United States persons with foreign assets are subject to an ever expanding universe of reporting requirements. A prime example of this can be found in Internal Revenue Code Section 667(a). This Internal Revenue Code Section provides that if a United States person beneficiary receives (directly or indirectly) a distribution from a foreign trust, that person is required to make a return with respect to such a trust using Internal Revenue Service (“IRS”) Form 3520, and show thereon the name of the trust, the amount of the aggregate distribution received, and any other data the IRS may require. A foreign gift, bequest, or inheritance that exceeds $100,000 from a nonresident must also be disclosed on a Form 3520.
This article will take a deep dive into Form 3520 and discuss each schedule and line of the form. This article is designed to supplement the IRS’ instructions to Form 3520.
Who Must File a Form 3520
A Form 3520 must be filed if any one of the following apply.
1) A Form 3520 must be filed with the IRS by a responsible party for reporting a reportable event that occurred during the current tax year or an individual that is a U.S. person who transferred property (including cash) to a related foreign trust (or a person related to the trust) in exchange for an obligation or a qualified obligation from that trust that is currently outstanding.
2) A Form 3520 must be filed by a U.S. person (In the case of individuals, a U.S. person means any one of the following: 1) a U.S. citizen; 2) A U.S. lawful permanent resident (i.e., a “green card holder;” and 3) an individual who satisfies the substantial presence test) who, during the current tax year, is treated as the owner of any part of the foreign trust under the rules of Section 671 through 679 (discussed below).
3) A Form 3520 must be filed by a U.S. person (including a U.S. owner) or an executor of the estate of a U.S. person who received, directly or indirectly, a distribution from a foreign trust during the current year; or you are a U.S. person who is a U.S. owner or beneficiary of a foreign trust and in the current year you or a U.S. person related to you received 1) a loan of cash or marketable securities (including an extension of credit) directly or indirectly from such foreign trust, or 2) the uncompensated use of trust property; or the person filing the Form 3520 is a U.S. owner of a foreign trust or beneficiary of a foreign trust and in the current year such foreign trust holds an outstanding qualified obligation (discussed below) of the U.S. filer of the Form 3520.
4) A Form 3520 must be filed by a U.S. person that received a gift of more than $100,000 from a nonresident alien or a U.S. person that received a gift from a foreign corporation or foreign partnership.
When and Where to File
In general, Form 3520 is due on April 15th following the end of such a person’s tax year for income tax purposes, unless the United States person lives outside the United States. If a United States person lives outside the United States, the Form 3520 is not due until June 15th following the end of such a person’s tax year for income tax purposes. If a U.S. person is granted an extension of time to file an income tax return, the due date for filing Form 3520 is October 15th following the end of a person’s tax year.
Who Must Sign the Form 3520
The Form 3520 must be signed by the following individuals:
1. An individual or fiduciary with a duty to file the return.
2. In the cases of a partnership, the Form 3520 must be signed and dated by a general partner or limited liability company member.
3. In the case of a corporation, the Form 3520 must be signed by the president, vice president, treasurer, assistant treasurer, chief accounting officer, or any other corporate officer.
In situations where an individual is compensated for preparing the Form 3520, the paid preparer must sign the return and provide a copy of the return to the filer.
Penalties
Internal Revenue Code Section 6677 authorizes penalties for not timely filing a Form 3520. Generally, the initial penalty is the greater of $10,000 or the following: 1) 35% of the gross value of any property transferred to a foreign trust; 2) 35% of the gross value of the distributions received from a foreign trust; or 3) 5% of the gross value of the portion of the foreign trust’s assets treated as owned by a U.S. person under the grantor trust rules under Sections 671 through 679.
Section 6039F of the Internal Revenue Code also authorizes a penalty of 24% of the value of a foreign gift that was not timely reported on a Form 3520.
Part I
Lines 1a through 1i. These questions ask the name of the U.S. person with respect to whom the Form 3520 is being filed and other basic information.
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 filer must disclose its name on this subsection of the return and identification number(s) in the same order as they appear on an IRS Form 1040, IRS Form 1120, IRS Form 1065 or IRS Form 1041.
Line 1j. This question asks if an automatic extension applies to the filing of the Form 3520.
Line 1k. This question 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. This question asks the name of the foreign trust.
If applicable, the name of the foreign trust being disclosed on the Form 3520 should be disclosed on Line 2a.
Line 2b. This question asks the preparer to state the Employer Identification Number (“EIN”) of the foreign trust if applicable.
Line 3. This question 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” or “No” 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.
As discussed above, lines 4a through 4f should be answered if the Form 3520 is being prepared on the behalf of an executor of the estate of a U.S. citizen or resident. In this case, 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
Line 5a. This question asks the preparer to state the name of the trust creator.
The preparer should enter the name of the trust creator on line 5a. If the individual who the Form 3520 is being prepared on behalf of 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. This question asks the preparer to enter the address of the trust creator.
The preparer should enter the address of the trust creator on line 5b.
Line 5c. This question asks the preparer to enter the identification number of the trust creator.
The preparer should enter the identification number of the trust creator on line 5c.
Line 6a and Line 6b. These questions ask the preparer to enter the code of the country where the trust was created.
The preparer should enter the applicable two-letter country code from the list at irs.gov/CountryCodes.
Line 6c. This question asks the preparer to state the date the trust being disclosed on the Form 3520 was created.
The preparer should state the date the trust being disclosed on the Form 3520 was created on Line 6c.
Lines 7a. and 7b. 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. This question asks if a transfer to the trust was a gift or bequest.
The question requires a “Yes” or “No” answer.
Lines 9a and 9b. This question asks 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 Form 3520 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. According to the instructions for Form 3520, a “related person” generally includes any person who is related to “you” for purposes of Internal Revenue Code Sections 267 and 707(b). This includes, but is not limited to:
1. A member of “your family”- “your brothers and sisters, half-brothers and half-sisters, spouse, ancestors (parents, grandparents, etc.), lineal descendants (children, grandchildren, etc.), and the spouse of any of these persons;” or
2. A corporation in which “you, directly or indirectly, own more than 50% in value of the outstanding stock.”
Line 11a. This question 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. If “No,” the form directs the preparer to question 11b.
Line 11b. This question asks the preparer if any of the obligations received from the foreign trust described in line 11a qualified obligations.
In order to answer this question, the preparer must understand Internal Revenue Code Section 684 and IRS Notice 97-34. According to the Internal Revenue Code Section, loans of cash or marketable by a foreign trust to any grantor, beneficiary or other U.S. person related to a grantor or beneficiary is trusted as a trust distribution and is taxable. However, if a loan is made within the provisions of Internal Revenue Code Section 643(i) to a person other than a grantor or beneficiary, it will be treated as a distribution to the grantor or beneficiary to whom the person is related.
In Notice 97-34, the IRS announced that “qualified obligations” would not be subject to the provisions of Internal Revenue Code Section 643(i). A “qualified obligation” is any obligation that is 1) in writing; 2) has a maturity that does not exceed five years (and cannot be extended); 3) all payments are made only in U.S. dollars; and 4) the yield to maturity is between 100 to 130 percent of the applicable adjusted federal rate. In addition, the obligor, related grantor, or beneficiary must extend the period for assessment to date three years beyond the obligation’s maturity date and must, in addition, report the ongoing status of the obligation, including principal and interest payments on Form 3520 on Part 1, Schedule C, line 19, and Part III, Line 28, as applicable, for each year the obligation is outstanding.
If the obligations received were qualified, the preparer is required to answer “Yes” or “No.” If “Yes,” complete the rest of Schedule A and attach a copy of each loan document entered into with respect to each qualified obligation reported on line 11(b).
Line 12. Line 12 asks with respect to each qualified obligation reported on Line 11b, do you agree to extend the period of assessment of any consequential income tax changes for each year that the obligation is outstanding. The question asks for a “Yes” or “No” answer. The instructions for Form 3520 state that “you have the right to refuse to extend the period of limitations.” However, as the instructions indicate, the refusal to extend the period of limitations with respect to each qualified obligation reported on line 11b will result in such obligation not being treated as a qualified obligation.
Schedule B- Gratuitous Transfers
In order to complete Schedule B of Form 3520, the preparer must understand the meaning of a “gratuitous transfer.” According to the instructions for Form 3520, 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 gratuitous transfer includes any indirect transfer that is structured with a principal purpose of avoiding Internal Revenue Code Section 679 or Internal Revenue Code Section 6048.
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. Line 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. This question 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. This question 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 17. This question 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, this question directs the preparer to attach a copy of the following documents. If these documents have been previously attached to Form 3520-A or Form 3520 filed within the previous 3 years, the form instructs the preparers to attach only relevant updates and answer the following questions:
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. This question 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
Complete Part II if you are considered the owner of any assets of a foreign trust under the rules of Sections 671 through 679 during the tax year. The preparer is required to enter a TIN for such foreign trust on line 2b(1) or line 2b(2) on page 1 of the form.
Line 20. This question 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). In Line 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) through (c). This question 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. This question 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).
Line 23. This question 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 FMW 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 entitled “Distribution to a U.S. Person From a Foreign Trust During the Current Tax Year,” the trust beneficiary must disclose the amount received as an amount from a portion of a foreign trust of which it is treated as the owner.
Line 24. This question 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. Line 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. This question 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. This question asks for each obligation reported as a “qualified obligation,” (qualified obligations are discussed above) does the taxpayer agree to extend the statute of assessment of income or transfer tax attributable to the transaction, and any consequential income tax changes for each year that the obligation is outstanding, to a date 3 years after the maturity of the obligation? The answer asks for a “Yes” or “No” answer.
As discussed above, in order to treat an obligation as a “qualified obligation,” the beneficiary must agree to extend the statute of limitations to 3 years after the maturity of the obligation. Failure to agree to extend the statute of limitations on a “qualified obligation” can have serious tax consequences.
Line 27. This question 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).
Line 28. This question 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. This question asks if the beneficiary received a “Foreign Grantor Trust Beneficiary Statement” from the foreign trust with respect to the distribution.
For U.S. federal income tax purposes, trusts are further classified as either grantor or non-grantor trusts. The grantor-owner of a grantor trust would generally file a federal tax return to report and pay tax on the trust’s income during the grantor-owner lifetime, if otherwise required to do so. In contrast, to the extent a trust was classified as a non-grantor trust, it would generally be treated as a separate entity for federal tax purposes and subject to federal income taxation on its U.S. source income unless such income is distributed to a trust beneficiary as current trust income.
If a trust is considered a grantor trust, then all of the trust’s income, deductions, credits, and other U.S. tax effects (if any) will flow through to the owner of the trust for U.S. income tax purposes. If the owner of a grantor trust is a non-resident alien, then the non-resident alien will only be subject to U.S. income tax on the following types of income: (1) non-exempt “passive” (“FDAP”) income from U.S. sources (e.g., dividends from U.S. corporations, interest payments received from U.S. persons, rents from U.S. real estate, etc.), which is generally subject to tax at a flat thirty percent (30%) rate, without the benefit of deductions; and (2) income effectively connected with the conduct of a U.S. trade or business, including U.S. real estate gains, which is generally subject to tax at graduated rates and entitled to deductions. Thus, during the owner’s lifetime, he or she will be the only person subject to U.S. income tax with respect to the income and gains realized by the grantor trust and, assuming said income and gains are not considered U.S. source FDAP income or income effectively connected with a U.S. trade or business, said income or gains will not be subject to U.S. income tax.
The grantor trust rules generally only apply to a “grantor” who is treated as the “owner” of the assets of a trust. For purposes of the application of the grantor trust rules, a “grantor” includes any person to the extent such person either creates a trust, or directly or indirectly makes a gratuitous transfer of property to a trust. However, a person who creates a trust but makes no gratuitous transfers to the trust will not be treated as the “owner” of the assets of the trust. Currently, the grantor trust rules, in combination with Rev. Rul. 69-70, 1969 1 C.B. 182, would cause a grantor trust’s income to be taxed in its owner’s hands and be converted to principal “as if” such income had been previously taxed to the grantor. Where the grantor is a foreign person and a trust’s income is, for example, dividends from a foreign corporation, the conversion of income to principal would be accomplished with no adverse U.S. income tax consequences. Any ultimate U.S. person beneficiary could later receive such “once” accumulated income as “principal” free from U.S. income tax.
The question on line 29 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. This question 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
If question 30 was answered “Yes,” the preparer may complete either Schedule A or Schedule B. Generally, however, if the preparer completes Schedule A in the current or prior years, the preparer should understand that the beneficiary must continue to complete Schedule A for all future years.
Line 31. This question asks the preparer to enter the amount from line 27.
Line 32. This question 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. This question 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. This question asks the preparer to multiply line 33 by 1.25 percent.
Line 35. This question 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).
To answer this question, the preparer must divide line 34 by 3 (or the number of years the trust has been a foreign trust if fewer than 3). In addition, the preparer should consider any portion of a year to be a complete year. 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. This question asks the preparer to determine the amount of ordinary income earned in the current year. This question also asks the preparer to enter the smaller of line 31 or line 35 to determine the ordinary income distribution from the foreign trust.
Line 37. This question asks the preparer to determine the accumulation distribution of the foreign trust. This is done by subtracting line 36 from line 31. If the number is “0,” the preparer is instructed not to complete the rest of Part III.
Line 38. This question 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 of Form entitled “Actual Calculation of Trust Distributions” determines the U.S. taxable income of the foreign trust. In order to understand how the throwback tax rules operate, it is necessary to review the income tax rules that govern complex trusts. A complex trust is a separate taxable entity, and is taxed on its gross income, less deductions. One of these deductions which is unique to trusts is the deduction for distributions of distributable net income or (“DNI”). DNI is taxable income of the trust, with the following modifications:
1) No distribution deduction is taken;
2) No personal exemption is taken;
3) Capital gains are ordinarily excluded;
4) Capital losses are not taken, except to the extent of capital gains which are included in DNI;
5) Tax-exempt interest is included, less certain expenses.
In general, distributions that carry out DNI are deducted by the trust and taxed to the beneficiary. Moreover, if the trust has DNI, trust distributions will ordinarily “carry out” DNI whether they are in fact made from DNI or not. Generally speaking, distributed income takes the same character in the beneficiary’s hands as it had in the trust. And, unless the terms of the governing instrument specifically allocate different classes of income to different beneficiaries, a trust distribution carrying out DNI is deemed to consist of the same proportion of each class of income included in DNI as the total of each class bears to total DNI. However, in order for an allocation mandated by a trust instrument to be respected by the Internal Revenue Service (“IRS”), it must have economic effect independent of the income tax consequences.
The items of deduction entering into the computation of DNI are generally allocated in proportion to the trust’s and beneficiary’s shares of income, with certain exceptions. In certain circumstances, a trustee may not be able to determine the DNI of a nongrantor trust. In these cases, under the so-called “65-day rule,” the trustee can elect to treat all distributions made within the first 65 days of the taxable year as made within the previous year.
To the extent that DNI is not distributed, it is taxed to the trust. The after-tax amount is accumulated, and constitutes UNI or (“undistributed net income”). When the UNI is ultimately distributed, it is an “accumulations distribution,” and is subject to a “throwback tax.” If a foreign nongrantor trust makes a distribution in excess of its DNI, the U.S. beneficiary who receives the distribution will be subject to the throwback tax. The throwback tax effectively results in federal tax being levied at the recipient’s highest marginal income tax rate for the year in which the income tax rate for the year in which the income or gain was earned by the trust. This means any capital gains accumulated by a foreign trust for distribution in a later taxable year will lose its favorable rate and instead be taxed at ordinary income rates. In addition, the throwback rule adds an interest charge to the taxes on a throwback distribution in order to offset the benefits of tax deferral. The 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, as adjusted compounded daily.
Step 1: An allocation needs to be made for the accumulated income for the prior years. The accumulation distribution is deemed made from each year’s UNI beginning with the earliest year. Determining the number of years and the amounts in each year, using the UNI in an earlier year before proceeding to the later year. If the amount of accumulated income exceeds the UNI for the earliest year of the trust, the excess income is allocated to the next year for which there is any remaining UNI. This process continues from year to year until all of the accumulation distribution has been properly allocated. Each allocation of accumulated income is distributed on the last day of the year for trust accounting purposes.
Below, please see Illustration 1. which demonstrates Step 1 to calculating the throwback tax.
Illustration 1.
Tom is a beneficiary of F, a foreign nongrantor trust. F was established in 2017 by Tom’s mother who is not a citizen or resident of the United States. F distributed $100,000 to Tom in 2024, a year in which F’s DNI and trust distributed income was $20,000. Consequently, $80,000 of the distribution is treated as an accumulation distribution. F’s DNI, none of which was distributed, in each of its preceding years was as follows:
2017- $4,000
2018- $20,000
2019- $30,000
2020 – $40,000
Tom’s $80,000 accumulation distribution is deemed to have been made $4,000 on the last day of 2017, $20,000 on the last day of 2018, $30,000 on the last day of 2019, and $40,000 on the last day of 2020.
Step 2: Next, add the income taxes paid by the trust attribution to the accumulation distribution. The sum is the deemed distribution. Such taxes include U.S. and foreign income taxes.
Below, please see Illustration 2. which demonstrates Step 2 in calculating the throwback tax.
Illustration 2.
Assume that F, the trust discussed in Illustration 1, paid taxes in each of its preceding taxable years equal to 40 percent of its DNI. The total amount deemed to have been distributed to Tom on the last day of 2017, 2018, 2019, and 2020 will be $5,600, $28,000, $42,000, and $36,400 for each year respectively. Based on this example, the entire amount deemed to be “Throwback Tax” is $112,000. See Example in “The Throwback Tax, by Ellen K. Harrison, Carlyn S. McCaffrey, Amy E. Heller, and Elyse G. Kirshner, February 2015.
Step 3: Next, determine the number of preceding taxable years in which the distribution is deemed to have been made to the beneficiaries of the trust. For purposes of this calculation, if any year’s deemed distribution is less than 25 percent of the total amount of the accumulation distribution divided by the number of preceding taxable years to which the accumulation distribution is allocated, that year will not be included for purposes of calculating the throwback tax.
Below, please see Illustration 3. which demonstrates Step 3 in calculating the throwback tax.
Illustration 3.
In Illustration 1. and Illustration 2. the number of preceding taxable years in which a distribution is deemed to have been is three. The year 2017 is disregarded because the amount of the accumulation distribution allocated to that year ($4,000) is less than 25 percent of the total accumulation distribution ($80,000) divided by the number of years to which the distribution is deemed allocated is four.
Step 4: Next, it will be necessary to ascertain the beneficiary’s taxable income for the beneficiary’s five taxable years preceding the distribution. This means, it is necessary to disregard the two years with the highest and lowest taxable income.
Below, please see Illustration 4. which demonstrates Step 4 in calculating the throwback tax.
Illustration 4.
Assume that Tom’s taxable income for the 2019, 2020, 2021, 2022, and 2023 tax years was $50,000, $100,000, $200,000, $150,000, and $175,000 respectively. The year of the highest taxable income was in 2021, and the year of the lowest taxable income received in 2019 are both eliminated for purposes of this calculation. We’ll call the remaining three years the “Base Years.” Tom’s three computation years or Base Years are 2010, 2012, and 2013.
Step 5: Next, it will be necessary to determine the average annual distribution amount. This is done by dividing the amount of deemed distribution by the number of preceding years in which the distribution is deemed to have been made to the beneficiaries.
Below, please see Illustration 5. which demonstrates Step 5 in the calculation of the throwback tax.
Illustration 5.
Here, in Illustration 2, the $112,000 deemed distribution was three. Under our facts, the average annual distribution amount is $37,333 ($112,000/3 = $37,333).
Step 6: Next, it will be necessary to determine the amount by which the beneficiary’s income tax would have increased in each of the three computation years if the annual distribution amount had been added to his or her taxable income for these years. To make this calculation, no differentiation is made among the various types of income that were included in the foreign nongrantor’s trust’s UNI (other than tax-exempt income). Consequently, if a portion of the trust’s UNI was long term capital gain, the beneficiary will not receive the advantage of the lower rate that generally applies to such grants. If any foreign income were added in Step 2 to the amount deemed to have been distributed, the amount of such taxes may be allowed as a credit against the increase in tax calculation in this step.
Step 7: It will next be necessary to determine the average tax increase by dividing the sum of the three increases by three.
Step 8: Next, it will be necessary to multiply the average tax increase by the number of preceding taxable years in which the distribution is deemed to have been made as determined under Step 3.
Step 9: Finally, it will be necessary to subtract from the product obtained in Step 8 by the amount of any U.S. income taxes that were added into the calculation in Step 2. The final result is the amount of the beneficiary’s throwback tax.
Reporting UNI on the Form 3520
If a foreign nongrantor trust makes a distribution of UNI to a U.S. beneficiary, the distribution will not only be subject to the throwback tax, the distribution will also be subject to an interest charge as per Internal Revenue Code Section 668. As per the Internal Revenue Code, the interest rate charged on the throwback tax is the rate applied under Internal Revenue Code Section 6621 to underpayments of federal income tax. This interest is also compounded daily. The number of years over which interest is calculated is determined by a process which is said to produce a “dollar-weighted” number of years.
The interest charge is calculated utilizing a three step formula. This formula is set forth in Schedule C “Calculation of Interest Charge” on Form 3520. First, the UNI for each year must be multiplied by the number of years between such a year and the year of the distribution. Second, all products calculated in the first step must be added together. Finally, the sum of such products calculated in the second step must be divided by the aggregate amount of the nongrantor foreign trust’s undistributed income. The quotient is to be rounded to the nearest half-year. For purposes of this calculation, an accumulation is treated as having come proportionately from each year with respect to which there is UNI.
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.” The “default” method of calculating distributions from a foreign nongrantor trust may, under certain circumstances, enable distributions of UNI to be made to U.S. beneficiaries without triggering a throwback tax. Part III, Schedule A of Form 3520 discusses three steps to determine if accumulated earning distributions can avoid the throwback tax under the default method:
First, the U.S. beneficiary enters the total distributions he or she received from the foreign trust in the three preceding years (or the number of years that the trust has been a foreign trust, if fewer than three). Second, the U.S. beneficiary of the foreign nongrantor trust multiplies that total by 1.25. Finally, the U.S. beneficiary of the nongrantor foreign trust divides the total stated in the last step by three or by the number of years that the trust has been a foreign nongrantor trust if it was in existence less than three years. If the amount of the actual distribution from the foreign trust does not exceed the product of the final calculation, the distribution will not be subject to the throwback tax. We go through the relevant sections of the Form 3520 to determine the default method for interest charge.
First, a U.S. beneficiary of a foreign nongrantor trust must disclose on Schedule B of Form 3520, Lines 39 through 44, the type of distributions he or she received from the trust (i.e., ordinary income, qualified dividends, capital gains, and unrecaptured Section 1250 gain).
On Line 45 of Schedule B of Form 3520, the foreign trust beneficiary must disclose the aggregate UNI. For example, assume that a nongrantor foreign 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 45 and 46 of Schedule B of Form 3520, the foreign trust beneficiary must disclose the trust’s aggregate and weighted undistributed net income.
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:
Year No. of years UNI from Weighted UNI
Since that year each year
2018 1 $0 $0
2017 2 60 120
2016 3 124 372
2015 4 87 348
2014 5 54 270
2013 6 25 150
To calculate a foreign trust’s UNI discussed on the example provided for Line 45 of the Form 3520:
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).
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
Next, on Line 47 of Schedule B of the Form 3520, the foreign trust beneficiary must calculate the trust’s number of years by dividing line 46 by line 45.
According to the instructions for Form 3520, 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).
Calculating the Interest Charge on the Form 3520
A beneficiary of a foreign trust calculates the interest charge on Schedule C of the Form 3520. A beneficiary of a foreign trust must complete Schedule C of the Form 3520 if there was an amount entered on Line 37 or Line 41a of the Form 3520.
If there were amounts entered on Line 37 or Line 41a of Form 3520, these amounts must be entered on Schedule C, Line 48 and Line 49 of the Form 3520.
According to the instructions for the Form 3520, the U.S. beneficiary of a foreign trust 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 U.S. beneficiary must compute the tax on the total accumulation distribution using Lines 1 through 28 on Form 4970. The beneficiary of the foreign trust must enter Line 49 the tax from Line 28 on Form 4970.
The beneficiary of the foreign trust must then enter the applicable number of years of the foreign trust. For Line 51 of Schedule C of the Form 3520, the beneficiary of the foreign trust must combine the interest rate on the total accumulation distribution.
According to the instructions for Form 3520, 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).
The beneficiary of the foreign trust must then disclose the interest charge by multiplying the amount on line 49 by the combined interest rate on line 52 of Schedule C of the Form 3520.
Finally, on Line 53 of Schedule C of Form 3520, the beneficiary of the foreign trust must disclose the tax attributes to accumulation distributions.
IV. U.S. Recipients of Gifts or Bequests Received During the Current Tax Year from Foreign Persons
The Small Business Job Protection Act of 1996 created reporting requirements for U.S. persons that receive large gifts after August 20, 1996 from foreign persons (including foreign corporations). Federal law requires gifts or bequests valued at more than $100,000 from a nonresident alien or foreign estate to be disclosed on an IRs Form 3520. Federal law also requires gifts valued at more than $19,570 from foreign corporations or foreign partnerships (adjusted annually for inflation) to be disclosed on an IRS Form 3520.
Besides the IRS reporting requirements of a Form 3520, anyone receiving a gift from a foreign corporation or foreign partnership should know that Internal Revenue Code Section 672(f)(4) broadly authorizes regulations to recharacterize gifts or bequests, directly or indirectly, from partnerships or foreign corporations, as income in appropriate circumstances to prevent avoidance of the payment of U.S. income taxes.
Under Treasury Regulation Section 1.672(f), as a general rule, if a U.S. donee receives a purported gift or bequest directly or indirectly from a partnership, the purported gift or bequest must be included in the U.S. donee’s income as ordinary income. If a U.S. donee receives a purported gift or bequest directly or indirectly from a foreign corporation, the purported gift or bequest it also must generally be included in the U.S. donee’s gross income as a distribution from the foreign corporation. In the latter case, the U.S. donee will not be treated as having a basis in the foreign corporation, and will be treated as having a holding period in the foreign corporation equal to the average holding period (using a weighted average) of the actual interest holders. However, the gift or bequest will not be recharacterized if the donee can establish that a U.S. citizen or resident alien who directly or indirectly holds an interest in the partnership or foreign corporation treated the purported gift as a distribution from the partnership or foreign corporation and a subsequent gift to the donee, subject to consistent reporting.
Line 54. This question asks the preparer to disclose any foreign gifts 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,” complete 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 on the columns for line 55. For 2024, U.S. persons are permitted to receive $19,570 (adjusted annually for inflation) from foreign corporations or foreign partnerships tax-free.
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 bequeathed that the beneficiary acted as a nominee or intermediary for any other person.
Conclusion
The rules pertaining to preparing IRS Form 3520 and taxation of foreign trust are complex. Despite detailed instructions provided by the IRS to prepare Form 3520, there are many issues not specifically addressed by the instructions. We prepare Form 3520 and advise clients regarding the rules pertaining to the taxation of foreign trusts. We also assist other tax professionals with the preparation Form 3520 and provide guidance regarding the taxation of foreign trusts to other tax professionals.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or [email protected].
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.
Written By Anthony Diosdi
Anthony Diosdi focuses his practice on international inbound and outbound tax planning for high net worth individuals, multinational companies, and a number of Fortune 500 companies.
