Editor: Kevin D. Anderson, CPA, J.D.
Late-filing penalties for foreign trust filings are significant. The amounts assessed can be devastating to clients and a significant challenge to CPAs trying to explain or eliminate them. This discussion focuses on these penalties in the context of individual taxpayers, but these reporting obligations exist for all U.S.-person taxpayers that have a filing obligation. For calendar-year taxpayers, the due date for Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner, is March 15, and the due date for Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, is April 15, though a six-month extension of time to file for either form may be obtained. Also, for Form 3520, certain U.S. citizens and residents residing outside of the United States are eligible for a June 15 due date, assuming a calendar-year-end tax year. The penalties for failure to timely file Forms 3520 and 3520-A are:
- 35% of contributions to a foreign trust (Form 3520);
- 35% of distributions received from a foreign trust (Form 3520);
- 5% of the end-of-tax-year value of the gross assets of a foreign grantor trust (Forms 3520 and 3520-A); and
- Up to 25% for failure to report the receipt of a gift or inheritance from a foreign person (Sec. 6039F(c)(1)(B)) (Form 3520).
With respect to the foreign trust reporting, if the percentage amount is less than $10,000, then the penalty will be $10,000. Furthermore, if any failure to report continues more than 90 days after the date of the mailing of a notice of that failure by the IRS, an additional penalty of $10,000 will be imposed for each 30-day period or fraction thereof for which the failure continues after the 90-day period. This additional penalty amount, however, will not exceed the reportable amount on Form 3520. In other words, the penalties for such a failure cannot exceed 100%. These penalties have no relationship to unreported income or unreported gifts. The taxpayer may have paid all income taxes associated with the activities of the foreign trust.
No penalty shall be imposed on any failure that is shown to be due to reasonable cause and not due to willful neglect (Secs. 6677(d) and 6039F(c)(2)).
First line of defense: Do not file late
To avoid filing late, the taxpayer must be aware of the obligation to file Form 3520 or Form 3520-A. Once the taxpayer is aware of the obligation to file, he or she needs to know the due dates for those filings. On its face, the determination of whether a taxpayer is involved with a foreign trust would appear to be easy, but it is not always. In addition to timely filing, the preparer needs to complete accurately the appropriate portions of the form. Preparers who do not have experience in preparing Forms 3520-A and 3520 are advised to find assistance from a CPA who does or refer the client to a CPA who has such experience. The forms are relatively short, but they contain elections that could have significant ongoing impact on the client. If a filing is incomplete, the IRS may consider the return filed as inadequate and therefore assert a late-filing penalty.
What is a trust?: To determine if you have a foreign trust, you must first determine if you even have a trust. Around the world, countries with historical ties to England often have the trust concept as part of their property law, so generally those trusts are easy to identify. Examples of common law countries or jurisdictions include Canada, Australia, New Zealand, Hong Kong, Singapore, South Africa, and many of the Caribbean island nations. Other countries, which are civil law countries, do not have the trust concept as part of their property law. Those jurisdictions may have an entity, which U.S. advisers might refer to as "foundations," that might function like a U.S. trust. The U.S. tax adviser must compare the function and activities of the entity to the definition of a trust contained in Treasury regulations to determine if the entity is a "trust" for purposes of foreign trust reporting.
The term "trust" as used in the Internal Revenue Code refers to an arrangement created by will or an inter vivos (during life) declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules of chancery or probate courts (Regs. Sec. 301.7701-4(a)). This type of trust must also be distinguished from a business trust, which for U.S. income tax purposes is generally classified as a partnership or corporation (Regs. Sec. 301.7701-4(b)). Thus, in the international context, the determination of whether a trust exists as to a given client can be challenging and complex.
Definition of a foreign trust is not intuitive: A trust is considered a domestic trust if a court within the United States can exercise primary supervision of the trust (court test) and one or more U.S. persons have the authority to control all substantial decisions with respect to the trust (control test). If a trust is not a domestic trust, then it is a foreign trust (Regs. Sec. 301.7701-7(a)(1)). One well-known international estate planning lawyer was asked to identify her favorite country to form foreign trusts. The lawyer replied, "Delaware." How could that be? A trust could be established under laws of the state of Delaware and even be governed by the Delaware courts, but if a non-U.S. person can make any substantial decision with respect to the trust, the trust will be a foreign trust for U.S. income tax purposes.
Contemplate the implications of how easy it is for a trust to become foreign. Often various parties, such as trustees, committees, trust protectors, trust advisers, and trust appointers, may be granted the power to make even one substantial decision with respect to a trust. Do we know the citizenship and/or residency status of all these parties within the trust agreement? A trust may by all appearances be a U.S. domestic trust, when in fact, it is not because a foreign person can make a substantial decision as to the trust. The inability of the client or the CPA to identify these "surprise" foreign trusts can result in sizable failure-to-file penalties. In addition, the statute of limitation on the income tax return associated with this client will likely not commence (Sec. 6501(c)(8)).
Common fact patterns requiring foreign trust reporting: Typical fact patterns that require foreign trust reporting include:
- A foreign individual pension plan is held in trust in the foreign country. Immigrants from Australia are particularly prone to exposure because of the superannuation pensions required of Australians. Americans living in Australia will have the same issue. Rev. Proc. 2014-55 and Rev. Proc. 2020-17 provide specific exemptions from the need to file and report foreign trusts with respect to certain Canadian retirement plans, tax-favored foreign retirement trusts, and tax-favored nonretirement savings trusts.
- An inbound immigrant establishes trusts in another country for income/estate tax planning prior to coming to the United States. Australians often have established irrevocable family trusts as part of common Australian planning, and upon the immigrant's arrival in the United States, those trusts will be considered foreign grantor trusts.
- A U.S. citizen living abroad establishes trusts in the foreign country for local income tax or estate planning reasons.
- A U.S. person establishes an offshore trust for international diversification of investments and possible asset protection.
- A U.S. person does U.S. estate planning and establishes a revocable trust to avoid probate. Some or all heirs are foreigners, and the successor trustees are foreign persons. The grantor/trustee dies.
- A U.S. person is a beneficiary of a foreign trust.
- A U.S. person receives a gift, bequest, or inheritance from a foreign person.
Due date for Form 3520-A: Once you have determined that you have a foreign trust, it must be classified as either a grantor trust or a nongrantor trust for U.S. income tax purposes. A foreign grantor trust has an obligation to file Form 3520-A each year if the grantor-owner is a U.S. person (Sec. 6048(b)). Assuming a calendar-year-end taxpayer, the Form 3520-A is due March 15 of the year following the calendar year for which the U.S. person grantor is reporting. The return can be extended to Sept. 15 by filing Form 7004, Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns. (See the discussion below concerning "substitute Form 3520-A" with an April 15 due date.)
The rules for determining grantor trust status are in Secs. 671–679. For those not well versed in U.S. income taxation of trusts, those rules are quite difficult to apply. And in the international context they are even more complicated because Sec. 672(f) narrows the application of the grantor trust rules significantly when the grantor is a foreign person.
Sec. 679(a)(4)(A) contains a five-year lookback rule whereby a person inbound to the United States will be considered to have made contributions to a foreign trust as of his or her residency start date of all those contributions made during the lookback period. Those contributions must be reported on a Form 3520, and if the foreign trust has any possibility of having U.S. person beneficiaries, the trust will be a grantor trust to the extent of any contribution to the foreign trust from a U.S. person (including those deemed contributions under the five-year rule). A full analysis of the grantor trust rules is beyond the scope of this discussion. If the foreign trust is not a grantor trust, then Form 3520-A should not be filed.
Compliance required for foreign grantor trust: If the trust is a foreign grantor trust, then each year both Forms 3520-A and 3520 must be filed. Form 3520-A contains extensive information about the trust along with a "Foreign Grantor Trust Owner Statement" to assist the grantor with filing his or her individual income tax return. If distributions have been made to someone other than the grantor-owner, then a statement is also prepared for that beneficiary. Form 3520, when filed in conjunction with Form 3520-A, reports the existence of the foreign grantor trust in Part II. If there were any contributions to the trust or any distributions received from the foreign grantor trust, those would also be reported. If the client fails to file both forms timely with respect to a foreign grantor trust, the IRS has imposed the 5% penalty referenced above even though one form was filed and not the other.
Substitute Form 3520-A: A Form 3520-A is prepared and signed by the trustee of the foreign trust. Oftentimes, the U.S. person may not have the full cooperation of the foreign trustee. Nevertheless, the penalty for failure to timely file Form 3520-A is imposed on the U.S. person. Considering this fact, the IRS has indicated that the U.S. person may file a "substitute Form 3520-A" by attaching the so-called substitute form to Form 3520. The attached substitute form should have a heading at the top of page one: "Substitute Form 3520-A." Since the substitute form is filed with Form 3520, the due date for the substitute form is the due date of the individual income tax return for the client. Typically, that will be April 15, rather than the March 15 due date for Form 3520-A, assuming a calendar-year-end taxpayer, though as mentioned previously, certain U.S. individual filers may have a June 15 due date. With the extension of the individual's income tax return, the Form 3520 could be filed as late as Oct. 15 (see instructions to Forms 3520A and 3520 starting in 2019 and Internal Revenue Manual (IRM) §21.8.2).
Due date for Form 3520: The due date for Form 3520 is the due date of the client's income tax return, which for an individual taxpayer will usually be April 15. That due date will be extended by filing for an extension of time to file as to the income tax return. Generally, for individuals the extended due date will be Oct. 15. As of this writing, Form 3520 contained a question concerning whether the due date had been extended. Failure to check the box and complete that line would likely result in a late-filing penalty even if the individual return was extended. Although the client would ultimately prevail if the income tax return was extended, it would be prudent to complete the line and check the box.
Forms 3520-A and 3520 are separate filings and are not attached to the Form 1040, U.S. Individual Income Tax Return. Form 8938, Statement of Specified Foreign Financial Assets, may report foreign trusts, and that form is attached to Form 1040. Schedule B, Interest and Ordinary Dividends, of the Form 1040 has a question whether the taxpayer received a distribution from, or was a grantor of, or transferor to, a foreign trust.
Second line of defense: Reasonable cause
As referenced above, no penalty shall be imposed on any failure to timely file that is shown to be due to reasonable cause and not due to willful neglect. Unfortunately, the IRS's approach of late has been to issue a penalty notice to the taxpayer assessing the penalty and communicating that the taxpayer may assert reasonable cause to have the penalty abated. The problem with this approach is that the assessment causes the IRS collection personnel to commence penalty collection. The IRS typically is generous in granting a collection hold while the taxpayer asserts reasonable cause. However, the response times for addressing the reasonable-cause relief have been extremely slow and, thus, numerous requests for extension of the collection hold may be necessary. In addition, if the taxpayer is entitled to a refund for any tax year, the IRS will apply that refund in payment of the penalty regardless of the collection hold and regardless of whether the taxpayer requested that the overpayment be applied to tax obligations of the subsequent year. Such an application most likely will cause the taxpayer to underpay his or her estimated tax obligations for the subsequent year.
Delinquent International Information Return Submission Procedure: The IRS's Delinquent International Information Return Submission Procedure is not available to most taxpayers. Any eligible taxpayer who knowingly files a late Form 3520-A and/or Form 3520 should submit the late filing using this process. The heading at the top of the late form should indicate "Filed Under Delinquent International Information Return Submission Procedure." It is hoped that by filing under this procedure and alerting the IRS to the late filing, the IRS will consider the request for abatement due to reasonable cause prior to assessing the late-filing penalty; otherwise, there would not appear to be any advantage to filing under the procedure.
Reasonable cause and not due to willful neglect: Both requirements must be satisfied to obtain an abatement of the penalties associated with foreign trust filings. The determination of whether the requirements have been satisfied depends on the facts of each situation. Starting with the second standard first, the U.S. Supreme Court has defined "willful neglect" to mean a conscious, intentional failure or reckless indifference (Boyle, 469 U.S. 241 (1985)). The other standard that must be satisfied is "reasonable cause." The Court in Boyle relied on the regulation's definition of this term as meaning the taxpayer exercised ordinary business care and prudence (id. and Regs. Sec. 301.6651-1(c)(1)). Thus, if taxpayers can show they exercised ordinary business care and prudence, they have reasonable cause for their delinquent filing.
To obtain an insight as to how the IRS approaches abatement of penalties based on reasonable cause and not due to willful neglect, practitioners should review Part 20 of the IRM. Generally, ignorance of the law or relying on an agent (e.g., a CPA) to file the forms timely will be insufficient. Well-placed, reasonable reliance on the advice of a qualified tax adviser likely will result in an abatement. Other mitigating factors that are highly relevant include a history of timely compliance with other filings, inclusion of the foreign trust income in properly filed income tax returns, and reasonably prompt filing of the late forms after determining the failure to timely file.
A full, in-depth discussion of the abatement of penalties is beyond the scope of this item. If the penalty is substantial and a CPA does not have extensive experience dealing with tax controversy matters, the CPA should seek advice from a CPA or legal counsel with that experience to properly advise the client.
Rev. Proc. 2020-17
On March 2, 2020, the IRS issued Rev. Proc. 2020-17 providing limited relief from the reporting requirements of Forms 3520 and 3520-A for certain U.S. citizens and residents who would otherwise be required to report transactions with "tax-favored foreign trusts." The taxpayer and the foreign trusts must satisfy specific requirements spelled out in the revenue procedure. (A full discussion of this revenue procedure is beyond the scope of this item.)
Generally, U.S. professionals will need advice from foreign professionals for the country in question as to whether the foreign trust satisfies the requirements. Of great importance for purposes of this item, individuals who qualify for relief under the revenue procedure may request an abatement of the penalty assessed, or a refund of the penalty paid, by filing Form 843, Claim for Refund and Request for Abatement. Relief is available only for all prior open tax years.
Compliance due diligence
Tax preparers need to proactively determine each year if a client who received a distribution was a grantor of or transferor to a foreign trust. Because of the March 15 due date for Form 3520-A, if a client is the grantor-owner of a foreign trust, this information must be acquired early in the calendar year. The compliance team should review the list of common fact patterns requiring foreign trust reporting and determine all the clients that may have a foreign trust reporting requirement. When foreign trust filing requirements are identified, place them on the due date listing and determine if specialist advice will be necessary to assist with the filing of complete and accurate forms. If foreign trust informational filings are being filed late, eligible clients should use the Delinquent International Information Return Submission Procedure. If the client receives penalty notices and abatement of the penalty is appropriate, obtain a power of attorney, obtain a hold on collection, and compose a thorough request for abatement applying the specific facts of the client's situation, considering the Boyle case, other case law, and the IRS's positions in Part 20 of the IRM.
Kevin D. Anderson, CPA, J.D., is a managing director, National Tax Office, with BDO USA LLP in Washington, D.C.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.