United States: Foreign Trust Reporting And Compliance - Part 1

In General

The United States generally imposes an income tax filing requirement on all U.S. persons and certain foreign persons, including certain foreign trusts with U.S. owners or other U.S. nexus. For purposes of U.S. federal income tax and reporting, section 7701(a)(30) of the Internal Revenue Code (the "Code")1 defines the term a "U.S. person" to mean a citizen or resident of the U.S., a domestic partnership, a domestic corporation, any estate other than a foreign estate and certain trusts. Section 7701(a)(31) defines the term a "foreign trust" broadly to mean any trust other than a trust treated as a U.S. person.

Section 6012 contains the requirements for when an individual or entity is required to file a U.S. federal income tax return. U.S. persons are generally required to file annually a Form 1040 to report their worldwide income, while foreign persons are generally required to file annually a Form 1040NR to report their fixed determinable and periodic ("FDAP") income from sources within the U.S. and income that is effectively connected with a U.S. trade or business for the year ("effectively connected income" or "ECI").2 Section 6012 also contains the exceptions for when an individual is not required to file a Form 1040.3

For purposes of U.S. federal income tax reporting, a foreign nongrantor trust is treated as a foreign individual and, thus, must file annually a Form 1040NR to report its U.S.-source FDAP income and effectively connected income. In addition, the Code imposes certain information reporting requirements on foreign grantor trusts with certain U.S. nexus and on any U.S. persons who maintain certain connections with foreign trusts during the year, including (1) ownership of a foreign grantor trust, (2) transfer of property to a foreign trust (i.e., the U.S. transferor must notify the IRS of the transfer and provide the IRS with the identify of the trustees and beneficiaries),4 and (3) receipt of property from a foreign trust. Reporting is also required for any testamentary transfer of property, as well as the death of a U.S. citizen or resident who was considered to own any portion of a foreign trust or in whose estate are included a foreign trust's assets.5 In the case of testamentary transfers and the death of a U.S. owner of a foreign trust, notice must be furnished by the decedent's executor.6

Since U.S. federal income tax reporting requirements vary depending on the residence and classification of trusts, the return preparer must determine both the residence and classification of the trust. The following discussion in Section II is provided to serve as a general guideline of factors to be considered in making these determinations. However, since the determination of a trust's residence and classification often entail intricate analyses of trust terms and agreements, practitioners should consult appropriate advice before determining the residence and classification of trusts for purposes of U.S. federal income tax and reporting.

Determining the Residence and Classification of a Trust

A. Determination of an Entity as a "Trust"

Before considering the residence and classification of a trust, the entity in question must be a "trust" from the U.S. perspective. For purposes of U.S. federal income tax, a "trust" is defined to mean an arrangement by which title to property is held by a person or persons, with a fiduciary responsibility to conserve or protect the property for the benefit of another person or persons.7 Thus, a trust is an arrangement by which trustees take title to property for the purpose of protecting or conserving the property for the beneficiaries.8

Depending on the terms and conditions of a trust, a trust can be treated as a grantor trust, a simple trust or a complex trust for purposes of U.S. federal income tax. However, certain arrangements are not treated as trusts because they behave more as business entities by actively engaging in the operation of a business, rather than merely holding and conserving the assets for the beneficiaries. These trusts are referred to as "business trusts" and are classified as corporations or partnerships for U.S. federal tax purposes.9 In addition, certain investment trusts are not classified as trusts.10

Note that certain foreign countries have structures that are similar to a trust, although they may not be technically referred to as a "trust" in the foreign country.

B. Determination of a Trust's Residence

A trust is defined as a "United States person" if (1) a court within the United States is able to exercise primary supervision over the administration of the trust (the "court test"), and (2) one or more United States persons have the authority to control all substantial decisions of the trust (the "control test").11 A trust which satisfies both the "court test" and the "control test" is treated as a U.S. person for purpose of U.S. federal income tax and reporting. A trust that is not a U.S. person is treated as a foreign trust.12

1. Court Test

In determining whether a trust satisfies the "court test," consideration must be given to all of the terms of the trust instrument. If the trust instrument states that the trust is to be administered outside of the U.S., then the trust fails the "court test" and it will be considered a foreign trust for purposes of U.S. federal income tax and reporting.13 If the trust instrument is silent on where the court is to be administered, the trust may be considered administered in the U.S., unless the trust is subject to an automatic migration provision (the "flee clause").14 The flee clause is a provision which indicates that if a U.S. court attempts to take primary control over the administration of the trust, then the trust will "migrate" to a foreign jurisdiction. If a trust contains the flee clause, then the trust is considered foreign for purposes of U.S. federal income tax and reporting.15

The regulations provide further guidance regarding whether a trust meets the "court test." In particular, the regulations provide that a trust will satisfy the "court test" if it meets all of the following three prongs: (1) the court with primary supervision over the trust must be within the 50 States or the District of Columbia;16 (2) the U.S. court must be "able to exercise" its authority over the trust, i.e., the U.S. court must have the authority to render judgments, orders, or resolve issues regarding the trust's administration;17 and, (3) the U.S. court must have "primary supervision" over the trust, i.e., the U.S. court must have authority regarding substantially all of the issues regarding the trust's administration.18 Note that a trust may satisfy the "court test" even if a U.S. court and a foreign court both have primary supervision over the trust.19 Thus, for example, a U.S. court may be considered to have primary supervision over the trust even if a foreign court has primary supervision over the trustee or one of the beneficiaries.

The regulations contain several safe harbor provisions for certain trusts to qualify as domestic trusts. In particular, the regulations provide that a trust will satisfy the "court test" and, thus, be treated as a domestic trust if: (1) the trust is registered with a State court under provisions similar to Article VII of the Uniform Probate Code;20 (2) the trust is created pursuant to a will probated in the U.S. and all fiduciaries have been qualified; or (3) the trustee or fiduciary of the trust takes affirmative steps with a U.S. court to cause the administration of the trust to be subject to the primary supervision of that U.S. court.21

2. Control Test

Similar to the "court test," the criteria for satisfying the "control test" are set forth in the regulations. In particular, the regulations define a "substantial decision" to mean:

[a] decision that persons are authorized or required to make under the terms of the trust instrument and applicable law and that are not ministerial. Decisions that are ministerial include decisions regarding details such as the bookkeeping, the collection of rents, and the execution of investment decisions. Substantial decisions include, but are not limited to, decisions concerning—

  1. Whether and when to distribute income or corpus;
  2. The amount of any distributions;
  3. The selection of a beneficiary;
  4. Whether a receipt is allocable to income or principal;
  5. Whether to terminate the trust;
  6. Whether to compromise, arbitrate, or abandon claims of the trust;
  7. Whether to sue on behalf of the trust or to defend suits against the trust;
  8. Whether to remove, add, or replace a trustee;
  9. Whether to appoint a successor trustee to succeed a trustee who has died, resigned, or otherwise ceased to act as a trustee, even if the power to make such a decision is not accompanied by an unrestricted power to remove a trustee, unless the power to make such a decision is limited such that it cannot be exercised in a manner that would change the trust's residency from foreign to domestic, or vice versa; and
  10. Investment decisions; however, if a U.S. person under section 7701(a)(30) hires an investment advisor for the trust, investment decisions made by the investment advisor will be considered substantial decisions controlled by the U.S. person if the U.S. person can terminate the investment advisor's power to make investment decisions at will.22

In addition, the regulations define "control" to mean:

...having the power, by vote or otherwise, to make all of the substantial decisions of the trust, with no other person having the power to veto any of the substantial decisions. To determine whether United States persons have control, it is necessary to consider all persons who have authority to make a substantial decision of the trust, not only the trust fiduciaries.23

C. Determination of a Trust's Classification

Generally, a trust that is not classified as a business trust is classified as either a nongrantor trust or a grantor trust.

1. Foreign Nongrantor Trust

A foreign nongrantor trust is either a "simple" trust or a "complex" trust, depending on what distributions are required by the trust agreement. An analysis of the foreign trust deed will be necessary to determine if the trust qualifies as a simple trust or a complex trust for U.S. federal tax purposes. In general, a simple trust is one in which the trust deed (i) requires that the trust distribute all of its income currently for the taxable year, and (ii) does not provide that any amounts may be paid, permanently set aside, or used in the taxable year for charitable purposes.24 If a trust is not considered to be a grantor trust or a simple trust, then the trust should be considered to be a complex trust for U.S. federal tax purposes. Generally, a complex trust is one which is not required to distribute all income annually.25

A foreign nongrantor trust, whether simple or complex, is treated as a separate taxpayer for U.S. federal tax purposes. Income is allocated between the trust and its beneficiaries using the concept of distributable net income or "DNI," limiting the amount of the distribution deduction available to the trust (see discussion below in Section III-A for a more detailed discussion of DNI).26 However, note that distribution deductions are calculated differently for "simple" and "complex" foreign trusts.

The following are two primary examples of foreign nongrantor trusts:

  • Section 651 "simple" trusts are nongrantor trusts where the trust instrument requires that all income be distributed currently. Trusts where the income may be paid to or permanently set aside for a charity are specifically excluded, as are trusts that make distributions of accumulated income or trust corpus. All income of a foreign trust that is classified as a simple trust is considered to be distributed to beneficiaries, whether or not it is actually distributed. Many foreign trust instruments that provide for distribution of current income do not specifically include capital gains in the amounts required to be distributed. Therefore, it is unclear whether such a foreign trust may be characterized as one that calculates the distribution deduction under section 651.27
  • Section 661 "complex" trusts are typically nongrantor trusts where the trustees have discretion to determine the amounts that should be distributed by the trust to the beneficiary class. The amount of the distribution deduction for this type of trust is limited by the amount of DNI in the trust in a given year.28

2. Foreign Grantor Trust

A trust is a grantor trust for U.S. federal income tax purposes when the grantor or another person is treated as the owner of that trust's assets because the grantor, trustee or beneficiary has certain powers over the trust's income or corpus.29 The term "grantor", however, is not defined in the Code. Under the regulations,30 the term a "grantor" generally includes "any person to the extent such person either creates a trust, or directly or indirectly makes a gratuitous transfer...of property to a trust." A gratuitous transfer is then defined "as any transfer other than a transfer for fair market value."31 Whether the transfer is gratuitous or not becomes a question of fact, which must be resolved by analyzing the terms of the trust instrument and related documents.

In the case of a grantor trust, all items of income, deduction and credit of the trust are includable in the grantor's income as if the assets were owned by the grantor personally.32 A domestic trust is a grantor trust if it meets any one of the criteria set forth under sections 671 through 679. The rules for foreign trusts with nonresident grantors, however, differ significantly.

In particular, a foreign trust with a nonresident grantor can only be a grantor trust if it meets the test set forth in section 672(f). The trust deed must provide that all payments of income or corpus are payable only to the grantor or his spouse during the grantor's lifetime, or the trust deed must provide that the grantor is able to revest himself of all trust property at any time.33 Further, if a U.S. beneficiary of the trust is treated as indirectly transferring property to the trust through a foreign intermediary, then such U.S. beneficiary will be treated as the owner of the trust and the trust will be treated as a grantor trust with respect to that beneficiary.34

The rules of section 672(f) apply to all foreign trusts, however, if a foreign trust were a grantor trust pursuant to section 676 or 677 (except for subsection (a)(3) thereof) on or before September 19, 1995, and no additional contributions to trust capital have been made since September 19, 1995 or, if additional contributions have been made, they were separately accounted for, the trust would be considered a "grandfathered" foreign grantor trust.35

In addition, a foreign trust with a U.S. settlor or transferor may be treated as a grantor trust with respect to the U.S. settlor or transferor. In particular, where a U.S. person transfers property to a foreign trust, section 679 may treat such U.S. transferor as the owner of the trust's assets for U.S. federal tax purposes if the foreign trust that has one or more U.S. beneficiaries.

Section 679 applies only if: (1) the transferor is a U.S. person; (2) the transferor makes a direct or indirect transfer to the trust (or the trust migrates to the U.S.); (3) the trust is a foreign trust; and (4) the trust has a U.S. beneficiary in the taxable year in question.36 Certain types of direct or indirect transfers are excluded for purposes of applying section 679, including (1) testamentary transfers,37 (2) transfers for fair market value, including transfers in exchange for qualified obligations,38 and (3) transfers to charitable or employee benefit trusts.39

Note that section 679 also applies to transfers in trust by certain foreign persons who later become a U.S. person. In particular, if a nonresident alien individual directly or indirectly transfers property to a foreign trust and thereafter becomes a resident of the United States within 5 years after the transfer, such individual will be treated as if he or she made the transfer on the residency starting date.40 Further, if a nonresident alien spouse of a U.S. person transfers property to a foreign trust in which, under applicable law, the U.S. spouse has a community property interest, section 679 should apply to the U.S. spouse to the extent of his or her one-half interest in the community property which has been used to fund the trust.41

U.S. Federal Income Taxation and Reporting of Foreign Trusts

A. Foreign Nongrantor Trusts

A nongrantor trust is treated as its own taxpayer, separate from the grantor or settlor, but is taxed as if it were an individual.42 However, note that the current highest tax bracket rate of 35% applies to nongrantor trusts with only $7,500 in taxable income.43

In determining the taxable income of a nongrantor trust, it is important to understand the concept of DNI as it applies to trusts. DNI serves a quantitative and qualitative role. In particular, (1) it acts as a limitation on the distribution deduction that that the trust may deduct in computing its own taxable income; (2) it sets the limit on the amount of income that would be taxable in the beneficiary's hands; (3) it acts to characterize the type income that is taxable to the beneficiaries (income can retain its character in the hands of the beneficiary); and (4) it acts to characterize the type of income included in the trust's distribution deduction (e.g., capital gains or dividends).

The term "DNI" is generally defined to mean taxable income with certain modifications.44 These modifications adjust taxable income by adding back certain deductions such as the distribution deduction, the personal exemption, capital losses (capital gains are subtracted from taxable income), and tax exempt interest. DNI conceptually represents the total income of the trust before any distributions to beneficiaries, etc.

A major distinction between the taxation of a foreign trust compared to a U.S. domestic trust is the inclusion of capital gains and losses in DNI.45 For U.S. trusts, capital gains and losses are generally included in DNI only if there is a specific provision to that effect in the governing trust instrument.46 In contrast, capital gains and losses of a foreign trust are always included in DNI, regardless of whether or not they are allocated to income under the governing trust instrument. Accordingly, capital transactions which may be considered on account of capital in the foreign jurisdiction become part of DNI for U.S. tax purposes. This may have a significant impact on the computation of undistributed net income ("UNI").47

Another major distinction is the continued application of the "throwback rules" to distributions of income determined to be accumulated in the trust.48 The combined impact of these two distinctions is that (i) the foreign trustees will accumulate income in the trust each year that they do not pass out the combined income and capital gains and (ii) a U.S. resident beneficiary of foreign nongrantor trust who receives a distribution of what constitutes accumulated income under U.S. tax rules may be faced with onerous taxation in the year of distribution.

1. U.S. Federal Income Taxation of Foreign Nongrantor Trusts

In a year when a foreign nongrantor trust makes distributions in excess of the current year DNI calculation, the U.S. beneficiaries will be required to calculate tax due on any part of that distribution which qualifies as an "accumulation distribution."49 That is, where a trust has made a distribution in excess of the trust's current year DNI, the trust either makes a distribution of capital or an accumulation distribution. An accumulation distribution is a distribution of prior year's undistributed net income which the trust has accumulated. An accumulation distribution triggers the throwback rule, as discussed below.

The throwback rule is designed to cause the beneficiary to pay approximately the same income tax that would have been imposed if the trustees had distributed income to the beneficiaries on an annual basis rather than accumulating income in the trust. That is, the receipt of an accumulation distribution triggers an income tax (including an interest charge) for previous years even though the beneficiary may never have received anything from the trust in those years.

The rules for computing the throwback tax are the time-consuming and complex completion of Form 4970 summarized below:

1. Establish preceding tax years to which the accumulated income is attributable:50

  1. The undistributed net income or "UNI" for each year must be calculated.
  2. The average annual accumulation must be determined by dividing the accumulation distribution by the number of years of accumulation and any year where the trust's UNI is less than 25% of the average annual accumulation shall be disregarded in a-calculating the number of years. Accumulations in all years and taxes paid in the accumulation years are included in the total accumulation.

2. Determine which of the preceding five tax years the should be used as base years in the calculation: 51

  1. Of the beneficiaries five immediately preceding tax years, ignore the years with the highest and lowest taxable income.

3. Add to the beneficiaries' taxable income for these three years the average annual accumulation:52

4. Calculate the additional tax due in each of these three years and determine the average increase in tax.

5. Determine the tax on the accumulation distribution by multiplying the average of the annual additional tax by the number of years of accumulation. The beneficiary can receive a foreign tax credit for taxes the trust has paid on the income in accumulation years53:

6. Calculations of the section 668 interest charge due on this accumulation distribution partial tax can be done using the tables attached to Form 3520.

2. U.S. Federal Income Tax Reporting: Form 1040NR

As a nongrantor trust is taxed as an individual, it also files U.S. income tax returns reporting its U.S.-source FDAP income and effectively connected income.54 However, unlike domestic trusts, which file Form 1041 to report their income, foreign nongrantor trusts, to the extent that they are not fully withheld at source, would file Form 1040NR, and modify the form to conform to the trust accounting rules.55

As section 1441 imposes withholding on payments of U.S.-source FDAP to all foreign payees, the foreign trust must have in place the appropriate withholding forms. The trust would file a Form W-8 BEN for itself, but to the extent that the trust distributes income to beneficiaries, the trust should provide the U.S. payor with a Form W-8IMY, and attached to the W-8IMY the appropriate Form W-8BEN (for foreign beneficiaries) and Form W-9 (for U.S. beneficiaries).56

In addition, section 1446 also imposes withholding on payments of effectively connected income from partnerships to nonresident alien partners and section 1445 imposes withholding tax on the sale of U.S. real property interest by nonresident aliens. If a foreign nongrantor trust holds a U.S. partnership interest or sells U.S. real property, similar rules to those described above would govern the proper withholding documentation for the trust and the beneficiaries.

Nothing in the IRS instructions for Form 1040NR or Form 1041 provide guidance on how to show that a foreign trust in receipt of FDAP or ECI with associated withholding is not the final taxpayer because a distribution deduction has been made to the trust beneficiary. The 2006 Form 1040NR instructions merely indicate that, "[i]f you are filing Form 1040NR for a nonresident alien estate or trust, change the form to reflect the provisions of Subchapter J, Chapter 1, of the Internal Revenue Code."

The most successful method to adapt the Form 1040NR to reflect distribution deductions may be to use offsetting negative entries on the Form 1040NR, accompanied by a description of the ultimate beneficial taxpayer, including their employer identification number ("EIN") or taxpayer identification number ("TIN"). This method may still require correspondence with IRS to correctly credit the withholding to the ultimate beneficial owner of the income. Therefore, it is wise to ensure the trustees understand that correct U.S. withholding documentation is important.

3. Practical Considerations

As witnessed by the summary of the steps necessary to determine taxation on accumulation distributions, it may be in the interest of foreign trustees and U.S. beneficiaries to avoid accumulation distributions.

It is important to note that any distribution of income or principal from a foreign trust to a U.S. beneficiary is generally treated as an accumulation distribution includable in the beneficiary's gross income unless adequate records can be provided to the IRS to determine the proper treatment of the distribution. Practitioners may consider recommending that the trustee supply the beneficiary with a "Foreign Nongrantor Trust Beneficiary Statement," which would indicate the exact composition of the distribution. As such, the beneficiary would not have to rely on the default rule to compute the throwback tax. The statement should indicate whether the distribution is made from income or principal of the trust and thus is required to evaluate whether the distribution exceeds the trust's DNI or accounting income for the year.

Further, to avoid accumulation distributions, practitioners may consider utilizing the "65-day election" under section 663(b) to calculate the annual DNI of the foreign trust during the first sixty-five days of the succeeding tax year and ensure that an amount equal to or greater than the DNI (including capital gains) has been passed out to the trust beneficiaries during that period. This technique is especially important for foreign trusts located in jurisdictions where the local tax rates on trust income are lower than the beneficiaries' tax rate.

A. Foreign Grantor Trusts

1. U.S. Federal Income Taxation of Foreign Grantor Trusts

Although foreign grantor trust status is often an issue for nonresident aliens who become U.S. residents within five years of settling a foreign trust, one may encounter nonresident aliens whose trusts meet the grantor trust requirements of section 672(f). These types of trusts often result from estate or gift planning done in the taxpayer's local jurisdiction which may result in the foreign trust holding U.S. partnership interests that generate U.S. ECI.

2. U.S. Federal Income Tax Reporting: Form 1040NR

Foreign grantor trusts would file a Form 1040NR indicating on Page 1 that (1) it is a grantor trust taxable under sections 671-679 of the Code and (2) that a statement of income taxable to the grantor is attached. This is similar to the way that Forms 1041 are completed for U.S. domestic grantor trusts.

As the regulations under section 1441 generally differentiate amongst whom the ultimate recipient of the income is, it is imperative that the foreign trust have in place the appropriate withholding forms to avoid the 30 percent at-source withholding on U.S.-source FDAP. The foreign grantor trust would provide the U.S. payor with a Form W-8IMY and either a Form W-8BEN (for a foreign grantor) or a Form W-9 (for a U.S. grantor) to take advantage of any reduced withholding rates.

3. Practical Considerations

Filing a Form 1040NR for a foreign grantor trust with ECI or FDAP income that is not properly withheld at source may also require correspondence with the IRS to ensure that the ultimate beneficiary receives proper credit for the withholding at source. If the foreign trust company is not a qualified intermediary able to provide copies of Form 1042-S or other IRS approved withholding forms, it may be helpful to ask the foreign trustee to provide a statement on the Trust Company letterhead to attach to the beneficial owners return, showing the withholding at source attributable to the beneficiaries "Foreign Grantor Trust Owner Statement."

C. Mechanics of Filing: When/Who/How

Form 1040NR is due on June 15th of the year following the calendar year when the nonresident alien individual, estate or trust received the taxable income. There is an exception for nonresidents that receive wages as an employee subject to U.S. income tax withholding. The Form 1040NR in this case is due by April 15th of the year following the receipt of the wages. The form must be signed by the trustee or executor, if it is for a trust or estate, or by the individual taxpayer on the return showing his beneficial share of the income.

D. Obtaining an EIN for a Foreign Trust

It appears that the IRS has adopted a policy of denying EINs to foreign trusts where they cannot identify the trust settlor's social security number ("SSN") or taxpayer identification number ("TIN"), although the IRS generally will assign an EIN automatically when a foreign trust files a Form 3520-A. Therefore, if an EIN is not needed before filing Form 3520-A, the trustees may prefer to obtain an EIN by filing the Form and having the IRS automatically assign an EIN, even where no EIN may be technically required. However, the Form 3520-A will also require the trust settlor's EIN and time constraints may require that the trustee's obtain an EIN before the first Form 3520-A for the foreign trust is filed. For nongrantor trusts, for example, the EIN will be necessary to process the 65-day election, as discussed above in Section III-A-3.

The most challenging exercise may be obtaining an EIN for a foreign nongrantor trust when the settlor of the trust is deceased or does not already have a taxpayer identification number.

In the difficult cases, it is best to obtain a photo identification card of one of the directors of the Trust Company to send in with the SS-4 application if the Form SS-4 cannot be completed with a TIN for the settlor.

Reportable Events of Foreign Trusts

In addition to the U.S. federal income tax and reporting discussed above in Section III, the U.S. generally imposes information reporting requirements on foreign trusts and U.S. persons that engage in certain transactions. Reporting of information is generally required on Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, and/or Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner.

A. Foreign Grantor Trust: Form 3520-A

The trustee of a foreign grantor trust must file an annual Form 3520-A.57 Section 6048(b) provides that a U.S. grantor of a foreign grantor trust is "responsible for ensuring" that the trustee (i) files a return with the IRS for each taxable year of the trust setting forth a full and complete accounting of all trust activities and operations,58 and (ii) furnishes specified income (i.e., Schedule K-1's) and other information to each U.S. grantor and trust beneficiary who directly or indirectly receives a trust distribution for that year.59

The Form 3520-A discloses the trust assets and the identity of the settlor and the name, social security number and contact details of the trust's agent in the U.S. who has been authorized to apply sections 7602, 7603, and 7604 with respect to any request by the IRS to examine records or produce testimony concerning the U.S. tax treatment of the amounts distributed.

In addition to the Form 3520-A filing requirement imposed on the foreign grantor trust, the U.S. grantor is also required to file a Form 3520 to report his contributions to and distributions from the foreign grantor trust during each calendar year that the trust is in existence and the settlor retains U.S. nationality.

B. Reporting of Transfers to Foreign Trusts: Form 3520

The Code requires any U.S. person who transfers property to a foreign trust to notify the IRS of the transfer and provide the IRS with the identity of the trustees and beneficiaries.60 Reporting a transfer to a foreign trust is done on Form 3520, which is attached to the U.S. transferor's Form 1040 for the year.61

1. Reportable Transfers

The instructions for Form 3520 provide that the following categories of filers must file a Form 3520: (i) responsible filers for reportable events or related party holders of qualified obligations of foreign trusts; (ii) U.S. persons who are treated as owning any part of a foreign trust; (iii) U.S. persons who received a distribution from a foreign trust or a related foreign trust held an outstanding obligation issued by you which is treated as a qualified obligation.

For purposes of Form 3520, the term "responsible parties" include: (i) the grantor in the case of an intervivos trust; (ii) the transferor in the case of a reportable event other than by reason of death; or (iii) the executor of the decedent's estate. The term "reportable events" include: (i) the creation of a foreign trust; (ii) the transfer of money or property to a foreign trust; and (iii) the death of a U.S. citizen or resident if the decedent owned any portion of a foreign trust or if any portion of a foreign trust was includable in the decedent's estate.62

Additional guidance on the trust reporting provision is found in Notice 97-34. For purposes of reporting transfers of property to a foreign trust, the section 671 regulations distinguish between "gratuitous" and "nongratuitous" transfers.63 Gratuitous transfers of property to foreign trusts are reportable under section 6048(a). A gratuitous transfer is any transfer other than a transfer for fair market value (to an unrelated foreign trust) or corporate or partnership distributions.64 The determination of whether a transfer is gratuitous is made without regard to whether the transfer is a gift for U.S. federal gift tax purposes.65 A gratuitous trust transfer is reported on Part I, Schedule B of Form 3520.66

Transfers to foreign trusts for fair market value include only transfers that are consideration for the fair market value of the property transferred to the foreign trust.67 Any trust interest received by a U.S. transferor will be excluded from the amount considered to be the fair market value received by the transferor.68 Notice 97-34 also provides that an election to recognize gain under section 1057 will not be treated as a transfer for fair market value.69

A sale of property by a U.S. person to a foreign trust must be reported as a transfer to a foreign trust unless the trust pays fair market value for the property.70 A credit sale to a trust will not be treated as a fair market value sale unless the obligation issued by the trust is a "qualified obligation."71 To be treated as a "qualified obligation," an obligation must: (i) be reduced to writing by an express written agreement; (ii) have a term not exceeding five years including options to renew and rollovers; (iii) be denominated in U.S. dollars; (iv) have a yield to maturity of between 100% and 130% of the applicable AFR on the date the obligation was issued; (v)have a U.S. person willing to extend the statute of limitations for assessment of any income or transfer tax changes attributable to the transfer to three years beyond the maturity date of the obligation; and (vi) have a U.S. person report on the status of the obligation and the interest and principal payments on Form 3520.

2. Exceptions

Form 3520 need not be filed for the following transactions: (i) transfers to foreign trusts described in sections 402(b) relating to nonexempt employee benefit trusts, 404(a)(4) relating to employee stock bonus, pension or profit-sharing trust organized outside the U.S., or 4040A relating to certain foreign deferred compensation plans; (ii) most fair market value transfers to foreign trusts, unless they are transfers in exchange for obligations treated as qualified obligations; (iii) transfers to foreign trusts having a current determination letter from the IRS recognizing their status as tax exempt under section 501(c)(3); (iv) transfers to, ownership of or distributions from a Canadian registered retirement savings plan or a Canadian registered retirement income fund, where the U.S. citizen or resident alien is eligible to file Form 8891, U.S. Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans; (v)distributions from foreign trust taxable as compensation and which have been reported as compensation on the applicable tax return; (vi) transfers from foreign trusts to domestic trusts having a current determination letter from the IRS recognizing their status as tax exempt under section 501(c)(3); (vii) domestic trusts that become foreign trusts to the extent the trust is treated as owned by a foreign person after the application of section 672(f).72

C. U.S. Beneficiary Receives a Distribution: Form 3520

Whenever a U.S. beneficiary receives a distribution, either directly or indirectly, from a foreign trust, the Code requires such U.S. beneficiary to file a Form 3520.73 For this purpose, a distribution from a foreign trust includes: (i) any gratuitous transfer of money or property from a foreign trust, whether or not the trust is deemed to be owned by another U.S. person; (ii) the receipt of trust corpus and the receipt of a gift or bequest that is not otherwise subject to income tax; and (iii) a direct or indirect loan of cash or marketable securities to a U.S. grantor or U.S. beneficiary by a foreign trust. Note that a distribution is reportable whether is it actually or constructively received.


1. Unless otherwise noted, all section references herein are to the Internal Revenue Code of 1986, as amended, and the regulations thereunder.

2. I.R.C. § 6012(a); Treas. Reg. § 1.6012-1(b)(1); see also Instructions to Form 1040NR.

3. I.R.C. § 6012(a)(1)(A) The only true exception to when a U.S. citizen or resident individual has to file a Form 1040 (or Form 1040A or 1040EZ) is where the individual does not meet certain income thresholds. Sections 6012(a)(1)(C) and (D) create certain exceptions to the exception in section 6012(a)(1)(A).

4. I.R.C. § 6048(a). In Notice 97-34, 1997-25 I.R.B. 22, the IRS clarified section 6048(a)'s notice requirements. The Form 3520, used to report transfers to foreign trusts, is filed with a U.S. transferor's annual income tax return.

5. I.R.C. § 6048(a)(3).

6. I.R.C. § 6048(a)(4).

7. Treas. Reg. §  301.7701-4(a).

8. Id.

9. Treas. Reg. § 301.7701-4(b).

10. Treas. Reg. § 301.7701-4(c). An investment trust is classified as a business trust if either (i) there is a power under the trust agreement to vary the investment of the certificate holders or (ii) with certain limited exceptions, the trust has multiple classes of ownership interests. Id.

11. I.R.C. § 7701(a)(30)(E).

12. I.R.C. § 7701(a)(31).

13. Treas. Reg. § 301.7701-7(c)(1)(i).

14. Treas. Reg. § 301.7701-7(c)(1)

15. Treas. Reg. § 301.7701-7(c)(4)(ii).

16. Treas. Reg. § 301.7701-7(c)(3)(ii).

17. Treas. Reg. § 301.7701-7(c)(3)(iii).

18. Treas. Reg. § 301.7701-7(c)(3)(iv).

19. Treas. Reg. § 301.7701-7(c)(4)(i)(D).

20. Treas. Reg. § 301.7701-7(c)(4)(i)(A).

21. Treas. Reg. § 301.7701-7(c)(4)(i)(C).

22. Treas. Reg. § 301.7701-7(d)(ii).

23. Treas. Reg. § 301.7701-7(d)(iii).

24. Treas. Reg. § 1.651(a)-1.

25. I.R.C. §§ 651 and 661.

26. I.R.C. §§ 651 and 661.

27. See discussion of foreign trust DNI at III-A below

28. I.R.C. § 661(a)(2)

29. I.R.C. § 671.

30. Treas. Reg. § 1.671-2(e)(1).

31. Treas. Reg. § 1.671-2(e)(2).

32. I.R.C. § 671 and Treas. Reg. § 1.671-2(c).

33. I.R.C. § 672(f)(2).

34. I.R.C. § 672(f)(5).

35. Pub. L. No. 104-188, section 1904(d)(2) & (e); Treas. Reg. § 1.672(f)-3(a)(3), (b)(3), (d).

36. I.R.C. § 679; see also Zaritsky, Howard M., U.S. Taxation of Foreign Estates, Trusts and Beneficiaries, BNA 911-2nd, A-23.

37. I.R.C. § 679(a)(2)(A).

38. I.R.C. § 679(a)(2)(B).

39. I.R.C. §§ 679(a)(1) and 6048(a)(3)(B)(ii).

40. I.R.C. § 679(a)(4).

41. See Zaritsky, supra note 44 at A-24.

42. I.R.C. § 641(b).

43. I.R.C. § 1(e).

44. I.R.C. § 643(a).

45. I.R.C. § 643(a)(6).

46. I.R.C. § 643(a)(3); Treas. Reg. § 1.643(a)-3.

47. To the extent that all DNI is not distributed to a beneficiary in any U.S. tax year, the undistributed amount is added to the trust's UNI. This has serious implications on future distributions in a number of ways. First, to the extent that the trust has income that would be subject to favorable U.S. tax rates (i.e., the 15% long term capital gain rate on assets held greater than one year and the 15% rate on "qualified dividends"), the benefit of the favorable rates is lost. All UNI is treated as ordinary income when it is distributed to a U.S. beneficiary.

48. I.R.C. § 666 and 667.

49. I.R.C. § 666(a).

50. I.R.C. § 667(b)(1)(A).

51. I.R.C. § 667(b)(1)(B).

52. I.R.C. § 667(b)(1)(C).

53. I.R.C. § 667(d)((1)(C)(ii)

54. Treas. Reg. § 1.6012-1.

55. See Instructions to Form 1040NR.

56. See Instructions to Forms W-8BEN, W-8IMY, and W-9.

57. I.R.C. § 6048(b).

58. I.R.C. § 6048(b)(1)(A).

59. I.R.C. § 6048(b)(1)(B).

60. I.R.C. § 6048(a).

61. Form 3520 is filed separately from Form 1040, but the Form is due on the date the individual's U.S. income tax return (Form 1040) is due (including extensions). Form 3520 must be filed timely to avoid penalties for failing to timely report. See Instructions for Form 3520.

62. These reporting rules apply generally to "reportable events" occurring after August 20, 1996, the date of enactment of the 1996 Small Business & Jobs Protection Act, Pub. L. No. 104-188. The 1996 Act created five types of reportable events: (1) the creation of a foreign trust by a U.S. person; (2) the transfer of any money or property by a U.S. person to a foreign trust (including by way of a testamentary transfer); (3) the death of a U.S. person who was the owner of any portion of a foreign trust under the grantor trust rules or in whose estate are included a foreign trust's assets; (4) the U.S. residency starting date of the grantor of a foreign trust subject to tax under section 679(a)(3) (relating to certain pre-immigration trusts); and (5) outbound trust migrations. Note that section 684 imposes a capital gains tax on transfers of appreciated property to foreign nongrantor trusts. A trust that migrates from domestic to foreign nongrantor trust status is subject to the tax imposed under section 684(a).

63. Treas. Reg. § 1.671-2(e)(2)(i).

64. Treas. Reg. § 1.671-2(e)(2)(ii).

65. Treas. Reg. § 1.671-2(e)(2)(i).

66. See Instructions for Form 3520.

67. Treas. Reg. § 1.684-3(d).

68. Notice 97-34, section III.

69. Id.

70. Section 679 provides for exceptions to the exception for transfers at fair market value to a foreign trust that is a related party (for transfers occurring after February 5, 1995.

71. Notice 97-34, section III C 2.

72. I.R.C. 6048(a)(3)(B)(ii); Notice 97-34.

73. I.R.C. 6048(c)

This article is designed to give general information on the developments covered, not to serve as legal advice related to specific situations or as a legal opinion. Counsel should be consulted for legal advice.

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