International Tax Gap Series
Although there are legitimate reasons why a U.S. person might create a foreign trust, or have transactions with a foreign trust, they can have tax consequences and result in filing responsibilities as well. Regardless of your motivation, failure to meet these reporting and filing requirements can result in very significant penalties.
In general, the reporting rules apply to a U.S. person who:
Creates a foreign trust
Transfers any money or property to a foreign trust
Receives a distribution from a foreign trust
Is treated as the U.S. owner of a foreign trust
Tax consequences can apply to the U.S. owners and U.S. beneficiaries of a foreign trust, and to the foreign trust itself.
Reporting Requirements and Tax Consequences
Who must file Form 3520? There are several situations in which a Form 3520 (or statement with similar information) is required to be filed. The most common circumstances are where a U.S. person:
Creates or transfers money or property to a foreign trust
Receives (directly or indirectly) any distributions from a foreign trust
Is treated as the U.S. owner of a foreign trust
Receives certain gifts or bequests from foreign entities
The Instructions for Form 3520 include more detailed information about who must file a Form 3520; when, where, and possible penalties for late or incomplete filing.
Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner, and instructions. This form provides information about the foreign trust, its U.S. beneficiaries, and any U.S. person who is treated as an owner of any portion of the foreign trust.
Who Must File Form 3520-A?
n addition to filing Form 3520, each U.S. person treated as an owner of any portion of a foreign trust under the grantor trust rules is responsible for ensuring that the foreign trust files Form 3520-A and furnishes the required annual statements to its U.S. owners and U.S. beneficiaries.
The Instructions for Form 3520-A include more detailed information about who must file a Form 3520-A; when, where, and possible penalties for late or incomplete filing.
Other Possible Reporting Requirements
Form 1040, Schedule B, Part III, Foreign Accounts and Trusts, must be completed if you receive a distribution from, or were grantor of, or a transferor to a foreign trust.
If you have a financial interest in or signature authority over a foreign financial account, including a bank account, brokerage account, mutual fund, trust, or other type of foreign financial account, the Bank Secrecy Act may require you to report the account yearly to the U.S. Internal Revenue Service (IRS) by filing FinCEN Form 114 (formerly TD F 90-22.1), Report of Foreign Bank and Financial Accounts (FBAR).
Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, and Instructions. A U.S. person who transfers money or property to a foreign trust may be required to file Form 709 United States Gift (Generation Skipping Transfer) Tax Return. See the Instructions for Form 709 for further information.
Form 1040-NR, U.S. Nonresident Alien Income Tax Return, and Instructions. A foreign trust , which is not taxed to a U.S. owner as a grantor trust, may be obligated to file a Form 1040-NR to pay U.S. tax on certain U.S. sourced income. See Publication 519, U.S. Tax Guide for Aliens and the instructions for Form 1040-NR for additional information.
Income Tax Consequences
U.S. owner of a foreign trust - In general, the U.S. owner of a foreign trust is taxed on the income of that trust.
A U.S. person is treated as the owner of a foreign trust under the grantor trust rules of Internal Revenue Code sections 671-679, which includes someone who transfers assets to a foreign trust which has a U.S. beneficiary of any portion of the trust. *Each U.S. owner should receive a Foreign Grantor Trust Owner Statement (Form 3520-A, page 3), which includes information about the foreign trust income they must report.
U.S. beneficiary of a foreign trust – In general, the U.S. beneficiary of a foreign trust will report their share of foreign trust income to the extent it is not reported by the transferors to the trust under the grantor trust rules. The U.S. beneficiary should receive a Foreign Grantor Trust Beneficiary Statement (or a Foreign Non Grantor Trust Beneficiary Statement which includes information about the taxability of distributions they have received and foreign trust income they must report.
U.S. transferor of assets to a non grantor foreign trust - Internal Revenue Code section 684 requires the recognition of gain on certain transfers of appreciated assets to a foreign trust. See the Instructions for Form 3520 for additional information.
Citizens and residents of the United States are taxed on their worldwide income. To help prevent the use of foreign trusts and other offshore entities for tax avoidance or deferral, Congress has enacted several specific provisions in the Internal Revenue Code. Some provisions trigger recognition of gains that would otherwise be deferred. Others deny deferral of tax on income moved offshore.
A specialized industry has developed in attempting to circumvent these provisions. The promoters of offshore schemes often advance technical arguments which purport to show that their scheme is legal. These arguments are used to provide some comfort to their clients, who are then induced to enter into a scheme which usually involves concealing the true ownership and control of assets and income.
The filing and reporting responsibilities discussed here also apply to the beneficial owners of foreign trusts as well. The term beneficial ownership applies to the true owner of an entity, asset, or transaction as opposed to any stated ownership provided in documents or oral representations. The beneficial owner is the one that receives or has the right to receive proceeds or other advantages as a result of the ownership. It is common practice in offshore financial secrecy jurisdictions to interpose entities, individuals, or both as stated owners. The beneficial or true owner is contractually acknowledged in side agreements, statements or by other devises.
For more information about offshore tax schemes, refer to Abusive Offshore Tax Avoidance Schemes.
Additional Information about any of the foreign trust reporting requirements and related income tax consequences is available by clicking on the relevant links throughout the article.
Filing tips to avoid penalties:
- Form 3520
- Be sure to check Form 3520, Box 1K, and enter the form number of the income tax return if an extension was filed.
- Form 3520-A
- File by the 15th day of the 3rd month after the end of the trust’s tax year, the due date may be extended by filing Form 7004, Application for Automatic Extension of Time to File Certain Business Income Tax, Information and Other Returns.
- Form 7004 must be filed with an Employer Identification Number (EIN) for the foreign trust. Forms 7004 for a foreign trust cannot be processed under an individual’s Social Security Number (SSN). Please obtain an EIN for the foreign trust.
- If the foreign trust will not file a Form 3520-A, the U.S. owner of the foreign trust must file a substitute Form 3520-A by completing a Form 3520-A to the best of their ability and attaching it to a timely filed Form 3520, including extensions (see Form 3520 Instructions for more information on filing a substitute Form 3520-A). Do not separately file a duplicate Form 3520-A if you are filing a substitute 3520-A.
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