Foreign Trust Classifications Complicate Tax Reporting

US taxpayers that engage in transactions with foreign trusts face a complex framework of federal income tax and reporting obligations. The identification of foreign arrangements as trusts under federal tax law isn’t always straightforward, and certain foreign pensions or savings accounts may potentially be classified as foreign trusts.

This ambiguity can have significant tax implications under anti-tax deferral rules or result in substantial penalties for untimely reporting of foreign trust information to the IRS.

As the 2023 tax year filing season nears its deadline, taxpayers and their advisers must carefully determine which foreign arrangements may be treated as foreign trusts and must understand the applicable tax and reporting obligations.

Information Reporting

The IRS has aggressively imposed penalties for failing to report foreign trust information since its compliance campaign began on May 21, 2018, which culminated in procedures now incorporated into the IRS Penalty Handbook. The National Taxpayer Advocate in January highlighted these penalties as a significant issue for taxpayers in her annual report to Congress.

US taxpayers must report ownership of a foreign trust annually on both Form 3520-A and Form 3520. They also must annually report on Form 3520 transfers of money or other property they make to a foreign trust and distributions they receive from a foreign trust during the tax year.

Additionally, certain gifts or bequests received from foreign persons during a tax year must be reported on Form 3520. The IRS has provided limited exceptions to the filing requirements for certain Canadian pensions, as well as other foreign pensions and foreign tax-favored savings accounts if the requirements for relief are satisfied.

For the 2023 tax year, Form 3520-A is due for calendar-year trusts on March 15. Its due date may be extended to Sept. 16 by filing Form 7004 on or before March 15.

Both Form 3520-A and Form 7004 must include the foreign trust’s employer identification number, which may be obtained from the IRS by phone with a Form SS-4. If Form 3520-A isn’t submitted by the original or extended due date, it will be treated as timely filed if submitted as a substitute Form 3250-A with the US owner’s timely filed Form 3520.

A US citizen or resident noncitizen required to file Form 3520 for the 2023 tax year must submit the form by April 15. Individuals may extend the due date to Oct. 15 by filing Form 4868 on or before April 15.

For US citizens and resident noncitizens who reside outside the US or Puerto Rico, the additional two-month discretionary extension to file their federal income tax return on Dec. 16 doesn’t apply to Form 3520-A and Form 3520. The maximum extended due date for both forms is Oct. 15 (if Form 3520-A is filed with Form 3520 as a substitute).

Failure to meet these deadlines can result in multiple penalties, especially for Form 3520, which addresses four separate reporting obligations. A taxpayer who must comply with more than one of these requirements could face multiple penalties for the same Form 3520 if it isn’t timely submitted.

Additionally, failure to timely report foreign trust information extends the IRS’s window to assess additional taxes for the related tax return beyond the standard three-year statute of limitations, as demonstrated in the 2023 US Tax Court case Fairbank v. Commissioner.

Taxation of Beneficiaries

A foreign trust can be classified either as a grantor trust or a non-grantor trust for federal tax purposes. A grantor trust is viewed as a transparent entity, with the income it generates taxed to the deemed owners of the trust.

Conversely, a non-grantor trust is regarded as an independent taxable entity. Its beneficiaries typically aren’t taxed on income unless they actually receive, or are deemed to receive, income distributions from the trust.

By distributing all its current income annually—referred to as distributable net income, or DNI—foreign non-grantor trusts with discretionary US beneficiaries can avoid the buildup of income that could potentially be distributed to US beneficiaries in a future year.

This strategy prevents the potential for triggering the accumulation distribution tax and interest charges for those US beneficiaries. The accumulation distribution tax mirrors the tax that would have been paid if income had been distributed to the US beneficiary in the year earned—except that long-term capital gains and qualified dividend income will be taxed at ordinary income rates.

The interest charge serves as an additional cost to the US beneficiary for delayed taxation. The IRS provided training to its employees in November 2023 on the taxation of foreign non-grantor trust distributions made to US beneficiaries, suggesting this may be a particular area of focus for the IRS.

If a foreign non-grantor trust failed to distribute all DNI in 2023, the trustee had the option to prevent income accumulation by distributing the remaining amounts by March 5, provided the trust operates on the calendar year and timely makes the 65-day election under Section 663(b) of the tax code.

The election enables distributions made within the first 65 days of the trust’s 2024 tax year to be treated as made on the last day of the previous year—Dec. 31, 2023. A trustee making the election should file a statement with the trust’s 2023 Form 1040-NR, generally due April 15. If the trust isn’t required to file a Form 1040-NR, the statement should be sent to the IRS by the filing deadline.

The intricate web of federal income tax and reporting requirements emphasizes the need for US taxpayers and their advisers to exercise caution. It’s crucial to stay informed to successfully steer through foreign trust compliance challenges and sidestep potential penalties.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Rosy L. Lor is managing director in the BDO USA Private Client Services National Tax Office, specializing in cross-border tax matters affecting high-net-worth individuals.

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