When Do I Have an IRS Form 3520/3520-A Filing Obligation?

When Do I Have an IRS Form 3520/3520-A Filing Obligation?

IRS Form 3520/3520-A Filing Obligation?

One of the most complicated aspects of international tax and reporting is when it comes to foreign entities such as businesses, corporations, and trusts. Unlike an entity such as a foreign corporation, when it comes to foreign trusts the rules are a bit more nebulous. That is because trusts can come in various different shapes and sizes, such as grantor and non-grantor trusts; irrevocable versus revocable trusts, foreign pension plans, etc. The reason why the reporting obligations for a foreign trust are very important to US taxpayers is that the failure to properly report a foreign trust may result in significant fines and penalties. In fact, under the Wilson case, a single owner of a foreign trust could get stuck with penalties as both the owner and the beneficiary of the same trust.

*The focus of this article is Foreign Trust reporting. We have a separate article about reporting gifts from foreign persons.

Form 3520/3520-A Foreign Trust Reporting Obligation

When it comes to reporting foreign trusts, just knowing whether you have a foreign trust or not can be a complex undertaking. On a recent case that we summarized in Rost vs USA/IRS, it provides a solid understanding of how foreign trust could be analyzed, at least in the fifth circuit involving Mississippi, Louisiana, and Texas—let’s take a look.

Legal Framework for Classifying Arrangement as Foreign Trust

In general, there are two main aspects of determining whether a trust is a “foreign” trust. The first step is to determine whether the entity or arrangement is considered a trust, and the second is to determine whether or not the is considered foreign — in accordance with the court and control tests.

As provided in Rost: 

      • Determining whether an arrangement is a foreign trust requires a two-step inquiry: (1) whether it is a trust under section 301.7701-4 or a business entity under sections 301.7701-2 or 301.7701-3, and (2) if it is a trust, whether it is a United States person (i.e., a domestic trust) or a foreign trust. See I.R.C. § 7701(a)(30)(E), (31)(B); Treas. Reg. §§ 301.7701-1(a)-(b), (d), 301.7701-2(a), 301.7701-4(a), 301.7701-5(a), 301.7701-7.

Step 1: Is it a Trust or Business Entity?

Sometimes, the same type of arrangement could be considered either an entity or a trust. In this particular case, the arrangement was created under the Stiftung regime. With this type of setup, depending on whether there is a business purpose or not (here there was no business purpose as it was designed to provide financial support for family members) will help determine whether or not it qualifies as either an entity — and whether the Form 5471 rules or Foreign Trust Form 3520 rules apply.

As provided in Rost:

      • The district court correctly found that Enelre qualifies as a foreign trust. Its organizing documents explain that Enelre’s purpose is to support its beneficiaries and limit its transactions to “pursuing and realising its purpose.” This is “characteristic of an ordinary trust.” Morrissey, 296 U.S. at 356-57. The documents also prohibit Enelre from conducting commercial trade. Liechtensteinian Public Registry filings confirm this prohibition.

      • Enelre’s familial purpose, lack of business objective, and bar on commercial activity render it a trust. See McKean v. Scofield, 108 F.2d 764, 765-66 (5th Cir. 1940) (holding a trust was taxable as a trust and not an association because “[s]olicitude for the future of [the settlor’s] family [wa]s a main purpose of the trust”); see also Estate of Bedell v. Comm’r, 86 T.C. 1207, 1221 (1986) (holding a “trust characterized by a dominant familial objective” was taxable as a trust and not an association because it lacked a business purpose).

      • A “trust” in the IRC is an arrangement where “trustees take title to property for the purpose of protecting or conserving it for the beneficiaries.” Treas. Reg. § 301.7701-4(a). An arrangement generally qualifies as a trust if “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 this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.” Ibid.; see also Frank Aragona Tr. v. Comm’r, 142 T.C. 165, 175 (2014).

Step 2: Is it A Foreign Trust?

Once it is determined that the arrangement was deemed to be a trust and not an entity, the next issue is whether or not the trust is foreign or not. Whether or not the trust is domestic or foreign will mpact both reporting and the taxation — the ladder which can become very complex in conjunction with the throwback tax rules and DNI versus UNI.

As provided in Rost:

      • A foreign trust is “any trust other than a trust” that is a “United States person” (i.e., a domestic trust). I.R.C. § 7701(a)(30)(E), (31)(B); Treas. Reg. § 301.7701-7(a)(2). A trust is domestic 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”). I.R.C. § 7701(a)(30)(E); Treas. Reg. § 301.7701-7(a)(1).

      • A trust satisfies the court test if the governing document “does not direct that the trust be administered outside of the United States,” “[t]he trust in fact is administered exclusively in the United States,” and “[t]he trust is not subject to an automatic migration provision” that would move it outside the U.S. if a U.S. court were to “attempt to assert jurisdiction” over it. Treas. Reg. § 301.7701-7(c)(1), (4)(ii).

      • As to the control test, “control means 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 [them].” Id. § 301.7701-7(d)(1)(iii). This includes anyone with authority over substantial decisions, not only trust fiduciaries. Ibid. Substantial decisions are those “authorized or required” under the trust instrument and applicable law “that are not ministerial.” Id. § 301.7701-7(d)(1)(ii) (providing examples).

Here, the court determined that it was a trust and it was a foreign trust. Therefore, this ruling is what led to significant fines and penalties.

Important: This is a Matter of Federal Tax Law

One important aspect to keep in mind when evaluating these types of foreign matters is that whether or not it qualifies as an entity, or trust, or PFIC is based on federal tax law when it is for federal tax purposes and not the local tax law in the foreign country at issue.

As provided in Rost:

      • The classification of an organization “for federal tax purposes is a matter of federal tax law and does not depend on whether the organization is recognized as an entity under local law.” Treas. Reg. § 301.7701-1(a). Sections 301.7701-2, 301.7701-3, and 301.7701-4 determine the classification of organizations recognized as separate entities, unless the IRC “provides for special treatment of that organization.” Id. § 301.7701-1(b).

      • Neither the IRC nor its regulations specifically classify or provide for special treatment of Stiftungen. Cf. id. § 301.7701-2(b)(8) (classifying Liechtenstein Aktiengesellschaften as corporations).

Missed Reporting Form 3520 in Prior Years?

If you missed reporting foreign trusts in prior years, you should consult with a Board-Certified Tax Law Specialist who focuses exclusively in offshore disclosure matters.

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