If you are involved with or owned one or more foreign trusts or you have received bequests or gifts from a foreign individual, you will be required to file Form 3520 with your US expat tax return. All the transactions for each foreign trust with which you’re involved must each be reported on separate forms, so it’s possible that you will use more than one Form 3520.
In order to understand your requirement to file, you must first understand the difference between a foreign trust and a domestic trust. A foreign trust is defined as a trust which was created and is supervised by a foreign person or institution. A domestic trust is defined as a trust over which a US court has primary supervision with at least one US Person who has a substantial amount of control over the decisions made for said trust. For the purpose of this article, the term US Person refers to any US Citizen or Green Card Holder, US Corporation, US Partnership, or US Estate.
Who is Required to File Form 3520?
Any US Person who meets at least one of the following requirements must file Form 3520:
- Qualified Obligation: If you were the responsible party for overseeing and reporting reportable events on a foreign trust or you held any of the obligations covered in Form 3520 Instructions on pages 3 and 4, you will be required to file Form 3520. As a person with qualified obligations, you will only be required to fill out the top portion of the form 3520 and all relevant portions of Part 1.
- Owner of Trust: If you are considered to own a foreign trust or any portion of a foreign trust, you will be required to file Form 3520. If this applies to you, you will be required to fill out all information at the top of the form and complete Part 2.
- Trust Distribution Recipient: If you directly or indirectly received a foreign trust distribution or you held qualified obligations with a related foreign trust, you will be required to file Form 3520 and complete all identifying information and Part 3.
- Gift Recipient from a Foreign Person or Estate: If you received at least $100K as a gift or bequest from a foreign person or estate, you will be required to file form 3520, completing the top identification section and Part 4.
- Gift Recipient from a Foreign Corporation or Trust: If you received at least $11,273 from a foreign corporation or partnership as a gift or bequest, you will be required to file form 3520, completing the top identification section and Part 4.
Who is NOT Required to File Form 3520?
Equally as important as knowing who is required to file Form 3520 is knowing who is not required to file this form. If any of the following circumstances apply to you, you won’t be required to file Form 3520:
- Predefined Foreign Trust Transfers: If you made transfers to a foreign trust which are defined in Sections 402(b), 404A, and 404(a)(4), you are not required to file Form 3520.
- FMV (Fair Market Value) Transfers: The majority of FMV transfers to a foreign trust by a US Person are not required to be reported on Form 3520, but there are some exceptions.
- Canadian Retirement Plans: Transactions from an RRSP (Canadian Registered Retirement Plan) or an RRIF (Canadian Registered Retirement Income Fund) do not qualify as transfers which must be reported on Form 3520; instead, you will use Form 8891.
- Compensation for Services: If you received a distribution from a foreign trust as compensation for services provided, you will not be required to report this information on Form 3520; instead, you will report the compensation as income on Form 1040 with your US expat tax return.
- Tax Exempt Status: If you receive a distribution from a foreign trust to a domestic trust which is recognized by the IRS as being tax exempt, you will not be required to file Form 3520.
- 672(f) Application: If you are involved in a domestic trust that became a foreign trust during the tax year, you will not be required to file Form 3520.
When to File Form 3520
If you are filing Form 3520 on behalf of yourself, it is due when you file your US expat tax return. If you are filing on behalf of a deceased US Person, you must file the form with Form 706. If you file a joint income tax return with the deceased, you may file a joint Form 3520 as well.
Penalties on Form 3520
If you fail to file Form 3520 or file the form with missing or incorrect information, penalties will be assessed by the IRS. Initially, assessed penalties will the greater number of either $10K or:
- 35% of the gross value of all the property transferred to the trust which was not indicated on Form 3520;
- 35% of the gross value of all received distributions from a foreign trust which were not indicated on Form 3520; or
- 5% of the gross value of all trust assets owned by a US Person which were either not reported or incorrectly reported on Form 3520.
The aforementioned penalties are only the beginning of the lengths the IRS will go to ensure proper reporting on Form 3520. If there is continued noncompliance after the initial penalties are assessed, the IRS will become even more punitive.
If you made an honest mistake when reporting Form 3520, you may be able to escape penalties if you can prove that you were not willfully and neglectfully omitting information. It’s important for you to understand that you must report all information, even if your host country imposes penalties for disclosure of certain information related to the foreign trust.
Now that you understand the basics of Form 3520, we will now examine some key words and provide detailed explanations for them.
In regard to Form 3520, distributions are defined as any transfer of money or property from a trust for which nothing was received in exchange (gratuitous transfer). It is immaterial whether or not the trust is owned by another individual as outlined by Section 671-679 or the trust has deemed the recipient a beneficiary. It’s important to consider all forms of distribution including constructive transfers. A constructive transfer is made if and when a trust account honors checks you’ve written or credit card charges you’ve accrued. If you are writing checks or using a line of credit which is covered by the trust, you are still considered to have received distributions.
If you receive a distribution from a foreign trust in the form of cash or property in exchange for property you’ve transferred into the trust, you will be obligated to report all income in excess of the FMV of the exchange. For example, if you transfer foreign stock worth $300 and you receive $500 from the trust, you will have received a distribution of $200. As such, this distribution must be reported on Form 3520.
A gratuitous transfer to any foreign trusts includes all transfers except for the following:
- An FMV transfer
- A transfer made to the trust by a party such as a corporation or partnership who holds an interest in the trust but is defined as a separate entity
- A transfer to the trust via an investment trust as defined in Regulations Section 301.7701-4
- A liquidating trust as defined in Regulations Section 301.7701-4
- A trust for environmental remediation
If there is a transfer of property to a trust, it may be considered a gratuitous transfer even if the transfer is not considered a gift by the IRS. If a US Person transfers property to a trust in exchange for interest in the trust, the interest will not be used to determine the FMV which has been received.
Definition of Grantor
In order to understand Sections 671-679, it’s important to understand the definition of the word ‘grantor.’ The IRS defines a grantor as any person who opens a trust or makes direct or indirect gratuitous transfers to a trust in the form of cash or property. If you are the owner of any part of a trust, you are considered to be a grantor. Additionally, corporations and partnerships are considered grantors if they make gratuitous transfers to trusts which are not made for specific business reasons. In the case of one trust making a gratuitous transfer to another trust, the grantor of the donating trust will also be viewed as the grantor of the receiving trust.
Definition of a Grantor Trust
A grantor trust is defined as a trust in which the assets are owned by a party other than the trust itself. In a grantor trust, a portion of the foreign trust can be treated as owned by the trust if only certain cash or assets are held by an individual other than the trust. You can refer to Sections 671-679 for detailed information about a grantor trust.
Earlier in this article, we spoke of ‘qualified obligations.’ We will now take a deeper look at what that means. First of all, in order to be considered a qualified obligation by the IRS, the following rules must apply:
- There is a written agreement outlining the obligation
- The obligation is for a period of 5 years or less and is repaid within a 5 year timeframe. The 5 year limit is inclusive of rollovers and renewal options.
- All obligatory payments are made in USD
- The mature yield of the obligation is higher than or equal to 100% and less than 130% of the applied federal rate as defined by Section 1274(d) on the date the obligation is issued
- The US Person involved with the qualified obligations agrees to a period extension for assessment of transfer tax or income which is attributable to each transfer for a period of 3 years after the obligation’s maturity date
- The US Person involved with the qualified obligations agrees to be responsible for any consequential income tax updates or changes for every year that the obligation is outstanding as long as the obligation’s maturity date is within the current tax year
For every tax year the obligation is active and outstanding, the US Person must report the obligation status on Form 3520. The principal balance and all interest payments must be included.
In regard to Form 3520, a related person includes immediate family members, step-siblings or parents, spouses, and any corporation to which at least 50% of the outstanding obligation is owed.