Forms 3520 and 3520-A and the Grantor Trust Rules
The United States taxes its citizens and residents on their worldwide income. To ascertain U.S. taxpayers’ foreign income, the Internal Revenue Service requires the filing of a series of international information returns. Those international information returns include 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.
The IRS requires the following taxpayers to file Form 3520:
- A U.S. person who is a “responsible party” with respect to a “reportable event” concerning a foreign trust during the current tax year, or who transferred property (including cash) to a foreign trust in exchange for an obligation.
- A U.S. person who, during the current tax year, is treated as the owner of any part of the assets of a foreign trust under the grantor trust rules of Internal Revenue Code (“IRC”) Sections 671-679.
- A U.S. person who received, directly or indirectly, a distribution from a foreign grantor or nongrantor trust during the current tax year.
- A U.S. person who received during the current tax year (a) more than $100,000 from a nonresident alien individual or a foreign estate which the U.S. person treated as nontaxable gifts or bequests; or (b) more than $15,797 from foreign corporations or foreign partnerships which the U.S. person treated as nontaxable gifts.
A “U.S. person” is a citizen or resident of the U.S., or a U.S.-based corporation, partnership, estate, or trust. A prior article examines “U.S. person.”
Reportable events include the following:
- The creation of a foreign trust by a U.S. person.
- The transfer or any money or other property, directly or indirectly, to a foreign trust by a U.S. person, including a transfer by reason of death.
- The death of a citizen or resident of the U.S. if:
- The decedent was treated as the owner of any portion of a foreign trust under the grantor trust rules of IRC Secs. 671-679, or
- Any portion of the trust was included in the gross estate of the decedent for U.S. estate tax purposes.
A responsible party means:
- The grantor, in the case of an inter vivos trust;
- The transferor, in the case of a reportable event (defined above) other than a transfer by reason of death; or
- The executor of the decedent’s estate in any other case (whether or not the executor is a U.S. person.
Form 3520 need not be filed to report an interest in a Canadian registered retirement savings plan (“RRSP”) or a Canadian registered retirement income fund (“RRIF”).
Form 3520 is due to be filed by the 15th day of the fourth month following the close of the taxpayer’s tax year. Extension of the taxpayer’s U.S. income tax return also extends the filing deadline of Forms 3520 due from the taxpayer for that year.
A taxpayer is subject to a penalty for each Form 3520 which he or she fails to file; the amount of the penalty equals the greater of $10,000 or 5% of the foreign trust assets reportable on the unfiled Form 3520.
The Form 3520 filing requirement applies to deemed ownership of the assets of a foreign trust by a U.S. person on or after October 16, 1962.
A taxpayer may be assessed a penalty for failure to file Form 3520 and a penalty for failure to file Form 3520-A with respect to the same foreign trust for the same tax year. If the IRS proposes or assesses such a penalty, the taxpayer should consider requesting reasonable cause penalty relief. A prior article reviews reasonable cause.
Each U.S. person who is treated as an owner of any portion of a foreign trust at any time during the tax year by application of the grantor trust rules is responsible for ensuring that the foreign trust files Form 3520-A, and furnishes the required annual statements concerning the foreign trust to the trust’s U.S. owners and beneficiaries.
Form 3520-A need not be filed to report an interest in a Canadian registered retirement savings plan (“RRSP”) or a Canadian registered retirement income fund (“RRIF”).
Form 3520-A is due to be filed with the IRS, and the required annual statements concerning the foreign trust must be given to the trust’s U.S. owners and U.S. beneficiaries, by the 15th day of the third month following the close of the foreign trust’s tax year. An extension of these deadlines may be granted, not by extending an individual income tax return, but by filing Form 7004, Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns.
A taxpayer is subject to a penalty for each Form 3520-A which he or she fails to file; the amount of the penalty equals the greater of $10,000 or 5% of the foreign trust assets deemed owned by application of the grantor trust rules.
The Form 3520-A filing requirement is effective for tax years beginning after December 31, 1976.
A taxpayer may be assessed a penalty for failure to file Form 3520-A and a penalty for failure to file Form 3520 with respect to the same foreign trust for a given tax year. If the IRS proposes or assesses such a penalty, the taxpayer should consider requesting reasonable cause penalty relief. A prior article reviews reasonable cause.
Significantly, Internal Revenue Code (“IRC”) § 6501(c)(8)(A) provides that the failure to file Form 3520 or Form 3520-A or like information return suspends the assessment statute of limitations, not only as to the penalty for failure to file the information return, but as to the taxpayer’s entire income tax return for that year.
As noted above, Form 3520 and Form 3520-A must be filed to report foreign trust assets deemed owned by a U.S. person by application of the grantor trust rules of IRC Sections 671-679.
IRC Section 671 provides that where the grantor or another person is treated as the owner of any portion of a trust under IRC Sections 671-679, there shall then be included in computing the taxable income and credits of the grantor or the other person those items of income, deductions, and credits against tax of the trust which are attributable to that portion of the trust to the extent that such items would be taken into account in computing taxable income or credits against the tax of an individual.
IRC Section 672 provides definitions and rules for application of the grantor trust rules.
IRC Sections 673-677 concern trusts created by a person (the “grantor”) for his or her own benefit. IRC Section 673(a) provides that the grantor shall be treated as the owner of any portion of a trust over which the grantor retains a reversionary interest in trust property greater than 5% of the value of such property.
IRC Section 674(a) provides that the grantor shall be treated as the owner of any portion of a trust the property of which is subject to a power of disposition exercisable by (which may be enjoyed by) the grantor.
IRC Section 675 provides that the grantor shall be treated as the owner of any portion of a trust which is subject to certain administrative posers which may be exercised for the grantor’s benefit. Such powers include the power to purchase or dispose of trust property for less than adequate and full consideration; the power to borrow trust property without adequate security; and the power to control investments of the trust, or to vote stock held by the trust. Section 675 also provides that the grantor shall be treated of the owner of a trust where the grantor borrowed funds from the trust, and failed to repay the loan before the beginning of the tax year.
IRC Section 676(a) provides that the grantor shall be treated as the owner of any portion of a trust over which the grantor retains the power to revest title to trust property in himself or herself.
IRC Section 677(a) provides that the grantor shall be treated as the owner of any portion of a trust the income of which may be (1) distributed to the grantor or the grantor’s spouse; (2) held for future distribution to the grantor or the grantor’s spouse; or (3) applied to the payment of premiums on policies of life insurance on the life of the grantor or the grantor’s spouse.
IRC Section 678(a) describes a trust created not for the benefit not of the grantor but of another beneficiary, where the beneficiary (1) has a power to vest title of trust property in himself or herself; or (2) has previously released or modified such a power, and after the release or modification retains such control over trust property as would, under IRC Sections 673-677, subject the grantor to treatment as the owner thereof.
IRC Section 679 provides that a U.S. person who directly or indirectly transfers property to a foreign trust (other than a transfer for fair value) shall be treated as the owner for his taxable year of the portion of such trust attributable to such property if for such year there is a U.S. beneficiary of any portion of such trust.
A Recent Case
A recent case involved a couple who removed to their native United States after living in the United Kingdom for 10 years. While the couple lived in the U.K., they filed U.K. income tax returns. But the couple had four years of unfiled U.S. income tax returns. The couple’s delinquent FBARs had already been filed.
The accounting firm engaged to prepare the couple’s delinquent U.S. income tax returns wanted to file with the returns Forms 3520 and 3520-A, on the theory that the couple’s U.K. retirement accounts are grantor trusts. The couple have four U.K. retirement accounts.
The couple’s U.K. pension accounts were created not by the couple but by their U.K. employers. Therefore, the U.K. pension accounts were grantor trusts if at all only if the clients have the power to vest title in trust property in themselves, under IRC Section 678(a)(1). We asked the clients whether they can make withdrawals from their U.K. retirement accounts, and they said that they cannot make withdrawals from the accounts until they reach age 55. The clients are both 40 years of age. The delinquent international return submission procedures did not apply because the clients had unfiled U.S. income tax returns. Had the clients made a submission under the Streamlined Procedures, they would have incurred a miscellaneous Title 26 offshore penalty of substantial amount, as they now reside in the United States.
So, on our recommendation, the clients filed their delinquent U.S. income tax returns without the Forms 3520 or 3520-A. It’s a good thing they did. Had the Forms 3520 and 3520-A been filed, the IRS surely would have penalized the clients $10,000 or more for each Form 3520 and each Form 3520-A not timely filed. At four Forms 3520 and four Forms 3520-A per year for four years, the IRS could have assessed the clients $320,000 or more in penalties for failure to timely file the forms.
Taxpayers should not gratuitously file international information returns. But a taxpayer who does have delinquent international information returns should file them as soon as possible, and seek reasonable cause abatement of penalties proposed or assessed.
This article is part of a recent series on international information returns in our sister blog Foreign Accounts Compliance.