US Tax Guide for Expats (2020): Form 3520 and Substitute Form 3520-A
Form 3520 and Substitute Form 3520-A for Foreign Trusts and Gifts From Nonresidents
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.
Additionally, an owner of a foreign trust might be required to file a Substitute Form 3520-A if the foreign trust fails to file Form 3520-A (See SUBSTITUTE Form 3520-A below). Here is Form 3520 and Instructions.
Important Update: In early March of 2020, the IRS issued Rev. Proc. 2020-17 that provides an exemption from the information reporting requirements under Section 6048 with respect to certain tax-favored foreign retirement trusts and certain tax-favored non-retirement savings trusts. 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, nowhere in the IRC is the term "trust" actually defined. There is a definition of 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 a foreign trust is one that is not under the jurisdiction of United States courts or controlled by a United States person. But what is a "trust"?
A Treasury regulation does a pretty good job defining a trust for purposes of the Internal Revenue Code. Here it is:
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 explanation makes a couple of critical points that many practitioners ignore when telling their clients they must file Form 3520 for a foreign investment vehicle that is called a trust.
The Trustee Must Be A Fiduciary
First, there must be a trustee who has responsibility for the protection and conservation of property for the beneficiaries "under the ordinary rules applied in chancery or probate courts." The general duties of a trustee 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.")
I suggest that the question be posed to whoever is in the position of trustee of a foreign trust whether they acknowledge a "fiduciary duty" to the beneficiaries. You might hear a little hemming and hawing at that point. It's interesting to note that the nature of fiduciary obligations differs from country to country, which could raise the question of whether laws in a particular country even allow for the protection contemplated by the regulation. (By the way, a fiduciary duty should include filing Form 3520-A with the IRS for the benefit of US beneficiaries, which is a legal duty ignored by every foreign trust with which I have ever dealt.)
An example of a foreign "trust" that fails the fiduciary test is the Mexican fideicomiso (Mexican Land Trust). If you are not Mexican, you cannot own real estate in Mexico too close to the coast or border. These areas are known as the "restricted zone." So if you wish to buy real estate in the restricted zone, you must buy 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 permission from the bank trustee.
For several decades, the IRS position was that a fideicomiso was 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) saying a fideicomiso is not a trust as defined in Reg. Sec. 301.7701-4(a) because the trustee was not a fiduciary, but merely an agent for holding the property.
Free Choice of Investment Options
The second critical point of the regulatory definition is that the beneficiaries "cannot share in the discharge of this responsibility." This appears to say that the trustee must have full control of trust assets. The regulation gives an example of a "business trust," which might be called a trust, but really is not a trust under the Internal Revenue Code because of the beneficiaries' involvement. (Reg Sec. 301.7701-4(b).)
Are Canadian TFSAs and UK ISAs Foreign Trusts?
Consider, for example, a Canadian Tax-Free Savings Account (TFSA) or a UK Individual Savings Account (ISA). Contributions to these accounts and account earnings are all taxable in the United States because they are not considered qualified retirement accounts under IRC Section 401(a). This is true whether or not they are considered foreign trusts. Also, they might contain foreign mutual funds, taxed to death in the US under the PFIC rules. But do they meet the regulatory definition of a trust? Unfortunately, the IRS has not ruled on this question, so we are left to our own means to figure this out.
If you're considering investing, or if you happen to own one, comb through the trust agreement and try to find where it talks about the responsibility of the financial institution (trustee) to the account holder (beneficiary). Does it talk about their "fiduciary duty"? Is the trustee really a "trustee" or just the manager of an account?
Also, the idea of a trust, as the regulation explains, is to protect and conserve trust assets "for beneficiaries who cannot share in the discharge of this responsibility." If the TFSA or ISA gives you an unrestricted right to invest in anything you want to, it probably violates the regulatory definition of a trust. Again, we have no idea what the IRS might say about this.
Should You File a Protective Form 3520?
Any other foreign retirement fund in which you have contributed more than an employer (see Who Is the Owner, below), such as an Australian superannuation account for self-employed individuals, should be put to the same tests. These are taxable accounts, subject to FBAR, Form 8938 and PFIC reporting, but if they fail the tests, don't file Form 3520.
Let's encourage the IRS publish a ruling or two explaining exactly what it considers a foreign trust to be, and for which Form 3520 is required. Lately, the best way to incur a penalty from the IRS (typically $10,000) is to file a protective Form 3520 as owner of a foreign trust, even when you file it correctly and on time. See When To File below for a discussion about this. See also Foreign Trusts: IRS Penalty Notices For Late Forms 3520-A Traumatize Many Innocent Taxpayers!
Are Foreign Pension Plans Foreign Trusts?
Generally, if there is a trustee who takes title to the property "under the ordinary rules applied in chancery or probate courts" the answer is yes. Again, that means the trustee has a fiduciary responsibility to the beneficiaries, as discussed above. Additionally, trust assets must be specifically set aside for the benefit of the beneficiaries. For example, if the trust assets are simply put in an employer account and designated for the beneficiaries, but still subject to general creditors of the employer, it is not a trust.
No Filing Requirement for Qualified Plans
The IRS has ruled that any foreign pension for which contributions would be deductible because it qualifies as an employee's trust or deferred compensation plan under US tax law (under IRC Section 402(b), 404(a)(4), or 404A), or is a tax exempt organization (under IRC Section 501(c)(3)) is exempt from Form 3520 and Form 3520-A filing requirements. (IRS Notice 97-34, 1997-1 CB 422.) (Very few foreign pensions qualify.)
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). These funds are considered foreign trusts, but in accordance with Article XVIII(7) of the US/Canada Tax Treaty, they are taxed the same as US qualified plans. However, these assets should still be reported on FBAR Form 114 and on Form 8938 if you are required to file these forms.
Who Is the Owner?
You are not considered the owner of an "employees' trust." Neither the Code nor the regulations define this term. However, if a foreign pension (i) was created by a foreign employer, (ii) is administered by the foreign employer, and (iii) is more than half funded by the foreign employer, it appears that the foreign pension (trust) would be considered an "employees' trust." (IRC Section 402(b).) If your pension plan meets these conditions, Form 3520 and Substitute Form 3520-A are not required, and earnings of the pension are taxed to you only on distribution. However, if you contributed more to the foreign pension than your foreign employer, you will be treated as the owner of the portion of the plan attributable to your contributions. Treas. Reg. Sec. 1.402(b)-1(b)(6). That means reporting is required on Form 3520 and possibly Substitute Form 3520-A. Whether or not you are not considered the owner for Form 3520 purposes, these accounts are subject to FBAR and Form 8938 reporting.
SUBSTITUTE Form 3520-A
Prior to the Small Business and Job Protection Act of 1996 (the Act), a US person who transferred property to a foreign trust was required to report the transfer on a prior version of Form 3520 within 90 days of the transfer. Also, US owners of foreign trusts were required to file annually a prior version of Form 3520-A. No reporting was required of US beneficiaries of foreign trusts or of US persons who received gifts from foreign persons.
In response to enhanced reporting requirements of the Act, and to reduce duplicative reporting requirements, the IRS revised Form 3520, "Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. The goal was to allow US persons to use a single form to comply with all the new reporting requirements of the Act pertaining to transactions with foreign trusts and the receipt of foreign gifts.
Also, Form 3520-A, "Annual Information Return of Foreign Trust With a U.S. Owner," was revised so that foreign trusts would be able to use that form to meet the new information reporting requirements of IRC Section 6048(b). US owners of foreign trusts are no longer required to file Form 3520-A. (See IRS Notice 97-34, 1997-1 CB 422.)
A foreign trust (that's the trust, not you) with a US owner (that's you) must file Form 3520-A to provide information about the foreign trust, it’s US beneficiaries, and any United States person who is treated as an owner of any portion of the foreign trust. Form 3520-A is required to be filed by the trust 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). Foreign trusts often do not meet this reporting requirement. In fact, they rarely do.
Congress recognized that it's tough to make foreign trusts obey US tax law, so if you are treated as the owner of a foreign trust, you get penalized if you fail to "ensure" that the foreign trust files a timely Form 3520-A. (See IRC Section 6048(b).)
The statute does not explain how an owner is to ensure that Form 3520-A is filed by the trust. However, the instructions to Form 3520 instruct a US owner of a foreign trust who has not received a Foreign Grantor Trust Owner Statement (Form 3520-A) from the foreign trust to complete a Substitute Form 3520-A, to the best of your ability, and attach it to your Form 3520. (See also CCA 201150029 - "Information With Respect to Certain Foreign Trusts.")
Receipt of Certain Large Gifts or Bequests From Certain Foreign Persons
If you received as a gift a) more than $100,000 from a nonresident alien individual or foreign estate, or b) more than $15,797 from foreign corporations or foreign partnerships, you are required to complete Part IV of Form 3520.
When To File
The due date to file Form 3520 is the 15th day of the 4th month following the end of the U.S. person's tax year. The instructions to Form 3520 explain that if the U.S. person is granted an extension of time to file Form 1040, the due date for filing Form 3520 is the 15th day of the 10th month following the end of the U.S. person's tax year. In other words, Form 4868 extends the time to file Form 3520 along with Form 1040.
This extension also applies to Substitute Form 3520-A if it is required to be attached to Form 3520. According to the Internal Revenue Manual (IRM) Section 126.96.36.199.7: "If the foreign trust does not file Form 3520-A, but the U.S. owner completes and attaches a substitute Form 3520-A for the foreign trust to the U.S. owner's timely filed Form 3520 in accordance with the instructions for Form 3520, the U.S. owner will not be subject to the penalty for failure to file Form 3520-A."
It happens that the due date for Form 3520-A, which is required to be filed by a foreign trust with US owners, is March 15, and a request for an extension to file this form must be made on Form 7004 by March 15. Remember, this is not the form the owner files. An owner is no longer required to file Form 3520-A. The owner only files Substitute Form 3520-A when Form 3520-A is not filed by the trust.
The traumatic experience of one of our clients, and me, over the due date of Substitute Form 3520-A is described in Foreign Trusts: IRS Penalty Notices For Late Forms 3520-A Traumatize Many Innocent Taxpayers! As the article explains, there is definitely a disconnect right now between the people (or robots) at the IRS who issue penalty notices and their own Internal Revenue Manual. This is a nightmare for countless innocent taxpayers. It is an issue that is currently under review by the IRS Systemic Advocacy Management System, but any resolution will take months. If you have been affected by this fiasco, please make your voice heard with the IRS at the Systemic Advocacy Management System or at the Taxpayer Advocate Service.
What Happens If You Don't File?
Unless you can demonstrate reasonable cause, a penalty applies if Form 3520 is not timely filed or if the information is incomplete or incorrect. The penalty is the greater of $10,000 or any of the following that apply:
- 35% of the gross value of any property transferred to a foreign trust for failure by a US transferor to report the creation of or transfer to a foreign trust.
- 35% of the gross value of the distributions received from a foreign trust for failure by a US person to report receipt of the distribution.
- 5% of the gross value of the portion of the foreign trust's assets treated as owned by a US person (under the grantor trust rules in the Code) for failure by the US person to report the US ownership information.
You are subject to additional $10,000 penalty (or 5% of the trust if greater) if the foreign trust a) fails to file a timely Form 3520-A, or b) does not furnish complete and accurate information, and you did not timely file Substitute Form 3520-A.
Relief Under Rev. Proc. 2020-17
This ruling provides an exemption from the information reporting requirements under IRC Section 6048 for certain U.S. citizens and residents with respect to their transactions with, and ownership of, certain tax-favored foreign retirement trusts and certain tax-favored foreign non-retirement savings trusts. As a general premise, Section 3 of the ruling states:
. . . 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 U.S. 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 U.S. individuals from the requirement to provide information about these trusts under section 6048.
But Section 5 of the ruling imposes arbitrary contribution limits and requirements that eliminate a large number of the foreign trusts that fall within the general premise.
For example, tax favored retirement trusts must meet the following requirements established by the laws of the trust's jurisdiction:
- Only contributions with respect to income earned from the performance of personal services are permitted, and
- Contributions to the trust are limited by a percentage of earned income of the participant, are subject to an annual limit of $50,000 or less to the trust, or are subject to a lifetime limit of $1,000,000 or less to the trust.
Tax favored foreign non-retirement savings trusts are trusts that are created to earn income for the provision of medical, disability, or educational benefits. But under the laws of the trust's jurisdiction, contributions must be limited to $10,000 or less annually, or $200,000 or less on a lifetime basis.
Hopefully, this ruling is just the first step as the IRS gathers information about how new regulations under Section 6048 should look. Here is the text Rev. Proc. 2020-17.