS could only assess the 5 percent penalty based on the relevant statute.
The court also ruled that the 5 percent penalty must be calculated on the value of the trust at the end of the year. In this particular case the all of the assets were distributed from the trust before the end of the year, so the penalty, as calculated, was $0.
Filing Options to Limit Penalties
Taxpayers who have missed filings have filing options that may help them limit the potential penalties related to Forms 3520-A and Form 3520.
For example, taxpayers residing outside of the U.S. may qualify for the Streamlined Foreign Offshore Procedures. Under the Streamlined Foreign Offshore Procedures, taxpayers can file back foreign information returns penalty-free.
Taxpayers who reside in the U.S. may consider the Streamlined Domestic Offshore Procedures where there is a 5 percent penalty on the value of unreported assets. Other alternatives include the Delinquent International Information Return Submission Procedures along with a reasonable cause statement.
Identifying a “Foreign” Trust
A trust is classified as a domestic trust if it satisfies both the court test and the control test. Those tests look at whether a U.S. court is able to exercise primary supervision over the administration of a trust and whether or not a U.S. person has the authority to control all substantial decisions of the trust.
If a trust does not satisfy both the court test and control test, then it will be considered a foreign trust for U.S. tax purposes.
Grantor and Non-Grantor Foreign Trusts
The U.S. tax treatment and reporting requirements for foreign trusts are different for grantor and non-grantor trusts. Therefore, after a taxpayer determines that a trust is in fact a foreign trust, he or she must also determine whether that trust should be treated as a grantor trust.
A grantor of a trust is the person who establishes the trust. For tax purposes, a grantor trust is any trust that has an owner for U.S. tax purposes. When dealing with a strictly domestic trust, we often analyze powers that the person who has funded (or established) the trust has over the trust. At a high level, if that person is able to control the trust then the trust is a grantor trust.
When dealing with foreign trusts, there are two broad rules that override much of that analysis. Those rules restrict situations in which a foreign person can be considered the owner of a foreign trust for U.S. income tax purposes and those rules expand when a U.S. person is considered the owner of a foreign trust.
- A foreign person is not considered the owner of a trust except under the following circumstances:
- The person has the power to distribute all trust property--including the corpus of the trust--to themselves without the approval or consent of any other person except for a related or subordinate party.
- The only amounts distributable during the lifetime of the grantor are distributable to that foreign person or their spouse.
- A U.S. person is considered the owner of a foreign trust
- If they directly or indirectly transfer property to the foreign trust.
- If they make a loan to a foreign trust that is not a qualified obligation.
A taxpayer is ready to analyze their filing requirements once they determine that a trust is a foreign trust and whether that trust is a grantor or non-grantor trust. As mentioned above, the Form 3520 and Form 3520-A are the primary foreign information reporting forms that apply to foreign trusts.
Form 3520 must be filed by any U.S. person who is an owner of a foreign trust, a beneficiary of a foreign trust who receives distributions, or people making loans to, or receiving loans from, foreign trusts among others.
Form 3520-A must be filed by a foreign trust with a U.S. grantor/owner. So, the filing requirement is by default the obligation of the trust itself and trustee. If a foreign trust fails to file Form 3520-A, then a U.S. owner is required to complete and attach a substitute Form 3520-A to their Form 3520.
Aside from the Forms 3520 and 3520-A, taxpayers may have a number of other reporting requirements related to their interest in a foreign trust. Those requirements include the foreign bank account reports (FBAR or Form 114), Form 8938, Form 5741, and Form 8621 among others. Taxpayers and their advisors need to review these filing requirements carefully because similar to the Form 3520 and Form 3520-A, there are significant penalties for missed filings.
The reporting requirements for U.S. persons benefitting from a foreign trust are extremely complex. This article gives an overview of the general rules that apply to those filing requirements, but it does not cover all of the nuances. Given the severe penalties for a missed filing, taxpayers would be well advised to ensure that their filing requirements are met.
If you have any questions, please do not hesitate to contact us.