United States citizens and residents[i] are subject to federal income tax on their worldwide income. For example, even if a United States citizen permanently relocates to a foreign country, he or she will generally continue to have income tax reporting obligations in the United States. And, in many cases, because of this newfound nexus between the United States citizen and the foreign country, that person will also have newfound United States reporting obligations (such as FBARs).
Perhaps more commonly, United States reporting obligations arise in these situations when the United States person establishes a retirement account in a foreign jurisdiction. As discussed more fully below, many of the issues surrounding the proper reporting of foreign retirement accounts remain murky and unresolved. Because harmless mistakes can result in significant penalties for failing to file information returns, taxpayers with foreign retirement accounts should take actions to ensure that the accounts are properly disclosed for United States reporting purposes.
IRS Guidance and the 2018 GAO Report.
The United States reporting obligations of any foreign retirement account depend largely on the governing plan document and foreign law. Complicating matters more, there is little IRS guidance on these issues. Indeed, in 2018, the United States Government Accountability Office (“GAO”) issued a report to the Senate Finance Committee summarizing the current state of affairs:
U.S. individuals who participate in foreign workplace retirement plans face challenges reporting their retirement savings for tax purposes because of complex federal requirements governing the taxation of foreign retirement accounts and a lack of clear guidance on how to report these savings. For example, stakeholders told GAO it is not always clear to U.S. individuals or their tax preparers how foreign workplace retirement plans should be reported to the Internal Revenue Service (IRS) and the process for determining this can be complex, time-consuming, and costly. In the absence of clear guidance on how to correctly report these savings, U.S. individuals who participate in these plans may continue to run the risk of filing incorrect returns.
What little guidance there is from the IRS is far from authoritative. For example, there are a handful of private letter rulings and revenue rulings that have held that certain foreign retirement accounts should be treated as foreign trusts for federal income tax purposes. See, e.g., PLR 201538008 (superannuation fund treated as foreign trust); PLR 200807003 (same); Rev. Rul. 2008-40, 2008-30 I.R.B. 166 (plan in foreign country maintained to provide retirement benefits to employees treated as foreign trust for United States income tax purposes). And, in response to a Freedom of Information Act (“FOIA”) request, the IRS released internal guidance that showed that the IRS had historically instructed its employees to take a position, at least for purposes of the now-closed Offshore Voluntary Disclosure Program (“OVDP”), that Australian superannuation funds (i.e., a form of a foreign retirement account): (1) not previously reported on an information return should be part of the OVDP penalty base; and (2) information returns, such as Forms 3520 and 3520-A, may be required to be filed with respect to the retirement account.
Thus, it is clear that the IRS views many foreign retirement accounts as “foreign trusts” for United States reporting purposes. This is significant: as discussed more fully below, the civil penalties for failure to timely report interests in or transactions with foreign trusts can reach up to 35% of the amount held in the foreign trust or the amount of any contributions to or distributions from the foreign trust.
Regardless of its tax characterization, many beneficiaries of a foreign retirement account will also have FBAR reporting obligations. Indeed, the IRS has hinted in informal guidance that it considers United States persons who hold interests in the following foreign retirement accounts to potentially have FBAR reporting obligations: (1) Canadian Registered Retirement Savings Plans; (2) Canadian Tax-Free Savings Accounts; (3) Mexican individual retirement accounts (referred to as “Fondos para el Retiro”); and (4) Mexican Administradoras de Fondos para el Retiro (AFORE). See IRS FBAR Reference Guide; see also IRM pt. 188.8.131.52.3(1) (11-6-15). The penalties for failing to file a timely and complete FBAR can be harsher than the penalties for failing to timely file a Form 3520. In addition, if the retirement account required the filing of both a Form 3520 and an FBAR, federal law permits the IRS to assess both sets of civil penalties against the United States person for each year of the non-compliance.
The terms “trust” and “foreign trust” are defined in the Internal Revenue Code (the “Code”) and regulations. Under the regulations, a “trust” means any arrangement in which title to property is held by a person or persons with fiduciary responsibilities to conserve or protect the property for the benefit of another person or persons. See Treas. Reg. § 301.7701-4(a). If the arrangement constitutes a “trust,” then the next determination is whether the trust is foreign. Under the Code, a trust is foreign if, among other things, no court within the United States is able to exercise primary supervision over the administration of the trust. See I.R.C. § 7701(e)(31)(B).
Given the above definitions, it may no longer surprise you to learn that the IRS takes the position that many foreign retirement accounts are foreign trusts. Indeed, in many retirement account arrangements (whether foreign or domestic), there is usually a plan administrator or trustee who collects funds from the employee and employer for eventual distribution to the beneficiary according to the plan’s provisions. The IRS has looked to these same definitions in support of its conclusions that certain foreign retirement accounts are foreign trusts for United States reporting purposes.
The requirement to file an FBAR is nothing new—it came about in 1970. Under that reporting regime, a United States person must file an FBAR if he or she has a financial interest in or signature authority over one or more foreign financial accounts with aggregate values of more than $10,000 at any time during the calendar year. If these requirements are met, the United States person must timely file a FinCEN 114, Report of Foreign Bank and Financial Accounts.
A United States person who fails to timely file an FBAR can face a litany of civil penalties depending on whether the conduct at issue was “non-willful” or “willful.” The non-willful penalty is $10,000 per violation (adjusted for inflation). However, federal courts currently disagree as to whether the term “violation” as used in Title 31, which houses the FBAR rules, means per bank account or per year. See, e.g., U.S. v. Boyd, 991 F.3d 1077 (9th Cir. 2021); U.S. v. Bittner, No. 20-40597 (5th Cir. Nov. 30, 2021). If the conduct was willful, the civil penalty is increased to the greater of $100,000 (adjusted for inflation) or 50% of the amount in the account at the time of the violation. Significantly, FBAR penalties can be imposed each year that an FBAR is not timely filed with full disclosure of the foreign accounts (up to the six-year statute of limitations on assessment).
The definition of a “financial account” is broad. It includes: (1) bank accounts; (2) securities accounts; (3) insurance or annuity policies with cash values; (4) commodity futures or options accounts; (5) mutual funds or similarly-pooled funds; and (6) any other account with a financial institution or a person that is in the business of accepting deposits as a financial agency. See 31 C.F.R. § 1010.350(c). Most, if not all, foreign retirement accounts fall squarely within this broad definition of reportable “foreign accounts.”
However, there are FBAR reporting exemptions. Applicable to foreign retirement accounts treated as foreign trusts, a participant or beneficiary of a tax-qualified retirement plan under I.R.C. §§ 401(a), 403, or 403(b) is not required to file an FBAR if the foreign account is held within the plan. See 31 C.F.R. § 1010.350(g)(4). Although somewhat helpful, this exemption is severely curtailed for most foreign retirement accounts because they do not meet any of the statutory requirements for these tax-qualified plans. See, e.g., I.R.C. § 401(a) (requiring among other things, “[a] trust created or organized in the United States . . .”); see also Treas. Reg. § 1.401-1(a)(3)(i) (“it must be maintained at all times as a domestic trust in the United States”).[ii]
Forms 3520 and 3520-A.
Section 6048 of the Code was enacted in 1996. It governs reporting requirements for foreign trusts. Under that provision, a “responsible party” must file an IRS Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts, if a “reportable event” occurs. Generally, a “reportable event’ includes the creation of a foreign trust by a United State person or the transfer of money or property to a foreign trust by a United States person. There is also a Form 3520 reporting requirement if the United States person receives a distribution from a foreign trust.
Section 6048 also requires the filing of a Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner, if certain requirements are met. Under this provision, if the foreign trust fails to file a timely Form 3520-A, the United States person must do so if the person is treated as the owner of any portion of the trust under the grantor trust rules of the Code.
Civil penalties apply for the failure to file either the Form 3520 or the Form 3520-A. If the United States person fails to timely file a Form 3520, he or she can be liable for civil penalties on the greater of $10,000 or 35% of the amount at issue (i.e., the amount of the trust, the amount of the contribution to the trust, or the amount of the distribution from the trust). Moreover, if the United States person fails to file a Form 3520-A, he or she can be liable for civil penalties on the greater of $10,000 or 5% of the amount held in the trust.
Similar to the FBAR reporting requirements, there are exceptions for filing a Form 3520. Section 6048(a)(3)(B)(ii) provides an exemption for reporting contribution to foreign trusts that are “described in section 402(b), 404(a)(4), or 404A.” But, by its terms, that provision does not apply to distributions from a foreign trust to a beneficiary. Compare I.R.C. § 6049(a)(3)(B)(ii) with I.R.C. § 6048(c). Moreover, retirement accounts that do not fall within section 402(b), 404(a)(4), or 404A would also fall outside the exception altogether.
The IRS has also carved out limited administrative exceptions through the issuance of revenue procedures. In Revenue Procedure 2014-55, 2014-44 I.R.B. 753, the IRS issued guidance for certain Canadian retirement plans. Under that revenue procedure, certain “eligible individuals”[iii] who make an election are generally exempt from filing Forms 3520 with the IRS.[iv] Later, the IRS issued Revenue Procedure 2020-17 to provide another “exemption from the information reporting requirements under section 6048 of the Internal Revenue Code for certain U.S. citizen and resident individuals . . . with respect to their transactions with, and ownership of, certain tax-favored foreign retirement trusts and certain tax-favored foreign nonretirement savings trusts[.]” As with Revenue Procedure 2014-55, taxpayers must meet numerous eligibility requirements to fall within the Form 3520 filing exception.
Foreign retirement accounts raise complex federal tax reporting issues. Taxpayers should carefully scrutinize their plan documents and foreign law to determine the proper tax forms to file, if any, associated with their interests in the retirement accounts. Taxpayers who fail to do so may do so at their own peril.
For potential methods to resolve past-due United States reporting obligations:
[i] A person is considered a resident of the United States for federal income tax purposes if the person is lawfully admitted for permanent residence (i.e., obtains a green card) or meets the substantial presence test. See I.R.C. § 7701(b).
[ii] The FBAR regulations also contain certain rules applicable to trusts to determine whether the person has a “financial interest” in the foreign accounts through the trust arrangement. See 31 C.F.R. § 101.350(e)(2)(iii). In many cases, an argument could be made that the employee’s contribution to the trust (and not the employer’s) is similar to a grantor trust. In these instances, the FBAR regulation would require FBAR reporting for that portion of the trust and the employer contribution portion only if the United States person has a present beneficial interest in more than 50% of the assets or from which such person receives more than 50% of the current income.
[iii] Generally, “eligible individuals” was defined in the Revenue Procedure as a beneficiary of a Canadian retirement plan who: (1) is or at any time was a U.S. citizen or resident while a beneficiary of the plan; (2) has satisfied any requirement for filing a U.S. federal income tax return for each taxable year during which the individual was a U.S. citizen or resident; (3) has not reported as gross income on a U.S. income tax return the earnings that accrued in, but were not distributed by, the plan during any taxable year in which the individual was a U.S. citizen or resident; and (4) has reported any and all distributions received from the plan as if the individual had made an election under the Canadian/U.S. tax treaty.
[iv] Significantly, the Revenue Procedure did not absolve persons who had failed to file Forms 8938 and/or FBARs. Rather, the guidance indicated that the Revenue Procedure did not “affect any reporting obligations that a beneficiary or annuitant of a Canadian retirement plan may have under section 6038D or under any other provision of U.S. law, including the requirement to file FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), imposed by 31 U.S.C. § 5314 and the regulations thereunder.”