Have You Received an IRS Penalty Notice for a Late Form 3520-A?
Read our post to learn the issue behind many of these notices and how to resolve it
Overview
Section 6048 of the Internal Revenue Code requires a United States person, as defined for FBAR reporting (and the executor of the estate of a US decedent), to file Form 3520 to report:
- Certain transactions with foreign trusts,
- Ownership of foreign trusts, and
- Receipt of certain large gifts or bequests from certain foreign persons.
If a foreign trust fails to file Form 3520-A, the owner of the foreign trust might need to file a Substitute Form 3520-A (see SUBSTITUTE Form 3520-A below).
Important Update: In early March of 2020, the IRS issued Rev. Proc. 2020-17. This procedure exempts certain tax-favored foreign retirement trusts and certain tax-favored non-retirement savings trusts from the information reporting requirements under Section 6048. (See Relief Under Rev. Proc. 2020-17 below.)
What Is a Foreign Trust For Which Form 3520 Must Be Filed?
Although the Internal Revenue Code (IRC) refers to trusts in numerous sections, it never defines the term “trust.” However, it does define “foreign trust.” IRC Section 7701(a)(31)(B) says:
The term “foreign trust” means any trust other than a trust described in subparagraph (E) of paragraph (30).
Subparagraph (E) describes:
. . . any trust if (i) a court within the United States is able to exercise primary supervision over the administration of the trust, and (ii) one or more United States persons have the authority to control all substantial decisions of the trust.
So, you must treat a trust as “foreign” if no United States court has jurisdiction over it or if no United States person controls its substantial decisions. But what does “trust” mean?
A Treasury regulation offers a practical definition of a trust for purposes of the Internal Revenue Code:
In general, the term “trust” as used in the Internal Revenue Code refers to an arrangement created either by a will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts. Usually the beneficiaries of such a trust do no more than accept the benefits thereof and are not the voluntary planners or creators of the trust arrangement. However, the beneficiaries of such a trust may be the persons who create it and it will be recognized as a trust under the Internal Revenue Code if it was created for the purpose of protecting or conserving the trust property for beneficiaries who stand in the same relation to the trust as they would if the trust had been created by others for them. Generally speaking, an arrangement will be treated as a trust under the Internal Revenue Code if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit. (Reg Sec. 301.7701-4(a).)
This regulation makes a couple of critical points that many practitioners ignore when they tell clients they must file Form 3520 for a foreign investment vehicle that carries the label “trust.”
The Trustee Must Be a Fiduciary
A trustee must take responsibility for protecting and conserving property for the beneficiaries “under the ordinary rules applied in chancery or probate courts.” The trustee’s general duties include a fiduciary responsibility (defined in IRC Sec. 7701(a)(6)) to the beneficiaries. (Here’s a Wikipedia discussion of the term “trustee,” and here’s a Wikipedia discussion of “fiduciary.”)
Ask the person serving as trustee of a foreign trust whether they acknowledge a “fiduciary duty” to the beneficiaries. At that point, you might hear some hemming and hawing. Because fiduciary obligations differ from country to country, you must also consider whether a particular country’s laws even allow for the protection that the regulation contemplates. (By the way, a fiduciary duty should include filing Form 3520-A with the IRS for the benefit of US beneficiaries. Every foreign trust I have dealt with has ignored this legal duty.)
A Mexican fideicomiso (Mexican Land Trust) provides an example of a foreign “trust” that fails the fiduciary test. If you are not Mexican, you cannot own real estate in Mexico too close to the coast or border—areas known as the “restricted zone.” To buy real estate in the restricted zone, you must purchase it through a Mexican Land Trust with a Mexican bank as trustee. The Mexican bank holds title and collects a fee but disclaims all responsibility for the property, including obtaining a clear title. Trust owners can buy and sell the property, make improvements, lease the property, and do everything a legal owner can typically do—without the bank trustee’s permission.
For decades, the IRS treated a fideicomiso as a foreign grantor trust. But in 2012, the IRS issued Private Letter Ruling (PLR) 201245003 (followed by Rev. Rul. 2013-14, 2013-26 IRB 1267) holding that a fideicomiso is not a trust as defined in Reg. Sec. 301.7701-4(a). The IRS reasoned that the trustee was not a fiduciary but merely an agent for holding property.
Free Choice of Investment Options
The second critical point of the regulatory definition requires that beneficiaries “cannot share in the discharge of this responsibility.” In other words, the trustee must retain full control of trust assets. The regulation gives the example of a “business trust.” Even though people might call it a trust, the Internal Revenue Code does not treat it as one because the beneficiaries participate in the trust’s activities. (Reg. Sec. 301.7701-4(b).)
Are Canadian TFSAs and UK ISAs Foreign Trusts?
Consider a Canadian Tax-Free Savings Account (TFSA) or a UK Individual Savings Account (ISA). The United States taxes contributions to these accounts and all account earnings because IRC Section 401(a) does not recognize them as qualified retirement accounts. This treatment applies whether or not the IRS considers them foreign trusts. These accounts may also hold foreign mutual funds, which are heavily taxed by the US under the PFIC rules. But do they qualify as trusts under the regulatory definition? The IRS has not ruled on this question, so we must work it out ourselves.
Update: In 2024, our firm appealed penalties for late-filed Forms 3520/3520-A. The client had a Canadian TFSA. His preparer told him that he needed to file the forms but did not prepare them. Trying to do the right thing, the client filled them out himself and mailed them in—but a few days late.
Two years later, the client received two CP15 notices charging him $20,000 in penalties. Examinations rejected his reasonable cause statement, and he came to us for help.
We argued on appeal that the client did not need to file the forms in the first place because a TFSA does not qualify as a foreign trust. A TFSA is not a separate entity, has no trustee, and therefore does not meet the definition of a foreign trust.
When Appeals took up the issue in 2024, the Appellate Officer immediately agreed and abated the penalties. He also indicated that Appeals treats this as a coordinated issue, meaning future TFSA cases should reach the same conclusion.
If you are considering investing—or already own—a tax-favored foreign account, read the trust agreement carefully. Look for any language describing the financial institution’s responsibility (as trustee) to the account holder (beneficiary). Does it mention “fiduciary duty”? Is the trustee acting as a true trustee, or merely managing an account?
The regulation also emphasizes that a trust exists to protect and conserve assets “for beneficiaries who cannot share in the discharge of this responsibility.” If your foreign account gives you unrestricted authority to invest however you want, it probably does not meet the regulatory definition of a trust.
Canadian RRSP and RRIF
The IRS has provided an exception to filing Forms 3520 and 3520-A (see SUBSTITUTE Form 3520-A below) for Canadian registered retirement savings plans (RRSPs) and registered retirement income funds (RRIFs) (see IRS Rev. Proc. 2014-55). The IRS treats these funds as foreign trusts, but Article XVIII(7) of the US/Canada Tax Treaty requires that they receive the same tax treatment as US qualified plans. However, you must still report these assets on FBAR Form 114 and on Form 8938, if you must file those forms.
Are Foreign Pension Plans Foreign Trusts?
Generally, if a trustee takes title to property “under the ordinary rules applied in chancery or probate courts,” the plan qualifies as a trust. In that case, the trustee has a fiduciary responsibility to the beneficiaries, as discussed above. Trust assets must also be specifically set aside for the beneficiaries. For example, if an employer merely designates assets in its own account for the beneficiaries but leaves them subject to the employer’s general creditors, the arrangement does not qualify as a trust.
No Filing Requirement for Qualified Plans
The IRS has ruled that certain foreign pensions do not require Form 3520 or Form 3520-A. Specifically, this applies to any pension that qualifies as an employee’s trust or deferred compensation plan under US tax law (IRC Sections 402(b), 404(a)(4), or 404A), or qualifies as a tax-exempt organization (IRC Section 501(c)(3)).
NOTE: (IRS Notice 97-34, 1997-1 CB 422.) Very few foreign pensions meet these conditions.
Should You File a Protective Form 3520?
You should apply the same tests to any other foreign retirement fund in which you contribute more than your employer, such as an Australian superannuation account for self-employed individuals. These accounts are taxable and subject to FBAR, Form 8938, and PFIC reporting. But if the account fails the trust tests, do not file Form 3520.
We should push the IRS to publish clear rulings explaining exactly what it considers a foreign trust and when Form 3520 is required. Recently, the fastest way to incur an IRS penalty (often $10,000) has been to file a protective Form 3520 as the owner of a foreign trust—even if you file it correctly and on time. (See When To File below for more on this. Also see Foreign Trusts: IRS Penalty Notices For Late Forms 3520-A Traumatize Many Innocent Taxpayers!).
Who Is the Owner?
The IRS does not consider you the owner of an “employees’ trust.” Neither the Code nor the regulations define the term directly. However, the IRS treats a foreign pension as an “employees’ trust” (IRC Section 402(b)) if:
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A foreign employer created the pension,
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The foreign employer administers it, and
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The foreign employer funds at least half of it.
If your pension plan meets these conditions, you do not need to file Form 3520 or a Substitute Form 3520-A. The IRS taxes you on the pension earnings only when you receive a distribution.
If you contribute more to the foreign pension than your foreign employer, however, the IRS treats you as the owner of the portion attributable to your contributions (Treas. Reg. Sec. 1.402(b)-1(b)(6)). In that case, you must report the plan on Form 3520 and possibly on a Substitute Form 3520-A. Regardless of ownership status for Form 3520, you must also report these accounts on FBAR and Form 8938 if you are required to file them.
SUBSTITUTE Form 3520-A
Before the Small Business and Job Protection Act of 1996 (the Act), a US person who transferred property to a foreign trust had to report the transfer on an earlier version of Form 3520 within 90 days. US owners of foreign trusts also had to file a prior version of Form 3520-A each year. However, US beneficiaries of foreign trusts and US persons who received gifts from foreign persons did not have to file anything.
After the Act enhanced reporting requirements, the IRS revised Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. The IRS designed the revision to let US persons use a single form to meet all new reporting requirements for transactions with foreign trusts and the receipt of foreign gifts.
The IRS also revised Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner, so foreign trusts could use that form to meet the new reporting requirements under IRC Section 6048(b). As a result, US owners of foreign trusts no longer have to file Form 3520-A. (See IRS Notice 97-34, 1997-1 CB 422.)
A foreign trust (the trust itself, not you) with a US owner (that’s you) must file Form 3520-A to provide information about the trust, its US beneficiaries, and any US person treated as an owner of any portion of the trust. The trust must file the form with the IRS by the 15th day of the third month after the end of the trust’s tax year (March 15 for a calendar-year trust). Foreign trusts rarely meet this requirement.
Because Congress knew it would be difficult to force foreign trusts to comply with US tax law, it penalized US owners who fail to “ensure” that the trust files Form 3520-A on time. (See IRC Section 6048(b).)
The statute does not explain how an owner should ensure compliance. However, the instructions to Form 3520 tell a US owner who has not received a Foreign Grantor Trust Owner Statement (Form 3520-A) from the trust to complete a Substitute Form 3520-A to the best of their ability and attach it to their Form 3520. (See also CCA 201150029 – Information With Respect to Certain Foreign Trusts.)
The IRS is currently penalizing taxpayers for filing Substitute Forms 3520-A “late,” even when they are not actually late. (See When To File below.)
Receipt of Certain Large Gifts or Bequests From Certain Foreign Persons
If you received a gift of:
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More than $100,000 from a nonresident alien individual or foreign estate, or
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More than $15,797 from foreign corporations or partnerships
You must complete Part IV of Form 3520.
When To File
The due date to file Form 3520 is the 15th day of the fourth month after the end of your tax year. If you obtain an extension of time to file Form 1040, the extension also moves the due date for Form 3520 to the 15th day of the tenth month after your tax year ends. In other words, filing Form 4868 extends the due date for both Form 1040 and Form 3520.
This extension also applies to Substitute Form 3520-A if you must attach it to Form 3520. According to the Internal Revenue Manual (IRM) Section 21.8.2.19.7:
If the foreign trust does not file Form 3520-A, but the US owner completes and attaches a Substitute Form 3520-A for the foreign trust to the US owner’s timely filed Form 3520 in accordance with the instructions for Form 3520, the US owner will not be subject to the penalty for failure to file Form 3520-A.
By contrast, the foreign trust itself must file Form 3520-A by March 15. If the trust needs more time, it must request an extension on Form 7004 by March 15. Remember, the trust—not you—files Form 3520-A. You only file a Substitute Form 3520-A when the trust fails to file.
One of my clients and I experienced this problem firsthand when the IRS penalized a timely filed Substitute Form 3520-A. I described this in Foreign Trusts: IRS Penalty Notices For Late Forms 3520-A Traumatize Many Innocent Taxpayers! As that article explains, the IRS currently suffers from a disconnect between the penalty notices it issues (often automatically by computer) and its own Internal Revenue Manual. Countless innocent taxpayers are caught in this nightmare. The IRS Systemic Advocacy Management System is currently reviewing the issue, but any resolution will take months. If you have been affected, you should raise your voice with the IRS through the Systemic Advocacy Management System or the Taxpayer Advocate Service.
What Happens If You Don't File?
If you fail to file Form 3520 on time or submit incomplete or incorrect information, the IRS will impose a penalty unless you can demonstrate reasonable cause. The penalty equals the greater of $10,000 or one of the following amounts:
- 35% of the gross value of any property you transferred to a foreign trust if you failed to report the creation of or transfer to the trust
- 35% of the gross value of any distributions you received from a foreign trust if you failed to report the receipt
- 5% of the gross value of the portion of a foreign trust’s assets that you are treated as owning (under the grantor trust rules) if you failed to report your ownership information.
You also face an additional penalty of $10,000, or 5% of the trust’s value (whichever is greater), if the foreign trust either (a) fails to file a timely Form 3520-A or (b) submits incomplete or inaccurate information, and you failed to timely file a Substitute Form 3520-A.
Relief Under Rev. Proc. 2020-17
Rev. Proc. 2020-17 exempts certain US citizens and residents from the information reporting requirements under IRC Section 6048 for their transactions with, and ownership of, certain tax-favored foreign retirement trusts and certain tax-favored foreign non-retirement savings trusts.
The IRS explained its reasoning in Section 3 of the ruling:
. . . because applicable tax-favored foreign trusts generally are subject to written restrictions, such as contribution limitations, conditions for withdrawal, and information reporting, which are imposed under the laws of the country in which the trust is established, and because US individuals with an interest in these trusts may be required under section 6038D to separately report information about their interests in accounts held by, or through, these trusts, it would be appropriate to exempt US individuals from the requirement to provide information about these trusts under section 6048.
However, Section 5 of the ruling imposed arbitrary contribution limits and requirements that excluded many foreign trusts that otherwise met the general premise.
For example, tax-favored foreign retirement trusts must meet the following conditions under the laws of their jurisdiction:
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They may accept only contributions based on income earned from personal services.
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Contributions must be limited by a percentage of earned income, capped annually at $50,000 or less, or capped over a lifetime at $1,000,000 or less.
Tax-favored foreign non-retirement savings trusts qualify if the trust was created to earn income for medical, disability, or educational benefits. However, the laws of the jurisdiction must limit contributions to $10,000 or less annually or $200,000 or less over a lifetime.
Hopefully, the IRS issued this ruling as a first step while it collects information to shape new regulations under Section 6048.
Here is the text of Rev. Proc. 2020-17.