Form 3520-A Instructions (How to File Foreign Trusts with IRS)

Form 3520-A (2020)

Form 3520-A Instructions: The Form 3520-A instructions are complicated. In recent years, the IRS has increased enforcement of offshore trust reporting. In general, the Internal Revenue Service has taken an aggressive approach to foreign accounts compliance — which includes offshore trusts. What makes offshore trust reporting so complex, is that the definition of a offshore trust may vary from one country to the next. And, if the offshore trust has its own bank accounts, the accounts may also need to be reported on other international reporting forms, such as the FBAR or Form 8938. The failure to report overseas accounts, assets, and investments may lead to offshore penalties. To avoid or reduce penalties, the Internal Revenue Service has developed various amnesty programs, collectively referred to as voluntary disclosure.

Form 3520-A Instructions

Form 3520-A is used to report Overseas Grantor Trusts.

What is a Grantor Trust?

As provided by the IRS:

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.  (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. 

Common issues with a Foreign Grantor Trust:

• Who gets taxed on the trust?
• What if the Trustee is a U.S. Person?
• Do I have to keep the money overseas?
• Can I avoid tax to the grantor?
• What if I am out of IRS compliance?

What is an Offshore Trust?

In order to not be a foreign trust, the trust must meet two (both) of these tests.

Court Test

Generally, the trust will be considered “Domestic” if a U.S. Court/Jurisdiction has the power to exercise primary or main control over how the trust is administered. For example, if your trust provides that the laws of California will govern – then chances are so far, you do not have a foreign trust.

Why? Because the trust is governed or “ruled by” a U.S. jurisdiction.

*There are various analyses used to determine if the trust meets the court test, such as where it is probated, does the U.S. still have “primary control,” is it registered with a U.S. Court, etc.

**There is a Safe-Harbor rule.

Control Test

In order to meet the control tests, the trust must authorize U.S. Person(s) to exercise sufficient control in order for the person to make “substantial decisions” over the trust. Generally, even if it is one person (as long as he or she cannot be overruled by non U.S. persons) this will be sufficient.

What makes a Foreign Trust, a Foreign Grantor Trust?

Generally,  the grantor retains sufficient control over the trust to make “important” decisions about the trusts

With a Foreign Grantor Trust, the Grantor (“owner of the trust”) not the beneficiaries (“recipients of the distributions”) must report the income.

Why? Because the IRS wants to avoid any artificial income assigning of income or gifting.

Example of What the IRS Wants to Avoid

Dave had 5 kids. None of them work (Why would they, Dave is “mega-rich.”) Dave forms a foreign grantor trust because he believes he can reduce his U.S. tax liability.

Why a Grantor Trust? Because Dave loves (but doesn’t trust) his spoiled kids. He wants to gift them money, but wants half of it to go their schooling,.

So, if each kid receives an annual distribution of $100,000 (as opposed to Dave taking a $500,000 distribution), then the distributed amounts to the kids would be taxed at a lower rate than Dave – who is in the highest tax bracket.

Then, each kid’s gifts dad back $50,000 which he used to pay for each kid’s college.

As a result, the U.S lost out on tax money, since the kids were each taxed at a lower rate than Dave. And, Dave is able to use part of the money that was taxed at a reduced rate to pay for each kid’s school.

Compare: Dave would be taxed at a much higher tax rate, vs. the kids (some who are married and not “life-motivated”) at 10%-20% so that Dave would have to withdraw and pay tax on significantly more money to arrive at the same net income.

And, since Dave is really holding the purse-strings, and still exercises control over the trust – the IRS requires him to pay tax on the trust income.

Offshore Grantor Trust IRS Filing Requirements

These are some of the more basic requirements:

Offshore Grantor Trust “Trustee”

The Trustee has a very important responsibility, which is to file Form 3520-A each year with the IRS.

Form 3520-A is the “Annual Information Return of Foreign Trust with U.S. Owner” form. The failure to file the form may result in significant fines and penalties.

*There are various rules and requirements that the trustee must follow, such as sending the Foreign Grantor Trust Owner Statement to each U.S. Owner of the foreign trust.

**An extension to file Form 3520-A may be requested.

Offshore Grantor Trust “Owner”

As mentioned above, the owner of the trust is subject to income tax on the foreign grantor trust. The U.S. Owner of the trust files the Form 3520 to show that he or she is the owner (or an owner) of the foreign trust, along with reporting any transfers to the foreign trust.

Form 3520 is due on the due date of the individual tax return.

*BE SURE your trustee files Form 3520-A, if not, then you should probably file it yourself.

Offshore Non-Grantor Trusts

A foreign non-grantor trust is different. The reason is because that since the grantor has not continued to exercise (formal) control the same way a grantor does in a foreign grantor trust – the IRS rules are more complex.

First and foremost, a non-grantor trust is not considered a U.S. Person – and therefore, the tax rules are different.

Some important tax rule basics:

– The non-grantor trust is not separate and distinct from the grantor (person who created the trust)

– The tax on capital gains rules varies from an NRA (183 day rule) and Foreign Trust (NDI).

Common U.S. Sources of Income for a Offshore Non-Grantor Trust

ECI (Effectively Connected Income)

This analysis would go far beyond a basic introduction. Generally, ECI is taxed progressive at varying rates (vs. FDAP, described below, which is a standard 30% subject to U.S. Tax Treaty reductions).

ECI may be impacted by Permanent Establishment and many other complexities. And, while rental income is considered FDAP, an election to ECI may help reduce taxes (due to all the expenses generated from Real Estate Income)

FDAP (Fixed, Determinable, Annua, Periodical)

FDAP is taxed at 30%, subject to exceptions, exclusion, and limitations (especially by most treaties, which reduce the rate to 15%, 10%, 5% or waived)

Essentially, FDAP is passive income such as:

• Rents
• Royalties
• Dividends
• Annuities
• Interest
• Certain Gains

In determining whether there is an FDAP issue, it is important to assess whether the common exception of the Portfolio Interest exemption applies.

Examples of non-taxable U.S. income of a Foreign non-grantor trust:

• OID <183 days to maturity
• Interest from a U.S. Bank or similar (excluding ECI)
• Portfolio Interest (excluding ECI)
• Interest related to certain dividends/STCG involving Mutual Funds.

Responsibilities Of The Trustee With Non-Grantor Trusts

The Trustee should determine if any U.S. Income was earned, by the trust and if a form 1040NR is required (not an 1040, since the foreign non-grantor trust is not a U.S, Person

Foreign Beneficiaries of a non-grantor trust must file Form 3520 by the due date (including extensions) and if possible, it should include a Foreign Non-Grantor Trust Beneficiary Statement.

The U.S. beneficiary (not the grantor) will have to pay U.S. tax on current year trust income included in the distribution.

*Noting, that if trust does not earn income, and the distribution is not considered “income,” the beneficiary should be careful not to report non-trust income as income.

**Even if the distribution is not income per se, you should be sure.

Are You Out of Compliance?

If you are out of IRS tax compliance, the penalties can be severe. Therefore, you may consider entering the IRS offshore voluntary disclosure/tax amnesty, before it is too late.

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure. 

Contact our firm today for assistance with getting compliant.