Foreign Trusts & IRS Tax Penalties (Form 3520-A) – FAQ Summary Review
The IRS hates foreign trusts; they are highly frowned upon by the U.S. government and if they are not reported properly and timely, the IRS may issue extensively high fines and penalties against you (Read: PFIC 8621)
The main reason the IRS hates Foreign Trusts, is because oftentimes people use them to shelter offshore funds, accounts and profits.
As a result, the United States is unable to obtain information about the funds which are sheltered abroad, and the Internal Revenue Service loses out on billions of dollars of tax liability that would be due for individuals with foreign trusts to pay each year.
U.S. Taxation of Foreign Trusts
It is important to remember that unlike other types of trusts, in a foreign trust (grantor trust) it is the owner of the trust was essentially liable for taxes due for income generated from the trust – and not the beneficiaries.
Thus, many trust owners are getting away tax-free simply by shifting their US money into a foreign trust and sheltering the income through a variety of means. Moreover, if the Grantor has”Deep Pockets” chances are he or she would be taxed at the higher U.S. Tax Rate of 33%, 35% or 39.6%
Form 3520-A – Foreign Trust Ownership
Form 3520-A is an “Annual Information Return of Foreign Trust With a U.S. Owner” and is required to be filed by the owner of a foreign trust if the owner is considered a US person (U.S. Citizen, Legal Permanent Resident, Foreign National who meets the Substantial Presence Test and possibly individuals who relinquished their Green Card but are considered Long-Term Green Card Holders). While there are some exceptions to filing the majority of individuals who are considered US owners of a foreign trust are going to have to file this form on an annual basis.
The penalties for failing to file this form are steep and amount 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.”
What is Included on the Form 3520-A
Form 3520-A is a comprehensive form that requires extensive reporting, such as Trust:
- Rents and Royalties
- Income Loss
- Capital Gain
- Ordinary Gains
- Other Income
Thus, the form is equivalent to having to file a 5471 or other type of business form detailing the income, assets and expenses of the trust.
Be Careful with “Questionable” Deductions
In order to offset profit, some trustees will pad the deductions in order to reduce the annual income. This is not a great strategy, especially when it involves a heavily scrutinized investment such as a foreign trust. For example, the following types of expenses must be detailed and parsed out individually on the form 3520-A:
- Interest Expense
- Foreign Taxes
- State and Local Taxes
- Amortization and Depreciation
- Trustee and Advisor Fees
- Charitable Contributions
- Other Expenses.
What if I never Filed the Form 3520-A?
If you have never filed a form 3520-A (and/or your foreign trustee never filed a form either), then you are out of compliance. It is important that you get back into compliance as quickly as possible to avoid fines and penalties. Beyond the mere failure to file the form 3520-A there may be other issues right around the bend such as:
- Does the trust have a foreign bank account(s)?
- What is the annual aggregate total of the foreign bank accounts?
- Does the owner of the trust reside in the United States?
- Where does the Trustee Reside?
- Does the owner of the trust file single, married or marry filing separate?
- Is the trust owned by foreign corporation? (5471 and 5472 issues)
- Is the trust part of a Passive Foreign Investment Company (PFIC and 8621 issues)?
- Does the trust own foreign mutual funds (PFIC and 8621 issues)
These are just some very basic/preliminary questions that may lead to additional reporting requirements that you should keep in mind when assessing your Foreign Tax situation. It is often a good idea to speak with an experienced offshore disclosure attorney involving these complex matters.
Reporting Foreign Income and Accounts – The Basics
Offshore disclosure is a complex area of law. To that end, many clients of ours have many of the same issues, questions, or concerns regarding their failure to report and/or be in compliance.
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Sean holds a Master's in Tax Law from one of the top Tax LL.M. programs in the country at the University of Denver. He has also earned the prestigious IRS Enrolled Agent credential. Mr. Golding's articles have been referenced in such publications as the Washington Post, Forbes, Nolo, and various Law Journals nationwide.
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