By Anthony Diosdi
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 6048(b). This Internal Revenue Code Section provides that a foreign trust owner must file Internal Revenue Service (“IRS”) Form 3520-A. Each U.S. person is treated as an owner of any portion of a foreign trust under the grantor trust rules (Internal Revenue Code Sections 671 through 679) is responsible for ensuring that the foreign trust files Form 3520-A and furnishes the required annual statements to its U.S. owners and U.S. beneficiaries.
The penalty for failure to file IRS Form 3520-A will be imposed directly on the U.S. owner of the foreign trust. The penalty is equal to five percent of the value of the trust assets treated as owned by the U.S. person. If failure to comply with the reporting requirements continues, the IRS is authorized to impose additional penalties of up to $10,000 for each thirty-day period during which the failure continues after the IRS mails a notice of failure to comply with the required reporting, not to exceed the value of the gross reportable amount. Internal Revenue Code Section 6039F imposes a penalty of five percent of the amount of a foreign gift received by a U.S. person which was required to be reported on IRS Form 3520. This five percent penalty is imposed monthly until the amount is reported, not to exceed twenty-five percent of the foreign gift. The penalty is imposed on the recipient of the gift, and not the donee. In addition, Internal Revenue Code Section 6677 imposes penalties to the extent that a transaction with a foreign trust was not reported or was not accurately reported. For example, if a U.S. person were to receive a distribution from a foreign trust in the amount of $100 but only reports $50 of the amount received, Section 6677 authorizes the IRS to impose a penalty of $50 on the amount that was unreported ($100 – $50 = $50).
Finally, criminal penalties may be imposed for failure to timely file a Form 3520-A and issue its required annual statements.
Unlike individual income tax returns, IRS Form 3520, or an FBAR, a Form 3520-A does not have an April 15th filing deadline. Instead, IRS Form 3520-As typically have a filing deadline of March 15th. A separate extension must be filed with the IRS if the trust owner requests an extension of time to file the Form 3520-A.
This article will review the Form 3520-A and discuss the questions of the form. This article is designed to supplement the IRS’ instructions to Form 3520-A.
What is the Definition of a Foreign Trust for Purposes of the Form 3520-A?
The first step in the preparation of the Form 3520-A is to determine if the trust at issue is a foreign trust. Anyone preparing a Form 3520-A should understand that Internal Revenue Code Sections 7701(a)(30)(E) and (31)(B) provide the definition of U.S. and foreign trusts but do so in a way that creates a strong statutory bias in favor of foreign trust status. According to the Internal Revenue Code, a trust is a foreign trust unless both of the following conditions are satisfied: 1) a court or courts within the U.S. must be able to exercise primary supervision over administration of the trust; and 2) one or more U.S. persons have the authority to control all substantial decisions of the trust. Under this test, a trust must be a foreign trust even if it was created by a U.S. person, all of its assets are located in the U.S., and all of its beneficiaries are U.S. persons. All it takes is one foreign person who has control over one “substantial” type of trust decision. Some clarity is provided by Treasury Regulation Section 301.7701-7, which is applicable to trusts. The regulations provide that a trust is a U.S. person on any day that the trust meets both the “court test” and the “control test.”
The “court test” is the regulatory interpretation of the statutory requirement that “a court or courts within the United States is able to exercise primary supervision over administration of the trust.” The final Treasury Regulations provide a safe harbor for the court test. The safe harbor provides that a trust satisfies the court test if the following three requirements are met:
1. The trust instrument does not direct that the trust be administered outside the U.S.:
2. The trust in fact is administered exclusively in the U.S.; and
3. The trust is not subject to an automatic migration provision described in Treasury Regulation 301.7701-7(c)(4)(ii).
According to the preamble to the regulations, IRS included the court safe harbor in the final regulations because it recognized the difficulty in determining whether the courts of a particular state would assert primary supervision over the administration of a trust if that trust never appeared before any court in that state. The “control test” is the regulatory explanation of the statutory requirement that “one or more United States persons have the authority to control all substantial decisions of the trust.” Treasury Regulation Section 301.7701-7(d)(1)(ii) provides the following critical definitions.
A. “United States person” means a U.S. person within the meaning of Internal Revenue Code Section 7701(a)(30).
B. “Substantial decisions” means, all decisions other than ministerial decisions that any person, whether acting in a fiduciary capacity or not, is authorized or required to make under the terms of the trust instrument or applicable law. Such decisions, but are not limited to:
1. The timing and amount of distributions;
2. The selection of beneficiaries;
3. The power to determine whether receipts are allocable to income or principal;
4. The power to terminate the trust;
5. The power to compromise, arbitrate, or abandon claims of the trust and to decide whether to sue on behalf of or defend suits against the trust;
6. The power to remove, add or replace a trustee;
7. The power to appoint a successor trustee (even if such power is not accompanied by an unrestricted power to remove a trustee) unless the appointment power is limited in such a way that it cannot be exercised in a manner that would alter the trust’s residency; and
8. The power to make investment decisions.
C. Ministerial decisions “include decisions regarding details such as the bookkeeping, the collection of rents, and the execution of investment decisions” made by the fiduciaries.
D. “Control” means “the power, by vote or otherwise, to make all of the substantial decisions of the trust, with no other person having the power to veto any of the substantial decisions.” See The Throwback Tax, by Ellen K. Harrison, Carlyn S. McCaffrey, Amy E. Heller, and Elyse G. Kirshner (February 2015).
An analysis of the above rules should be conducted by any preparer to determine if the trust being disclosed on IRS Form 3520-A is indeed a foreign trust.
The Grantor Trust Rules
A Form 3520-A reporting requirements must only be complied by owner’s of foreign trusts. An owner of a foreign trust is the person treated as owning any of the assets of a foreign trust under the grantor trust rules. An individual will be treated as the owner of a foreign trust for Internal Revenue Code purposes if any of the following statements are true:
1. The trust is revocable. See IRC Section 676.
2. A trust will be wholly or partially a grantor trust if either the grantor of his spouse has a beneficial interest in the trust. See IRC Sections 673, 677(a)(1), 677(a)(2).
3. A trust will be a grantor trust to the extent that premiums on life insurance actually held by the trust on the life of the grantor or his spouse can be paid from trust income. See IRC Section 677(a)(3).
4. As a general rule, a trust will be a grantor trust unless the trustee’s power to make distributions is limited by an independent trustee.
5. As a general rule, a trust will be a grantor trust if anyone has the power to add to the trust beneficiaries, except to provide for after-born or after-adopted children. A testamentary power of appointment does not violate this rule. A power to assign or appoint during a lifetime does not violate this rule if the assignment or appointment would be adverse to the assignor or appointor. See Treas. Reg. Section 1.674(d)-2(b).
6. As a general rule, a trust will be a grantor trust if certain administrative powers exist with respect to the trust.
7. As a general rule, a trust will be a grantor trust if the grantor or his spouse can remove and replace the trustee. See Treas. REg. Section 1.674(d)-2(b).
8. A loan of cash or marketable securities from a foreign trust with a U.S. transferor, directly or indirectly, to a U.S. person, or the use of any other trust property directly or indirectly by any U.S. person may trigger the grantor trust rules.
The grantor trust rules should carefully be analyzed to determine if any U.S. person associated with a foreign trust has a 3520-A obligation
Part-I General Information
Question 1a. Name of the foreign trust
Question 1a Name of Foreign Trust
This question asks the preparer to state the name of the foreign trust being disclosed on the Form 3520-A.
Question 1b(1) Employer identification number
This question asks the preparer to enter the employer identification number of the foreign trust.
Only EINs should be used to identify the foreign trust. If you do not have an EIN for the foreign trust, see Form SS-4, Application for Employer Identification Number.
Question 1b(2) Reference ID number
This question asks the preparer to provide the reference ID number.
A reference ID number is required on line 1b(2) only in cases where no EIN was entered for the foreign trust on lb(1). However, filers are permitted to enter both EIN on line 1b(1) and a reference ID number on line 1b(2).
Because reference ID numbers are established by or on behalf of the U.S. owner of the foreign trust filing Form 3520-A, there is no need to apply to the IRS to request a reference number or for permission to use these numbers. The reference ID number must be alphanumeric (the term “alphanumeric” means the entry can be alphabetical, numeric, or any combination of the two). The length of a given reference ID number is limited to 50 characters. The same reference ID number must be used consistently from tax year to tax year with respect to the foreign trust.
This question asks if the foreign trust appointed a U.S. agent who can provide the IRS “with all relevant information.”
If the foreign trust being disclosed on Form 3520-A appointed a U.S. agent that can provide the IRS with information about the trust, the preparer should check “Yes” in the applicable box. Any foreign trust may appoint a U.S. Agent for purposes of responding to 1) IRS requests to examine records or produce testimony with respect to any items included on Form 3520 or Form 3520-A or 2) an IRS summons regarding such records or testimony. A U.S. Agent is a U.S. person (this can include a U.S. grantor, a U.S. beneficiary, or a U.S. corporation) as long as the agent enters into a binding contract with the foreign trust. There are serious consequences if a U.S. agent is not appointed to act on behalf of a foreign trust.
If the trust is a foreign grantor trust, the IRS can determine the items of income the foreign trust must include in the U.S. owners and beneficiaries of the trust. If the foreign trust has a U.S. agent, the preparer should check “Yes” for Question 2 and move on to line 3. If the foreign trust did not designate a U.S. agent, the preparer should check “No” for Question 2. In addition, the preparer should include the following items with the Form 3520-A: 1) a summary of the terms of the trust and all written and oral agreements and understandings with the trustee that are related to the trust; and 2) copies of all trust documents, including the trust agreement, and amendments, memoranda or letter of wishes.
In addition, the preparer must answer questions 2a, 2b, 2c, 2d, and 2e.
Questions 3a through 3g.
Questions 3a through 3g asks the preparer to disclose the number and contact information of the U.S. agent (defined above) of a foreign trust if one has been appointed.
Questions 4a through 4g.
Questions 4a through 4g asks the preparer to disclose the name and contact information of the trustee of the foreign trust.
Question 5 asks the preparer to state if the trust transferred (directly or indirectly) any property (including cash) to another person during the foreign trust’s tax year. This question calls for a “Yes” or “No” answer. If the preparer answered “Yes” to Question 5, the following information should be furnished to the IRS with the Form 3520-A:
1. Name, U.S. taxpayer identification number (if any), and country of organization or residence of the person to whom the property was transferred.
2. A general description of the transfer, and any broader transaction of which it forms a part, including a chronology of the transfers involved and an identification of the other parties to the transaction to the extent known.
3. A description of the property transferred, including the estimated FMV and the adjusted basis of the property.
4. A description of the consideration received by the trust, including its estimated FMV, and for stock or securities, the class or type, amount, and characteristics of the interest received, indicate whether the trust or a trust owner exercises any powers over the entity to which the property was transferred Including a description of such powers), and identify the name, U.S. taxpayer identification number (if any), and country of organization or residence of all beneficial owners of such entity.
5. To the extent known, a description of any subsequent transfer of the property, including the name, U.S. taxpayer identification number (if any), and country of organization or residence of the person to whom the property was subsequently transferred.
The statement furnished to the IRS must also contain a description of the trust ownership structure setting forth the name, U.S. taxpayer identification number (if any), and country of organization of all entities in which the trust has an ownership interest, including an ownership chart showing the trust’s position in the chain of ownership and the percentages of ownership.
Question six asks the preparer to state the number of “Foreign Grantor Owner Statements” included with the Form 3520-A. The “Foreign Grantor Owner Statement” will be discussed in more detail below.
Part II- Foreign Trust Income Statement
Part II of Form 3520-A is the trust’s income statement. This should include income from U.S. and non-U.S. sources. The financial statement must reasonably reflect the trust’s income. The Foreign Trust Income Statement should disclose the following sources of income:
Line 1. Interest
The preparer must report all taxable interest income on this line that was received during the tax year.
Line 2. Dividends.
The preparer must report all ordinary dividends on this line received during the tax year.
Line 3. Gross Rents and Royalties.
The preparer must report all gross rents and royalties on this line received during the tax year.
Line 4. Income (loss) from Partnerships and Fiduciaries
The preparer must report all income and losses on this line received from partnerships and fiduciaries during the tax year.
Line 5. Capital Gains (losses).
The preparer must report all capital gains and losses on this line received during the tax year attributable to a U.S. owner
Line 6. Ordinary Gains (losses).
The preparer must report the ordinary gain or (loss) on this line received from the sale or exchange of property other than capital assets or involuntary conversions (other than casualty or theft losses).
Line 7. Other Income.
The preparer must report all other income received not included on lines 1 through 6. The preparer must attach a statement to Form 3520-A if the trust has more than one item of income.
Line 8. Total Income
The trust’s total income should be disclosed on line 8.
The preparer must also disclose all expenses incurred by the foreign trust on the Foreign Trust Income Statement on Lines 9 through 14.
Line 9. Interest Expenses
The preparer must enter on this line the amount of interest paid or incurred by the trust on amounts borrowed by the trust or debt acquired by the trust. If the proceeds of a loan were used for more than one purpose, the preparer should make an interest allocation discussed in Treasury Regulation 1.163-8T.
Line 10a. Foreign Taxes
The preparer should enter on this line all foreign taxes imposed by the authority of a foreign government.
Line 10b. State and local taxes
The preparer should enter on this line state and local taxes or real property taxes paid or incurred during the tax year.
Line 11. Amortization
The preparer should enter on this line any amortization and depreciation allowed during the taxable year.
Line 12. Trustee and Advisor Fees
The preparer should enter on this line fees paid or incurred to the fiduciary for administering the foreign trust during the tax year.
Line 13. Charitable Contributions
The preparer should enter on this line any income reported on line 8 that was paid for charitable purposes allowable under Internal Revenue Code Section 170(c).
Line 14. Other Expenses
The preparer should enter items of expenses not listed on lines 9 through 13. The preparer should attach a statement to Form 3520-A if there is more than one item of “other expenses.”
Line 15. Total Expenses
The preparer should disclose the total trust’s expenses on Line 15.
Line 16. Net Income (Loss)
The trust’s net income or loss is disclosed on Line 16.
Line 17a. Fair Market Value of Distributions
Line 17a asks the preparer to disclose the fair market value (“FMV”) of total distributions from the trust to all persons whether U.S. or foreign.
According to the instructions for the Form 3520-A, a distribution includes any gratuitous transfer of money or other property from the trust. A distribution also includes constructive transfers from a trust. For example, if a beneficiary makes charges on a credit card which are paid by the foreign trust, guaranteed by the foreign trust, or secured by the assets of the foreign trust, the amount charged by the beneficiary will be treated as a distribution. Also, if a beneficiary writes checks on a foreign trust’s bank account, the amount will be treated as a distribution. In addition, if a beneficiary receives a payment from the foreign trust in exchange for property transferred to the trust or services rendered to the trust, and the FMV of the payments received by the beneficiary that exceeds the property transferred or services rendered will be treated as a distribution.
Lines 17b and 17c Distributions to U.S. Owners and Beneficiaries
Lines 17b and 17c asks the preparer to separately list the total amount of distributions (including the uncompensated use of trust property) to each U.S. owner and beneficiary. A U.S. owner of the foreign trust is the person that is treated as owning any of the assets of the foreign trust under the grantor trust rules. On the other hand, a U.S. beneficiary generally includes any person that could possibly benefit (directly or indirectly) from the trust (including an amended trust) at any time, whether or not the person is designated in the trust instrument as a beneficiary and whether or not the person can receive a distribution from the trust in the current year. In addition, a U.S. beneficiary includes:
1. A foreign corporation that is a controlled foreign corporation.
2. A foreign partnership if a U.S. person is a partner of the partnership; and
3. A foreign estate or trust if the estate or trust has a U.S. beneficiary.
In general, a foreign trust will be treated as having a U.S. beneficiary unless the terms of the trust instrument specifically prohibit any distribution of income or corpus to a U.S. person at any time, even after the death of the U.S. transferor or any event terminating the trust, and the trust cannot be amended or revised to allow such a distribution.
The preparer must list the full name, identification number, date of distribution, and FMV on the date of distribution (dollar amount) for each U.S. owner and beneficiary receiving a distribution in the proper sections of the form.
The preparer must also attach a separate “Foreign Grantor Trust Owner Statement” or “Foreign Grantor Trust Beneficiary Statement” for each U.S. owner and for each U.S. beneficiary who receives a distribution from the trust.
Part III- Foreign Trust Balance Sheet
The preparer must list all assets and liabilities of the trust, including those assets and liabilities attributable to the portion(s) of the trust (if any) not treated as owned by a U.S. person.
Form 3520-A also requires the preparer to issue “Foreign Grantor Owner Statements” and/or “Foreign Grantor Trust Beneficiary Statements” when applicable
Foreign Grantor Trust Owner Statement
The Foreign Grantor Trust Owner Statement is found on page three of Form 3520-A. The statement sets forth the name and address of the trust owner. The statement also states the FMV of property distributed from the trust to its owner and the gross value of the trust treated as owned by a U.S. owner. In addition, the Foreign Grantor Trust Owner Statement states the date property is distributed from the trust to its owner, description of the property distributed to its owner, the FMV of the property distributed to its owner, and description of the property transferred to its owner. Finally, the Foreign Grantor Owner Statement provides an income statement to its owner somewhat similar to a K-1 income statement.
Foreign Grantor Trust Beneficiary Statement
The Foreign Grantor Trust Beneficiary Statement is found on page four of Form 3520-A. The statement sets forth the name and address of the trust, the name and address of the trustee, the name and address of the beneficiary, a description of the property distributed to the beneficiary, whether the owner of the trust is an individual, partnership, or corporation, and an explanation of the facts and law establishing that the foreign trust is treated as owned by other person, the grantor. In addition, the preparer must indicate whether or not the trust appointed a U.S. agent who can provide the IRS with all relevant trust information.
The rules pertaining to preparing IRS Form 3520-A and taxation of foreign trust are complex. Despite detailed instructions provided by the IRS to prepare Form 3520-A, there are many issues not specifically addressed by the instructions. We prepare Form 3520-A 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 Form 3520-A and provide guidance regarding the taxation of foreign trusts to other tax professionals.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. Anthony Diosdi may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.
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.