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Retirement brings significant changes to the way U.S. taxpayers receive income, and report that income to the IRS. Up until now, if some part of that retirement income came from a foreign trust, beneficiaries ran the risk of IRS penalties unless they had been reporting the trust on a separate form each year. Now, the IRS is considering excusing foreign trust reporting for some beneficiaries.
When U.S. taxpayers live or work overseas, foreign trust accounts are often part of the employment package. They are the equivalent of U.S. 401(k) retirement accounts, pensions, IRAs, and health or education savings accounts. Just like American retirement accounts, these assets can sometimes grow quite valuable over time, and that can translate into substantial taxes and IRS penalties once the worker retires or uses the account.
Section 6048 of the Internal Revenue Code contains a little-known requirement for U.S. taxpayers to annually report any foreign trusts they own or receive distributions from. Along with their federal income tax return, U.S. taxpayers with foreign trust accounts must complete Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, and Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner (Under section 6048(b)).
When those forms go missing, retirement can come with an unwanted surprise. The Internal Revenue Code imposes a penalty of $10,000 or 35% of the gross reportable amount for each missed report. If the IRS learns of the account and issues a notice for failure to file the forms, the U.S. taxpayer has 90 days to correct the error or they will suffer an additional $10,000 penalty for each additional 30-day delay.
A taxpayer may have several foreign trust accounts. They may have received a bundle from the same employer. A financial advisor may have recommended dividing their assets into different accounts. Or the taxpayer may have been employed by more than one foreign employer. In these cases, each year there will be new penalties for each account. Those accumulated penalties will quickly eat into a taxpayer’s retirement assets, leaving them unable to live a comfortable life in their final years.
The penalties for failing to file Form 3520 and 3520-A are steep, especially given how little information they provide to the IRS. Proposed IRS Guidance changes distributed in March 2020 acknowledge that “the United States has no significant tax interest” in gathering the information on the forms. Most foreign trusts report to their own governments, which communicate with the IRS. U.S. taxpayers are also required to include any income from those trusts on their federal income tax return. That is why the new IRS guidance would excuse foreign trust reporting for qualifying individuals holding specific types of accounts.
To qualify for the foreign trust reporting exemption, an eligible individual must be caught up on filing their U.S. federal income tax returns for any year they had an interest in the foreign trust account. They must also have reported any contributions, earnings, or distributions from the account as part of their income on those returns.
The change in reporting requirements is intended to apply only to certain retirement, health, and education accounts similar to those received by U.S. employees from their employers. These accounts are favored under their country’s tax systems. They may be exempt from income tax, contributions may be deductible from income or taxed at a lower rate, create a tax credit, or be eligible for a government subsidy or contribution. They have annual income reporting requirements in their home countries and can include rollover assets from other similar accounts. They fall into two categories, each with their own qualifications:
The retirement category applies to foreign trust accounts made up of income for personal services. Employers can maintain these trusts, but only if they are nondiscriminatory and offered to a wide range of staff, including rank-and-file employees, who actually benefit from their use. Taxes on the investment income earned by the trust must also be deferred until distribution, or be taxed at a lower rate. Contributions to these accounts must be limited to a set percent of the participant’s income, have an annual limit equivalent to $50,000 or less, or a lifetime limit of $1 million. Withdrawals and distributions must also depend on reaching retirement age, disability, or death, with early withdrawal penalties. However, loans to pay for hardship, education, or to purchase a home are allowed.
The foreign trust account can also qualify if it is set apart for medical, disability, or educational benefits of its participants. These are similar to U.S. health savings accounts or qualified tuition plans. Withdrawals must be limited to the intended purposes, and penalties must apply for any other payments. However, they have a lower limit: $10,000 or less per year or $200,000 or less over a lifetime.
U.S taxpayers who have already been assessed penalties for failing to file Form 3520 and 3520-A can still benefit from this change. The IRS guidance allows taxpayers to request an abatement of penalties assessed or a refund of penalties paid by filing Form 843, Claim for Refund and Request for Abatement, showing that they and their accounts qualify under the new guidance. However, the time limit to seek these abatements or refunds is only 2 to 3 years, so taxpayers should see if they qualify quickly to avoid overpaying the IRS for their foreign trust accounts on retirement.
Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 30 years experience. If you have questions regarding foreign trust account reporting requirements, contact Joe Viola to schedule a consultation.