The IRS requires certain U.S. persons to file informational returns to report their relationships to, and transactions with, foreign trusts. Internal Revenue Code § 7701(a)(30). This requirement also imposes the responsibility to file such informational trust returns on the estates of some deceased U.S. persons. Informational returns are just that, used to report certain information, but not to directly impose taxes. This article specifically explores the effects of these filing requirements on the executors of the estates of U.S. decedents, while also considering the effect of the open-ended Offshore Voluntary Disclosure Program (OVDP), offered by the IRS as an option to seek resolution of prior filing mistakes or omissions.
General Requirements for Form 3520 and Form 3520-A
The informational returns relating to foreign trusts include Form 3520 and Form 3520-A. Specifically, Form 3520 is the “Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts.” Form 3520-A is the “Annual Information Return of Foreign Trust with a U.S. Owner.” To determine whether a U.S. person has a responsibility to file either or both of these forms, analysis of four elements is required: (1) whether the person is a “U.S. person,” (2) whether the foreign entity is classified as a trust for U.S. tax purposes, (3) whether the trust is a foreign trust for U.S. tax purposes, and (4) whether the U.S. person is required to file under the rules governing each particular return.
For this purpose, the definition of “U.S. person” includes individual U.S. citizens and residents, as well as certain entities, such as the estate of a deceased U.S. citizen or resident. U.S. residents include U.S. green card holders and individuals who meet the substantial presence test. An individual generally meets the substantial presence test if he or she is present in the United States for 183 days in one year or an average of more than 121 days per year over the current year and the two preceding years.
Is There a “Trust”?
Although the Internal Revenue Code does not define the word “trust,” the Treasury Regulations provide definitional parameters for various types of trust entities.
The Code can classify an entity as an ordinary trust, whether created by third parties or created by beneficiaries. Ordinary trusts are the typical type of trust that estate planners will certainly recognize. An entity created by third parties (that is, not beneficiaries of the trust) is also an ordinary trust if it operates “for the purpose of protecting or conserving property of the beneficiaries,” does not regularly conduct business, and does not have associates. Treas. Reg. § 301.7701-4(a); see IRC § 7701(a)(30)(E). In this situation, the “beneficiaries of such trust do no more than accept the benefits thereof and are not the voluntary planners or creators of the trust arrangement.” Treas. Reg. § 301.7701-4(a).
If the beneficiaries themselves create an entity, it still may be classified as an ordinary trust under the Code if it was created for the purpose of protecting or conserving trust property for those beneficiaries, and they “stand in the same relation to the trust as they would if the trust had been created by others for them.” Id. Therefore, notwithstanding the identity of the creators, an arrangement will be treated as an ordinary trust “if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of responsibility . . . , are not associates in a joint enterprise,” and the beneficiaries do no more than accept the benefits of the trust. Id.
In the international context, entities exist that may be labeled or referred to as “trusts,” but would not actually constitute trusts for U.S. federal tax purposes. For example, in PLR 201245003, the IRS determined that a Mexican fideicomiso (or Mexican land trust) was not in fact a trust for U.S. tax purposes. Other examples, such as Australian superannuation funds, which somewhat resemble a U.S. 401k/IRA, may not at first appear to be trusts, but some practitioners would take a position that certain of these arrangements would be trusts. As such, it is a good rule to think expansively about whether a foreign entity or account may result in a trust for U.S. income tax purposes.
Do You Have a Foreign Trust?
An entity classified as a trust for U.S. tax purposes is a foreign trust if it fails either of the following tests: (1) the court test—a U.S. court is able to exercise primary supervision over the administration of the trust; or (2) the control test—one or more U.S. persons have the authority to control all substantial decisions of the trust. Treas. Reg. § 301.7701-7(a)(1). The control test requires analysis of two elements.
First, a “U.S. person” is defined as a U.S. citizen or resident, domestic partnership or corporation, domestic estate, or domestic trust. Treas. Reg. § 301.7701-7(d)(1)(i); IRC § 7701(a)(3). For example, a domestic corporation is a U.S. person, regardless of whether its shareholders are U.S. persons. Treas. Reg. § 301.7701-7(d)(1)(i).
Second, a U.S. person has control over a particular trust if he or she has the power to make substantial decisions relating to the trust. This control includes 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. Treas. Reg. § 301.7701-7(d)(1)(iii). A “substantial decision” means “[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.” Treas. Reg. § 301.7701-7(d)(1)(ii). Decisions that are ministerial include decisions regarding details such as bookkeeping, the collection of rents, and the execution of investment decisions. Substantial decisions include, but are not limited to, decisions concerning one or more of the following:
- whether and when to distribute income or corpus;
- the amount of any distributions;
- the selection of a beneficiary;
- whether a receipt is allocable to income or principal;
- whether to terminate the trust;
- whether to compromise, arbitrate, or abandon claims of the trust;
- whether to sue on behalf of the trust or to defend suits against the trust;
- whether to remove, add, or replace a trustee;
- 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
- investment decisions; if a U.S. person under IRC § 7701(a)(30) hires an investment advisor for the trust, however, 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.Treas. Reg. § 301.7701-7(d)(ii).
To determine whether a U.S. person has control, it is necessary to consider all persons who have authority to make a substantial decision for the trust, for example, appointors, trustees, or nominees, and not only the trust fiduciaries/trustees. If multiple individuals have substantial decision-making authority, U.S. persons will be treated as controlling the trust if they make up a majority of the control power. See Treas. Reg. § 301.7701-7(d)(1)(v), ex. 2.
Form 3520 and Form 3520-A
Very generally, a U.S. person is required to file informational foreign trust returns based on the following rules.
Form 3520. U.S. persons must file Form 3520 at the time their individual income tax returns are due. Form 3520 is used to report certain transactions with foreign trusts, distributions from foreign trusts, and receipt of certain large outright gifts from foreign persons (currently more than $100,000 from foreign persons or $14,375 from foreign corporations or partnerships, in the aggregate). A U.S. person failing to file Form 3520 is subject to an initial penalty of the greater of (1) $10,000 or (2) (a) 35% of the gross value of the property transferred to a foreign trust, (b) 35% of the gross value of the distributions received from a foreign trust, or (c) 5% of the gross value of the trust. IRC § 6677. Additional penalties for subsequent filing failures may follow.
Form 3520-A. A U.S. person treated as the grantor/owner of a trust for U.S. federal tax purposes is required to file Form 3520-A. Conflicting authority exists for whether the grantor/owner must file Form 3520-A by the 15th day of the third month after the close of the trust’s tax year or within 90 days of the occurrence of a reportable event. This discrepancy is discussed further in the analysis below of CCA 201208028. Generally though, taxpayers file Form 3520-A by March 15. This date often comes as a surprise because the individual’s return is not due until April 15. It is possible to extend the 3520-A, on Form 7004, to September 15.
For purposes of Form 3520-A, a reportable event includes the following: (1) the creation of any foreign trust, (2) the transfer of any money or property (directly or indirectly) to a foreign trust, and (3) the death of a citizen or resident of the United States who was either the owner of the trust for U.S. federal tax purposes or all or a portion of the foreign trust was includable in the person’s gross estate. IRC § 6048(a)(3)(A).
For any failure to file Form 3520-A, the U.S. owner is subject to an initial penalty of the greater of $10,000 or 5% of the gross value of the trust. IRS § 6048(b)(1). For continued failure to file past 90 days after the IRS mails notice of such filing failure, the U.S. owner is subject to an additional $10,000 penalty for each 30-day period during which the failure continues (subject to certain penalty thresholds).
Chief Counsel Advice 201208028
On February 24, 2012, the IRS national office addressed two important issues in the area of foreign trust compliance in Chief Counsel Advice (CCA) 201208028 (Feb. 24, 2012). See IRC § 6110(i)(1)(A), (k)(3) (a CCA is “written advice or instruction . . . prepared by any national office component of the Office of Chief Counsel which is issued to field or service center employees . . . and conveys any legal interpretation of a revenue provision; any . . . position or policy concerning a revenue position . . . [and] [t]he analysis of the law and the conclusions in a CCA do not establish a binding position of the IRS and may not be used or cited as precedent”). First, the IRS resolved the inconsistency between the Form 3520 instructions and the Code and Regulation guidance on the filing deadline to disclose a reportable event. Second, the IRS clarified its position on a fiduciary’s obligation to handle the foreign trust reporting responsibilities of a decedent and the decedent’s estate. The IRS attributed Form 3520 and Form 3520-A filing responsibilities of a decedent accruing before death and after death on the executor of the decedent’s U.S. estate. The IRS also held the executor responsible for both initial and additional penalties for the previous failures to file Forms 3520 and 3520-A.
Based on the limited information provided, the most plausible interpretation of the pertinent facts of the CCA appear to be as follows. The decedent created a foreign grantor trust at least six years before death, and for each of those years he was treated as the owner of it. In each year leading up to death, the decedent received distributions from the trust. In the year of death, the trust became a nongrantor trust and subsequently paid the decedent’s estate tax liability.
Neither the decedent nor the executor had properly or timely filed any foreign trust reporting forms required for the five years before death or the year of death. Following death, the decedent’s accountant filed amended Forms 1040 as the decedent directed during life. Prompted by these amended filings, within two years of the decedent’s death, the executor received a letter from the IRS advising of the delinquency of both Forms 3520 and 3520-A for the prior tax years, even though the decedent never received notice from the IRS during life for his failure to file either form. The IRS determined the delinquency based on the failure to file Form 3520-A annually on March 15 and Form 3520 with the decedent’s (individual and estate) annual federal income tax returns in required years.
The letter indicated that the IRS can impose both (1) initial penalties for the previous failures to file of the greater of $10,000 or 35% of the reportable amount for each 30-day period of continued filing delinquency after notice is received (up to 90 days) and (2) additional penalties of the greater of $10,000 or 5% of the reportable amount for each 30-day period of continued delinquency after the expiration of the initial 90-day notice period. IRC § 6677(a)-(b).
Seventy-two days after the 90-day period expired and without disputing the filing responsibilities, the executor filed the required forms. Specifically, the executor filed Form 3520 for three tax years preceding death and the year of death (consisting of two short tax years—individual and estate). The executor also filed Form 3520-A for four tax years preceding death and the year of death (consisting of only the first of the two short tax years in that calendar year). Id.
Filing Form 3520 to Disclose a Reportable Event. Both the Code and Regulations state that a U.S. person must file Form 3520-A within 90 days of the occurrence of a “reportable event.” IRC § 6048(a); Treas. Reg. § 16.3-1(e)(1). In Notice 97-34, the IRS expressly provided the same deadline. Notice 97-34, 1997-1 C.B. 422 (June 2, 1997). According to the Form 3520-A instructions, though, the Form is not due until the 15th day of the third month following the end of the trust’s tax year—meaning it was not necessary to file within 90 days of a reportable event. Form 3520-A, Instructions (2011).
For many years, these conflicting authorities left taxpayers in confusion about which filing deadline to follow. The CCA seems to resolve the discrepancy in favor of taxpayers, permitting the “more generous reporting requirement in its instructions for Form 3520-A.” Form 3520-A, Instructions (2011). This conclusion seems appropriate when considering IRC § 6048, which, after setting the 90-day rule, also provides leeway for the Secretary to prescribe a later filing deadline.
Fiduciary Responsibility for Foreign Trust Reporting Penalties. Although the executor filed these forms on behalf of both the decedent and the decedent’s estate, the executor disputed whether the IRS could impose penalties stemming from filing omissions during the decedent’s lifetime. This argument was unsuccessful, however. The IRS imposed certain penalties, as follows:
- Initial penalties for lifetime Forms 3520 and Forms 3520-A. As a rule, the IRS assesses initial penalties on the person required to file Form 3520. IRS § 6677(a). Because the executor timely notified the IRS of his role as executor, the executor assumed the “rights, duties, and privileges” the decedent held before death. IRC § 6903(a). The IRS advised that “it is well-established . . . that any unpaid tax liabilities of a deceased taxpayer [are] collectible from that taxpayer’s estate.” See Treas. Reg. § 301.6903-1(a); Estate of Rau v. Commissioner, 301 F.2d 51, 56−57 (9th Cir. 1962). Therefore, the estate assumes liability for the initial penalties stemming from the decedent’s failure to file Forms 3520 and Forms 3520-A during life.
- Additional penalties for lifetime Forms 3520 and Forms 3520-A. The IRS imposes additional penalties in a manner different from initial penalties—assessing them on the “person required to pay [the initial] penalty.” IRC § 6677(a). Because the IRS notified the executor of the requirement to pay the initial penalties, the estate became the person required to pay the initial penalties. As such, the estate had 90 days to pay before additional penalties began accruing to the estate. Because the executor filed the returns more than 90 days after receiving the IRS notice, the IRS also advised the executor of the responsibility to pay additional penalties for Forms 3520 and Forms 3520-A due for tax years preceding the decedent’s death. CCA at 9. (This is true unless the executor has a reasonable cause for the delay. The IRS indicates that IRC § 6677(d) provides some flexibility by providing a reasonable cause exception when imposing additional penalties on estates, for example, recent discovery of foreign trusts. The exception can also apply to initial penalties.)
- Initial penalties for post-death (estate) Forms 3520 and Forms 3520-A. After the decedent’s death, the executor became the party responsible for filing Forms 3520 in the year of death (including both short tax years—attributable to both the decedent and the decedent’s estate), to report at the decedent’s death the deemed transfer of property by the decedent immediately before death and the payment of estate tax by the trust on behalf of the decedent. IRC § 6048(a)(3)(A)(iii), (4); Treas. Reg. § 1.684-2(e); see Notice 97-34, 1997-1 C.B. 422, § V (June 2, 1997). The IRS held that the executor owed initial penalties for Forms 3520 applicable to the two short tax years in the year of death if he in fact filed untimely, incomplete, or incorrect returns.
Until the decedent’s death—at which time the trust became a nongrantor trust—he had the responsibility to file Form 3520-A. The executor again assumed the responsibility to file Form 3520-A because the decedent was the owner of the foreign trust before death. As such, the IRS also imposed initial penalties for Forms 3520-A, applicable to the short tax year before the date of the decedent’s death, because the executor filed the form nearly one and a half years after the due date (imposed unless the executor can show reasonable cause).
General Information Regarding the Offshore Voluntary Disclosure Program
In an effort to provide an avenue for tax noncompliant U.S. persons to come forward, pay past-due taxes and interest, and potentially avoid criminal penalties, the IRS announced its third official OVDP on June 26, 2012, and subsequently released guidelines for this program by amending and supplementing prior frequently asked questions (FAQ) to detail its parameters. See IR-2012-64; IR-2012-65. The program is intended to provide a more favorable avenue to become compliant with U.S. tax responsibilities. One aspect of this compliance program focuses on foreign trust reporting. Specifically, FAQ Nos. 5 and 18 address foreign trusts. FAQ No. 5 details the penalty structure for previous filing failures, and FAQ No. 18 details information for delinquent Form 3520 filers. These FAQs are found on the IRS web site. The IRS does not seek to impose penalties for delinquent informational returns as long as there are no underreported tax liabilities, and the IRS has not initiated any tax investigations for such delinquent returns.
At a time when ever-increasing cross-border reporting requirements are imposed on U.S. persons, it is imperative to have clear guidance setting forth taxpayer responsibilities. The CCA confirms the more lenient filing deadline for Form 3520-A, while also providing an example of how the IRS imposed penalties on an estate for the decedent’s, and later the executor’s, failure to properly file the Forms 3520 and 3520-A.
Because significant penalties accompany the failure to file foreign trust informational returns, if an executor becomes aware of the delinquency of any returns attributable to the decedent or the decedent’s estate, he or she should consult competent professional advisors who are familiar with the IRS processes and penalties. It is important to consider and begin resolving before filing Form 706 to permit the executor to attest to U.S. tax compliance of both the decedent and the decedent’s estate. This path to compliance may include participation (in some capacity) in the OVDP, which can be a timely and costly process. In some cases, advisors may be able to assist in minimizing penalties by taking a position that the failure to file was because of reasonable cause.