By Anthony Diosdi
The Form 3520 is an informational return used to report certain transactions with foreign trusts, ownership of foreign trusts, or large gifts from certain foreign persons to the Internal Revenue Service (“IRS”). The failure to correctly and timely report certain transactions with a foreign corporation or the failure to disclose certain gifts received from a foreign person can result in a penalty up to 35% of the unreported transaction or distribution. Lately, the IRS has been handing out penalties for not timely and incorrectly filing Form 3520s like its candy. Given the seriousness of these penalties, if you had transactions with foreign trusts or received foreign gifts, the Form 3520 may be the most important return you will ever file. This article is designed to introduce the reader to the Form 3520 and goes through this incredibly complicated return line-by-line.
If you are attempting to prepare the Form 3520 by yourself, you should understand that the Form 3520 is broken down into five major components. The first component is where the individual completing the form discloses basic information about the foreign trust, the individual’s name and address, the names of any U.S. beneficiaries of the foreign trust. The second component of the Form 3520 (entitled Part I “Transfers by U.S. Persons to a Foreign Trust During the Current Tax Year”) is utilized to document transfers by U.S. persons to a foreign trust. The purpose of the third component of the Form 3520 (entitled Part II “U.S. Owner of a Foreign Trust”) provides the IRS with the names of the owners of the foreign trust; The fourth and probably most complicated component of the Form 3520 (entitled Part III “Distributions to a U.S. Person From a Foreign Trust During the Current Tax Year”) documents distributions from foreign trusts to U.S. beneficiaries and calculates the U.S. tax on distributions from foreign trusts. The fifth and final component of the Form 3520 (entitled Part IV “U.S. Recipients of Gifts or Bequests Received During the Current Year From Foreign Persons”) requires U.S. persons to report the receipt of gifts or bequests from certain foreign persons.
Since we now know the Form 3520 landscape, we will now dive into each of the five components of the Form 3520 and examine the questions raised in each section of the Form 3520.
Basic Information
The first section of the Form 3520 asks the preparer of the informal return to provide basic information regarding the foreign trust and the trust beneficiaries. We will not walk the reader through the first component of the Form 3520.
Lines 1a through 1h. Questions on Lines 1a through 1i ask the name of the “U.S. person with respect to whom this form is filed and a number of other basic questions. Anyone completing the Form 3520 should know that only U.S. persons are required to file an IRS Form 3520. Nonresidents of the U.S. are not required to complete the Form 3520. For purposes of the Form 3520, a U.S. person is defined as: 1) a citizen or resident alien of the United States; 2) a domestic partnership; 2) a domestic corporation; 3) any estate (other than a foreign estate, within the meaning of Internal Revenue Code Section 7701(a)(31)(A)); and 4) any domestic trust. The U.S. person filing the Form 3520 must disclose his or her name and identification number(s) in the same order as it appears on an IRS Form 1040, IRS Form 1120, IRS Form 1065 or IRS Form 1041.
Line 1k. Question 1k asks the preparer if an extension was requested for the tax return.
If an extension of time was filed for an individual, partnership tax return, or corporate tax return associated with the Form 3520, the box on line 1K should be checked. In addition, the tax form number of the original tax return filed with the IRS should be stated.
Line 2a. Question 2a asks the preparer to name the foreign trust being disclosed on the Form 3520. If applicable, the name of the foreign trust being disclosed on the Form 3520 should be stated on Line 2a.
Line 2b. Question 2b asks the preparer to state the Employer Identification Number (“EIN”) of the foreign trust if applicable. The preparer of the Form 3520 should enter the EIN number of the foreign trust on Line 2b. If the foreign trust was not assigned an EIN number, and the Internal Revenue Service (“IRS”) assigned the trust a reference, the reference number should be entered on line 2b.
Line 3. Question 3 asks if the foreign trust appointed a U.S. agent who can provide the IRS “with all relevant trust information.” If the foreign trust being disclosed on Form 3520 appointed a U.S. agent that can provide the IRS with information about the trust, the preparer should check “Yes” in the applicable box. A U.S. agent is a U.S. person that has a binding contract with a foreign trust that allows the U.S. person to act as the trust’s authorized U.S. agent with respect to: 1) any request by the IRS to examine records or produce testimony related to the proper U.S. tax treatment of amounts distributed, or required to be taken into account under the rules of Sections 671 through 679 (grantor trust rules to be defined later), with respect to a foreign trust; or 2) any summons by the IRS for such records or testimony. If the preparer checked “Yes,” in the box for Line 3, the preparer should complete lines 3a through 3g. Lines 3a through 3g ask the preparer to disclose the name of the U.S. agent and the agent’s contact information.
Lines 4a through 4f. Questions on lines 4a through 4f are to be answered when the Form 3520 is being prepared on behalf of a decedent. Questions 4a through 4f ask for the name of the decedent, address, date of death, and identification numbers. The preparer must provide information about the decedent on lines 4a through 4e. The preparer must also check the applicable box on line 4f to indicate which of the following applies: the U.S. decedent made a transfer to a foreign trust by reason of death, the U.S. decedent was treated as the owner of a portion of a foreign trust immediately prior to death, or the estate of the decedent included assets of a foreign trust.
Part I- Transfers by U.S. Persons to a Foreign Trust During the Current Tax Year
Part I of Form 3520 asks the preparer to provide information regarding transfers by U.S. persons to a foreign trust during the current tax year. We will not walk the reader through Part I of the Form 3520.
Line 5a. Question 5a asks the preparer to state the name of the trust creator. If the individual who the Form 3520 is being prepared for was the trust creator, the preparer should enter “Same as line 1a” on line 5a. If the individual or entity who the Form 3520 is being prepared is not the trust creator, the preparer should enter the name of the person who created or originally settled the foreign trust.
Line 5b. Question 5b asks the preparer to enter the address of the trust creator.
Line 5c. Question 5c asks the preparer to enter the identification number of the trust creator.
Line 6a and Line 6b. Questions 6a and Line 6b ask the preparer to enter the code of the country where the trust was created and whose law governs the trust. The preparer should enter the applicable two-letter country code from the list at irs.gov/CountryCodes.
Line 6c. Question 6c asks the preparer to state the date the trust being disclosed on the Form 3520 was created.
Lines 7a. Question 7a asks the preparer to state “Yes” or “No” if there is any person (other than the foreign trust) that can be treated as the owner of the transferred assets after the transfer. If the preparer answers “Yes” to question 7a, the preparer must complete question 7b and part II.
When considering how to answer question 7a, it is important to understand the grantor trust rules of the Internal Revenue Code. If a U.S. person is an owner of any portion of the foreign trust under the grantor trust rules, that individual must be disclosed on Line 7b. The grantor trust rules are defined in Internal Revenue Code Sections 671 through 679. Under the grantor trust rules, a grantor or third person is required to include in his or her personal income U.S. income tax computations those items of income, deduction, and credit allocable to any portion of a trust that such grantor or third person is deemed to own under the grantor trust rules. A “grantor” for purposes of Internal Revenue Code Section 679 is defined in Prop. Regs. Section 1.671-2(e) to include any person who acquires an interest in a trust in a non-gratuitous transfer from a person who is a grantor of the trust. In addition, if one person creates or funds a trust primarily as an accommodation for another person, the other person will be treated as a grantor with respect to such a portion of the trust. If a foreign trust is a grantor trust (within the meaning of Sections 671 through 679), its income and gains will be taxed to the grantor. In contrast, a non-grantor trust is a separate taxpayer for U.S. tax purposes. If the trust received transfers from third parties under the grantor trust rules, these transfers must be disclosed on Line 7b.
If the preparer is reporting multiple transfers to a single foreign trust, the preparer must complete a separate line for each transfer on duplicate copies of the relevant pages of the form.
Line 8. Question 8 asks if any transfer to the trust was a gift or bequest. The question requires a “Yes” or “No” answer. Whether or not a transfer can be defined as a complete gift is defined in Regulation Section 25.2511-2. If a U.S. person made a complete gift to a foreign trust, he or she may be required to disclose the gift on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return to the IRS. If the transfer was a bequest, the U.S. person may need to disclose the bequest on Form 706, U.S. Estate Tax Return to the IRS.
Lines 9a and 9b. Questions 9a and 9b ask the preparer if now or any time in the future, can any part of the income or corpus of the trust benefit any U.S. beneficiary. This question requires a “Yes” or “No” answer. If the answer is “No,” the preparer is directed to answer question 9b which asks if the trust could be revised or amended to benefit a U.S. beneficiary. The preparer must answer “Yes” or “No.”
Schedule A- Obligation of a Related Trust
Schedule A of Part I must be completed to report all transfers related to the foreign trust in exchange for an obligation of the trust or a “person related” to the trust that took place during the current tax year. A “related person” is defined as brothers or sisters (whole or half-blood), spouses, and lineal descendants. A related party is also a corporation in which a transferor or transferee owns directly or indirectly more than 50% of the corporation’s outstanding stock.
Line 11a. Question 11a asks the preparer if during the current year if there was a transfer of property to a related foreign trust in exchange for an obligation of the trust or an obligation of a person related to the trust. This question requires a “Yes” or “No” answer. The reason that the IRS wants to know if property was transferred to a foreign trust in exchange of an obligation of the trust is because certain transfers of “obligations” are treated as taxable distributions. For purposes of Form 3520 reporting, an “obligation” includes bonds, notes, debentures, certifications, bills or notes receivable, open accounts, annuity contracts or any other evidence of indebtedness.
If the preparer answers “No” in response to Question 11a, the form directs the preparer to question 11b.
Line 11b. Question 11b asks the preparer if any of the obligations received from the foreign trust described in line 11a are “qualified obligations” and if so, the preparer must list the qualified obligations. Determining whether or not an obligation is “qualified” is terribly important because unlike ordinary obligations, “qualified obligations” will not be treated as a taxable distribution from a foreign trust. According to Internal Revenue Code Section 684 and IRS Notice 97-34 a “qualified obligation” can be defined as: 1) an obligation reduced to writing by an express written agreement; 2) the term of the obligation does not exceed 5 years; 3) all payments on the obligation are denominated in U.S. dollars; 4) the yield to maturity is between 100 to 130 percent of the applicable adjusted federal rate.
Line 12. If a preparer takes the position that any obligation is a “qualified obligation,” the preparer must agree to extend that statute of limitations on assessments to a date 3 years after the maturity date of the obligation otherwise the obligation will not be treated as a “qualified obligation” by the IRS.
Schedule B- Gratuitous Transfers
Schedule B is utilized to report any gratuitous transfers to a foreign trust. In order to properly complete Schedule B of Form 3520, the preparer must understand the meaning of a “gratuitous transfer.” A gratuitous transfer to a foreign trust is any transfer to the trust other than (a) a transfer for fair market value (“FMV”); or (b) a distribution to the trust with respect to an interest held by the trust (i) in an entity other than a trust (for example, a corporation or a partnership), or (ii) in an investment trust described in Treasury Regulation 301.7701-4(c), a liquidating trust described in Treasury Regulation Section 301.7701-4(d), or an environmental remediation trust described in Treasury Regulation 301.7701-4(e). A transfer of property to a trust may be considered a gratuitous transfer without regard to whether the transfer is a gift for gift tax purposes. For purposes of this determination, if a U.S. person contributes property to a trust in exchange for any type of interest in the trust, such interest in the trust will be disregarded in determining whether FMV has been received. In addition, a U.S. person will not be treated as making a transfer for FMV merely because the transferor is deemed to recognize gain on the transaction.
Line 13. Question 13 asks the preparer to attach a copy of each sale or transfers (directly or indirectly) to the trust and receive less than FMV or no consideration at all, for the property transferred. The question calls for a “Yes” or “No” answer.
If the answer to line 12 is “Yes,” columns (a) through (i) should be completed.
(a) Enter date of transfer of property.
(b) Enter description of property and indicate whether property transferred is tangible or intangible.
(c) Enter the fair market value of the property transferred.
(d) Enter the U.S. adjusted basis of the property transferred.
(e) Enter the gain that is immediately recognized at the time of the transfer.
(f) If the reported transaction is a sale, report the gain on the appropriate form or schedule of the tax return.
(g) Enter the description of the property received.
(h) Enter the fair market value of the property received.
(i) Enter the excess of column (c) over column (h).
Line 14. Question 14 tells the preparer to attach a copy of each sale or loan document entered into in connection with a transfer reported on Line 13.
Line 15. Question 15 directs the preparer to enter the names, address, whether the person is a U.S. beneficiary, and TIN, if any, of all reportable beneficiaries. Include specified beneficiaries, classes of discretionary that could be named as additional beneficiaries.
Line 16. Question 16 directs the preparer to enter the names, address of the trustee of the foreign trust, and TIN, if any.
Line 17. Question 17 directs the preparer to enter the name, address, and TIN, if any, of any person, other than those listed on line 16, that has significant powers over the trust (for example, “protectors,” “enforcers,” any person that must approve trustee decisions or otherwise direct trustees, any person with a power of appointment, any person with powers to remove or appoint, any person with powers to remove or appoint trustees, etc). Include a description of each person’s powers.
Line 18. If the preparer checked “No” on line 3, Question 18 directs the preparer to attach a copy of the following documents:
1. A summary of the terms of the trust that includes a summary of any oral agreements or understandings the filer has with the trustee, whether or not legally enforceable.
2. A copy of all trust documents (and any revisions), including the trust instrument, any memoranda of wishes prepared by the trustees summarizing the settlor’s wishes, any letter of wishes prepared by the settlor summarizing his or her wishes, and any similar documents.
3. A copy of the trust’s financial statements, including a balance sheet and an income statement similar to those on Form 3520-A. These financial statements must reasonably reflect the trust’s accumulated income under U.S. income tax principles.
Schedule C- Qualified Obligations Outstanding in the Current Tax Year.
The purpose of Schedule C is to report “qualified obligations.” The term “qualified obligation” is discussed above.
Line 19. Question 19 asks the preparer if at any time during the tax year did the foreign trust (or a person related to the trust) report a “qualified obligation” in the current year. This is a “Yes” or “No” question. If “Yes,” columns (a) through (e) must be completed.
(a) Enter the date of the original obligation.
(b) Enter the tax year the qualified obligation was first reported.
(c) Enter the amount of principal payments made during the tax year.
(d) Enter the amount of interest payments made during the tax year.
Part II- U.S. Owner of a Foreign Trust
The purpose of Part II of Form 3520 is to disclose the U.S. owners of a foreign trust. Part II should not only be included by named beneficiaries of a foreign trust, but also individuals that can be considered as owners of a foreign trust under the grantor trust rules of Sections 671 through 679 during the tax year. We will not walk the reader through Part II of the Form 3520.
Line 20. Question 20 asks the preparer to enter information regarding any person, including the filer, who is considered the owner of any portion of the trust under Sections 671 through 679. Question 20 also asks the preparer to enter in column (e) the specific Code section that causes the beneficiary and any other person to be considered an owner for U.S. income tax purposes to be an owner of the trust. In answering this question, the preparer must consider a number of Internal Revenue Code provisions that can cause another person to be considered the owner of a foreign trust. In particular, the preparer must consider the very purpose of the enactment of Internal Revenue Code Section 679. Internal Revenue Code Section 679 was enacted to make virtually all foreign trusts settled by U.S. persons as not only taxable in the U.S. but also owners of such a trust.
Line 21(a) and Line21(b). Questions 21(a) and (b), enter the applicable two-letter code from the list at IRS.gov/CountyCodes where the foreign trust was created and the country code whose laws govern the foreign trust.
Line 21(c). Question 21(c) asks the preparer to provide the country code where the foreign trust was created, country code whose laws govern the foreign trust, and the date the foreign trust was created.
Line 22. Question 22 asks if the foreign trust filed a Form 3520-A for the current year. This is a “Yes” or “No” question. If “Yes” the copy of the “Foreign Grantor Trust Owner Statement” (pages 3 and 4 of Form 3520-A) should show the amount of the foreign trust’s income that is attributable to the beneficiary for U.S. income tax purposes. If the answer is “No,” to this question, the IRS asks the preparer to complete and attach a substitute Form 3520-A for the foreign trust to the Form 3520 by the due date of the Form 3520 (and not the due date for the Form 3520-A). For those that do not know the meaning of a “Foreign Grantor Trust Owner Statement,” think of a “Foreign Grantor Trust Owner Statement” as an informational return that determines a trust beneficiary’s individual income tax liabilities similar to a K-1 issued by a domestic trust.
Line 23. Question 23 asks the preparer to enter the gross value of the portion of the foreign trust that the filer treated as owning at the end of the tax year.
This question requires the preparer to enter the FMV of the trust assets that the beneficiary is treated as owning. This includes all assets at FMV as of the end of the tax year. For this purpose of answering this question, the preparer is told to disregard all liabilities.
Part III- Distribution to a U.S. Person From a Foreign Trust During the Current Tax Year
Part III of Form 3520 is used to determine the taxable distributions from a foreign trust to a U.S. beneficiary or owner of a foreign trust. We will not walk the reader through Part III of the Form 3520
Line 24. Question 24 asks the preparer to disclose the cash amounts or FMV of property received, directly or indirectly, during the current tax year, from the foreign trust (excluding loans and uncompensated use of trust property included on line 25). To answer this question, the preparer must report any cash or the FMV of other property the beneficiary received (actually or constructively, directly or indirectly) from a foreign trust trust during the current tax year, whether or not taxable, unless the amount is a lent to the beneficiary from the trust or constitutes uncompensated use of trust property, both of which must be reported on line 25. Question 24 requires an itemization of the distributions received in the columns discussed below:
(a) Date of distribution.
(b) Description of property received.
(c) FMV of property received.
(d) Description of property transferred.
(e) FMV of property transferred.
Line 25. Question 25 asks if during the tax year, the beneficiary (or a person related to the beneficiary) received a loan or uncompensated use of trust property from a related foreign trust. This is a “Yes” or “No” question. If the beneficiary or a U.S. person related to the beneficiary received a loan of cash or marketable securities, directly or indirectly, from a related foreign trust, or the uncompensated use of trust property, the amount of such loan or the FMV of the use of the trust property will be treated as a reportable distribution, whether or not taxable. For this purpose, a loan to the beneficiary or by an unrelated third party that is guaranteed by a foreign trust is generally treated as a loan from the trust.
If the preparer answers “Yes,” the preparer must complete columns (a) through (g) for each loan or use of trust property.
(a) FMV of loan proceeds or property.
(b) Date of original transaction.
(c) Maximum term of repayment of obligation.
(d) Interest rate of obligation.
(e) Is the obligation a “qualified obligation.”
(f) FMV of the qualified obligation.
(g) Amount treated as distribution from the trust (subtract column (f) from column (a)).
Line 26. Question 26 asks if any of the obligations reported on Question 25 can be treated as a qualified obligation.
Line 27. Question 27 asks what the total distributions received during the current tax year. This question asks the preparer to add line 24 of column (f) and line 25 of column (g).This is the total amount of the trust distributions received by the beneficiary from a foreign trust that is classified as a “nongrantor trust” in the tax year.
Line 28. Question 28 asks if at any time during the current tax year the trust held an outstanding obligation of yours (or a person related to you) that you reported as a “qualified obligation”? This question calls for a “Yes” or “No” answer. If the preparer answered “Yes” to question 28, the preparer is instructed to complete columns (a) through (e) below for each obligation.
(a) Date of original loan transaction.
(b) Tax-year qualified obligation was first reported.
(c) Amount of principal payments made during the tax year.
(d) Amount of interest payments made during the tax year.
(e) Does the qualified loan still meet the criteria of a qualified obligation.
Line 29. Question 29 asks if the beneficiary received a “Foreign Grantor Trust Beneficiary Statement” from the foreign trust with respect to the distribution. This question calls for a “Yes” or “No” answer. If you answered “Yes” to question 29, attach the “Foreign Grantor Trust Beneficiary Statement” (page 5 of Form 3520-A) from the foreign trust and do not complete the rest of Part III with respect to the distribution. If a U.S. beneficiary receives a complete “Foreign Grantor Trust Beneficiary Statement” with respect to a distribution during the tax year, the beneficiary should treat the distribution for income tax purposes as if it came directly from the owner.
In addition to the basic identifying information (name, address, TIN, etc) about the foreign trust and its trustee, this statement must contain these items:
1. The first and last day of the tax year of the foreign trust to which this statement applies.
2. An explanation of the facts necessary to establish that the foreign trust should be treated for U.S. tax purposes as owned by another person. (The explanation should identify the Internal Revenue Code Section that treats the trust as owned by another person).
3. A statement identifying whether the owner of the trust is an individual, trust, corporation, or partnership.
4. A description of property (including cash) distributed or deemed distributed to the U.S. person during the tax year, and the FMV of the property distributed.
5. A statement that the trust will permit either the U.S. beneficiary to inspect and copy the trust’s permanent books of account, records, and such other documents that are necessary to establish that the books should be treated for U.S. tax purposes as owned by another person. This statement is not necessary if the trust has appointed a U.S. agent.
6. A statement as to whether the foreign trust has appointed a U.S. agent. If the trust has a U.S. agent, include the name, address, and TIN of the agent.
If the preparer answered “No,” the preparer is instructed to complete Schedule A with respect to the distribution.
Line 30. Question 30 asks if the beneficiary received a “Foreign Nongrantor Trust Beneficiary Statement” from the foreign trust with respect to a distribution. This question calls for a “Yes” or “No” answer. If you answered “Yes,” attach the “Foreign Nongrantor Trust Beneficiary Statement” from the foreign trust. A “Foreign Nongrantor Trust Beneficiary Statement” must include the following items:
1. An explanation of the appropriate U.S. tax treatment of any distribution or deemed distribution for U.S. tax purposes, or sufficient information to enable the U.S. beneficiary to establish the appropriate treatment of any distribution or deemed distribution for U.S. tax purposes.
2. A statement identifying whether any grantor of the trust is a partnership or a foreign corporation. If so, attach an explanation of the relevant facts.
3. A statement that the trust will permit either the IRS or the U.S. beneficiary to inspect and copy the trust’s permanent books of account, records, and such other documents that are necessary to establish the appropriate treatment of any distribution or deemed distribution for U.S. tax purposes. This statement is not necessary if the trust has appointed a U.S. agent.
4. The “Foreign Nongrantor Trust Beneficiary Statement” must also include the name, address, TIN numbers of the foreign trust and its trustees.
In addition, you must complete either Schedule A or Schedule B. If the preparer answered “No,” the preparer must complete Schedule A with respect to that distribution.
Schedule A- Default Calculation of Trust Distributions
Lines 25 through 30 are utilized to determine the amount of trust distributions a foreign trust beneficiary or foreign trust owner has received during the tax year. Now that we know the amount of trust distribution, it is time to compute the federal income tax due as a result of the trust distributions. As you may recall, Question 30 asked whether the foreign trust beneficiary or foreign trust owner received a “Foreign Nongrantor Beneficiary Statement.” If the answer is “No,” the preparer must complete Schedule A of Part III of Form 3520 to calculate whether the trust distributions can be classified as ordinary income for tax purposes or whether the trust distributions will be characterized as a distribution of accumulated earnings.
Line 31. Question 31 asks the preparer to enter the amount from line 27.
Line 32. Question 32 asks the preparer the number of years that the trust has been a foreign trust. When answering question 32, the preparer should know that the instructions instruct the preparer to the best of his or her knowledge, state the number of years the trust has been in existence as a foreign trust and attach an explanation of the preparer’s basis for this statement. Consider any portion of a year to be a complete year. If this is the first year that the trust has been a foreign trust, the preparer should not complete the rest of Part III.
Line 33. Question 33 asks the preparer to provide the total distributions received from the foreign trust during the preceding three years (or during the number of years the trust has been a foreign trust, if fewer than three years). To answer this question, the preparer must enter the total amount of distributions that the beneficiary received from the foreign trust during the three preceding tax years. For example, if a trust distributed $50 in year 1, $120 in year 2, and $150 in year 3, the reported amount on line 33 would be $320 ($50 + $120 + $150).
Line 34. Question 34 asks the preparer to multiply line 33 by 1.25 percent.
Line 35. Question 35 asks the preparer to determine the average distribution of the foreign trust. To make this determination, the preparer must divide line 34 by 3 (or the number of years the trust has been a foreign trust, if fewer than 3). For example, a foreign trust created on July 1, 2017, would be treated on a 2019 calendar year as having 2 preceding years (2017 and 2018). In this case, the preparer would calculate the amount on line 35 by dividing line 34 by 2.
Line 36. Question 36 asks the preparer to compute the ordinary income amount of this year’s distribution. Ordinary income is the amount stated on line 35. In other words, the foreign trust beneficiary or foreign trust owner is given a 125 percent of the prior three years average trust distribution as ordinary income.
Line 37. Question 37 asks the preparer to determine the accumulation distribution of the foreign trust. This is the excess of the distribution received this year (line 31) over 125% of the average distribution for the prior three years (line 35). Once this question is complete, the preparer can determine if the trust beneficiary or trust owner must calculate tax on accumulated distributions. If line 37 has a number greater than zero, then the preparer must complete a separate IRS Form 4970 to calculate the tax on accumulated distributions.
Line 38. Question 38 asks the preparer to determine the applicable number of years of the trust. This is done by dividing line 32 by 2 and entering the result.
Schedule B- Actual Calculation of Trust Distributions
Schedule B Part III is entitled “Actual Calculation of Trust Distributions.” Schedule B determines the U.S. taxable income of the foreign trust. In order to complete this schedule of the Form 3520, it is necessary to understand how a foreign trust is taxed. In calculating its taxable income, a foreign trust will receive a deduction for distributions to its beneficiaries; the concept of “distributable net income” (“DNI”) for the taxable year is important. Foreign trusts must include both capital and ordinary income items in their DNI. Distributions to beneficiaries are considered first to carry out the DNI of the current year (pro rata to each item of income) and will be taxed to each U.S. beneficiary.
If a foreign trust does not distribute all of its DNI in the current tax year, the undistributed DNI will be reclassified as “undistributed net income” (“UNI”). Distributions of the UNI of a foreign trust received by a U.S. beneficiary are taxed under the “throwback rule.” This rule treats a beneficiary as having received the income in the year in which it was earned by the trust. See IRC Section 667. The throwback rule results in tax being assessed at the beneficiaries’ highest marginal income tax rate for the year in which the income or gain was earned by the trust. This means that capital gains accumulated by a foreign trust are treated as ordinary income for tax purposes. In addition, an interest charge accrues for the period beginning with the year in which the income or gain is recognized and ending with the year that the UNI amount is distributed, and is assessed at the rate applicable to underpayments of tax (compounded daily).
In order to avoid the harsh throwback rules, the Department of Treasury and the IRS allows U.S. trust beneficiaries of a foreign trust to utilize the so-called “default method.” Under the default method, they are only taxed on the portion of a foreign trust distribution that exceeds 125 percent of the average distribution received during the prior three years is subject to the compounded interest charge application.
Line 39. Question 39 directs the preparer to enter the amount from Line 27.
Line 40a. Question 40a asks the preparer to enter the amount distributed from the foreign trust as ordinary income. Line 40a the amount received from the foreign trust treated as ordinary income for the current tax year. Ordinary income is all income that is not capital gains.
Line 40b. Question 40b asks the preparer to disclose qualified dividends. Qualified dividends are typically dividends from shares in domestic corporations and certain foreign corporations held for at least one year.
Lines 41a. and 41b. Questions 41a and 41b ask the preparer to disclose accumulated distributions (this includes amounts that are tax exempt and non-tax exempt). Line 41a and Line 41b includes any accumulated distributions whether tax exempt from U.S. tax or not.
Lines 42a, 42b, 42c, and 42d. Questions 42a, 42b, 42c, and 42d ask the preparer to disclose short-term, long-term, and unrecaptured capital gains. Lines 42a, 42b, 42c, and 42d include amounts received from the foreign trust that is treated as capital gains.
Line 43. Question 43 asks the preparer to disclose amounts treated as distributions from the trust corpus.
Line 44. Question 44 asks the preparer to disclose amounts received from the foreign trust not included on lines 40a, 41a, 42a, 42b, and 43.
Line 45. Question 45 asks the preparer to disclose the amount of aggregate UNI.
This question requires the preparer to disclose the foreign trust’s aggregate UNI. For example, assume that a trust was created in 2013 and has made no distributions prior to 2019. Assume the trust’s ordinary income was $0 in 2018, $60 in 2017, $124 in 2016, $87 in 2015, $54 in 2014, and $25 in 2013. Thus, for 2019, the trust’s UNI would be $350. If the trust earned $100 and distributed $200 during 2019 (so that $100 was distributed from accumulated earnings), the trust’s 2020 aggregate UNI would be $250 ($350 + $100 – $200).
Line 46. Question 46 asks the preparer to disclose the amount of the trust’s weighted UNI.
The foreign trust’s weighted UNI is its accumulated income that has not been distributed, weighted by the years that it has accumulated income. To calculate weighted UNI, multiply the undistributed income from each of the trust’s years by the number of years since that year, and then add each year’s results. The instructions promulgated for Form 3520 provide guidance how to calculate weighted UNI as follows:
To calculate a foreign trust’s UNI:
1. Begin with 2019 weighted UNI.
2. Add UNI at the beginning of 2019.
3. Add trust earnings in 2019.
4. Subtract trust distributions in 2019.
5. Subtract weighted trust accumulation distributions in 2019 (Weighted trust accumulation distributions are the trust accumulation distributions in 2019 multiplied by the applicable number of years from 2019).
| Year | No of years Since That Year | UNI from each year | Weighted UNI |
| 2018 | 1 | $0 | $0 |
| 2017 | 2 | 60 | 120 |
| 2016 | 3 | 124 | 372 |
| 2015 | 4 | 87 | 348 |
| 2014 | 5 | 54 | 270 |
| 2013 | 6 | 25 | 150 |
Using the example above, the foreign trust’s 2020 weighted UNI would be $1,150, calculated as follows:
2019 weighted UNI $1,2
UNI at beginning of 2019 + 3
Trust earnings in 2019 +1
Trust distributions in 2019 – 2
Weighted trust distributions in 2019
($100 x 3.6) -3
2020 weighted UNI $1,1
Line 47. Question 47 asks the preparer to calculate the trust’s number of years by dividing line 46 by line 45. Line 47 is determined by calculating the trust’s applicable number of years by dividing line 46 by line 45. This would be the weighted UNI divided by the annual UNI. Using the examples in the instructions for lines 45 and 46, the foreign trust’s applicable number of years would be 3.6 in 2019 (1,260/350) and 4.6 in 2020 (1,150/250).
Schedule C- Calculation of Interest Charge
Schedule C entitled “Calculation of Interest Charge” calculates the interest charge on any UNI of the foreign trust. The preparer must complete Schedule C if there was an amount entered on line 37 or line 41a.
Line 48. Question 48 requires the preparer to enter the distribution amount from line 37 or line 41a.
Line 49. Question 49 requires the preparer to include the total accumulation distribution from line 28 of Form 4970. The preparer must include the amount from line 48 of the Form 3520 on line 1 of Form 4970, Tax on Accumulation Distribution of Trusts. Then the preparer must compute the tax on the total accumulation distribution using lines 1 through 28 on Form 4970. Finally, the preparer must enter line 49 the tax from line 28 on Form 4970.
Line 50. Question 50 requires the preparer to enter the applicable number of years of the foreign trust from line 38 or 47.
Line 51. Question 51 requires the preparer to combine the interest rate on the total accumulation distribution. Interest accumulates on the tax from line 49 for the date beginning on the date that is the applicable number of years prior to the applicable date and ending on the applicable date. For the purposes of making this interest calculation, the applicable date is the date that is mid-year through the tax year for which reporting is made. For portions of the interest accumulation period that are prior to 1996 (and after 1976), interest accumulates at a simple rate of 6 percent annually, without compounding. For portions of the interest accumulation period that are after 1995, interest is compounded daily at the rate imposed on underpayments of tax under Internal Revenue Code Section 6621(a)(2).
Line 52. Question 52 requires the preparer to disclose the interest charge by multiplying the amount on line 49 by the combined interest rate on line 51.
Line 53. Question 53 requires the preparer to disclose the tax attributes to accumulation distributions. The preparer must report this amount as additional tax (“ADT”) on the appropriate line of the U.S. beneficiary’s tax return. For individual taxpayer’s, ADT is disclosed on line 8 on Schedule 2.
IV. U.S. Recipients of Gifts or Bequests Received During the Current Tax Year from Foreign Persons
Part IV is not utilized to report distributions from foreign trusts. Rather, Part IV of Form 3520 is utilized to report gifts from certain foreign persons or entities.
Line 54. Question 54 asks the preparer to disclose any foreign received from a nonresident alien or foreign trust that exceeds $100,000. The preparer must answer “Yes” or “No” to this question.
If the preparer answers “Yes,” the columns for line 54.
To calculate the threshold amount of $100,000, the preparer must aggregate gifts from different foreign nonresident aliens and foreign estates. In addition, line 54 requires the preparer to disclose foreign gifts that exceed $5,000 on line 54.
Line 55. This question requires the preparer to disclose gifts received from foreign corporations or foreign partnerships that exceed $16,388 on the columns for line 55.
Line 56. This question requires the preparer to answer whether he or she had reason to believe that a foreign donor made a gift or bequest the beneficiary acted as a nominee or intermediary for any other person.
Conclusion
A U.S. person who receives a distribution, directly or indirectly, from a foreign trust is required to report a number of matters relevant to the trust on Form 3520, including the name of the trust and the aggregate distribution received during the tax year. For this purpose, a distribution from a foreign trust includes any gratuitous transfer of money or property from a foreign trust, whether or not the trust is deemed to be owned by another person (such as a foreign person). A reportable distribution from a foreign trust includes the receipt of trust corpus. U.S. persons that received gifts from nonresident aliens or foreign estates in the aggregate of more than $100,000 must also disclose the gift on the Form 3520. Finally, U.S. persons that received certain gifts from a foreign corporation or a foreign partnership may be required to disclose the gift on a Form 3520. Failure to timely file a Form 3520 and/or accurately complete the Form 3520 must result in a civil penalty of 35% on the gross amount of the unreported portion of the distribution. The Form 3520 is complicated and given what’s at stake, should only be prepared by a professional with significant experience in internal tax compliance matters.
Anthony Diosdi is an international tax attorney at Diosdi Ching & Liu, LLP. As an international tax attorney, Anthony Diosdi advises clients in areas of international tax planning and international tax compliance throughout the United States, Asia, Europe, Australia, anada, and South America.
Diosdi Ching & Liu, LLP also has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.