Reporting Foreign Trusts & the IRS
Foreign Trust Reporting: When it comes to Foreign Trust Reporting, the IRS has many rules and requirements. Unlike a domestic trust, once a trust becomes a foreign trust, the rules change. There is additional foreign account reporting requirements (usually) on Form 3520 and 3520-A.
In addition, if the trust has its own accounts, there may more reporting in accordance with FBAR & FATCA. Moreover with the IRS taking an aggressive approach on matters involving foreign accounts compliance and unreported income – compliance is crucial to avoid Offshore Penalties.
The reporting foreign trusts rules are complex. In order to best understand the process of trust filing, we will break the reporting down into parts.
The IRS takes a heavy hand against non-compliance, so it is important that if you believe you have a foreign trust reporting requirement, that you stay (or get into) compliance.
As provided by the IRS:
International Tax Gap Series
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.
In general, the reporting rules apply to a U.S. person who:
- Creates a foreign trust
- Transfers any money or property to a foreign trust
- Receives a distribution from a foreign trust
- Is treated as the U.S. owner of a foreign trust
Tax consequences can apply to the U.S. owners and U.S. beneficiaries of a foreign trust, and to the foreign trust itself.
What is a Foreign Trust?
As provided by Treasury Regulation 301.7001-4 and IRS Practice Unit Rules:
The Regulations define a “trust” as an arrangement created either by a will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries.
In a legitimate trust, the grantor transfers property to a trustee to hold and protect for the benefit of the trust beneficiaries, often pursuant to the terms of a written trust agreement.
A trust is a separate legal entity or arrangement typically used for family and estate planning purposes. Trusts allow assets to be held by an entity, other than a natural person, with an indeterminate life. Accordingly, trusts are often used to hold property and facilitate a transfer of such property to beneficiaries without the need for probate proceedings.
An arrangement will be treated as a trust if it can be shown that its purpose is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.
Foreign Grantor Trust vs. Non-Grantor Trust
The rules for foreign grantor trusts and non-grantors trusts different.
As provided by the IRS:
Foreign Grantor Trust
- A grantor trust is any trust to the extent that the assets of the trust are treated as owned by a person other than the trust. See the grantor trust rules in sections 671 through 679.
- A part of the trust may be treated as a grantor trust to the extent that only a portion of the trust assets are owned by a person other than the trust.
- Note. Due to changes to section 679(c) made by the HIRE Act, effective after March 18, 2010, a loan of cash or marketable securities from a foreign trust with a U.S. transferor, directly or indirectly, to a U.S. person, or the use of any other trust property directly or indirectly by any U.S. person (whether or not a beneficiary under the terms of the trust) will cause a foreign trust to be treated as having a U.S. beneficiary, unless the U.S. person repays the loan at a market rate of interest or pays the FMV of the use of such property within a reasonable period of time.
- Thus, in the case of a foreign trust with a U.S. transferor that is treated as having a U.S. beneficiary, the foreign trust is treated as a grantor trust under the grantor trust rules.
- A nongrantor trust is any trust to the extent that the assets of the trust are not treated as owned by a person other than the trust. T
- Thus, a nongrantor trust is treated as a taxable entity.
- A trust may be treated as a nongrantor trust with respect to only a portion of the trust assets. See Grantor Trust above.
What Forms do I File?
There are various different forms a person may have to use to report a foreign trust. The most common IRS international reporting form for foreign trusts is Form 3520-A.
As provided by the Form 3520 instructions:
- “A foreign trust with a U.S. owner must file Form 3520-A in order for the U.S. owner to satisfy its annual information reporting requirements under section 6048(b). Each U.S. person treated as an owner of any portion of a foreign trust under the grantor trust rules (sections 671 through 679) is responsible for ensuring that the foreign trust files Form 3520-A and furnishes the required annual statements to its U.S. owners and U.S. beneficiaries.
- If a foreign trust fails to file Form 3520-A, the U.S. owner must complete and attach a substitute Form 3520-A for the foreign trust to the U.S. owner’s Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. See Part II, line 22, of the Instructions for Form 3520. Otherwise, the U.S. owner may be liable for a penalty. See Penalties, later.”
When is Form 3520 A Filed & How to Apply for an Extension to Report a Foreign Trust
As provided in the Form 3520 instructions:
- File a complete Form 3520-A (including the statements on pages 3 through 5) with the Internal Revenue Service Center, P.O. Box 409101, Ogden, UT 84409, by the 15th day of the 3rd month after the end of the trust’s tax year.
- Give copies of the Foreign Grantor Trust Owner Statement (pages 3 and 4 of Form 3520-A) and the Foreign Grantor Trust Beneficiary Statement (page 5 of Form 3520-A) to the U.S. owners and U.S. beneficiaries by the 15th day of the 3rd month after the end of the trust’s tax year.
Extension of Time to Report the Foreign Trust An extension of time to file Form 3520-A (including the statements on pages 3 through 5) may be granted by filing Form 7004, Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns. For details, see Form 7004. Note. An extension of time to file an income tax return will not provide an extension of time to file Form 3520-A. Form 7004 must be filed in order to request an extension of time to file Form 3520-A
What is the Penalty for not Reporting the Foreign Trust
The penalties can be pretty bad.
As provided in the Form 3520 instructions:
- “The U.S. owner is subject to an initial penalty equal to the greater of $10,000 or 5% of the gross value of the portion of the trust’s assets treated as owned by the U.S. person at the close of that tax year, if the foreign trust (a) fails to file a timely Form 3520-A, or (b) does not furnish all of the information required by section 6048(b) or includes incorrect information. See section 6677(a) through (c).
- The U.S. owner is subject to an additional separate penalty equal to the greater of $10,000 or 5% of the gross value of the portion of the trust’s assets treated as owned by the U.S. person at the close of that tax year, if the U.S. owner (a) fails to file a timely Form 3520 (Part II), or (b) fails to furnish all of the information required by section 6048(b) or includes incorrect information. See section 6677(a) through (c) and the Instructions for Form 3520.
- Additional penalties will be imposed if the noncompliance continues for more than 90 days after the IRS mails a notice of failure to comply with the required reporting. For more information, see section 6677.
- Criminal penalties may be imposed under sections 7203, 7206, and 7207 for failure to file on time and for filing a false or fraudulent return.
- Penalties also may be imposed under section 6662(j) for undisclosed foreign financial asset understatements. Reasonable cause. No penalties will be imposed if the taxpayer can demonstrate that the failure to comply was due to reasonable cause and not willful neglect. Note.
- The fact that a foreign country would impose penalties for disclosing the required information is not reasonable cause. Similarly, reluctance on the part of a foreign fiduciary or provisions in the trust instrument that prevent the disclosure of required information is not reasonable cause.”
How Can I Avoid Foreign Trust Penalties for Unreported or Late Reported Foreign Trusts?
Generally, a person can qualify for reasonable cause or offshore voluntary disclosure (aka tax amnesty) in an effort to avoid penalties. Once a taxpayer is under audit or examination, they generally lose the right to submit to voluntary disclosure.
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