According to the IRS, foreign trusts are a major compliance issue:
Citizens and residents of the United States are taxed on their worldwide income. To help prevent the use of foreign trusts and other offshore entities for tax avoidance or deferral, Congress has enacted several specific provisions in the Internal Revenue Code. Some provisions trigger recognition of gains that would otherwise be deferred. Others deny deferral of tax on income moved offshore.
A specialized industry has developed in attempting to circumvent these provisions. The promoters of offshore schemes often advance technical arguments which purport to show that their scheme is legal. These arguments are used to provide some comfort to their clients, who are then induced to enter into a scheme which usually involves concealing the true ownership and control of assets and income.
The foreign trusts rules in I.R.C. 671-679 are some of the most complex set of rules in the tax code. Foreign trust tax compliance typically poses three challenges: 1.) properly defining the type of entity, 2.) financial and information reporting of a U.S. person’s beneficial interest in a foreign trust 3.) and a U.S. person’s reporting of trust income and distributions. This article will discuss the first two.
Defining the entity — what is a “foreign trust”?
The Regulations define a trust as an arrangement created by either a will or inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries.
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.
An entity created to operate a business rather than to protect or conserve assets is not recognized as a trust for U.S. tax purposes. Instead, entities conducting business activities are more properly classified as business entities.
Where a trust exists solely for tax avoidance purposes, it is an “abusive trust arrangement” or “sham” whereby the IRS may ignore the purported form for U.S. tax purposes.
Is it a foreign trust or a U.S. trust?
A trust is considered to be a foreign trust unless it meets both of the following tests: the Court Test, and the Control Test
A trust meets the Court Test if a court within the United States can exercise primary supervision over the administration of the trust.
The Court Test has a “safe harbor” rule that is satisfied if:
- The trust instrument does not direct that the trust be administered outside of the U.S.;
- The trust is administered exclusively in the U.S.; and
- The trust is not subject to an automatic migration provision.
A trust meets the Control Test if one or more United States persons have the authority to control all substantial decisions of the trust with no other person having the power to veto any of the substantial decisions.
Is it a grantor trust or non-grantor trust?
Determining whether a trust is a grantor or non-grantor trust is important because it affects who is taxed on the income of the trust and when they are taxed. The consequence of grantor trust status is that the trust is generally not recognized as a separate taxable entity. Instead, the grantor continues to be treated as the owner of the property transferred to the trust and all items of trust income, gain, deduction, loss, and credit are reported directly by and taxable to the grantor.
A non-grantor trust, on the other hand, is recognized as a separate taxable entity. That is, in general, a non-grantor trust will be liable for tax on any income (including capital gains) that it retains, while to the extent the non-grantor trust distributes income to its beneficiaries, the beneficiaries will be liable instead.
I.R.C. §§ 673-679 contain various rules for determining whether an entity is a grantor trust.
I.R.C. § 679 takes precedence over the rules. IRC §679 was designed to prevent U.S. taxpayers from achieving tax-free deferral by transferring property to foreign trusts. A foreign trust that has U.S. beneficiaries will be treated as a foreign grantor trust under IRC §679 to the extent a U.S. person has gratuitously transferred property to it.
Under § 673-677, a U.S. person who is the grantor of a foreign trust will be treated as the owner of all or a portion of the trust if the grantor retains certain interests in or powers over the trust. In general, these interests and powers include:
- a reversionary interest worth more than 5 percent of the total value of the portion to which the reversion relates,
- certain powers of disposition over the trust property that are generally exercisable in favor of persons other than the grantor,
- certain administrative powers that allow the grantor to deal with the trust property for his or her own benefit,
- a power to revoke the trust, and
- a right to the present possession, future possession, or present use of the income of the trust.
Finally, § 678 applies if a person, other than the grantor, has a power to appoint trust income or corpus to himself or herself. That person is deemed to be the owner of all or a portion of the trust, provided the grantor is not otherwise treated as the owner of all or that portion of the trust.
International information reporting
Form 3520, Annual Return to Report Transactions with Foreign Trusts. Form 3520 is due on the date your income tax return is due, including extensions. It is filed separately from your income tax return. The penalty for failure to file a Form 3520 is equal to the greater of $10,000 or 25% of the gross value of any property transferred to a foreign trust for failure by a U.S. transferor to report the creation of or transfer to a foreign trust.
A Form 3520 is required in circumstances such as where a U.S. person:
Creates or transfers money or property to a foreign trust
Receives (directly or indirectly) any distributions from a foreign trust
Is treated as the U.S. owner of a foreign trust
Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner. In addition to filing Form 3520, each U.S. person treated as an owner of any portion of a foreign trust under the grantor trust rules 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.
Form FinCEN 114, Report of Foreign Bank and Financial Accounts (“FBAR”). The FBAR is required to be filed annually by “each United States person having a financial interest in, or signature or other authority over, a bank, securities, or other financial account in a foreign country.”
A person who is required to file an FBAR and fails to properly file may be subject to a civil penalty not to exceed $10,000 per violation. A person who willfully fails to report an account or account identifying information may be subject to a civil monetary penalty equal to the greater of $100,000 or 50 percent of the balance in the account at the time of the violation.
If you are required to file an FBAR, you must file it with the Department of Treasury by April 15th of each tax year. It is automatically extended to October 15 if you file an extension for your individual income tax return.
Beneficiaries: FBAR filings on FinCEN Form 114 are generally required to be made by U.S. persons who have reportable financial interests in or signature authority over a foreign financial account (“FFA”). A U.S. person who has more than a 50% present beneficial interest in a trust’s income or assets may be deemed to have an FFA interest and may be required to make an FBAR filing. A beneficiary of a foreign non-grantor trust is exempt from FBAR reporting if a trustee who is a U.S. person makes an FBAR filing disclosing the trust’s FFAs and provides information as required.
Trustees: A U.S. trustee of a foreign trust generally has signature authority over and/or a financial interest in the trust’s foreign accounts and thus, must file the FBAR form.
Form 1040, Schedule B. Part III, Foreign Accounts and Trusts must be completed if you receive a distribution from, or were grantor of, or a transferor to a foreign trust. Further, if as a trustee or beneficiary you have more than 50% beneficial interest or signature authority over trust (or personal) accounts exceeding $10,000 in the aggregate, you must indicate as such under Part III.
Form 8938, FATCA. The “FATCA” (Foreign Account Tax Compliance Act) provisions require specified individuals to report ownership of specified foreign financial assets if the total value exceeds the applicable reporting threshold. Form 8938 is due on the date your income tax return is due, including extensions. It is filed with your income tax return. Failure to report foreign financial assets on Form 8938 may result in a penalty of $10,000, and a penalty up to $50,000 for continued failure after IRS notification.
An interest in a foreign trust or a foreign estate is not a specified foreign financial asset unless you know or have reason to know based on readily accessible information of the interest. If you receive a distribution from the foreign trust or foreign estate, you are considered to know of the interest.
For a beneficiary of a foreign trust, the maximum value of your interest in the trust is the sum of 1.) the value of all of the cash or other property distributed during the tax year from the trust to you as a beneficiary, and 2.) the value using the valuation tables under section 7520 of your right as a beneficiary to receive mandatory distributions as of the last day of the tax year.
Furthermore, to alleviate the burden of duplicative tax reporting, an specified financial asset is not required to be reported on Form 8938, if it is reported on another timely filed international information return, such as Form 3520, Form 5471, Form 8621, or Form 8865.
Reporting of foreign gifts and inheritances
A little-known related compliance issue is the reporting of foreign inheritance or gift. Under I.R.C. 6039F, the receipt of a gift or inheritance by a U.S. person from a nonresident alien individual in excess of $100,000 is required to be reported to the IRS. Congress, in its infinite wisdom, required this information to be reported on Form 3520, the same form used to report transactions with foreign trusts.
While the use of foreign trusts can be used for tax avoidance purposes, that is not the case when one receives a foreign inheritance or gift – as there is no tax assessed on a foreign gift or inheritance. Last year the IRS announced a compliance campaign which targets noncompliance with foreign trust reporting on Form 3520/3520-A.
In furtherance of this campaign, the IRS service center has been automatically assessing penalties on Form 3520/3520-A even if a reasonable cause statement is attached. Unfortunately, individuals who simply file a late Form 3520 to report a foreign inheritance or gift are swept up in this compliance campaign (again, a campaign with has nothing to do with foreign gifts and inheritances). Penalties can be severe – up to 25% of the amount of the gift or inheritance. Therefore, if you are late filing a Form 3520, you should be ready for an automatic penalty assessment and then for a lengthy appeals process to dispute it. It appears there is discussion about potential changes to the statute: link here.
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