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Stricter Reporting Requirements Create Planning Opportunities for Foreign Trusts by Joel G. Young, JD, LLM

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Posted on August 06, 2024 by Joel Young

In May 2024, the IRS issued proposed regulations concerning the reporting requirements and tax consequences of U.S. persons who create, fund, transact with and receive gifts or loans from foreign trusts. The guidance, which applies to Sections 643(i), 679, 6039F, 6048, and 6677 (the foreign trust and gift provisions) of the U.S. tax code, updates rules first enacted in 1997 to prevent the use of foreign trusts as a method for hiding assets or avoiding U.S. tax.

To that end, U.S. taxpayers, including grantors of foreign trusts, executors of their estates and U.S. beneficiaries of foreign non-grantor trusts (“FNGT”), are required to annually report their transactions with foreign trusts on IRS Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts, and Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner. A failure to timely file these forms or submitting an incomplete or inaccurate form will result in penalties of $10,000 or 35 percent of the gross unreported or underreported amount, whichever is greater.

In addition, U.S. persons who receive more than $100,000 in gifts from a foreign individual or a foreign estate in a specific tax year are required to report these gifts annually. Under the proposed guidance, these individuals will have to begin reporting separately on Form 3520 each foreign gift they receive exceeding $5,000, including, for the first time, the names and addresses of the foreign providers of those gifts. Failure to do so can result in penalties of up to 25 percent of the foreign gift amount. In a taxpayer-friendly move, under the proposed regulations, the $100,000 filing threshold, which has not been adjusted since 1997, would now be increased for a cost-of-living adjustment.

The latest guidance also addresses transactions with foreign trusts, increasing the circumstances where Forms 3520 and 3520-A reporting is required and when a U.S. person is deemed to receive a taxable distribution. The expanded application of these rules particularly impacts three areas:

Loans

Under current law, a loan from a FNGT to a U.S. grantor or beneficiary is treated like a deemed distribution, subject to U.S. income tax. However, taxpayers may avoid distribution treatment when the loan is structured as a “qualified obligation” that must meet the following criteria: 1) it is in writing, 2) it is in U.S. dollars, 2) it has a term no longer than five years, 4) it accrues market level interest, and 5) it is reported on a Form 3520 with an election to extend the period of assessment.

The proposed regulations expand this definition of “qualified obligations,” capable of avoiding distribution treatment, to include 1) loans by any person to a U.S. grantor, beneficiary or related person where the FNGT guarantees the loan; 2) loans by a person related to the FNGT to a U.S. grantor or beneficiary is a deemed distribution; or 3) loans by a FNGT to a foreign person related to the U.S. grantor or beneficiary.

Additionally, the proposed regulations provide that if a nonresident alien grantor or beneficiary receives a loan and subsequently becomes a U.S. tax resident within two years, the outstanding loan balance should be treated as distributed upon the first date of their residency unless the loan was a “qualified obligation” since inception. The expansion of the qualified obligation rules will require taxpayers to employ additional diligence when planning to avoid a loan becoming an inadvertent deemed distribution.

Use of Trust Property

Current law treats the uncompensated use of FNGT property by a U.S. beneficiary like a deemed distribution unless fair market value payment for the use of the property is made within a “reasonable period.”

The proposed regulations expand the definition to include “indirect use” of trust property, including use by any U.S. person related to a U.S. grantor or beneficiary, an agent/nominee of a U.S. grantor or beneficiary, or an agent/nominee of U.S. persons related to a grantor or beneficiary. Under these circumstances, it is critical taxpayers keep track of who is allowed to use trust property, including homes, vehicles, vessels and artwork, to avoid accidentally having a deemed distribution.

Also included in the proposed regulations is a provision that the aggregate use of trust property for 14 days or less in a year by a U.S. grantor, beneficiary and U.S. persons related to U.S. grantor or beneficiary will not be a deemed distribution.  Previously, there was no guidance on what constitutes payment within a “reasonable period,” but the proposed regulations provide that payment is made within a “reasonable period” if payment is made, or periodic payments commence, within 60 days of the start of the use of trust property.

Trust Domestication

Generally, U.S. tax law provides that a trust is considered a foreign trust if it has a foreign trustee, or it is governed by the laws of a foreign country. Currently, converting a non-U.S. trust to a U.S. trust by replacing the foreign trustee with a U.S. trustee and changing the law governing the trust to a U.S. state is not deemed a distribution and, therefore, not subject to reporting.

The proposed regulations provide that for reporting purposes, the foreign trust is treated as distributing its trust corpus and income to the domestic trust on date foreign trust is domesticated. While the proposed rule does not state that domestication would trigger immediate U.S. income tax consequences, the transaction would need to be disclosed to the IRS, potentially attracting additional IRS scrutiny.

In light of these proposed regulations taxpayers should meet with their CPAs and tax advisors to determine if they qualify for an exemption from the foreign trust reporting requirements or if they should consider employing different estate planning tools to maintain tax efficiency across international borders.

About the Author: Joel G. Young, JD, LLM, is an associate director of Tax Services with Berkowitz Pollack Brant, where he provides tax, income and estate tax planning and compliance services for high-net-worth families and closely held businesses with international operations. He can be reached at the firm’s Boca Raton, Fla., office at (561) 361-2000 or info@bpbcpa.com.