By Ian Weinstock and Heather Fincher
For nearly thirty years, taxpayers have been waiting for the IRS to issue regulations related to foreign trusts and foreign gifts. Since 1996, when Congress enacted a myriad of provisions to prevent tax avoidance through the use of foreign trusts and gifts, taxpayers have had to rely on less formal guidance (e.g., Notice 97-34, Rev. Procs. 2014-55 and 2020-17) on those provisions.
At last, on May 8, 2024, Treasury and the IRS published proposed regulations, Transactions With Foreign Trusts and Information Reporting on Transactions With Foreign Trusts and Large Foreign Gifts (REG-124850-08) (the “Proposed Regulations”). Although the Proposed Regulations are generally consistent with existing IRS guidance, they also incorporate various modifications. Our focus here is to highlight those changes.
What’s New for Reporting?
Taxpayers use Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts (“Form 3520”), to report certain foreign trust and gift transactions. U.S. persons are required to report information about large foreign gifts, as well as their ownership of, contributions to, and distributions from a foreign trust. The Proposed Regulations modify the current rules as follows:
Foreign Gift Reporting
A U.S. person who receives a gift, bequest, devise, or inheritance from a non-U.S. person is generally subject to reporting requirements on Part IV of Form 3520 if certain thresholds are met. Failure to file the Form timely can result in civil penalties of up to 25% of the amount of the gift. Since 1997, the IRS has only required a transferor’s identifying information (name, address, and TIN (if any)) for gifts from a foreign corporation or foreign partnership, but no information about any other transferor.
Highlights of what’s new:
- Reporting Threshold Increase: The $100,000 threshold for reporting gifts from foreign individuals or foreign estates is now increased by a cost-of-living adjustment.
- Donor Information: Recipients reporting foreign gifts who separately identify gifts in excess of $5,000 must provide identifying information about the transferor.
- Covered Gifts: Certain gifts or bequests from covered expatriates exceeding the per-donee gift tax exclusion threshold will be reportable on Form 3520 and under IRC section 2801.
- Anti-Avoidance Rule: The IRS may recharacterize as a foreign gift an amount received from a non-U.S. person even where the recipient treats such amount as a loan rather than as a gift or as taxable income. (To minimize the risk of recharacterization, U.S. taxpayers who receive a loan from foreign persons should appropriately substantiate the debt, for example with a written loan agreement and a record of principal and interest payment history.)
Reporting with Respect to Foreign Trusts
Any U.S. person who owns or engages in certain transactions with a foreign trust may be subject to Form 3520 reporting requirements. A U.S. person’s transfer of money or property to a foreign trust is generally reportable on Part I of Form 3520. Additionally, any U.S. person who receives a distribution from a foreign trust must report on Part III of Form 3520. Failure to comply may result in civil penalties, namely, the greater of $10,000 or 35% of the gross value of the property transferred or the amount of the distribution, respectively.
Separately, a U.S. person treated as owner of a foreign trust must submit information on Part II of Form 3520 and ensure the trust (i) files Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner, with the IRS, and (ii) furnishes a Foreign Grantor Trust Owner Statement to the owner and a Foreign Grantor Trust Beneficiary Statement to all beneficiaries to whom the trust made distributions. Failure to comply may again result in civil penalties, namely, the greater of $10,000 or 5% of the gross value of the portion of the trust’s assets treated as owned by the U.S. person.
Highlights of what’s new:
- Constructive Transfers: Direct and indirect transfers are currently reportable. The Proposed Regulations explicitly include constructive transfers by a U.S. person to a foreign trust, including a U.S. person’s (i) assumption or satisfaction of a foreign trust’s obligations to a third party, (ii) guarantee of a foreign trust’s obligation; (iii) transfer to an entity owned by a foreign trust, and (iv) deemed transfer of assets to a foreign trust when a foreign grantor trust ceases to be treated as owned by the U.S. person.
- Constructive Distributions: For years, the rules relating to distributions have included language requiring actual and constructive distributions to be reported. The Proposed Regulations clarify that (i) transfers from a foreign trust to a grantor trust or disregarded entity are treated as distributions to the owner of the grantor trust or disregarded entity, (ii) distributions through an intermediary, nominee, or agent are treated as distributions to the U.S. person, and (iii) transfers to a U.S. person from an entity owned by a foreign trust are treated as distributions first from the entity to the foreign trust, and then from the trust to the U.S. person.
- Foreign Pensions and Retirement Accounts Exception: In 2020, the IRS issued Rev. Proc. 2020-17 to exempt eligible individuals from reporting transactions with, or ownership of, certain tax-favored foreign retirement plans. Because the exemptions were narrow, few individuals qualified. The Proposed Regulations make it marginally easier to qualify by replacing the strict contribution limitations requirement with a disjunctive test: the plan must incorporate either (i) contribution limitations based on a percentage of earned income, an annual limit of $75,000 (increased from $50,000), or a lifetime limit of $1,000,000; or (ii) a new value threshold of $600,000 at any point during the taxable year. However, we suspect that most individuals will still have a difficult time qualifying for this relief because multiple other requirements need to be met.
- Mirror Code Exception: Transfers, ownership, and distributions from trusts located in certain U.S. possessions (e., Virgin Islands, Guam and the Commonwealth of the Northern Mariana Islands) whose income tax systems determine the tax liability of its residents by reference to the tax laws of the United States are not reportable on Form 3520 to the extent the responsible party, U.S. owner or U.S. recipient, respectively, is a bona fide resident of the U.S. possession.
U.S. Persons” – a Modified Definition
One change that appears throughout the Proposed Regulations modifies the definition of “U.S. person” with respect to dual resident taxpayers and dual status taxpayers. A dual resident taxpayer is an individual who is considered a resident of both the United States and a treaty country pursuant to the internal laws of each country. A dual status taxpayer is an individual who either acquires U.S. citizenship or residence or abandons U.S. citizenship or residence during the year. In either case, the individual may be treated as a nonresident alien for part of the year.
Under the Proposed Regulations, these individuals are not treated as “U.S. persons” for the portion of the year they are treated as nonresident aliens for purposes of computing their U.S. income tax liability. For example, if an individual with a green card who is also a resident of another country and who takes a treaty position to be taxed as a resident of the other country gives $150,000 to her daughter, a U.S. citizen, the gift is a foreign gift and the daughter must report it (along with identifying information about her mother, the transferor) on Form 3520.
What’s New Regarding Transactions with Foreign Trusts?
Indirect Transactions
Seventy years ago, Congress codified the grantor trust rules under which a trust’s grantor who is deemed to have retained a certain measure of control over, or beneficial interest in, a trust is treated as the owner of all of the trust’s assets and is therefore taxable on the income generated by those assets. Internal Revenue Code (“IRC”) Section 679 includes foreign trusts set up by U.S. persons that have U.S. beneficiaries among the trusts subject to the grantor trust rules.
Separately, IRC Section 643(i) treats certain transactions between foreign nongrantor trusts and U.S. beneficiaries as deemed distributions for U.S. income tax purposes.
Since enactment of these provisions, taxpayers have made “creative” arguments that certain indirect transactions do not trigger these rules. The Proposed Regulations are intended to reduce the scope for taxpayer creativity.
Highlights of what’s new:
Loans or Uncompensated Use of Property. The Proposed Regulations clarify that an indirect loan from a foreign trust to a U.S. beneficiary, or the indirect use of foreign trust property by a U.S. beneficiary, either (i) causes the foreign trust to have a U.S. beneficiary (under IRC Section 679 related to grantor trusts), or (ii) results in a deemed distribution from a foreign nongrantor trust (under IRC Section 643(i)). For example, a loan to a single-member LLC owned by a U.S. beneficiary is treated as a loan to the U.S. beneficiary.
Qualified Obligations
As noted above, foreign grantor trust treatment is triggered under IRC Section 679 when a U.S. person transfers property to a foreign trust that has a U.S. beneficiary. Loans can impact whether (i) a U.S. person is deemed to have transferred property in exchange for less than fair market value, or (ii) a foreign trust is deemed to have a U.S. beneficiary. Specifically, even if a foreign trust does not already have a U.S. beneficiary, it will be treated as having one if it loans cash or marketable securities to a U.S. person. An exception applies, however, where the loan is a so-called “qualified obligation.” Current regulations define “qualified obligation” to be a loan that is (i) in writing, (ii) for a term up to five years, and (iii) with payments denominated in U.S. dollars, but (iv) only if the U.S. person reports the loan on Form 3520 every year it is outstanding.
In other words, a U.S. person would not be taxed as the owner of a foreign trust under IRC Section 679 if the only transfer to the trust was in exchange for a qualified obligation of the trust. Additionally, a foreign trust would not be treated as having a U.S. beneficiary based solely on the trust transferring cash to a U.S. person in exchange for a qualified obligation.
In addition, and as noted above, a loan from a foreign nongrantor trust to a U.S. beneficiary will be taxed as a deemed distribution from the foreign trust under IRC Section 643(i). However, a loan of cash or marketable securities will not be taxed as a deemed distribution if the loan is a qualified obligation.
Highlights of what’s new:
Qualified Obligation Definition. The Proposed Regulations require payments to be in cash in U.S. dollars, not in-kind property. Also, the obligation must be issued at par and provide for stated interest at a fixed or qualified floating rate, and all stated interest must be qualified stated interest (defined by reference to regulations under IRC Sections 1275 and 1273, respectively).
Furthermore, the U.S. person must timely make all payments of principal and interest according to the terms of the obligation, which may allow a grace period of no more than 30 days for late payments.
Finally, new anti-abuse rules allow the IRS to treat two or more loans as one if the IRS deems that the loans were structured with a principal purpose to avoid the qualified obligation restrictions.
