Ensuring compliance with your foreign trust reporting obligations, including Form 3520 and Form 3520-A, will help maximize the benefits it brings you and your family.
US tax law imposes significant responsibilities on parties involved with foreign trusts – including grantors, beneficiaries, and trustees.
Here’s a quick recap of the parties involved in a trust.
The grantor is the person who transfers assets to the trust.
As discussed more thoroughly in our blog about foreign trust taxation, US law treats US grantors of a foreign trust as the “owner” of the trust’s assets for tax purposes – hence the term “US owner.”
Beneficiaries are the people who receive distributions or otherwise benefit from the trust’s assets.
Trustees are responsible for safeguarding and directing the use of trust assets.
Let’s go through the foreign trust reporting for each of various types of foreign trusts.
Foreign Trust Reporting: Foreign Grantor Trusts With US Grantor
Trustee Obligations – The trustee of a foreign grantor trust with a US grantor must file IRS Form 3520-A (Annual Information Return of Foreign Trust with a US Owner) to report certain information.
The trustee must also send a “Foreign Grantor Trust Owner Statement” to all US owners of the trust.
Additionally, the trustee must send a “Foreign Grantor Trust Beneficiary Statement” to each US beneficiary who received a distribution during the year.
“Distributions” include loans to US beneficiaries (other than loans considered “qualified obligations”) and also include the uncompensated use of trust property.
For example, a beneficiary who stays in a home owned by a trust has received a deemed distribution equal to the fair rental value of the property for the relevant number of nights.
US Grantor Obligations – If a trustee fails to file Form 3520-A as required, penalties are imposed on the US grantor. However, these penalties can be avoided if the US grantor signs and files Form 3520-A.
IRS Form 3520 must not be confused with IRS Form 3520-A.
Form 3520 (Annual Return To Report Transactions with Foreign Trusts and Receipt Of Certain Foreign Gifts) is used to report any transfers to a foreign trust, to report ownership of a foreign trust (even if no transfer is made to the trust during that tax year).
As described above, US grantors are treated as US owners of a foreign trust for tax purposes and are responsible for paying US income tax on their portion of the trust’s income.
For example, suppose someone is a 75% owner of a foreign trust. This person is responsible for paying 75% of all taxes due on the trust’s income.
When required, US owners must also file information returns like Form 8938 and may have to file an FBAR for accounts held by the trust.
Beneficiary Obligations – Beneficiaries must file Form 3520 to report receiving a distribution. The distribution will not be taxed provided they attach the “Foreign Grantor Trust Beneficiary Statement” to it.
Foreign Trust Reporting: Foreign Grantor Trusts With Non Resident Alien Grantor
Trustee Obligations – Trustees of foreign grantor trusts are not required to file Form 3520-A.
However, they should send a “Foreign Grantor Trust Beneficiary Statement” to all beneficiaries who received distributions.
Grantor Obligations – Because they are not a “US person,” non resident alien grantors are only required to pay tax on “US sourced” income – this is done by filing Form 1040-NR.
If the trust has no “US sourced income,” then the grantor has no filing requirement.
Beneficiary Obligations – US beneficiaries are not liable for tax on distributions from the trust provided a “Foreign Grantor Trust Beneficiary Statement” is obtained and attached to Form 3520.
If a US beneficiary fails to attach a “Foreign Grantor Trust Beneficiary Statement” to their Form 3520, then the US beneficiary will owe tax on the distributions received from the trust.
Foreign Trust Reporting: Foreign Non Grantor Trusts
The distinction between grantor and non grantor trusts comes down to who owes tax liability.
Under US law, foreign non grantor trusts are not considered to have an “owner.”
Thus, the trust itself (NOT the settlor) is required to pay tax on US source income.
It sounds a little strange, but a foreign non grantor trust still has a grantor.
Trustee Obligations – Trustees of foreign non grantor trusts are not required to file Form 3520-A.
However, they should send a “Foreign Non Grantor Trust Beneficiary Statement” to all beneficiaries who received distributions.
If the trust earns US sourced income, the trustee is responsible for filing Form 1040-NR (Nonresident Alien Income Tax Return) to report and pay any taxes due.
Grantor Obligations – Grantors of foreign non grantor trusts have no tax obligations to the US.
Beneficiary Obligations – Beneficiaries of a foreign non grantor trust must file Form 3520 to report receiving a distribution from the trust.
They should include the “Foreign Non Grantor Trust Beneficiary Statement” they receive from the trustee with their tax filings.
They must report and pay tax on the current year trust income – including the fair rental value of trust property to used (such as staying in a home owned by the trust).
Additionally, US beneficiaries must report and pay tax on accumulated trust income (which will likely be subject to the punitive throwback tax).
Foreign Trust Reporting: Form 3520 Penalties
There are significant penalties for not filing 3520 on time.
Initial penalty is the greater of $10,000 or
- 35% 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 It, OR
- 35% 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.
- 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 (sections 671 through 679) for failure by the U.S. person to report the U.S. owner information in Part II.
U.S. person may also be subject to an additional separate 5% penalty (or $10,000 if greater), if such person
(a) fails to ensure that the foreign trust files a timely Form 3520-A and furnishes the required annual statements to its U.S. owners and U.S. beneficiaries, or
(b) does not furnish all of the information required by section 6048(b) or includes incorrect information. If a foreign trust fails to file Form 3520-A, the U.S. owner must complete and attach a substitute Form 3520-A to the U.S. owner’s Form 3520 by the due date of the U.S. owner’s Form 3520 (and not the due date for the Form 3520-A, which is otherwise due by the 15th day of the 3rd month after the end of the trust’s tax year in order to avoid being subject to the additional separate penalty for the foreign trust’s failure to file Form 3520-A.
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 the IRS can determine the gross value of the portion of the trust’s assets treated as owned by the U.S. person at the close of the tax year, then the additional penalties will be reduced as necessary to assure that the aggregate amount of such penalties do not exceed the gross value of the trust. For more information, see section 6677.
Foreign Trust Reporting: IRS Initiative
In the fall of 2020, the IRS announced an initiative to crack down on high-net-worth taxpayers holding foreign assets, including foreign trusts.
Foreign Trust Reporting: Filing Costs
It’s critically important to file Forms 3520 and 3520-A accurately and on time.
Few tax professionals are capable of accurately preparing these forms.
Unfortunately, many in the market for a foreign trust overlook the time, effort, and cost associated with the associated tax filing requirements.
Foreign trusts can provide many benefits like asset protection and multigenerational estate planning.
But they do not come without potential drawbacks.
One of the most important factors when considering a foreign trust is its ongoing expenses, such as:
- Paying a trustee
- Administrative costs
- Government fees for entities inside the trust like corporations and LLCs.
Some close (shut down) a trust due in part to the yearly fees associated with tax filings.
Foreign trust reporting including Form 3520, and 3520-A among others require expert guidance.
Our experienced consultants can help you form or restructure a foreign trust and meet your tax filing and reporting obligations. Click here to schedule the consultation!