Top 6 Traps for US Expat Trust Owners and Beneficiaries Filing the Form 3520
By many accounts, the IRS Form 3520, and its sister form, the IRS Form 3520-A, represent two of the most complex forms on the IRS filing roster.
In brief, these forms are used to report income and activities of foreign trusts to the IRS. The complex nature of reporting on the Form 3520 is in many ways an outgrowth of the somewhat unusual legal form that trusts take as well as the temptation to abuse non-US trusts to avoid or defer US taxes.
In our experience, these inherent complexities manifest themselves in a number of filing traps for inexperienced US expat taxpayers and tax practitioners. Such traps have now become particularly dangerous because of a recently-launched IRS audit campaign focusing squarely on Form 3520 non-US trust reporting.
In this blog, we share with you our top 6 Form 3520 traps for the unwary.
Trap #1 - Trusts Are Often Misclassified for Form 3520 Purposes
When considering whether the Form 3520 is required, the first and most basic question is not so simple to answer – what is a trust?
In the US tax world, this question is asked more particularly – when is a plan or arrangement that is otherwise legally classified as a trust also treated as a trust for US tax purposes?
The US Treasury regulations (Treas. Reg. 301.7701-4) lay out a nuanced set of rules that classify a trust as either an “ordinary” trust – which is treated as a trust for US tax purposes, or as a “business” or “investment” trust – which is treated as a corporation or partnership for US tax purposes, depending on the trust’s features.
Generally speaking, an arrangement will be treated as an ordinary trust 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 a profit.
However, a number of further rules and exceptions apply with respect to trust classification. As a result, an entity that is treated in an expat’s foreign country as a trust may not be treated as a trust for US tax purposes and vice versa.
Trust classification, of course, directly affects the Form 3520 filing requirement – a non-US trust that is not treated as a trust for US tax purposes would not require Form 3520 reporting, but rather foreign corporation reporting (Form 5471) or foreign partnership reporting (Form 8865).
As such, careful consideration of a non-US trust’s features within the context of the US tax classification rules and regulations is required in order to overcome this very basic trap for the unwary.
Trap #2 - Trusts Are Often Mischaracterized for Form 3520 Purposes
Classifying a plan or arrangement as a trust for tax purposes is only the beginning of a thorough trust analysis.
Next, a trust must be scrutinized under the nuanced trust characterization statutes of the Internal Revenue Code (Sections 671-679) and the regulations promulgated thereunder to determine how the trust should be characterized.
In brief, the Code and regulations distinguish between so-called “grantor” and “non-grantor” trusts, and the difference in characterization significantly impacts the substantive tax rules as well as Form 3520 and Form 3520-A reporting.
A trust will be treated as a grantor trust to the extent that the assets of the trust are treated as owned by a person other than the trust (normally, the settlor, grantor, or appointer). A person may be treated as owning the assets of the trust if that person maintains certain powers with respect to the trust, such as the power to revoke the trust.
As a substantive matter, if a non-US trust is treated as a grantor trust, then all items of income, deduction and credit of the trust are includable in the grantor’s income as if the assets were owned by the grantor personally. In contrast, income from a non-US non-grantor trust is generally taxed when distributed to its US beneficiaries (subject to a “throwback tax” on accumulation distributions), except to the extent US source or income effectively connected with a US business is earned and retained by the trust, in which case the non-grantor trust pays US income tax for the year such income is earned.
As a compliance matter, each US person treated as an owner of a foreign grantor trust is responsible for filing the Form 3520 annually as well as ensuring that the foreign trust files the Form 3520-A and that the trust annually furnishes copies of the so-called “Foreign Grantor Trust Owner Statement” and the “Foreign Grantor Trust Beneficiary Statement” to the US owners and US beneficiaries of the grantor trust. Each US beneficiary of a non-grantor trust, in contrast, generally requires Form 3520 reporting when a distribution is received from the trust.
As such, careful consideration of a non-US trust’s terms and features within the context of the trust characterization rules is required in order to overcome this trap for the unwary.
Trap #3 - Foreign Pensions Are an Awkward Fit for Form 3520 Reporting
In addition to the nuanced trust classification and characterization rules, the Internal Revenue Code and regulations contain yet another layer of complexity involving so-called employees’ trusts.
In the case of foreign pensions that qualify as “employees’ trusts” within the meaning of Section 402(b) of the Code, plan earnings may be tax deferred until retirement assuming certain conditions are met.
The Form 3520 instructions explicitly exempt contributions to a 402(b) employees’ trust from Form 3520 reporting (in contrast to ordinary trust contributions). In accordance with Section 402 regulations, however, certain employees’ trusts with majority employee contributions may not qualify for such an exemption and will therefore require both Form 3520-A and Form 3520 reporting.
Practically speaking, it can be difficult from the outset to determine whether a particular foreign pension qualifies as a trust and/or as an employees’ trust for purposes of Section 402. This is because non-US plan provisions aren’t designed to fit within the definitional parameters of the Internal Revenue Code. The analysis can become further complicated in the case of foreign tax-advantaged investment accounts (e.g., Stocks and Shares ISA or Cash ISA in the UK, Kiwi Saver in New Zealand, RRSP in Canada), which don’t fit cleanly within the US rules. The dearth of IRS guidance in this area certainly doesn’t help matters.
As such, careful consideration of a non-US pension and its features within the context of the employees’ trust rules is required in order to overcome this trap for the unwary.
In this regard, it should be pointed that the IRS recently lifted the foreign pension reporting burden to a significant extent by issuing a revenue procedure (Revenue Procedure 2020-17), which essentially exempts so-called "tax-favored foreign retirement" plans as well as "tax-favored foreign non-retirement savings" plans from Form 3520 and Form 3520-A reporting. The rule contains a number of requirements and conditions, and more guidance is expected to help taxpayers and their advisors understand which foreign pension plans do and do not qualify for the new reporting exemption.
Trap # 4 – Form 3520 Information from Trusts is Often Delayed
Moving on to less technical and more logistical concerns, US owners and beneficiaries of non-US foreign trusts and pensions often find it difficult to timely file the Form 3520 and 3520-A because information from the trust or pension is only provided much later in the year. US expats are particularly prone to this trap because non-US trusts and pensions often do not have a calendar-year end.
For calendar-year non-US trusts, the due date for the Form 3520 is relatively early, April 15, which is the same as the US tax return. The Form 3520-A is actually due a month earlier, which itself is a trap for the unwary that we discuss further below. The due dates for both forms can be even earlier in the year if the trust or pension has a fiscal year end.
It’s important to pay attention to these original dates, as they also serve as the deadline for filing the 6-month extension, which the IRS will only grant if filed on time.
If the Form 3520 or Form 3520-A is filed late, the penalties can be severe. Generally, the initial penalty is equal to the greater of $10,000 or:
- 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; or
- 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; or
- 5% of the gross value of the portion of the trust's assets treated as owned by a US person for failure by the US person to report the US owner information.
Additional penalties may be imposed if the noncompliance continues after the IRS mails a notice of failure to comply with the required reporting.
In the case of a late filing, IRS amnesty programs may be available to avoid penalties. These should be carefully considered, and sooner rather than later, as amnesty generally becomes unavailable once the IRS catches the misfiling and examines the issue.
Trap # 5 – Form 3520-A Has a Unique Filing Deadline (Important!)
Speaking of deadlines, perhaps the nastiest of the traps on our list is this trap #5 – the unique filing deadline for the Form 3520-A.
As mentioned above, the Form 3520 is generally due on April 15, or three-and-a-half months following the end of the tax year. This, like nearly all other IRS forms for individuals, matches the filing deadline of the US tax return itself, which is quite intuitive.
The Form 3520-A, in contrast, is due a month earlier, which can wreak havoc for the uninformed taxpayer or tax preparer who is unaware of the distinction. Once the March 15 deadline has passed, an extension is no longer available – leaving the taxpayer with few good options.
Taxpayers caught in this trap should, again, consider an amnesty program to request an abatement of penalties in advance. Our experience has been that the IRS is more amenable to a penalty abatement request if it is made as part of a disclosure rather than as part of a “gotcha” examination.
Trap # 6 - Form 3520 Trust Reporting is Now on the IRS Radar
While the Form 3520 has long presented significant technical and logistical challenges for US expat filers, it is only recently that the IRS has begun to pay particular attention to foreign trust reporting.
In June of 2018, the IRS added Form 3520 compliance to its list of tax compliance campaigns. Since then, taxpayers have seen a major uptick in examinations and penalty notices focusing on late Form 3520 and 3520-A filings, beginning with the 2017 tax year.
Taxpayers and tax practitioners have, in many ways, been blindsided by this development, and have only now begun to tackle all the complexities that go into a timely and accurately filed Form 3520 and to seek effective solutions for late filings.
The Takeaway for US Expats
At the end of the day, complying with Form 3520 trust reporting can be a difficult, if not impossible, task for even a sophisticated filer if he or she is not grounded and experienced in US international taxation.
For this reason, the Form 3520 is normally best left to the experts. Due to the difficulties involved in reporting your non-US trust, even if you do obtain the help of a professional, we recommend gathering trust and/or pension information earlier rather than later so your preparer has the information necessary to timely and accurately prepare your Form 3520 and/or 3520-A.
We also recommend that you gain some familiarity with the US tax basics and the international tax provisions applicable to foreign trusts and foreign pensions. This will help you better communicate your background story to your preparer to ensure an accurate and timely filing and avoid the risk of penalties.