The Internal Revenue Service (IRS) is looking for money. As part of the hunt, it has instituted various “campaigns” (full list here) aimed at areas in which there is greater taxpayer noncompliance that may involve significant tax dollars and penalties. One such campaign involves the failure by a US person to file complex information-reporting tax forms related to the US person’s transactions with foreign trusts. This particular IRS campaign is called “Forms 3520/3520-A Non-Compliance and Campus Assessed Penalties”. The campaign employs a “multifaceted approach” to improving compliance with respect to the timely and accurate filing of information returns reporting ownership of, and transactions with, foreign trusts. The agency will address noncompliance through a variety of “treatment streams” including audits and penalty assessments for late or incomplete forms.
Are You Dealing With a “Trust?” Is it a “Foreign” Trust?
Generally speaking, an arrangement will be treated as a “trust” (as opposed to some other type of entity) under the Internal Revenue Code (IRC), 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. If this is the purpose, then the parties are not associates in a joint enterprise for the conduct of business for profit, which might be taxable as a partnership, or corporation, for example. An entity created to “operate a business” rather than to “protect or conserve assets” is not recognized as a trust for US tax purposes. Instead, entities conducting business activities are more properly classified as business entities.
The question may sound simple, but in cross-border situations, the answer is not always easily reached. Once it is determined that the entity is properly classified as a “trust”, the next task is to determine if it is a US (domestic) trust or a “foreign” trust. Whether a trust qualifies as “foreign” is, in itself, a complicated topic and is examined in my earlier blog post.
Foreign Pension/Retirement Schemes
What comes as a rude awakening to many is the fact that foreign pension and retirement plans may be treated as “foreign trusts” requiring the filing of these complex forms. The IRS recently announced exceptions for certain retirement schemes, but the qualification requirements are very strict and until regulations are issued, a lot of questions remain. You can read about this topic in my earlier blog post, here.
What Tax Forms Might be Required?
Assuming one has a foreign trust, taxpayers may soon receive a letter from the IRS detailing the possible forms that may be missing from the taxpayer’s tax filing, including Forms 3520 and/or 3520-A. The IRS letter goes on to explain the filing requirements with respect to these and other forms. A short overview of these two forms follows below:
IRS Form 3520: US Informational Return – Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts
US persons use this Form to report certain transactions with foreign trusts. It is required for example, of US persons who are treated as the tax owner of any part of the foreign trust during the current tax year. The US grantor of a foreign trust is considered a so-called “responsible party” and he must notify the IRS of a “reportable event” on Form 3520 (“reportable events” include for example, the creation of a foreign trust by a US person, the transfer of money to a foreign trust by a US person, including a transfer by reason of death). Form 3520 is also used by US persons who receive any distributions from a foreign trust during the year (discussed in my earlier blog post).
Generally, the following information is reported on the Form 3520: the names, addresses, and taxpayer identification numbers of the foreign trust, the fiduciary, the beneficiaries and their percentage interest, the amount of cash and value of other property transferred to or received from the foreign trust.
IRS Form 3520-A: Annual Information Return of Foreign Trust with a US Owner
A foreign trust treated as having a US owner is required to annually file Form 3520-A. Under the relevant tax rules (IRC Section 6048(b)), when a US person, is treated as the “owner” of a foreign trust (or any part thereof) because of the “grantor” trust rules, that US person is responsible: for ensuring that the trust file the Form 3520-A, and; for ensuring that the trust provide other information as prescribed by the IRS to the US persons treated as owners and those receiving distributions from the trust (whether directly or indirectly). The onus is technically on the US person-owner to ensure that the trust comply with the aforementioned rules. As a practical matter, however, the trustee of the foreign trust would be the party having to provide the necessary information to the IRS, to file the Form and to furnish the information statements to owners and those receiving trust distributions.
The IRC section does not explain how the US owner is to “ensure” that Form 3520-A is filed; there are no regulations to elucidate the matter. The instructions to Form 3520, (at instruction for Line 22) instruct the US owner of a foreign trust who has not received a Foreign Grantor Trust Owner Statement from the foreign trust to complete a “substitute” Form 3520-A to the best of his ability and attach it to the Form 3520 as this may avoid penalties – more fully discussed below.
The IRS letter then explains that the “[f]ailure to timely file a complete and accurate return could result in penalties.”
Oh! The Penalties!
If either form is not timely filed or is incomplete, the penalties can be simply outrageous. Here’s the lowdown:
Possible Penalties Regarding Form 3520
Generally, the initial penalty is equal to the greater of US$10,000 or the following (as applicable):
- 35 percent of the gross value of any property transferred to a foreign trust by a US person
- 35 percent of the gross value of the distributions received from a foreign trust by a US person
- 5 percent 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
An additional separate 5 percent penalty (or US$10,000 if greater), can be assessed if the US person:
(a) Fails to ensure that the foreign trust files a timely Form 3520-A and furnishes the required annual statements to its US owners and US beneficiaries, or
(b) Does not furnish all of the information required by IRC section 6048(b) or includes incorrect information.
Possible Penalties Regarding Form 3520-A
The US owner of a foreign trust is subject to an initial penalty equal to the greater of $10,000 or 5 percent of the gross value of the portion of the trust’s assets treated as being owned by the US person at the close of that tax year if the foreign trust (a) fails to file a timely Form 3520-A or (b) does not furnish all of the information required by IRC section 6048(b) or includes incorrect information.
The US owner is subject to an additional separate penalty equal to the greater of $10,000 or 5 percent of the gross value of the portion of the trust’s assets treated as owned by the US person at the close of that tax year if the US owner (a) fails to file a timely Form 3520 (Part II) or (b) fails to furnish all of the information required by Internal Revenue Code section 6048(b) or includes incorrect information. See IRC section 6677(a) through (c) and the Instructions for Form 3520.
There is also the possibility of further penalty assessments if the noncompliance continues after IRS notice. US$10,000 can be assessed every 30 days until the gross reportable amount is reached if the noncompliance (failure to file Forms 3520/3520-A) continues for more than 90 days after the IRS mails a notice of failure to comply.
If you Get an IRS Letter – What to Do
Most importantly, do not ignore the IRS letter. The filing requirements for Forms 3520/3520-A are extremely complicated. In addition, the IRS recently announced in Rev. Proc. 2020-17 exemptions from filings for certain types of foreign trusts. My blog post here provides all the details. Generally the filing exemption applies to foreign trusts that provide pension or retirement benefits, or medical, disability, or educational benefits. Perhaps the foreign trust in question can meet the stringent definitions.
It should be noted that the foreign trust information reporting forms are relatively new to IRS field agents and there is scant case law available for guidance. In fact, last year, many penalty notices were sent by the IRS to innocent taxpayers about the “late” filing of Form 3520-A. Evidently, these notices were incorrect and the IRS supposedly was to investigate the matter.
The applicable rules are so complex and unclear that professionals and the IRS are confused. Thus, the IRS agent may, in good faith, believe that the penalty assessment is correct, and close the case. As illustrated by the recent case, Wilson v. United States, No. 19-cv-5037 (BMC) (E.D.N.Y. 11/18/19) , this is not necessarily accurate – the IRS may have blundered in its interpretation of the law and in its calculations.
In the Wilson case which involved an individual taxpayer’s untimely filing of a Form 3520, the court reduced the penalty amount to zero from the IRS assessment of US$3,221,183! The court ruled that the IRS could assess only a 5% penalty (not both a 5% penalty and a 35% penalty). Wilson demonstrates the importance of engaging a tax professional who can understand how the IRS computed the penalty. For example, the professional should confirm that the IRS correctly computed the civil penalty based on the account balance at the close of the year. If the taxpayer terminated the trust and transferred the assets back to his US bank accounts prior to the end of the year, the penalty should be zero, as was the result in the Wilson case.
A so-called “reasonable cause” exception exists for unfiled information returns, such as Form 3520 and this may be a valid defense that can be asserted in the face of a penalty assessment. Establishing reasonable cause, however, is not easy and generally will require professional assistance.
Fix Before IRS Calls…
Even better – fix the problem before the IRS comes calling. There may be a penalty-free avenue for addressing unfiled Forms 3520 and 3520-A. Establishing reasonable cause can avoid penalties on a proactive basis (i.e., before the IRS notifies the taxpayer of a problem). I am happy to assist on such cases.
UPDATED – Unfortunately the Wilson case was overturned on appeal and both the 5% and 35% penalties were applied.
Posted October 29, 2020
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