This post addresses the IRS reporting requirements applicable to a U.S. taxpayer following the establishment of a foreign trust. Foreign trusts discussed herein and subject to the reporting requirements include foreign trusts where a U.S. person is the Settlor/Grantor and/or Beneficiary of the trust, including many “Asset Protection Trusts”.
A foreign trust may be an excellent tool for asset protection purposes, but please understand and be prepared to follow all I.R.S. reporting requirements, and pay all taxes due to the I.R.S. even though the trust is domiciled overseas and trust assets are located offshore.
Overview of the Reporting Requirements
If you are a U.S. person and you have established a foreign Asset Protection Trust, you are the “Grantor” (also known as the “Settlor”) of the trust and your reporting responsibilities include:
- “Checking the box” on IRS Form 1040, Schedule B, Part III;
- IRS Form 3520
- IRS Form 8938;
- FinCEN Form 114 (the “FBAR”).
In addition, the foreign trustee must file:
- IRS Form 3520-A, and if the Trustee does not file this form, then you must.
If you are a beneficiary of a foreign trust, and you receive a distribution from the foreign trust, then your reporting responsibilities include:
- “Checking the box” on IRS Form 1040, Schedule B, Part III;
- IRS Form 3520; and
- IRS Form 8938.
In addition, if you receive more than 50% of trust income or assets, you must also file:
- FinCEN Form 114 (the “FBAR”).
The various reporting requirements and forms are discussed more in depth immediately below.
Reporting Requirements – Grantors
As a threshold matter, a U.S. taxpayer who creates (“Grantor” or “Settlor”) or makes a transfer to (“Transferor”) a foreign trust must “check the box” on his or her individual IRS Form 1040, Schedule B, Part III, for the year of transfer to, or creation of, the foreign trust. The Schedule B line item then refers the taxpayer to IRS Form 3520 (further discussed below), on which the U.S. taxpayer will report further information regarding the trust creation and transfer to the trust.
A U.S. grantor of a foreign trust is also required to file Form FinCEN 114, Report of Foreign Bank and Financial Accounts (also known as the “FBAR”), if the grantor has an ownership interest in the trust for U.S. federal tax purposes.1 Because foreign asset protection trusts are considered “Grantor trusts” under the Internal Revenue Code, the grantor of a foreign trust is deemed to own the Trust assets for U.S. tax purposes and must annually file the FBAR. The FBAR must be filed electronically on FinCEN’s (Financial Crimes Enforcement Network, a division of the United States Treasury Department) website.
In addition, pursuant to IRC § 6048(a) and IRS Notice 97-34, the Grantor, Transferor or executor of a decedent’s estate (the “responsible party”2) must file Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts, upon the following “reportable events”3: (1) the creation of the foreign trust, (2) any transfers to the foreign trust from U.S. persons, and (3) the death of a U.S. citizen who was an owner of the foreign trust or whose estate included any portion of the foreign trust. Pursuant to IRC § 6048(a)(2), the amount of money or other property transferred to the trust must be reported, along with the identity of each trustee and beneficiary (or class of beneficiaries).
Form 3520 requires the provision of the following information: name, address and identification information of the foreign trust, beneficiaries (including their percentage interests) and the value of cash or other property transferred to the foreign trust.
Form 3520 is required to be filed by the due date of the taxpayer’s annual income tax return, including extensions. Form 3520 must be sent to the IRS Service Center, P.O. Box 409101, Ogden, Utah 84409.
Additional Reporting Requirements – Owners
In addition to the reporting requirements imposed on Grantors and “responsible parties” discussed above, pursuant to IRC § 6048(b), the “United States owner”4 of any portion of a foreign trust must insure that:
- the trust annually files Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner, which sets forth a full and complete accounting of all trust
- The trust furnishes copies of the Form 3520-A that was filed with the IRS to each of the U.S. owners of the foreign trust and U.S. persons who received distributions from the foreign trust.
A trustee may file Form 3520-A for the foreign trust. However, if the trustee fails to file Form 3520-A, the responsibility will rest with the U.S. owner to file the form and provide the required annual statements to the foreign trust’s U.S. owners and U.S. beneficiaries. In the case of a foreign Asset Protection Trust, the “owner” of the foreign trust responsible for making sure the Form 3520-A is filed is any U.S. person who transfers property to the foreign trust, where the foreign trust has at least one U.S. beneficiary; see also footnote 1, section (f). The 3520-A is due March 15.
In 2010, the IRS implemented additional reporting requirements for foreign accounts and assets by U.S. taxpayers.7 Under the IRS’ additional requirements, an owner of a foreign trust may also be required to file new Form 8938, Statement of Specified Foreign Financial Assets. Form 8938 reports the specified foreign financial assets8 held by the part of the foreign trust in which the owner has an ownership interest.9 The owner is required to file Form 8938 if the total value of those assets exceeds an applicable threshold amount.10
However, the owner does not have to report any of the specified foreign financial assets held by the trust if: (I) the owner reported the foreign trust on a Form 3520 that was timely filed with the IRS for the same year; and (ii) the foreign trust timely files Form 3520-A. Instead, the owner must then identify on Form 8938 the form(s) on which the owner reported the specified foreign financial assets and how many of each form the owner filed.
Form 8938 is due at the same time as the taxpayer’s annual income tax return, including extensions. The form should be sent to the IRS attached to the taxpayer’s annual income tax return.
As noted earlier, the Treasury Regulations also require the owner to file an FBAR reporting the owner’s interest in the foreign trust11.
Additional Reporting Requirements – Beneficiaries
Pursuant to IRC § 6048(c), a beneficiary12 of a foreign trust who receives (directly or indirectly) any distribution13 from the foreign trust during the taxable year must file Form 3520, disclosing the amount and source of the distribution, by the due date of the beneficiary’s income tax return for the year of the receipt of the distribution. In addition, a U.S. taxpayer who has received a distribution as a beneficiary of a foreign trust is also required to disclose this on IRS Form 1040, Schedule B, Part III.
An additional reporting requirement is imposed where a taxpayer, who is not considered an owner, has an interest in a foreign trust.14 The taxpayer is required to report the interest in the foreign trust on Form 8938, if the taxpayer knows or has reason to know based on readily available information of the interest. If a taxpayer receives a distribution from the foreign trust, the taxpayer will be considered to know of the interest. Note that this is different from the FBAR requirement applicable to beneficiaries who have a present beneficial interest in 50% of trust assets (see below). In other words, the FBAR is required for trust beneficiaries who have the right to receive a present distribution, whereas Form 8938 seemingly applies if the trust beneficiary actually receives a distribution.
However, such a taxpayer is not required to report specified foreign financial assets on Form 8938 if the taxpayer reported the assets on one or more of the following forms that was timely filed with the IRS for the same year: (I) Form 3520 (discussed above); (ii) Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations; (iii) Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund; (iv) Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships; and (v) Form 8891, U.S. Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans. Instead, the taxpayer must identify on Form 8938 the form(s) on which the taxpayer reported the specified foreign financial asset.
A beneficiary with a greater than 50 percent present beneficial interest in the assets or income of the foreign trust must also file an FBAR reporting such financial interest.15 A beneficiary of a purely discretionary trust, i.e., where trust distributions are made solely in the discretion of a trustee, does not have a “present” interest. Most foreign asset protection trusts are discretionary trusts. However, a beneficiary who receives more than fifty percent of a trust’s annual income, or fifty percent of trust assets, has a present beneficial interest that is reportable on the FBAR.
Creating a foreign trust and transferring assets to the foreign trust can provide valuable asset protection advantages. At the same time, U.S. taxpayers with interests in foreign asset protection trusts must comply with all IRS reporting requirements, including: Form 1040, Schedule B, Part III; FinCEN 114 (the “FBAR”); Form 3520; Form 3520-A; and new Form 8938. These reporting requirements are complex and penalties for non-compliance can be severe.
Please contact us if you have any questions.
1 An “owner” is defined under Internal Revenue Code (IRC) §§ 671-679 as:
(a) Where the grantor has a reversionary interest exceeding 5% of the foreign trust’s principle or income, if, at the inception of that portion, the value of such interest exceeds 5 percent of the value of such portion. This does not include a reversionary interest that takes effect upon the death of a lineal descendant who hold present interests in a portion of the trust before such beneficiary attains age 21;
(b) Where the beneficial enjoyment of the principle or income of the trust is subject to a power of disposition, exercisable by the grantor or a non-adverse party, or both, without the approval or consent of any adverse party;
(c) Where the grantor has the power to purchase, sell or otherwise deal with or dispose of trust principle or income for less than adequate consideration; power to borrow from the trust without adequate security or interest; has borrowed from the trust and has not completely repaid the loan; and general powers of administration (i.e. power to vote stock/securities of a corporation where the holdings of the trust and grantor are significant, power to control the investment of the trust funds and a power to require the trust corpus by substituting other property of an equivalent value);
(d) Where the grantor or non-adverse party has the power to revoke transfers of property to the trust (but not if revocation only affects beneficial enjoyment of income after the occurrence of an event such that a grantor would not be treated as an owner under section 673); or
(e) Where trust income may be distributed to the grantor or the grantor’s spouse, or held for future distribution the grantor’s spouse, or applied to the payment of premiums on policies of insurance on the life of the grantor or the grantor’s spouse – except those for a purpose under section 170(c), without the approval or consent of any adverse party or in the discretion of the grantor or a non-adverse party.
(f) A U.S. person who directly or indirectly transfers property to a foreign trust, excluding deferred compensation trusts and charitable trusts, if there is a U.S. beneficiary of any portion of such trust for such year.
2 IRC § 6048(a)(1) imposes the duty to provide written notice of a reportable event regarding the foreign trust on the “responsible party”. A “responsible party” is defined under IRC § 6048(a)(4), as either:
(a) The grantor, in the case of the creation of an inter vivos trust;
(b) The transferor, in the case of a transfer of money or property to a foreign trust, including a transfer by reason of death; or
(c) The executor of a decedent’s estate, in any other case.
3 A “reportable event” is defined under IRC § 6048(a)(3).
4 See footnote 1.
5 Pursuant to IRC § 6048(b)(2) and IRS Notice 97-34, where a foreign trust with a U.S. owner does not have a U.S. agent, the Secretary of the Treasury may determine the amounts with respect to the foreign trust to be included by the U.S. owner under the grantor trust rules. The Secretary can make the determination based on its own knowledge or information obtained through testimony or otherwise. If appointed, the U.S. agent is responsible for responding to (1) requests by the Secretary to examine records or produce testimony related to the proper treatment of amounts to be required to be taken into account with respect to such foreign trust by a U.S. person under the grantor trust rules; and (2) any summons by the Secretary. A U.S. owner may serve as the U.S. agent of the foreign trust.
6 Note that whereas Form 3520 is due on the date that the taxpayer’s regular return is due, Form 3520-A is due by the fifteenth day of the third month after the end of the trust’s tax year. If the trust’s tax year ends on December 31st, then Form 3520-A is due the following March 15th.
7 These additional reporting requirements were implemented as part of the Foreign Account Tax Compliance Act (also known as “FATCA”), which was included in the Hiring Incentives to Restore Employment Act (also known as the “HIRE” act).
8 IRC § 6038D(b) defines “specified foreign financial asset” as follows:
(a) Financial accounts maintained by a foreign financial institution;
(b) The following foreign financial assets if they are held for investment and not held in an account maintained by a financial institution: (i) stock or securities issued by someone that is not a U.S. person; (ii) any interest in a foreign entity; and (iii) any financial instrument or contract that has an issuer or counterparty that is not a U.S. person.
9 For example, where the Grantor of a foreign Asset Protection Trust transferred 100% of the foreign trust’s assets to the foreign trust, the Grantor will be treated as owing 100% of the foreign trust for purposes of Form 8938.
10 The applicable threshold amounts, pursuant to Treasury Regulation 1.6038D-2(a)(1)-(3), are as follows:
(a) Unmarried taxpayers, and married taxpayers filing separately, living in the U.S. must file Form 8938 if the value of the foreign trust assets the taxpayer owns exceeds $50,000 on the last day of the tax year or $75,000 at any time during the tax year.
(b) Married taxpayers filing joint income tax returns and living in the U.S. must file Form 8938 if the total value of the foreign trust assets in which the taxpayers have an interest exceeds $100,000 on the last day of the tax year or $150,000 at any time during the tax year.
(c) Taxpayers living abroad are required to file Form 8938 if the total value of the foreign assets they own exceeds $200,000 on the last day of the tax year or $300,000 at any time during the tax year if they are married, and exceeds $400,000 on the last day of the tax year or $600,000 at any time during the tax year if they are married filing a joint income tax return. Taxpayers living abroad are defined as either (i) a U.S. citizen who has been a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year; or (ii) a U.S. citizen or resident who is present in a foreign country or countries at least 330 full days during any period of 12 consecutive months that ends in the tax year being reported.
11 See 31 C.F.R. § 1010.350(e)(2)(iii).
12 The IRS defines a beneficiary as “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. [I]f the trustee is given complete discretion to distribute trust income to anyone, friends and business associates of the family would be considered beneficiaries of such a trust because it could be reasonably anticipated that the trust could possibly benefit such persons.” Notice 97-34; 1997-25 I.R.B. 22.
13 Distributions include:
- Cash payments
- Payments in excess of fair market value of goods or services provided to the trust
- Constructive distributions (loan or debt forgiveness, credit guarantee, etc.)
14 Pursuant to IRC § 6038D(b), such an interest is considered a “specified foreign financial asset”. For a definition of “specified foreign financial asset”, see footnote 8, supra.
15 “Present beneficial interest” in a trust is defined as where “the United States person has a greater than 50 percent present beneficial interest in the assets or income of the trust for the calendar year”. See BSA Electronic Filing Requirements For Report of Foreign Bank and Financial Accounts (FinCEN Form 114).