Do You Have a Foreign Trust?

This article was featured in the Naples Daily News on March 3, 2024.

If you are involved in the estate planning world or have engaged in estate planning for yourself and your family, you are likely familiar with the concept of a trust. In general, a trust holds title to property for the benefit of others (the beneficiaries). A foreign trust is a trust that a U.S. court is not able to exercise primary ·supervision over administration over the trust, and is not controlled by one or more U.S. persons. While this may seem simple in theory, determining when a foreign trust exists is not always easy and may be missed in certain situations.

For example, in the United States we do not typically think of retirement or pension plans as trusts because there are special rules related to their taxation, and they often provide a tax-advantaged method of saving for retirement. Similar retirement arrangements established in a foreign countries may not qualify for this same tax-advantaged treatment in the United States, and could be considered foreign trusts. In addition, many foreign countries have unique entities with ownership structures that are similar to a trust, and there­ fore could be classified as a foreign trust in the U.S.

If you have a foreign trust, the U.S. tax reporting requirements can be very complicated, and gen­erally depend on whether a trust is considered a grantor trust (a U.S. person is treated as the own­er of the trust for income tax purposes) or a nongrantor trust (the trust is treated as a separate taxpayer from the grantor and beneficiary).

Where a foreign trust is a grantor trust, the U.S. person who is treated as the grantor/owner must file Form 3520 to report the activity of the trust during the year. The trustee of the trust is required to file Form 3520-A. If the trustee does not file Form 3520-A, the grantor may be able to file a substitute form on the trust’s behalf. The income from the foreign trust must also be reported on the grantor/owner’s individual income tax return each year. The beneficiaries of the foreign grantor trust may also have a Form 3520 filing requirement if they received a distribution from the trust during the year.

In contrast, where a foreign trust is a nongrantor trust, the beneficiary should receive a beneficiary statement from the trustee providing important tax reporting information. If the beneficiary receives distributions during the year, the distributions may pass out income that needs to be reported by the beneficiary on Form 3520 and on their individual income tax return. If the trust has accumulated in­ come in the past, the accumulated income may be distributed to the beneficiary and subject to an ac­ cumulation distribution tax. The beneficiary is also subject to an interest charge using the same rates used for underpayments of tax.

The penalties for failing to file a complete and accurate Form 3520 and 3520-A can be significant, with a minimum penalty of $10,000. Additional penalties may apply if the failure to file is not corrected. It is possible that penalties could be abated by the IRS if the U.S. person can demonstrate reasonable cause for failing to file the required form(s).

If you are a U.S. citizen or resident who has lived and/or worked in a foreign country, has made in­ vestments in a foreign country, or even has family in a foreign country, you should speak with a professional familiar with international tax reporting to make sure you are complying with the U.S. foreign information reporting requirements.