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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.
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:
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.
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.
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.
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.
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.
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.