This memorandum addresses the reporting requirements applicable to a U.S. taxpayer following the establishment a foreign trust. Foreign trusts covered herein and subject to the reporting requirements include foreign trusts where a U.S. taxpayer is the Settlor or Grantor of the trust, including many “Asset Protection Trusts”.1
As we have previously advised clients, a foreign trust may be an excellent tool for asset protection purposes, but clients must 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. Clients should give a copy of this memorandum to their accountant.
As a threshold matter, a grantor or transferor to a foreign trust must report on his or her individual IRS Form 1040, Schedule B, Part III, for the year of transfer to or creation of the foreign trust, information regarding the trust creation, transfer to the trust, and if applicable, whether the taxpayer has an interest in or signature or other authority over a foreign financial account.2
With respect to foreign trusts, Internal Revenue Code (“IRC”) § 6048(a) imposes a duty upon the “responsible party”3 to provide written notice4 of any “reportable event”5 to the Secretary6. In IRS Notice 97-34, the Secretary prescribed that form 3520 shall be used to report all transactions with foreign trusts and receipts of foreign gifts. Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts, requires the provision of the following information: names, addresses and identification information of the foreign trust, beneficiaries (including their percentage interests), the location of the trust, and the value of cash or other property transferred to the foreign trust. For your convenience, a copy of Form 3520 is attached to this memorandum. Form 3520 should be filed with the taxpayer’s annual income tax return by the due date of the taxpayer’s return for the taxable year of the transfer to the foreign trust. A copy of Form 3520 must also be sent to the IRS Philadelphia Service Center.
Additional Reporting Requirements – Owners
In addition to the reporting requirements imposed on “responsible parties”, IRC § 6048(b) imposes upon an “owner” of any portion of a foreign trust the responsibility of insuring that:
- the trust files a return for each year which sets forth a full and complete accounting of all trust activities and operations for the year, the name of the U.S. agent for the trust, and such other information as the Secretary prescribes; and
- the trust furnishes such information as the Secretary requires to each U.S. person who is treated as an owner of any portion of the trust or who receives (directly or indirectly) any distribution from the trust.
A Trustee may use Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Onwer, to satisfy the trust’s reporting requirements. For your convenience, a copy of Form 3520-A is attached to this memorandum7. Form 3520-A reports to the IRS the taxable income of the trust and allocation of that income among the trust’s U.S. owners. If the trustee fails to file Form 3520-A, the responsibility will rest with the U.S. owner.
The owner can avoid many of these reporting requirements by insuring that there is a U.S. agent appointed and authorized to act pursuant to IRC § 6048(b). Once appointed and authorized to act, the agent can insure that all reporting requirements are met and any IRS inquiries can be made directly to him or her. The owner may serve as the U.S. agent of the trust.
Additional Reporting Requirements – Beneficiaries
IRC § 6048(c) imposes a duty upon a beneficiary8 of a foreign trust who receives (directly or indirectly) any distribution9. from the foreign trust during the taxable year to file a return, which must include: (1) the name of such trust; (2) the aggregate amount of the distributions so received from such trust during the taxable year, and (3) such other information as the Secretary may prescribe.
The beneficiary is required to file Form 3520 and disclose 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.
Transferring assets to a foreign trust can provide valuable asset protection advantages. But at the same time, U.S. foreign trust clients must comply with all IRS reporting requirements.
- The reporting requirements described herein are not applicable where a client has purchased a foreign annuity from an overseas annuity company, and that annuity company has then funded a trust. A U.S. taxpayer who has received a distribution from a foreign trust may still be required to file IRS Form 3520; see infra at p.3. A U.S. taxpayer who has received annuity payments from a foreign annuity company is not required to file IRS Form 3520.
- Where a U.S. taxpayer has signature or other authority over a foreign financial account, that person is also required to file Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (also known as the “FBAR”). Recent revisions to the FBAR instructions require that a U.S. grantor of a foreign trust has to file an FBAR if that trust has a protector. The instructions do not distinguish between a U.S. protector or a foreign protector.
- A “responsible party,” is defined under IRC § 6048(a)(4), as either:
- The grantor, in the case of the creation of an inter vivos trust;
- The transferor, in the case of a transfer of money or property to a foreign trust, including a transfer by reason of death; or
- The executor of a decedent’s estate, in any other case.
- IRC § 6048(a)(2) provides that, at a minimum, the required notice shall contain:
- The amount of money or other property transferred to the trust in connection with the reportable event; and
- The identity of the trust and of each trustee and beneficiary (or class of beneficiaries) of the trust.A “reportable event” is defined under IRC § 6048(a)(3) as:
- The creation, by a United States person, of any foreign trust;
- The transfer of any money or property (directly or indirectly) to a foreign trust by a U.S. person, including transfer by reason of death; and
- The death of a citizen or resident of the U.S. if:
- The decedent was treated as the owner of any portion of a foreign trust; or
- Any portion of a foreign trust was included in the gross estate of the decedent.
- NOTE: Fair market value sales and transfers to deferred compensation and charitable trusts are not considered “reportable events” in most circumstances. See IRC § 6048(a)(3)(b)(I) & (ii).
- The term “Secretary” means the Secretary of the Treasury or his delegate. IRC § 7701(a)(11)(B). The term “Delegate” means any officer, employee, or agency of the Treasury Department duly authorized by the Secretary of the Treasury. IRC § 7701(a)(12)(A)(i).
- Clients should 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 31, then Form 3520-A is due the following March 15. Clients should discuss the return date with their accountants, especially if the trust’s tax year is not the calendar year.
- The Service 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.
- 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.).