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A trust can be a useful wealth management tool to reduce tax obligations, and ensure beneficiaries receive their intended assets. However, when that trust is held overseas, the IRS requires extra tax returns from both owners and beneficiaries to make sure the correct amount of tax is paid. But what if a sole owner and beneficiary fails to file a foreign trust’s tax return? Are they penalized as a beneficiary, an owner, or both?
The IRS likes to keep careful track of money held overseas for the benefit of U.S. taxpayers. The agency requires each person involved in a foreign trust to file tax returns, but the forms and the amounts reported are different, depending on the person’s relationship to the trust.
Before getting to the tax implications of trust fund reporting, it is important to clearly understand how trusts work, and who is involved. A trust is a separate legal entity -- like a business with the single function of managing money. The owner is the person who created the trust and retains the ability to make changes to it (in a revocable trust). The beneficiary is the person for whom the trust is managed; the person entitled to receive funds from the trust, called distributions.
When beneficiaries receive money from domestic and foreign trusts, they must report that income along with their wages, salary, or other income sources every year. If the trust is held overseas, they must also complete Form 3520, the “Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts.” This form requires beneficiaries to disclose distributions they received from the foreign trust each year.
Since trusts are separate legal entities, they must file their own tax returns. This is generally done by the owner. Form 3520-A, the “Annual Information Return of Foreign Trust With a U.S. Owner” requires the foreign trust owner to disclose various information related to the trust, including gifts and distributions to beneficiaries.
When one person both created and received benefit from a foreign trust, that person is required to file both Form 3520 and Form 3520-A. However, Part III of Form 3520 says that owners do not have to separately disclose distributions already included on a correctly completed Form 3520-A. In other words, owner / beneficiaries don’t need to account for distributions twice.
As with most IRS forms, there is a penalty for failing to file foreign trust tax returns completely, truthfully, and on time. However, the statute controlling foreign trust tax penalties sets different penalties depending on the person’s role in the foreign trust.
Section 6048(c) of the U.S. Tax Code applies to “any United States person [who] receives (directly or indirectly) . . . any distribution from a foreign trust.” This generally means the trust beneficiaries. If these beneficiaries fail to disclose their distribution income on Form 3520, the IRS may impose a 35% penalty on the gross amount of the distributions.
Owners of foreign trusts must contend with Section 6048(b). That section substitutes “5 percent” for “35 percent” as the penalty amount. That 5% penalty applies to “the gross value of [the owner’s] portion of the trust assets at the close of the year.” Because the penalty applies to the owner's share of the entire principle of the trust, those balances are generally far higher than the distribution amounts for a given year, and the penalties assessed can be larger, too.
The question, then, is whether a sole owner / beneficiary is penalized as owner or beneficiary. The courts took up this issue in Wilson v United States.
Joseph Wilson opened a foreign trust account worth more than $9 million USD in 2003. He was trying to shield assets from his wife after their relationship had broken down. When the divorce proceedings were over, Wilson terminated the trust in 2007, distributing $9.2 million back to his own U.S. bank accounts. Then he was late filing his foreign trust tax returns for 2007. The IRS imposed a 35% penalty based on Wilson’s beneficiary status, but his estate (he died while the case was pending), argued that as an owner, the 5% penalty should have applied instead.
This blog has covered Mr. Wilson’s case before. The U.S. District Court for the Eastern District of New York found in favor of the taxpayer’s estate. It ruled that the 5% owner’s penalty applied, and then only to the value of the trust at the end of the tax year. Because Wilson closed the account in 2007, the District Court said the proper penalty was $0.
But the Second Circuit Court of Appeals disagreed. It said that the U.S. tax code had two separate reporting requirements that Wilson violated. Section 6048(c) applied to any taxpayer who receives a distribution -- beneficiary and owner alike. Section 6048(b) imposed a separate reporting requirement on owners. The 35% penalty applies to violations of 6048 as a whole, applying to more than just a failure to meet the owner’s filing requirements under 6048(b). While Form 3520-A excuses an owner / beneficiary from reporting distributions twice, there is other information on the form that still must be provided on time. Because Wilson was late to file both 3520-A (as owner) and 3520 (as beneficiary), the larger penalty applied.
Foreign trust reporting is difficult, and many accountants have never had to navigate the various forms and penalties that apply to owners and beneficiaries. If you are connected with a foreign trust, be certain to work with an accountant and tax lawyer who understand the reporting requirements to avoid paying a steep penalty on what you receive, and on the balance you hold in reserve for your family and your future.
Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 30 years experience. If you have questions regarding foreign trust asset reporting penalties, contact Joe Viola to schedule a free consultation.