The Internal Revenue Service (IRS) is always interested to know if a U.S. taxpayer has had any dealings with foreign trusts or received large amounts of money from abroad. As a result, the IRS requires the filing of Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. Unlike a tax return, where a tax liability or refund is calculated, Form 3520 is an informational return. As the title suggests, Form 3520 is used by U.S. persons to report (1) certain transactions that have occurred with respect to foreign trusts and (2) the receipt of gifts from foreign persons. The form’s reach, however, is slightly broader, as it is also used to report “ownership” of a foreign trust.
This alert provides an overview of the circumstances that require Form 3520 reporting, the information required to be reported and the penalties for not reporting. The circumstances under which Form 3520 filing is required are technical and rely on specific terms defined in the Internal Revenue Code and the Treasury Regulations. A full explanation of each of these terms is beyond the scope of this alert, but they are introduced here to assist you in determining whether you may have Form 3520 reporting obligations. The information reported on Form 3520 itself can also be quite detailed, so you should be sure to have an attorney or tax preparer review the form before filing it. Steep penalties may be imposed if a taxpayer fails to comply with his or her Form 3520 reporting obligations.
- What Is a Foreign Trust?
- What Needs To Be Reported?
- Transfers to Foreign Trusts Reportable on Part I of Form 3520
- Foreign Trusts Owned by a U.S. Person Reportable on Part II of Form 3520
- Distributions From Foreign Trusts Reportable on Part III of Form 3520
- Receipt of Foreign Gifts or Bequests Reportable on Part IV of Form 3520
- Exceptions and Penalties
Because Form 3520 deals with foreign trusts, it is important to know when a trust is classified as a foreign trust for U.S. tax purposes. This topic alone merits a full discussion, but, very briefly, a domestic trust is defined as any trust that satisfies the “court test” and the “control test” under Section 7701(a)(30)(E) of the Code. The court test requires that a court within the United States be able to exercise primary supervision over the administration of the trust. The control test requires that one or more U.S. persons (generally, U.S. citizens, residents or domestic business entities) control all substantial decisions of the trust (e.g., decisions as to timing and amount of distributions, beneficiary selection and trustee selection, among other decisions). Any trust that fails either of these tests is classified as a foreign trust. Many people are surprised to learn that a foreign person holding the power to appoint a trustee under a trust is sufficient to fail the control test, and that most trusts settled or created outside the U.S. are subject to court supervision outside the U.S. and therefore fail the court test, resulting in foreign trust classification.
There are four broad categories of transactions that are reported on Form 3520; each is reported on a different part of the form:
- Transfers to foreign trusts, reported on Part I
- Ownership of foreign trusts, reported on Part II
- Distributions from foreign trusts (including rent-free use of trust property), reported on Part III
- Receipt of large gifts from foreign individuals, estates, corporations or partnerships, reported on Part IV
The following persons are required to file Form 3520 to report certain transfers during the tax year to foreign trusts:
- A U.S. person who transfers property, directly or indirectly, to a foreign trust (whether by creating the trust or by transferring to an already existing trust)
- A U.S. person who (1) transfers property to a related foreign trust (or a person related to the trust) in exchange for an obligation or (2) holds an outstanding “qualified obligation” from a foreign trust
- The executor of the estate of a U.S. decedent where (1) the decedent made a transfer to a foreign trust by reason of death, (2) the decedent was treated as the owner of any portion of a foreign trust immediately prior to death under the “grantor trust” rules, or (3) the decedent’s estate included any portion of the assets of a foreign trust
A person is related to a foreign trust if that person (1) created the trust or made a gratuitous transfer to the trust at any time, (2) is a beneficiary of the trust, or (3) is related to any grantor or beneficiary of the trust.
A qualified obligation is a loan that meets the requirements set forth in Section 1.679-4(d) of the Treasury Regulations. The obligation (1) must be in writing, (2) must have a term not exceeding five years, and (3) all payments on the obligation must be denominated in U.S. dollars. To be “qualified,” the obligation must also meet some technical requirements set forth in the Treasury Regulations relating to (1) the obligation’s yield to maturity, (2) the period of assessment of certain taxes attributable to the transfer and (3) the reporting of the status of the obligation on Form 3520 while the obligation is outstanding.
If reporting is required on Part I of Form 3520, certain identifying information for the trust must be reported, including the name of the trust’s creator, the date of the trust, the country in which the trust was created and the country’s laws that govern the trust.
The reporting of any transfer to a foreign trust will require the date of transfer, a description of the property transferred, as well as the property’s fair market value, adjusted basis, gain recognized (if any), and a description and fair market value of any property received in exchange. Identifying information for the beneficiaries, trustees, and other persons with powers over the trust may also be required.
If an obligation of the trust is received in exchange for property transferred to the trust, the reporting of the obligation will require the date of transfer, the maximum term of the obligation, the yield to maturity and the fair market value of the obligation. If the obligation is a qualified obligation, details about principal and interest payments and past reporting of the qualified obligation will also be required.
The U.S. owner of all or any portion of a foreign trust must report on Form 3520 the existence of the trust and the value of the trust assets that are treated as owned by the U.S. owner. This reporting will also require certain identifying information as to the owner (i.e., name, address, country of tax residence), the relevant Code section causing U.S. ownership and certain identifying information as to the trust (i.e., country in which and date on which the trust was created). This reporting is required regardless of whether a distribution has been made from the trust during the tax year.
A U.S. person is treated as “owning” a trust if any of the “grantor trust” provisions are applicable. Under the grantor trust provisions, if the creator or other donor of a trust maintains certain controls or powers over the trust or a portion thereof, the creator or donor will be treated as the owner of that trust or portion for U.S. income tax purposes. Common powers that trigger grantor trust status include (1) the power to control beneficial enjoyment, (2) the power to add or change beneficiaries, (3) the power to borrow without adequate interest or security and (4) the power to substitute assets of equal value. Additionally, if any U.S. person makes a transfer to a foreign trust with U.S. beneficiaries, the trust will be treated as a grantor trust under Code Section 679. This provision also covers trusts formed by non-U.S. persons for the benefit of U.S. persons if the donor becomes a U.S. person within five years of forming the trust. Therefore, if a U.S. person has ever made a transfer to a foreign trust, it is very likely that the trust will be a grantor trust as to that donor.
The following persons are required to file Form 3520 to report certain distributions (or deemed distributions) during the tax year from foreign trusts:
- A U.S. person or the executor of the estate of a U.S. person who receives any direct or indirect distributions from a foreign trust
- A U.S. person who is the owner or beneficiary of a foreign trust and who receives (or a U.S. person related to him or her receives) either (1) a loan of cash or marketable securities from the trust (whether directly or indirectly) or (2) the uncompensated use of trust property
- A U.S. person who is the owner or beneficiary of a foreign trust that holds an outstanding qualified obligation of either the U.S. person or a U.S. person related to the filer
The reporting of any distribution from a foreign trust will require the date of distribution, a description of the property distributed, as well as the property’s fair market value, and a description and fair market value of any property received in exchange.
If a loan or uncompensated use of trust property has been received from a foreign trust, the reporting will require the fair market value of the loan proceeds or property, the date of the transaction, the maximum term of the obligation, the interest rate of the obligation, and the fair market value of the obligation. If the obligation is a qualified obligation, details about principal and interest payments and past reporting of the qualified obligation will also be required.
In order to facilitate the calculation of any U.S. tax owed on a distribution from a foreign trust, a trustee of a foreign trust should issue an annual tax statement (either a Foreign Nongrantor Trust Beneficiary Statement or a Foreign Grantor Trust Beneficiary Statement, depending on the type of trust). Providing such a statement (which is given by a trustee directly to the U.S. beneficiary) is generally beneficial to a U.S. beneficiary.
A U.S. person must file Form 3520 if that person receives as a gift during the tax year either of the following:
- More than $100,000 from a nonresident alien individual or a foreign estate
- More than a threshold amount from a foreign corporation or foreign partnership ($17,339 for gifts made in tax year 2022)
The obligation to report occurs once the aggregate value of all gifts from a single transferor exceeds the stated amount. However, you must also aggregate gifts from different foreign persons if you know (or have reason to know) that those persons are related to each other. For example, a U.S. person could receive a $99,000 gift from each of his French uncle and his Australian aunt during the tax year without triggering a Form 3520 reporting obligation if the French uncle and Australian aunt are unrelated. Conversely, if the French uncle and Australian aunt are related to each other, the reporting obligation would be triggered because the U.S. person received more than $100,000 from related persons.
The reporting of any such gifts or bequests will require the date of the gifts or bequests, a description of the property received, and the fair market value of the property received, although the name of the foreign donor is not reported. If gifts are received from a foreign corporation or foreign partnership, the name, address and U.S. tax ID number (if any) of the entity must also be provided.
It should be noted that there are certain limited exceptions to the reporting obligations detailed above. For example, the IRS no longer requires Form 3520 to be filed for transfers made to many tax-favored foreign trusts (i.e., certain employee benefit plans, trusts that are tax deferred until distribution or trusts that are tax exempt).
Filing Form 3520 correctly is important because the penalties are significant if it is not timely filed or if the information is incomplete or incorrect. Under Section 6677 of the Code, the initial penalty is equal to the greater of $10,000 or the following:
- 35% of the gross value of any property transferred to a foreign trust for failure to report the creation of or transfer to the foreign trust in Part I of Form 3520
- 35% of the gross value of distributions received from a foreign trust for failure to report receipt of the distributions in Part III of Form 3520
- 5% of the gross value of the portion of the foreign trust’s assets treated as owned by a U.S. person
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.
It may be possible to come into compliance and reduce or eliminate penalties for prior Form 3520 filing noncompliance by entering into one of the IRS’s available amnesty programs (read our alert “IRS Programs for Taxpayers Who Haven’t Kept Up With Their Foreign Reporting Obligations” here), although this is dependent on the taxpayer’s individual circumstances.
Loeb & Loeb’s International Trust & Estate Planning practice has assisted many clients in handling their Form 3520 filing obligations. For more information, please contact a member of our International Trust & Estate Planning practice.