Form 3520 “Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts”
Form 3520, reports certain transactions with foreign trusts as well as the receipt of certain foreign gifts or bequests from certain foreign persons. Additionally, U.S. persons file Form 3520 to report the ownership of foreign trusts under the rules of sections 671 through 679 (to be discussed in detail in a later post). Transactions with each foreign trust must be reported on a separate Form 3520.
Foreign Trusts vulnerable?
A foreign trust is any trust other than a domestic trust. A domestic trust is any trust if a court within the United States is able to exercise primary supervision over the administration of the trust and one or more U.S. persons have the authority to control all substantial decisions of the trust. For purposes of our discussion, a U.S. person includes:
(i) a citizen or resident alien of the United States
(ii) a domestic partnership
(iii) a domestic corporation
(iv) any estate (other than a foreign estate)
(v) any domestic trust
Who must file
A U.S. person must file Form 3520 if any of the following situations apply:
(a) You held an outstanding obligation of a related foreign trust or an obligation of a person related to the trust that you treated as a qualified obligation (see definition below) during the current tax year. You therefore are required to complete both the identifying information on the first page of the form as well as relevant sections of Part I.
(b) You are treated as the owner of any part of the assets of a foreign trust under the rules of sections 671 through 679 during the current tax year. You are required to complete the identifying information on the first page of the form as well as Part II. It is important to note that even if there are no transactions involving the trust during the tax year you are still required to complete Part II.
(c) You directly or indirectly received a distribution from a foreign trust during the tax year or a related foreign trust held an outstanding obligation issued by you or by a person related to you that you treated as a qualified obligation during the current tax year. Please note that a distribution from a foreign trust includes the uncompensated use of trust property. You are required to complete the identifying information on the first page f the form and Part III. Distributions will be discussed in detail in a later post.
(d) During the current tax year you received either:
(i) More than $100,000 that you treated as gifts or bequests from a nonresident alien individual or a foreign estate (or from foreign persons related to that nonresident alien individual or foreign estate)
(ii) More than $14,375 that you treated as gifts from foreign corporations or foreign partnerships (or from foreign persons related to such foreign corporations or foreign partnerships).
There are several exceptions, however. In a later post we will discuss the transactions for which one is excluded from filing Form 3520.
If either (i) or (ii) above apply, you will have to complete the identifying information on the first page of the form and Part IV.
When to file
In most cases Form 3520 is due when your income tax return is due (including extensions). However, if Form 3520 is filed with respect to a U.S. decedent then it is due on the date that Form 706 (United States Estate and Generation-Skipping Transfer Tax Return) is due or would be due if the estate were required to file a return. A joint Form 3520 may be filed for two transferors or grantors of the same foreign trust (or two U.S. beneficiaries of the same foreign trust) but only if the individuals file a joint income tax return.
Penalties
Several penalties apply if Form 3520 is not timely filed or if the Form is missing information or incorrect. Per the IRS, the initial penalty is generally equal to the greater of $10,000 or:
(i) 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
(ii) 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 or
(iii) 5% of the gross value of the portion of the trust’s assets treated as owned by a U.S. person for failure of the U.S. person to report the U.S. owner information
Furthermore, if the noncompliance continues after the IRS mails a notice of failure to comply with required reporting, additional penalties will be imposed. However, if the taxpayer can demonstrate that the failure to comply was due to reasonable cause and not purposeful neglect, then no penalties will be imposed. Here, there is a fine line between what is considered reasonable and what is not. For example, even if a foreign country would impose penalties for disclosing the required information, it is not considered reasonable cause. Additionally, it is not reasonable cause if provisions in a trust instrument prevent the disclosure of the information. Likewise, reluctance or refusal on the part of the foreign fiduciary is not considered reasonable cause.
Additionally, if a person fails to report the foreign gifts described in Section 6039F, there will be a 5% penalty on the amount of such foreign gift for each month in which the failure to report continues, subject to a maximum of 25%. Again, if the taxpayer can demonstrate that the failure to comply was not due to willful neglect and instead due to reasonable cause, no penalty will be imposed. According to Section 6039F, foreign gifts are defined as any amount received from a person other than a United States person that the recipient treats as a gift or bequest. Qualified transfers as defined by section 2503 (e)(2)) or any distribution properly disclosed in a return under section 6048 (c) are not considered foreign gifts.
Not only will you get penalized for the failure to report gifts, but under Section 6662(j) there are penalties imposed for undisclosed foreign financial asset understatements. Similar to above, if a taxpayer can demonstrate that the underpayment was due to reasonable cause and he acted in good faith he can avoid such penalty.
The IRS wants to know everything about your foreign Trust through tax form 3520.
Qualified Obligations
To clarify what we meant above by “qualified obligation” – according to the IRS it is any obligation only if the obligation also meets the following criteria:
-The obligation is in writing by an express written agreement
-The term of the obligation is not greater than 5 years and it is repaid within the 5-year term. This includes options to renew and rollovers
-All payments on the obligation are denominated in USD
-The yield to maturity of the obligation is greater than or equal to 100% but less than 130% of the applicable federal rate (under section 1274(d)) for the day on which the obligation is issued)
-The U.S. person agrees to extend the period for assessment of any income or transfer tax attributable to the transfer and any consequential income tax changes for each year that the obligation is currently outstanding, to a date not earlier than 3 years after the maturity date of the obligation, unless the maturity date of the obligation does not extend beyond the end of the U.S. person’s tax year and is paid within such period; and
-For each year that the obligation is outstanding, the U.S. person reports the status of the obligation on Part I, Schedule C, line 19, and Part III, line 28 as applicable (including principal and interest payments)
For purposes of Form 3520, a related person includes, but is not limited to, a member of your family (this includes grandparents, parents, brothers/sisters, spouses, half-brothers/sisters, children, grandchildren, etc.). It also includes the spouses of any of the listed persons. A related person is also considered to any corporation in which you own more than 50% in value of the outstanding stock (it does not matter whether you own it directly or indirectly). 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.
In Part II of our article explaining IRS Form 3520, we will discuss Filing Exceptions, Distributions, Grantor and Non Grantor Trusts.
Preparing form 3520 is not a task to be taken lightly. You should consider hiring professional help.
Foreign Trusts vulnerable?
