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Foreign Trust Reporting Requirements – (3520-A) IRS Common Question & Answers

IRS Foreign Trust Reporting Forms - 3520, 3520A, FBAR & 8938

Foreign Trust Reporting Requirements – (3520-A) Common Question & Answers

Foreign Trusts (especially Foreign Grantor Trusts) are traps for the unwary. Namely, this is because the Internal Revenue Service is a strong believer that anybody who has any money offshore or in a foreign country is doing so to avoid U.S. tax. This is very common for our clients with an active New Zealand Foreign Trust.

It is the reason why the IRS has made International Tax Enforcement a key priority, and it is why the penalties associated with non-filing of foreign informational returns and account reporting are so unnecessarily extreme.

Despite all the different types of reporting requirements for different types of accounts, the foreign trust is one of the most overbearing. There are particular rules involving foreign trusts, and while we were not going to go into all of those rules in this article, will provide a brief summary of some of the key issues to watch out for.

U.S. Citizens Abroad

In many countries, it is common to have a foreign trust to hold all of your assets (somewhat similar to a revocable trust is set it is more active during the lifetime of the trustee/beneficiary). As a result, it is important to note that the United States does not really care where you live, insofar as if you reside abroad and are following foreign trust rules, you will still have to report a foreign trust to the United States. This is true, when there is a US person who serves as a member of the foreign trust.

What is a U.S. Owner?

Leave it to the Internal Revenue Service to keep the task somewhat esoteric and ambiguous. The reality is, anybody who is considered a U.S. person is most likely going to be considered a U.S. owner. This includes U.S. Citizens, Legal Permanent Residents and other individuals who meet the Substantial Presence Test (at least during the time in which they meet the test). While IRS likes to build ambiguity into its definitions, it is usually preferred to error on the side of caution and report the Foreign Trust because you can better believe that the IRS is going to find any ambiguity to be in favor of the IRS and US government (Read: they are going to penalize you).

As provided by the IRS: “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.”

What is a Foreign Trust?

As we mentioned above, the IRS doesn’t like to nail down specifics – most likely because most solid tax attorneys would find a way around them. As such, the Internal Revenue Service defines a foreign trust as “A foreign trust is any trust other than a domestic trust. A domestic trust is any trust if: 1. A court within the United States is able to exercise primary supervision over the administration of the trust, and 2. One or more U.S. persons have the authority to control all substantial decisions of the trust.”

In other words, to perform the analysis you would determine if it is a domestic trust. If it is not a domestic trust then by default it is a foreign trust. While there are definitely times in which you can argue semantics (and probably win) if not drag the matter out for a very long time through the court system, if the trust is located overseas, or the property is comprised of foreign property, and/or the owner is a non-US person, then most likely you will be required to report the trust.

Who has to Report The Foreign Trust?

If there is a trustee, then typically the trustee as part of his or her duties will prepare and file the form with the Internal Revenue Service. It is important to note, that if the trustee does not file the form, the U.S. owner must still file the form. An example we deal with often will be when we have a client based in the United States, who has a multi-million dollar funded foreign trust a broad, through a trust company that may have ‘baited’ the client into the investment by explaining that since it is a foreign trust it does not need to be reported in the United States.

Thereafter, the US owner learns of the reporting requirement (3520, 3520-A, FBAR, Form 8938, 8621) and realizes that the trustee never filed the form. This is a nonissue to the IRS, and the owner still must file the form(s).

Trust Accounting

Depending on how active or passive your foreign trust is, chances are there will be some accounting that needs to be handled in order for the trust to be properly reported. For example, assets, equity, and liabilities will need to be detailed in the form 3520-A. The Internal Revenue Service will want to be aware of which Beneficiaries or Trustees received what distribution (if any), and especially, whether taxes have already been paid either abroad or in the United States.

Generally, trust distributions that are income will be reported by the grantor as income in a foreign trust scenario. The purpose is to avoid the deep pocket grantor from artificially reducing his or her tax liability by distributing money to his children or other family members which would presumably be taxed at a lower tax bracket than Mr. or Mrs. Deep Pockets.

Grantor Trust

Whether or not a trust is a grantor trust is well beyond the scope of this article. It is important to keep in mind that the IRS will default to a trust being a grantor trust because that will increase the amount of tax the IRS can recover. To be fair,  most foreign trusts are most likely going to be grantor trusts.

A typical scenario would be the owner of the trust maintains control or at least the purse-strings of the trust. No matter how many layers of rhetoric the grantor will try to place between himself or herself and the beneficiaries, if in reality the grantor is making the final decision (even if through a conduit in which he or she has some control) it is probably going to be a grantor trust.

Foreign Trust Penalties

The IRS loves penalties — especially Offshore Penalties. And, due to the fact that the IRS is understaffed and under budget, they rely on these penalties to make it through the year. As such, if you are high-net worth individual with a substantial amount of money overseas in a foreign trust, it will behoove you to get into compliance. To better understand the penalties, the IRS provides the following:

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). 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 may also 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.

Reasonable Cause

Depending on the facts and circumstances of your non-disclosure, you may qualify for Reasonable Cause. As provided by the IRS: No penalties will be imposed if the taxpayer can demonstrate that the failure to comply was due to reasonable cause and not willful neglect.

IRS Offshore Voluntary Disclosure Programs

When it comes time to report your undisclosed trust, you really need to speak with an experienced Offshore Voluntary Disclosure Lawyer. That is because beyond the non-reporting of the trust, you may also have unreported income, and various other documents which should have been filed timely with your tax returns.

In fact, the IRS has the right to penalize you extensively for the non-filing of many different key International Tax forms such as: FBAR, Form 8938, Form 3520, Form 3520-A, Form 5471, Form 5472, Form 8621 and Form 8865. These fines and penalties can reach upwards of $10,000 per occurrence. 

In this type of situation, a Reasonable Cause Statement may not be your best approach (although it might still be), and you may want to consider making offshore voluntary disclosure through one of the approved disclosure programs (aka IRS Offshore Voluntary Disclosure).

When Do I Need to Use Voluntary Disclosure?

If the IRS discovers that you are out of compliance, you may become subject to extensive fines and penalties – ranging from a warning letter all the way up to tax liens, tax levies, seizures, and criminal investigations. To combat this, you can take the proactive approach and submit to Voluntary Disclosure.

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