By Anthony Diosdi
This article is designed to provide the reader with an understanding of the Internal Revenue Service (“IRS”) Form 3520. U.S. persons who receive distributions, directly or indirectly, from a foreign trust are required to report a number of matters relevant to the trust on Form 3520, including the name of the trust and the aggregate distributions received during the taxable 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 grantor). A reportable distribution from a foreign trust includes the receipt of trust corpus and the receipt of a gift or bequest even though such amounts may not be taxable.
In addition, U.S. persons that receive gifts from nonresident aliens and foreign estates in the aggregate amount of more than $100,000 in a taxable year must report the gifts on a Form 3520. The aggregate annual threshold level for reporting gifts received from foreign corporations and partnerships is significantly less.
The Form 3520 is broken down into Four major components. The first component is where the filer will complete basic information such as the name and address of the trust and U.S. beneficiaries. The second component is utilized to document transfers by U.S. persons to a foreign trust. The third component and probably most complicated part of the Form 3520 is utilized to document distributions to a U.S. person from a foreign trust. The fourth and final component of the Form 3520 is utilized to report U.S person’s receipt of gifts or bequests from foreign persons. The first component of the Form 3520 is fairly simple. So, we will skip the basic information portion of the Form 3520 and begin our discussion with Part II entitled Transfers by U.S. persons to a Foreign Trust.
Transfers by U.S. Persons to a Foreign Trust
Let’s start with Part I of the Form 3520 entitled “Transfers to U.S. Persons to a Foreign Trust during the Current Tax Year.” This section of the Form 3520 begins by asking you to name the trust creator, address of the trust creator, and the country code whose law governs the trust. Where things get interesting is lines 7a. Question 7a asks a simple “Yes” or “No” question as to “will any person (other than the foreign trust) be treated as the owner of the transferred assets after the transfer?
What question 7a is really asking is a U.S. person be treated as the owner of the transferred asset after the transfer. A U.S. person will be considered an owner of any portion of the foreign trust if the grantor trust trust rules are satisfied. The grantor trust rules are defined in Internal Revenue Code Sections 671 through 679. The grantor trust rules state that if the grantor, that is, the creator of the trust maintains certain “strings” of control over the trust, then all the income from the said trust must be reported on the grantor’s individual income tax return. This includes: 1) the power to control beneficial enjoyment; 2) the power to add or change the beneficiary of a trust; 3) the power to deal for less than adequate and full consideration; 4) the power to use the income from the trust to pay life insurance premiums; or 5) the power to substitute assets of equal value. If the grantor trust rules are satisfied, the U.S. grantor of the trust asset will be taxed on the assets income and gains.
Schedule A- Obligation of a Related Trust
Now let’s move to Schedule A of Part I of Form 3520. The purpose of Schedule A is to report all transfers related to a foreign trust in exchange for an obligation of the trust or a “person related” to the trust that took place.
Question 11a asks if you transferred property (including cash) to a related foreign trust in exchange for an obligation of the trust or an obligation of a person to the trust? In order to answer Question 11a, the terms “obligation” and “related person” must be defined.
An obligation includes bonds, notes, debentures, certifications, bills or notes receivable, open accounts, annuity contracts or any other evidence of indebtedness.
A related party is defined under Section 267(b) a “related person” can be defined as brothers or sisters (whole or half-blood), spouses, and lineal descendants. Under Section 707(b) a related party is also a corporation in which the transferor directly or indirectly owns more than 50 percent of the corporation’s outstanding stock.
A person is related to a foreign trust if such person, without regard to the transfer at issue, is a grantor of the trust, a beneficiary of the trust, or is related to any grantor or beneficiary of the trust.
If during the current year, you transferred property to a related foreign trust in exchange for an obligation of the trust or a person related to the trust, you check “Yes.”
Question 11b asks if any obligations you received during the tax year are a “qualified obligation.” The definition of a qualified obligation is an obligation: 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.
The reason the IRS asks for obligations of a foreign trust to be listed on the Form 3520 is that certain obligations can be treated as distributions to the U.S. beneficiaries of a foreign trust. We will get to when this can happen in a minute. There is an exception to this rule. If a loan from a foreign trust is a “qualified obligation” it will be treated as a loan and not a distribution from a foreign trust.
If you received a qualified obligation during the tax year, you must attach a copy of each loan document. You must also disclose to the IRS the date of transfer giving rise to the obligation, maximum term, yield to maturity, and fair market value of the obligation.
In order for a loan to be treated as a qualified obligation, Question 12 asks you to agree to extend the statute of limitations on any income tax or transfer tax attributable to the transfer to a date of 3 years after the maturity date of the obligation.
Schedule B. Gratuitous Transfers
Schedule B is utilized to report any gratuitous transfers to the trust. Generally, any transfer to a trust other than: 1) A transfer for fair market value; or 2) a distribution to the trust through a corporation, partnership, or other investment.
A transfer can be treated as a “gratuitous transfer” regardless of whether it is treated as a gift for gift tax purposes.
Any transfer of property to a forein trust in exchange for an obligation of the trust will be a gratuitous transfer unless the obligation is a qualified obligation.
Gratuitous transfers must be reported for Question 13. Copies of sale or loan documents are required to be attached to the Form 3520. You must also be prepared to identify the loan documents that you are attached to the Form 3520. Question 13 also asks you to answer a number of questions in the columns. These are discussed below.
In column (a), you must state the date of the transfer.
In column (b), you must describe the property transferred and indicate if the property transferred was tangible or intangible.
In column (c), you must state the fair market value of the property transferred to the trust.
In column (d), you must enter the adjusted basis of the property transferred to the trust.
In column (e), you must include any gain that is immediately recognized at the time of transfer to the foreign trust. (Any transfer of appreciated assets by a U.S. person to a foreign nongrantor trust is treated as a sale and the transferor must recognize as gain the excess of the fair market value of the transferred property over its basis).
In column (f), if you reported a sale on column (d), the amount is reported on this column.
In column (g), you must report any property that you received from the foreign trust.
In column (h), you must report the fair market value of the property received.
You will only need to answer Questions 15 through 18 if the foreign trust did not appoint a U.S. agent to provide the IRS with all relevant trust information.
For Question 15, you will need to enter the name; address; and whether any person is a U.S. beneficiary of the trust.
For Question 16, you will need to enter the name; address of the trustee.
For Question 17, you will need to enter the name; address, and TIN, if any, of any person, other those those listed on Question 16, that has significant powers over the trust such as “protectors” or “enforcers,” or any person that has the power to remove the trustee.
For Question 18, you should attach a copy of the following documents (unless previously attached to a Form 3520-A or Form 3520 within the past three years): 1) a summary of the terms of the trust that includes a summary of any oral agreements or understandings with the trustee, whether or not legally enforceable; 2) a copy of all trust documents, including any memoranda of wishes or letter of wishes; 3) a copy of the trust’s financial statements, including a balance sheet similar to the Form 3520-A; and 4) a copy of the trust’s organizational chart, including ownership structure and percentage of ownership.
Schedule C. Qualified Obligations Outstanding in the Current Tax Year
The purpose of Schedule C is to report qualified obligations.
Question 19 asks you to provide information on the status of outstanding obligations of the related foreign trust (or an obligation of a person related to the foreign trust) that you reported as a qualified obligation in the current tax year. If there was a qualified obligation or obligations, you must state the date of the original obligation, the tax year the obligation became qualified, the amount of principal payments made during the year, amount of interest paid during the year, and the balance of the obligation at the end of the year.
Part II Owner of a Foreign Trust
You must complete Part II of the Form 3520 if you are considered the owner of any assets of the foreign trust under the grantor trust rules.
Question 20 asks you to name the foreign trust owner and address.
Questions 21a and 21b asks you to enter the applicable two-letter code from the IRS country code list.
Question 22 asks if the foreign trust filed a Form 3520-A for the current year. (A Form 3520-A is the annual information return of a foreign trust with at least one U.S. owner. A Form 3520-A is prepared and signed by the trustee of the foreign trust). This is a “Yes” or “No” question. If the answer is “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,” a substitute Form 3520-A must be attached. A Foreign Grantor Trust Owner is similar to K-1 used for distributing income from a domestic trust to its beneficiaries for tax purposes.
Question 23 requires the U.S. owner of the foreign trust to disclose the portion of the foreign trust treated as being owned at the end of the year for income tax purposes.
Part III. Distribution to a U.S. Person a Foreign Trust During the Current Tax Year
Part III is entitled distributions to “U.S. Persons From a Foreign Trust During the Current Tax Year.” This is probably the most complicated section of the Form 3520.
Question 24 asks you to state the fair market value of property received, directly or indirectly during the current year from the trust (excluding loans and uncompensated use of trust property). The following distributions should be reported in Question 24, 1) date of distribution, 2) description of property received, 3) FMV of property received; 4) description of property transferred.
Question 25 is a “Yes” or “No” question. Question 25 asks if the trust beneficiary (or a person related to the beneficiary) received a loan or uncompensated use of trust property from a related foreign trust. 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. If you checked “Yes” for Question 25, the following must be disclosed: 1) fair market value of loan proceeds or property from the trust; 2) date of original transaction with the trust; 3) maximum term of repayment of obligation with the trust; 4) interest rate of obligation on any obligations with the trust; 5) additional disclosures regarding qualified obligation; 6) the fair market value of the qualified obligation; and the 7) amount treated as distribution from the trust.
For Question 26, the IRS asks if any of the obligations reported on Line 25 can be treated as a qualified obligation and if you agree to extend the statute of limitations with respect to the obligation.
For Question 27, you must list any obligations the beneficiary (or related person) has reported as a qualified obligation and the total value of those obligations.
For Question 28, you must provide information regarding the status of any outstanding obligation to the foreign trust that was reported as a qualified obligation.
For Questions 29 and 30, you must state if any items required for the Foreign Grantor Trust Statement or the Foreign Nongrantor Trust Beneficiary Statement are missing. If items are missing, you must complete Schedule A, Schedule B, and Schedule C to Part III.
Schedule A- Default Calculation of Trust Distributions
If the trust beneficiary has not received a foreign grantor or foreign nongrantor beneficiary statement, the Internal Revenue Code has a default method for taxing trust distributions to a U.S. beneficiary from a foreign trust. The default presumption means the entire distribution from the trust is taxed at the worst possible case scenario- the distribution is classified as accumulated income.
What are the tax consequences? Everything is treated as ordinary income and an interest charge can be imposed on the calculated income tax on the distribution. There is a three step process for the default computations.
Step 1: Calculate the distribution
The first thing to calculate is the amount of the distribution that the U.S. beneficiary received. This is done in Form 3520, Part III, Lines 24 through 28 state the different types of transactions that are considered distributions from trusts.
Classic distributions of cash or property are listed at Line 24.
Loans from trusts are treated as distributions. These can be problematic because loans need not be to the beneficiary- they can be to related persons and still be considered as distributions to the U.S. beneficiary- See Form 3520, Part III, Line 25.
Use of trust assets without paying for the use (living rent free in a trust owned house) is treated as a loan, hence is deemed to be a trust distribution- See Form 3520, Part III, Question 25.
Question 27 is the grand total. This is the total amount of trust distributions received by the beneficiary from the foreign nongrantor trust in the tax year.
Step 2. Default Calculation Method
Now that we know the amount of the trust distribution, it is time to compute the income tax due. Here is where the IRS asks you about the quality of the trust accounting. Form 3520, Part III, Question 30 asks you whether a Foreign Nongrantor Beneficiary Statement.
If the answer is “No.” this commits you to completing Schedule A (Questions 31 through 38) to calculate the character of the trust distribution received. It will either be a distribution of ordinary income or it will be a distribution of accumulated income.
Step 3: How Much Ordinary Income and How Much is Accumulated Distribution
Lines 31 through 38 will take the total calculated on Question 27 and run it through some simple math to determine whether the trust distribution will be treated as a distribution of ordinary income or a distribution of accumulated income.
Question 31 asks you to write in the amount you computed on Question 27.
Question 32 asks about the trust. How long has it been a foreign trust?
Question 33 asks you to report the total amount of distributions received from the trust in the preceding three years. If you are preparing the 2021 income tax return, you report the total distributions received in 2018, 2019, and 2020.
Question 34 is simple multiplication. You must multiply the number reported on Question 33 by 1.25 percent
Question 35 is simply, you divide the number stated in Question 34 by three.
Question 36 is where you compute the ordinary income amount of this year’s distribution. Ordinary income is the amount stated on Question 35. In other words, you are given a 125 percent of the prior three years average trust distribution as ordinary income.
Question 37 is the excess of the distribution received this year (Question 31) over the 125 percent of average distributions for the prior three years (Question 35).
Step 4: Calculate the Tax on the Accumulated Distribution
If you have an accumulation distribution- that is the amount reported on Question 37. If the amount is a number greater than 0- then you have to go to a separate Form 4970 and calculate the income tax that is accumulated distributions
U.S. Recipients of Gifts or Bequests Received During the Current Tax Year from Foreign Persons
Part IV of Form 3520 asks you to list certain gifts or bequests received during the tax year from foreign persons.
Question 54. This question asks you to disclose any foreign gifts received from a nonresident alien or a foreign trust that exceeds $100,000.
To calculate the $100,000 threshold, you must aggregate gifts from foreign nonresidents and foreign estates. In addition, Question 54 requires you to disclose foreign gifts that exceed $5,000.
Question 55 asks you to disclose gifts from foreign corporations or foreign partnerships.
Question 56 asks you to state if you had reason to believe if the foreign donor was acting as a nominee or intermediary. If you answered “Yes” to this question, you must attach an explanation to the Form 3520.
Conclusion
The penalties associated with not timely filing or incorrectly filing an IRS Form 3520 is serious. Generally, the initial penalty is equal to the greater of $10,000 or the following:
1) 35 percent of the gross value of any property transferred to a foreign trust for failure by a U.S. transferor to report the creation of or transfer to a foreign trust in Part 1.
2) 35 percent of the gross value of the distributions received from a foreign trust for failure by a U.S. person to report receipt of the distribution in Part III.
3) 5 percent 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, if the foreign trust a) fails to timely file a Form 3520-A and furnish annual statements to its U.S. owners and U.S. beneficiaries or b) does not furnish all required information or includes incorrect information. Additional penalties will be imposed if the noncompliance continues for more than 90 days after the IRS mails a notice of failure to comply with the required reporting.
If you are a beneficiary of a foreign trust or you have received a gift or bequest from a nonresident, you should consult with an international tax attorney regarding your 3520 filing requirements. Failure to properly and/or timely file a Form 3520 with the IRS can have disastrous consequences.
Anthony Diosdi is one of several international tax attorneys at Diosdi Ching & Liu, LLP. As an international tax attorney, Anthony Diosdi advises foreign and domestic clients on U.S. federal income, gift, and estate tax matters, including cross-border investments, U.S. real estate investments, and business activities. Anthony Diosdi also routinely counsels clients with respect to pre-immigration planning, FIRPTA, expatriation planning, and tax treaties. Anthony Diosdi is a frequent speaker at international tax seminars. Anthony is a member of the California and Florida bars.
Diosdi Ching & Liu, LLP has offices in San Francisco California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. 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.