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 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 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. Transfers to foreign trust also need to be reported on a Form 3520. In addition, large foreign gift, bequest, or inheritance that exceeds $100,000 from a nonresident must also be disclosed on a Form 3520.
This article discusses the circumstances that trigger a requirement to file a Form 3520 with the Internal Revenue Service (“IRS”).
The Definition of a Foreign Trust
The Form 3520 is often utilized to report transactions with foreign trust. Since the Form 3520 is utilized to report transactions with foreign corporations, it is important to define the term “trust.” A trust is a fiduciary arrangement that allows a third party, or trustee, to hold assets on behalf of a beneficiary or beneficiaries. Only transactions with foreign trusts must be reported on a Form 3520. It is therefore important to determine whether a trust is domestic or foreign for U.S. federal income tax purposes.
A trust is a domestic trust if it satisfies both the “Court Test” and the “Control Test.” A trust is a foreign trust by default if it fails either the “Court Test” or the “Control Test.”
To satisfy the Court Test, a court within the U.S. must be able to exercise primary supervision over the administration of the trust. See Treas. Reg. Section 301.7701-7(a)(i). This means, more specifically, a (1) a U.S. court has authority to render orders or judgments concerning administration, (2) a U.S. court has authority to determine substantially all issues regarding administration and 3) the trust does not contain an automatic migration clause. See Treas. Reg. Section 301.7701-7(a)-(e).
The Control Test is satisfied if the only persons that can exercise “substantial decisions” over the trust are either U.S. citizens, U.S. federal income tax residents or U.S. state-based companies (“U.S. persons”). See Treas. Reg. 301.7701-7(a)(ii). In other words, if at least one non-U.S. person can make or veto a “substantial decision,” the trust fails the Control Test even if a U.S. person, is serving as trustee. “Substantial decisions” include (but are not limited to) the following: 1) the timing or amount of distributions; 2) selecting of a beneficiary; 3) allocation of receipts between income and principal; 4) whether to terminate a trust; 5) whether to sue or defend the trust; 6) whether to remove or add a trustee; and 7) and investment decisions. See Treas. Reg. 301.7701-7(d)(ii).
What are the Relevant Sections of the Form 3520
The Form 3520 has four major parts. Part I is used to report transfers to foreign trusts. Part II is utilized to report ownership interests in foreign trusts. The purpose of Part III is to report distributions from foreign trusts. Finally, taxpayers report large foreign gifts from foreign individuals, estates, corporations, and partnerships on Part IV of the Form 3520.
The Transactions that Need to be Reported on Part I of the Form 3520
The following transfers are required to be reported on Part I of Form 3520:
1. If a U.S. person (United states person means United States citizens, United States residents, corporations, partnerships, or limited liability companies created or organized in the United States) directly or indirectly transfers property to a foreign trust, the transfer must be disclosed on Part I of Form 3520;
2. If a U.S. person transfers property to a person related to a foreign trust or a related foreign trust in exchange for an obligation, the transfer must be disclosed on Part I of the Form 3520. 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. A “related person” is defined as brothers or sisters (whole or half-blood), spouses, and lineal descendants. A related party is also a corporation in which a transferor or transferee owns directly or indirectly more than 50 percent of the corporation’s outstanding stock.
If a U.S. person holds a “qualified obligation” from a foreign trust, the transaction must be disclosed on Part I of Form 3520. Internal Revenue Code Section 684 and IRS Notice 97-34 provides that a “qualified obligation” can be defined as: 1) an obligation reduced to writing by an express written agreement; 2) the term of the obligation does exceed 5 years; 3) all payments on the obligation are denominated in U.S. dollars; and 4) the yield to maturity is between 100 to 130 percent of the applicable adjusted federal rate.
3. If the executor of an estate of a U.S. decedent where: i) the decedent made a transfer to a foreign trust by reason of death; ii) the decedent was treated as the owner of any portion of a foreign trust immediately prior to death under the so-called “grantor trust” rules, or iii) the decedent’s estate includes any portion of the assets of a foreign trust must be disclosed on Part I of Form 3520.
In essence, Part I of Form 3520 will require a U.S. person to disclose any property directly or indirectly transferred to a foreign trust and anything received in exchange for the property transferred to the foreign trust. The U.S. person will also need to disclose the date of the transfer, a description of the property transferred, the fair market value of the property transferred, the U.S. person’s adjusted basis in the property, gain recognized in connection with the property transferred, and the fair market value of any property received from the foreign trust in exchange for the property transferred to the foreign trust.
Ownership Interests that Need to be Disclosed on Part II of Form 3520
A U.S. person that has an ownership interest in any portion of a foreign trust must report that interest on Part II of Form 3520. A U.S. person is treated as “owning” a trust if any of the “grantor trust” provisions are applicable. Under the grantor trust provisions, if the creator or other donor of a trust maintains certain controls or powers over the trust or a portion thereof, the creator or donor will be treated as the owner of that trust or portion for U.S. income tax purposes. Common powers that trigger grantor trust status include: 1) the power to control beneficial enjoyment; 2) the power to add or change beneficiaries; 3) the power to borrow without adequate interest or security; and 4) the power to substitute assets of equal value.
A U.S. owner is also considered an owner of all or any portion of a foreign trust in which he or she must report on Form 3520 the value of trust assets that are treated as owned by the U.S. owner. Consequently, if a U.S. person makes a transfer to a foreign trust, the U.S. portion may be considered an owner of the foreign trust for purposes of the Form 3520. Ownership of a foreign trust is important to determine how the trust will be taxed for U.S. purposes. Below, is a general discussion regarding the general rules in regards to how the ownership of a foreign trust will determine how the trust will be taxed for U.S. purposes.
The General Rules for Determining the Taxation of a Foreign Trust
For U.S. federal income tax purposes, trusts are treated as either trusts or non-grantor trusts. The grantor-owner of a grantor trust would generally file a federal income tax return to report and pay tax on the trust’s income during the grantor-owner’s lifetime, if otherwise required to do so. See Treas. Reg. Section 1.671-4(a). In contrast, to the extent a trust was classified as a non-grantor trust, it would generally be treated as a separate taxable 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 income.
The Taxation of a Foreign Grantor Trust
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 the owner of the trust for U.S. income tax purposes. See IRC Section 671. If the owner of a grantor trust is a non-resident alien, then the non-resident alien owner will only be subject to U.S. income tax on the following types of income: 1) non-exempt “passive” income from U.S. sources and 2) income effectively connected with the conduct of a U.S. trade or business.
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 makes no gratuitous transfers to the trust will not be treated as the “owner” of the assets of the trust. See Treas. Reg. Section 1.671-2(e)(1)
Taxation of a Foreign Non-Grantor Trust
Foreign Non-Grantor Trust is subject to U.S. income tax in a manner similar to a non-resident individual that is not present in the U.S. at any time. That is, a foreign non-grantor trust will only be subject to U.S. income tax on its: 1) non-exempt “passive” income from U.S. sources, which is generally subject to tax at a flat 30% rate, without the benefit of deduction; and 2) income effectively connected with the conduct of a U.S. trade or business. On the other hand, a U.S. beneficiary of such a trust would generally be subject to U.S. income tax on the income of the trust to the extent such beneficiary receives distribution of such trust’s current income or gains, or has an unconditional right to receive a distribution of such income or gains, but only to the extent of such trust’s worldwide distributable net income. This would apply even if such income or gains are not subject to U.S. income tax and interest on any distribution of accumulated income under so-called “throwback rules.”
Distributions from Foreign Trusts that Need to be Disclosed on Part III of Form 3520
A U.S. person that is classified as trust beneficiary will need to report a distribution from a foreign trust on Part III of Form 3520. A trust beneficiary is any person that could possibly benefit (directly or indirectly) from the trust at any time (including any person who could benefit if the trust were amended), whether or not the person is named in the trust instrument as a beneficiary and whether or not the person can receive a distribution from the trust in the current year, is included in definition of a beneficiary, and a person will not be considered a beneficiary only if, based on all relevant facts and circumstances, it could not be reasonably anticipated that the person could possibly benefit from the trust.
The U.S. tax consequences of a trust distribution depends on the type of distribution received by the U.S. person. Below, please find of the U.S. tax consequences to a trust beneficiary of the following distributions:
Loans by Foreign Trust to U.S. Persons
Internal Revenue Code Section 643(i) provides that the fair market value of a loan or marketable securities owned by a foreign trust, other than a “qualified obligation,” will be treated as a trust distribution when the loan is made to any U.S. grantor or U.S. beneficiary; or a party related to either the U.S. beneficiary or U.S. grantor.
Trusts Created by Certain Foreign Corporations
Where a foreign trust holds assets through a foreign corporation, the effect of the non-grantor foreign trust rules is to render U.S. beneficiaries potentially taxable under the subpart F and/or GILTI rules because the application of the attribution rules will deem the U.S. beneficiaries to be shareholders in the foreign corporations owned by the foreign trust.
The U.S. Taxation of Trust Distribution to U.S. Beneficiaries
A U.S. beneficiary will be taxed on distributions to the extent of the person’s share of the trust’s current distribution net income (“DNI”).
In calculating its taxable income, a trust will receive a deduction for distributions to its beneficiaries to the extent that these distributions carry out the trust’s “distributable net income” or “DNI” for the taxable year. Generally, the DNI of a domestic nongrantor trust for a particular year is equal to its taxable income for that year adjusted 1) by adding to taxable income the amount deducted as a personal exemption, the amount of its tax exempt income, and the amount of the trust’s deduction for distributions to beneficiaries and 2) by subtracting from taxable income the trust’s capital gains except to the extent such capital gains are “paid, credited or required to be distributed to any beneficiary during the taxable year.” See IRC Section 643(a)(3). Any DNI so distributed will retain its character in the hands of the recipient beneficiaries and will be taxed to them.
Capital gains of a domestic nongrantor trust generally do not enter into the DNI calculation and are usually taxed to the trust. Any distributions by a domestic trust to beneficiaries in excess of DNI will be a non-taxable distribution of capital. The DNI of a foreign nongrantor trust includes its capital gains. In addition, a foreign nongrantor trust’s DNI includes the amount of its income from non-U.S. sources subject to certain reductions. Distributions to beneficiaries are considered first to carry out the DNI of the current year (pro rata as to each item of income or gain) and will be taxed to the recipient beneficiaries.
If a foreign trust does not distribute all of its DNI in the current year, the after tax portion of the undistributed DNI will become “undistributed net income” or “UNI.”
Distributions of the UNI of a foreign nongrantor trust received by a U.S. beneficiary are taxed under the “throwback rule,” which generally seeks to treat a beneficiary as having received the income in the year in which it was earned by the trust. A foreign nongrantor to UNI for for any particular year is equal to the amount by which its DNI for such year exceeds the sum of:
1. The amount of trust accounting required to be distributed in such year;
2. The amount of any other amount properly paid or credited or required to be distributed for such year; and
3. The amount of any taxes imposed on the trust that are attributable to its DNI for the year. See IRC Section 665(a).
The throwback rule 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.
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.
Reporting Foreign Gifts and Bequests on Part IV of Form 3520
Section 1905 of the 1996 Tax Created reporting requirements under Section 6039F for U.S. persons. These reporting provisions require U.S. donees to provide information concerning the receipt of large amounts that the donees treat as foreign gifts, giving the IRS an opportunity to review the characterization of these payments and determine whether they are properly treated as gifts. Donees are currently required to report certain information about such foreign gifts on Part IV of Form 3520.
Section 6039F(b) generally defines the term “foreign gift” as any amount received from a person other than a U.S. person that the recipient treats as a gift or bequest. However, a foreign gift does not include a qualified transfer (within the meaning of Section 2503(e)(2)) or any distributions from a foreign trust. A distribution from a foreign trust must be reported as a distribution under Section 6048(c) and not as a gift under Section 6039F.
Under Sections 6039F(a) and (b), reporting is required for aggregate foreign gifts in excess of $100,000 during a taxable year. Once the $100,000 threshold has been met, the U.S. donee is required to file a Form 3520 with the IRS.
U.S. donees must also report a threshold amount from a foreign corporation or foreign partnership ($17,339 for gifts received during the 2022 tax year).
Internal Revenue Code Section 672(f)(4) broadly authorized regulations to recharacterize gifts or bequests, directly or indirectly, from partnerships or foreign corporations, as income in appropriate circumstances to prevent avoidance of the purpose of Section 672(f) of the Internal Revenue Code. 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 generally must be included in the U.S. donee’s gross income as a distribution from the foreign corporation. 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.
Other Foreign Information Returns
If you have a Form 3520 filing obligation, you may also be required to file a Form 8938 and FinCEN 114.
Form 8938
Pursuant to the Foreign Account Tax Account Compliance Act, the U.S. requires “specified individuals” to report their “specified foreign financial assets” on IRS Form 8938 when the aggregate value of such assets is more than $50,000 on the last day of a tax year or more than $75,000 at any time during a tax year (for married individuals filing a joint U.S. income tax return, these filing thresholds are $100,000 and $150,000, respectively). Enhanced filing thresholds apply to “specified individuals” residing outside the United States.
According to the IRS, examples of other specified foreign financial assets (not an exhaustive list) include, if they are held for investment; stock issued by a foreign corporation; a capital or profits interest in a foreign partnership; and interest in a foreign trust or foreign estate. Consequently, many U.S. beneficiaries of foreign trust have an obligation to disclose their beneficial interest in a foreign trust on Form 8938.
FinCEN Form 114
A U.S person that has a financial interest in or signatory authority over foreign financial accounts must file an FBAR (FinCen Form 114) if the aggregate value of the foreign financial accounts exceeds $10,000 at any time during the calendar year. A U.S. person has a financial interest in a foreign financial account for which:
1. The United States person is the owner of record or holder of legal title, regardless of whether the account is maintained for the benefit of the United States person or for the benefit of another person; or
2. The owner of record or holder of legal title is one of the following:
A. A trust of which the United States person: (i) is the trust grantor and (ii) has an ownership interest in the trust for United States federal tax purposes.
B. A trust in which the United States person has a greater than fifty percent present beneficial interest in the assets or income of the trust for the calendar year.
Any beneficiary of a foreign trust should carefully review their FBAR filing obligations.
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 Ching & 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 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.