This piece originally appeared in Bloomberg Tax. Duncan Treed contributed to this article.
On May 8, 2024, the Treasury Department issued new proposed regulations that mark a significant development in the reporting obligations for Americans abroad (REG–124850–08, RIN 1545–BI04, 89 Fed. Reg. 39,440 (May 8, 2024)). The extensive revisions and new rules aim to close loopholes, provide clarity, and ensure compliance with U.S. tax laws regarding foreign trusts. These proposals will significantly impact U.S. taxpayers and certain foreign executors with obligations related to foreign trusts. U.S. taxpayers with foreign trust interests must carefully review these proposed changes, understand their implications, and ensure timely compliance to avoid severe penalties and ensure proper tax reporting.
The proposed rules would amend regulations under §6048, §643, §679, §6039F, and §6677. This article focuses on the proposed regulations under §6048 and §6677, which aim to revise, clarify, and further develop prior IRS guidance. The comment period closed on July 8, 2024, with more than 1,000 comments submitted. The majority of comments came from individuals asking for exemptions from the reporting requirements to their foreign pensions, which would add both complexity and cost (See Andrew Velarde, IRS Urged to Make Trust Reporting Changes for Retirement Accounts, Tax Notes (July 8, 2024)). This period of public comment was crucial to voice concerns and suggestions, potentially shaping the final regulations to better address practical compliance challenges while maintaining the integrity of the U.S. tax system.
Foreign pensions and retirement accounts routinely create reporting challenges for taxpayers. Often, these retirement vehicles fall within the federal income tax definition of a foreign trust, necessitating compliance with the demanding reporting requirements under §6048, which may include filing annual Forms 3520 and 3520-A. In 2020, the IRS issued Rev. Proc. 2020-17 to exempt certain foreign retirement plans from these requirements, provided they met specific contribution limitations.
Overview of §6048 and §6677
Section 6048 requires U.S. taxpayers and certain foreign executors to report and disclose activity related to foreign trusts. These reports manifest as Form 3520 (for those receiving a distribution, gift, or other benefit from a foreign trust), Form 3520-A (for owners of a foreign trust or part thereof), and various statements detailing activity related to foreign trusts. The applicable statements include:
- Foreign Grantor Trust Owner Statement: For a foreign trust with a U.S. owner (applies to the portion owned by the U.S. person);
- Foreign Grantor Trust Beneficiary Statement: For any U.S. person other than the owner who receives a distribution from a Foreign Grantor Trust owned by a U.S. person;
- Foreign Nongrantor Trust Beneficiary Statement: For a U.S. person receiving a distribution from any foreign nongrantor trust; and
- Foreign-Owned Grantor Trust Beneficiary Statement: For any U.S. person receiving a distribution from a grantor trust with a non-U.S. person as the grantor.
Section 6677 details penalties for failing to file or properly report events as required by §6048.
Reportable Events
Section 6048 and its new proposed regulations address three types of reporting obligations arising from a U.S. person’s interactions with foreign trusts, known as reportable events:
- Creation of a Foreign Trust: When a U.S. person establishes a foreign trust;
- Transfers to a Foreign Trust: Includes both direct and indirect transfers, with the regulations expanding on the concept of indirect transfers to include the outbound migration of a U.S. domestic nongrantor trust to a foreign nongrantor trust; and
- Inclusion in Gross Estate: When the death of a U.S. person causes any part of a foreign trust to be included in the decedent’s gross estate.
Certain transfers are considered exempt and are excluded from being reportable events, such as transfers to a foreign charitable trust, tax-favored accounts, and compensatory trusts.
Responsible Party
When an inter vivos foreign trust is created, the grantor is a responsible party, this includes all grantors (including nominees such as attorneys).
- In the event of property transfer to a foreign trust, the transferor is a responsible party (excluding transfers by reason of death); this can include a domestic trust that may be winding up due to becoming a foreign trust, within the context of §6048 reporting the new foreign trust has received a transfer from a US person, the domestic trust and the domestic trust must report such distribution; or
- The executor, regardless of resident jurisdiction or nationality, of a deceased grantor or transferor’s estate.
Due Dates
The regulations confirm that Form 3520 can only be extended to October 15 of the tax year, and not further. Form 3520-A remains due on March 15 with a six-month extension available.
Additional Reporting Requirements
Foreign accounts which qualify for an exception to Form 3520 or other §6048 filings may still be subject to other US reporting and disclosure requirements, such as disclosure of specified foreign assets on Form 8938 or an FBAR filing.
Exceptions to Filing
The proposed regulations detail several exceptions to the reporting required under §6048, including:
- Transfers for Fair-Market Value: Covering typical business transactions for services or goods at arm’s length terms and prices; and
- Tax-Favored Foreign Trusts: Including foreign retirement, non-retirement savings, and de minimis savings trusts.
No scoundrels allowed—for any taxpayer seeking to avail themselves of the reporting exemptions for a tax favored foreign trust, the taxpayer must be able or willing to show full tax compliance for the relevant statute of limitations time period, generally three years.
Tax-Favored Foreign Retirement Trusts
The proposed regulations create a new class of foreign trusts called tax-favored foreign retirement trusts. These must:
- Operate to provide or earn income for pension or retirement benefits;
- Be tax-favored in their local jurisdiction;
- File annual reports with local tax authorities;
- Limit contributions to earned income;
- Satisfy value or contribution limit tests; and
- Restrict withdrawals to specific events like retirement age, disability, or death, with penalties for early withdrawals.
Tax-Favored Foreign Non-Retirement Savings Trusts
These accounts operate similarly to U.S. Health Savings Accounts, providing for medical, disability, or educational benefits. They must be tax-favored, file annual reports, and meet value or contribution thresholds.
Tax-Favored Foreign De Minimis Savings Trusts
These trusts follow similar rules but with a lower value threshold of $50,000.
Penalties
The proposed regulations under §6677 provide some minor relief in this complex compliance area. The default civil penalties remain the greater of $10,000 or 35% of the gross reportable amount, with ongoing penalties for continued non-compliance after an IRS notice.
Penalties are ameliorated as follows:
- The penalty for a U.S. grantor failing to file required returns (e.g., Form 3520-A) is now the greater of $10,000 or 5% of the gross reportable amount, payable by the U.S. grantor rather than the trust; and
- Penalties are subject to a reasonable cause exception.
Gross Reportable Amount
The term “Gross Reportable Amount” has three meanings:
- The gross value of property involved in a reportable event when the penalty arises due to a failure to report such an event;
- The total value of a foreign trust deemed owned by a U.S. person when ownership (in full or part) is not reported; or
- The value of an unreported distribution.
Importance of Compliance for US Citizens and Tax Filers Abroad
Understanding and complying with these regulations is crucial for several reasons:
- Avoiding Penalties and Legal Issues: Severe financial penalties and legal issues can arise from non-compliance.
- Ensuring Proper Tax Reporting: Accurate reporting ensures compliance with U.S. tax laws and prevents disputes with the IRS
- Protecting Beneficiary Interests: Proper filings protect U.S. beneficiaries of foreign trusts.
- Benefiting from Exemptions: Taxpayers can strategically manage their foreign assets to benefit from favorable tax treatment.
- Simplifying Compliance: Appointing a U.S. agent can streamline the compliance process. • Effective Financial Planning: Knowledge of reporting requirements and exemptions aids in global financial planning.
- Promoting Transparency and Fairness: Compliance contributes to a fair and transparent tax system.
The proposed rules not only tighten compliance but also offer some relief through revised exemptions for tax-favored foreign retirement and savings trusts. However, the complexity and rigor of the new requirements necessitate careful review and proactive management by U.S. taxpayers with foreign interests. Compliance challenges for U.S. taxpayers abroad persist, and it is unlikely that the final regulations will fully provide the clarity that tax professionals and Americans abroad desire as they plan for their futures. Ultimately, these regulations emphasize the importance of meticulous compliance to avoid penalties, protect beneficiary interests, and benefit from available exemptions. For U.S. citizens and tax filers abroad, understanding and navigating these changes is crucial for effective financial planning and contributing to a transparent and fair tax system.
About the Author
Arielle Tucker is a Certified Financial Planner™ and IRS Enrolled Agent with Connected Financial Planning. She’s spent over a decade working with US expats on US tax and financial planning issues. She is passionate about working with US expats and their families to help secure their financial future reflective of their core values. Arielle grew up in New York and has lived throughout the US, Germany, and Switzerland. You can get in touch with Arielle or schedule a discovery meeting with her here.