You’ve probably heard the expression that the only two things certain in life are Death and Taxes. The United States’ Internal Revenue Service (the IRS) works very hard at making the second item in that short list true, especially for expats and US foreign taxpayers.
One example is Form 3520, yet another of the “Informational Returns” required to be filed by US persons who are owners (grantors) of foreign trusts, transferred assets into a foreign trust, received a distribution from a foreign trust, or received a gift or bequest of $100,000 or more from a foreign source (individual, trust or estate) during the current tax year.
Form 3520’s full designation is a mouthful: Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts.
The word “certain” in the form’s title means that while the foreign gift giver would be the one paying any tax due, typically it’s the size of the gift that interests the IRS and thus may need to be reported. But you won’t know this until you plow your way through the documentation.
This article will give you a comprehensive look at Form 3520, enough for you to determine whether or not it’s something you need to consider for your tax planning purposes. It will also alert you to a couple of situations that could prove costly, in the way of penalties or additional taxes.
PURPOSE OF FORM 3520
As its title states, Form 3520 is an information return by which US persons, as well as executors of the estates of US decedents, report:
1. Certain transactions with foreign trusts,
2. Ownership of foreign trusts,
3. Receipt of large gifts or bequests from certain foreign persons (or trusts or estates).
Form 3520 is a complex tax form consisting of six pages and 12 pages of instructions.
Page one is the basic informational section in which you indicate what type of filer you are (Individual, Partnership, Corporation, Trust or Executor), and which of the four types of “reportable events” as designated under “Purpose” above, you were involved in.
The following five pages, divided into sections titled Part I, Part II, Part III, and Part IV, are each applicable to one of these types of events.
Which part or parts you are required to complete depends upon which type of US person you are and what type of event you are reporting.
IMPORTANT TERMS TO KNOW
To understand the filing requirements and the information needed to complete this form, it’s important to first understand several terms the IRS frequently uses on the form and in the instructions.
1. Distribution – is any gratuitous transfer of money or property from a foreign trust and without regard to whether the recipient is a beneficiary by the terms of the trust.
2. Grantor – any person who creates a trust and directly or indirectly makes a gratuitous transfer of cash or other property to a trust, and includes any person who is treated as the owner of any part of the foreign trust’s assets.
3. Gratuitous Transfer – any transfer to the trust other than a transfer for FMV, or a distribution to the trust from an interest held by the trust (say a corporation or partnership).
4. Owner – the person that is treated as owning any of the assets of a foreign trust under sections 671 and 679.
5. Obligation – any bond, note, debenture, certificate, etc. Any evidence of indebtedness.
6. Qualified Obligation – for purposes of the 3520, it is an obligation with an express written whose term does not exceed 5 years. All payments are denominated in USD.
7. Reportable Event – the creation of a foreign trust by a US person, the transfer of money or property (including the transfer by death), death of a US citizen if the decedent owned any portion of a foreign trust, or any portion of a foreign trust was included in the gross estate of the decedent.
8. Responsible Party – the grantor, the transferor (other than by death), the executor of a decedent’s estate.
9. Related Person – a member of your family, lineal descendants and spouses of any of these persons, or a corporation in which you, directly or indirectly, own more than 50% of the outstanding stock.
10. Person related to a foreign trust – the grantor of the trust, a beneficiary of the trust, or is related to any grantor or beneficiary of the trust.
11. US Person – a citizen or resident alien of the United States, a domestic partnership, a domestic corporation, any estate (other than a foreign estate), or any domestic trust.
WHO MUST FILE FORM 3520?
You must file Form 3520 if:
(A) you are the responsible party for reporting a reportable event;
(B) you are a US person who transferred property into a related foreign trust in exchange for an obligation;
(C) you are a US person who during the tax year is treated as the owner of any part of the assets of a foreign trust;
(D) you are a US person who received a distribution from a foreign trust;
(E) you are a US person who received either $100,000 or more from a nonresident alien individual or foreign estate that you treated as a gift or bequest, or you received more than $16,076 from foreign corporations or foreign partnerships, including persons related thereto, that you treated as gifts.
WHICH PART OR PARTS TO COMPLETE?
Depending upon which type of US person you are and what type of “reportable event” you may have been a part of determines which part or parts of Form 3520 you must complete.
Below are brief descriptions of the types of “reportable events” required by each of the four parts of Form 3520. You may need to complete only one part, or more than one part, again depending on the types of transactions which need to be reported.
PART I – Transfers – complete this section if you are a US person who made a transfer of assets (including cash) to a foreign trust during the year. A great deal of additional information about the transfer is required, such as to whom it was made, the country, was it a gift or bequest and whether it was in exchange for an obligation.
There are three schedules, A, B and C. Under Schedule A, report any Obligations of a related trust. Under Schedule B, report Gratuitous Transfers. And under Schedule C, report any outstanding Qualified Obligations for the current tax year.
PART II – U.S. Owner of a Foreign Trust – complete this section if you are the US owner of a foreign trust. Under this section, you must indicate whether or not the foreign trust filed Form 3520-A (yet another information return).
Form 3520-A, “Annual Information Return of Foreign Trust With a US Owner,” is one of the special situations to be aware of when filing Form 3520. It is the responsibility of the trust owner to make sure this form is timely filed. In it, you report basic information about the trust (trust name, date of creation, ID number, etc.).
In Part II, you provide an Income Statement, and Part III, the Balance Sheet. The final section, the “Foreign Grantor Trust Owner Statement,” should be prepared by the trustee and a copy provided for each US owner. This statement must be attached to the US owner’s Form 3520 filing.
PART III – Distributions to a US Person from a Foreign Trust – complete this section if the US person received distributions from a foreign trust. Again, very detailed information about the distributions are required: dates, descriptions, Fair Market Value (FMV) received or transferred. Under this section, you must also describe any loans received from a foreign trust.
Following the recording of any distributions, loans, etc., you must calculate the amounts of the Trust Distributions, whether they are ordinary income, qualified dividends, short-term or long-term capital gains (or losses), unrecaptured section 1250 gain which a type of depreciation-recapture income that is realized on the sale of depreciable real estate, and taxable at a maximum 25% capital gains rate.
In Part III, there is another situation to be aware of. In this section, the trust’s undistributed net income (UNI) must be reported. Annually, the income earned by a trust is known as DNI or Distributable Net Income. DNI is used to allocate income between a trust and its beneficiaries. To prevent double taxation on income, estates and trusts are allowed to deduct the lesser of distributable net income or the sum of the trust income required to be distributed and other amounts “properly paid or credited or required to be distributed” to beneficiaries. (Investopedia)
The caveat with UNI is that it could trigger something called “the throwback rule.” The IRS uses a complex process to calculate the base tax on accumulation distributions from foreign trusts on Part III of Form 3520.
The value of these accumulated distributions can trigger additional taxes due, and it is even possible these rules could add additional tax of 100% of the value of accumulated distributions. With hidden traps such as these, it makes sense to engage a tax attorney with experience in foreign trusts and expat taxation rules.
PART IV – U.S. Recipients of Gifts or Bequests Received From Foreign Persons – complete this section if you have received gifts or bequests of $100,000 or more, from Foreign Persons. Only gifts of $5,000 or more need to be itemized. Gifts or bequests can be from individuals, trusts or estates.
Gifts received from a foreign corporation or partnership need to be reported if they exceed $16,076.
PENALTIES FOR LATE FILING OR FAILURE TO FILE
Form 3520 carries severe penalties for failure to file, the first being the greater of $10,000 or 35% of the gross value of any property transferred to a foreign trust as reported in Part I. The 35% of the gross value of the distributions received as reported in Part II or 5% of the gross value of the portion of the foreign trust’s assets treated as owned by a US person under the grantor trust rules in sections 671 through 679, for failure to report the US Owner information.
If you recall the brief discussion of Form 3520-A above, the US owner is subject to an additional 5% penalty (or $10,000, whichever is greater) if this person fails to ensure that Form 3520-A is timely filed by the trust and that each US owner and beneficiary is provided with the required annual statements. Also, of course, that all information required by the Form is complete and accurate.
If non-compliance continues for more than 90 days after the first notice of failure to comply, additional penalties will be imposed according to Section 6677, “Failure to File Certain Information with Respect to Certain Foreign Trusts.”
The rules under this section impose an additional $10,000 penalty for each 30 day period in which non-compliance continues. However, the total penalties imposed cannot exceed the gross reportable amount.
There are somewhat less severe penalties if the failure to report involves a foreign gift, being 5% of the amount of the gift. This penalty accumulates 5% each 30 day period of non-compliance, but tops out at 25%, which of course can be substantial in the case of large gifts.
It may be possible to have penalties waived if you can show a reasonable cause for a failure to file was not due to willful neglect. One interesting caveat here is that even if the country in which the trust was formed imposes penalties for disclosure of certain information about the trust, or if there are specific provisions contained within the trust to prevent disclosure of such information, these are not considered a sufficient reason for failure to file by the IRS.
Clearly, Form 3520 (and 3520-A) are highly complex tax forms, requiring an intimate knowledge and understanding of foreign taxation rules for US persons, as well as for foreign trusts and foreign gifts received. With failure-to-file penalties starting at $10,000, the stakes are too high to leave it to chance.