Understanding Foreign Trust Reporting for United States Persons: What You Need to Know

For U.S. citizens or residents who have established a foreign trust, transferred assets to one, or have received distributions, understanding the U.S. tax implications and related reporting requirements is of utmost importance, as the penalties for not filing these forms can be substantial. You need to file Form 3520 for reporting transactions and distributions, while the foreign trust has to file Form 3520-A with an itemized statement showing the trust's income and activities. For example, if you transferred stocks with values of $300,000 into a trust in the India and subsequently received a distribution in the amount of $20,000, you are required to report the same transfer and the subsequent distribution on Form 3520 and confirm that the trust has filed Form 3520-A. Without doing so will make any reasonable cause power void and will attract significant penalties, together with extended periods for assessing any due taxes. Here's a breakdown of what you need to know to stay compliant and avoid costly mistakes.

Who Qualifies as a U.S. Person?

A "U.S. person" includes not only U.S. citizens, but also U.S. residents, domestic corporations, partnerships, estates, and trusts in which the courts of the United States are able to exercise primary supervision over the trust and one or more United States persons have the authority to control all substantial decisions of the trust. If you fit into one of the aforementioned categories and you have a transaction involving a foreign trust, the IRS has certain reporting requirements you need to follow.

Important Tax Implications for U.S. Owners and Beneficiaries of Foreign Trusts

Foreign trusts can create many different types of United States tax liabilities, such as:

Foreign Trust - U.S. Owner: If you are considered the owner of a foreign trust for purposes of the grantor trust rules, then you generally will be required to report and pay tax on such portion of the trust's income, even though the income is not distributed to you. For example, IRC will deem you to be the owner if you transfer assets to a foreign trust that has U.S. beneficiaries.

U.S. Beneficiaries: In this case, as a beneficiary, you are getting distributions from the foreign non-grantor trust. You report your share of the trust's Distributable Net Income (DNI). You should receive a beneficiary statement from the trust to help understand your tax liability.

Transfers to Foreign Non-Grantor Trusts: The transferring of appreciated assets to a foreign trust may have immediate tax consequences under IRC section 684. This prevents the taxpayers from avoiding U.S. taxes by moving assets offshore.

Key Forms for Reporting of Foreign Trust

The IRS has laid down certain forms which are used for reporting the transactions and income of foreign trusts. These forms include the following:

Form 3520:

Who Must File: You will need to file Form 3520 if you create or transfer assets to a foreign trust, receive distributions, or are treated as the U.S. owner under the grantor trust rules. Additionally, you will be required to file if you receive large gifts or bequests from foreign persons.

Why it is important: The penalties for failure to timely file or completely file this form are substantial and can be as high as 35% of the amount considered transferred to the foreign trust or received by you as distributions.

Form 3520-A:

Who's responsible? If you're a U.S. person and owner of a foreign trust, then you are responsible to make sure that a Form 3520-A is filed for the foreign trust. If the foreign trust does not file a Form 3520-A, you are required to file a substitute Form 3520-A and attach it to your Form 3520. Failure to properly file can result in significant penalties.

Filing deadlines: This form is considered timely filed if sent on or before the 15th day of the 3rd month following the close of the trust's tax year. Requesting an automatic six-month extension of time to file can be done with Form 7004.

Exceptions to Filing

Most foreign trusts require reporting; however, there are some exceptions. For example:

Canadian Retirement Plans - RRSPs and RRIFs: Thanks to Revenue Procedure 2014-55, there are no Forms 3520 and 3520-A filings required for Canadian retirement plans.

Specific Tax-Favored Foreign Trusts: U.S. owners of certain foreign retirement or non-retirement savings trusts are exempt from filing provided certain criteria have been met according to Revenue Procedure 2020-17. This said, the filing obligation of Form 8938 with respect to specified foreign financial assets, and a FinCEN Form 114 (FBAR) if applicable, remains intact.

How to Avoid Common Pitfalls

Here's how you can avoid common, costly errors:

Know your deadlines: For calendar-year filers, Form 3520 is due on April 15. Extensions are possible, but at the latest, you need the form to be filed by October 15.

Substitute Form 3520-A: If the foreign trust doesn't file Form 3520-A, ensure you complete a substitute form and attach it to your Form 3520.

Maintain a record in detail: Keep all your documents regarding your foreign trust transactions, including beneficiary statements, since it will make reporting easier and smoother without mistakes.

Involvement with foreign trusts can sometimes be tricky, but understanding the tax consequences and filing requirements may save you a lot in fines. Get in touch with our experts at Water and Shark and be certain to file on time, report any transactions or income correctly, and stay in the loop with possible exemptions or updates from the IRS.