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Reporting On Transactions With Foreign Trusts And Receipt Of Large Foreign Gifts.

By David Kerzner - Email Editor

Date : Nov 02, 2006

In my previous article , I wrote about the hidden and potentially substantial civil and criminal penalty risks related to the failure to report foreign bank and financial accounts by U.S. persons. The message of this short piece addresses the reporting obligations in connection with the use of foreign trusts, and the distribution of amounts from foreign trusts to U.S. persons. Also mentioned are the reporting requirements relating to large foreign gifts in excess of $100,000 to U.S. persons.

If you are tired, busy, stressed out, and really don't give a damn about reporting rules for foreign trusts and gifts, you can stop reading now. Throw this article away, and you'll still derive the full benefits of what I am writing here if you remember one thing: If you have any foreign facts in a trust or a gift, contact your U.S. international tax advisor.

You are a loser if you are still reading. These rules are so complex that just this month the IRS put out a notice requesting comments to improve/simplify Form 3520 (Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts). It is impossible for anyone to explain them all in 800 words, so if you have these issues, it's just more efficient for you to take them to your tax advisor rather than try to understand them.

A client of mine received a distribution from a discretionary foreign trust for a paltry $35,000 and had to hire me to advise him on his reporting, which included having the foreign trustee complete a detailed statement to the IRS relating to, amongst other mind perplexing subjects, the grantor trust rules and the throwback rules. The throwback rules, if applicable, can be heinous for two reasons. First, they can impose a confiscatory interest charge (which is cumulative) on accumulated trust income. Second, the accounting rules for these trusts are nightmarish. The trust income had in fact been accumulating for over 10 years! (Don't even think of what the bills for professional costs were.) Many wealthy families have children who live in the U.S. and establish foreign trusts for their benefit. This can result in horrible interest charges and accounting expenses, and the same benefits could be achieved through the use of a living or testamentary U.S. trust specifically set up for the U.S. resident family member.

Generally, persons who may be required to file Form 3520 are U.S. persons who:

--Are the grantor of an inter vivos foreign trust.

--Are the transferor of money or property (directly or indirectly) to a foreign trust (including a transfer by reason of death).

--The executor of a decedent's estate (whether or not the executor is a U.S. person) on the death of a U.S. citizen or resident, if the decedent was treated as the owner of any portion of the foreign trust (under the grantor trust rules) or any portion of the foreign trust was included in the gross estate of the decedent.

--Are treated as the owner of any part of the assets of a foreign trust under the grantor trust rules.

--Received (directly or indirectly) a distribution (or loan) from a foreign trust during the current tax year.

--Received more than $100,000 from a non-resident alien (NRA) individual or a foreign estate that are treated as gifts or bequests.

--Received more than $12,375 from a foreign corporation or foreign partnership treated as a gift.

The U.S. generally imposes its gift tax on transfers by a NRA if the gifted property is U.S. real estate. Many foreigners who own real property in the U.S. (directly vs. in trust) are not only subject to U.S. estate tax, but also to the gift tax at close to 50 percent on transfers to their non-citizen spouses. Gift tax also applies to transfers of tangible personal property situated in the U.S., but does not apply to intangible personal property (such as stock). This exception may not apply to expatriates. Careful planning can often avoid the gift and estate tax for foreign transferors.

A penalty may apply if either Form 3520 is not timely filed, or if the information is incomplete or incorrect. Specific penalties that may apply include: 35 percent of the gross value of any property transferred to a foreign trust for failure by a U.S. transferor to report the transfer; 35 percent of the gross value of the distributions received from a foreign trust for failure by a U.S. person to report receipt of the distribution; 5 percent of the amount of certain foreign gifts for each month for which the failure to report continues (not to exceed a total of 25 percent). Moreover, if a foreign trust has a U.S. owner and the trust fails to file the required annual reports on trust activities and income, the U.S. owner is subject to a penalty equal to 5 percent of the gross value of the portion of the trust's assets treated as owned by the U.S. person. Additional penalties may apply, and a waiver of penalties may be available in circumstances where the taxpayer can demonstrate failure was due to reasonable cause (usually relying on a tax professional), and not willful neglect.

Foreign trusts may provide Asset Protection benefits that Trustmakers and your lawyer are able to describe, and if properly planned for, may be useful too. But as my article illustrates, they can also be a trap for the unwary (to wit: gain recognition on transfers of appreciated property to non-grantor trusts). Perhaps the most important message lost on taxpayers with sophisticated personal and business matters, is not so much the wealth to be saved through proper tax planning, but equally the savings in time and money that can be relatively easily achieved by avoiding costly tax mines through good counsel. These rules are so ridiculously dense, that the reality is they will never be understood by all the people they affect. This brings us full circle to my admonishment at the start of this piece: If you have foreign facts in your business and personal planning, be sure to get a hold of your international tax advisor sooner rather than later. I will be back in a couple of months.

Thanks for your interest.

David Kerzner

David Kerzner is an international tax lawyer admitted to practice in New York, London and Toronto.

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