In a word, “yes”—it is possible for a domestic trust inadvertently to become a foreign trust. This is significant because that means different tax rules apply, and because, unlike domestic trusts, foreign trusts are subject to certain information reporting (beyond the standard income tax filing) requirements.
Many people do not realize that their trust is a foreign trust. Other taxpayer’s will purposely—and thus knowingly—create a foreign trust. However, it is another thing for one’s trust that was intended to be domestic to become, unintentionally, a foreign one. This happens more than one would think—usually due to change circumstances, modification of assets, change of trustee, etc.
Sections 7701(a)(30)(E) and (a)(31)(B) are the Code Sections that classifies whether a trust is foreign. A trust’s situs is determined by a two-pronged test. A trust is deemed foreign unless “(i) a court within the United States is able to exercise primary supervision over the administration of the trust, and (ii) one or more United States persons have the authority to control all substantial decisions of the trust.”
Call the first and second prongs the “Court Text” and the “Control Test,” respectively. Stated conversely, a trust is a domestic one only if the Court Test and the Control Test are satisfied.
Why might a domestic trust become (inadvertently) a foreign one? There are several reasons. We mention three. A trust might become a foreign one if (1) the trustee moves overseas to become a non-U.S. resident, or the successor trustee that is appointed pursuant to the trust document itself is a non-U.S. resident. (2) Interestingly also, when a nonresident person has the power to “veto” the U.S. trustee’s decisions the trust becomes a foreign one. (3) When a foreign court is able to exercise its jurisdiction over the trust’s administration (under its laws) the trust is a foreign one. This will remain true even if the trust document itself calls for administration under a State within the U.S.
Why does the IRS have different informational reporting requirements depending upon whether a trust is foreign or domestic? What income tax reporting requirements apply to foreign trusts?
The IRS scrutinizes a U.S. taxpayer’s dealings with foreign trusts because often they are rife with tax abuse. For example, foreign trusts are often used tax shelter schemes, or to further bank secrecy goals (making a tax audit more difficult). For this reason, the IRS requires that taxpayers with foreign trusts submit information reporting on them. They must report foreign trusts when they are created and property is transferred to them; when the trust earns income; and information must be provided on the trust’s beneficiaries. The identity of the transferor, the beneficiaries, and the value and nature of the property transferred to or from the trust must be reported.
There are four “main” forms that a foreign trust may be required to file with the IRS:
- Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts. https://www.irs.gov/pub/irs-pdf/f3520.pdf
- Form 1040NR, U.S. Nonresident Alien Income Tax Return. https://www.irs.gov/pub/irs-pdf/f1040nr.pdf
- FinCEN Form 114 https://bsaefiling.fincen.treas.gov/NoRegFBARFiler.html
- Form 3520A (https://www.irs.gov/uac/About-Form-3520A), which includes three aspects:
- Annual Information Return of Foreign Trust with a U.S. Owner (Under Section 6048(b)).
- Foreign Grantor Trust Owner Statement (on Form 3520A).
- Foreign Grantor Trust Beneficiary Statement (on Form 3520A).
Under what conditions must a foreign grantor trust file Form 3520? Must it also be filed when property is sold to the trust—or only when gratuitously transferred? And what information must be reported on Form 3250?
Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts) must be filed annually by U.S. taxpayers who own the assets that are transferred to a foreign grantor trust. It must also be filed whenever: (i) a foreign trust is created by a U.S. person, regardless whether the trust has U.S. beneficiaries; (ii) property or other assets are gratuitously transferred to a foreign trust by a U.S. person; (iii) a distribution is made from the foreign trust to a U.S. beneficiary; or (iv) a U.S. person dies who was the grantor or some of the foreign trust assets are included in the decedent’s estate.
Sometimes clients ask whether Form 3520 must be filed when one sells property, at fair market value, to a foreign trust. Generally, the answer is “no”—Form 3520 does not need to be filed provided, however, that the trust does not give back a promissory note and gain is not deferred.
What information must be disclosed on Form 3520? The answer to this question turns on the reason Form 3520 is being filed in the first place. The Form could require disclosure of (i) the grantor’s identity (for a grantor trust); (ii) information on the foreign trust’s U.S. agent; (iii) the foreign trust’s name, address, EIN; (iv) the trust’s beneficiaries; (v) the nature of the property contributed to or from the trust (its value and tax basis); (vi) the trust document itself and its financial statements, including any debt it may have; and (vii) descriptions of trust distributions.
When is the filing deadline for Form 3520? And what happens if I do not file Form 3520 when I am required to?
The filing deadline for Form 3520 is the same as a person’s income tax return. The penalty for failing to file (including filing it late) is steep: 35% of the property’s gross value—but this requires some clarification. The penalty is not on the foreign trust’s entire value, but just that property that triggered the need to file Form 3520 in the first place. For example, when property is transferred to or from the trust, the penalty applies to the gross value of said property. Moreover, a $10,000 penalty applies for every 30 days Form 3520 is late (starting after 90 days).
