How Do I Know if I Have an IRS Form 3520/3520-A Filing Obligation?

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Jason B. Freeman

Jason B. Freeman

Managing Member

214.984.3410
jason@freemanlaw.com

Mr. Freeman is the founding member of Freeman Law, PLLC. He is a dual-credentialed attorney-CPA, author, law professor, and trial attorney.

Mr. Freeman has been named by Chambers & Partners as among the leading tax and litigation attorneys in the United States and to U.S. News and World Report’s Best Lawyers in America list. He is a former recipient of the American Bar Association’s “On the Rise – Top 40 Young Lawyers” in America award. Mr. Freeman was named the “Leading Tax Controversy Litigation Attorney of the Year” for the State of Texas for 2019 and 2020 by AI.

Mr. Freeman has been recognized multiple times by D Magazine, a D Magazine Partner service, as one of the Best Lawyers in Dallas, and as a Super Lawyer by Super Lawyers, a Thomson Reuters service. He has previously been recognized by Super Lawyers as a Top 100 Up-And-Coming Attorney in Texas.

Mr. Freeman currently serves as the chairman of the Texas Society of CPAs (TXCPA). He is a former chairman of the Dallas Society of CPAs (TXCPA-Dallas). Mr. Freeman also served multiple terms as the President of the North Texas chapter of the American Academy of Attorney-CPAs. He has been previously recognized as the Young CPA of the Year in the State of Texas (an award given to only one CPA in the state of Texas under 40).

Interests in or transactions with foreign trusts can cause headaches for federal income tax purposes.  Depending on the interest or transactions at issue, U.S. citizens or residents may have to file a Form 3520, a Form 3520-A, or both each and every single tax year.  And the failure to file either form when required can (and often does) result in significant civil penalties.

But, commonsensically, these civil penalties only apply if the entity in question is a “foreign trust”—which begs two questions:  (1) what is a “trust”; and (2) when is it “foreign”?  The Fifth Circuit’s recent decision in Rost v. U.S., No. 21-51064 (5th Cir. Aug. 11, 2022) provides some insight on these two questions and is discussed more fully below.

IRS Form 3520 and Form 3520-A Civil Penalties

Prior to any discussion of Rost, it is important to understand what was at stake in that case:  civil penalties.  As indicated above, federal tax law requires the disclosure of foreign trusts.  Under section 6048(a), a “United States person” must report “the creation of any foreign trust” and “the transfer of any money or property (directly or indirectly) to a foreign trust.”[i]  For these purposes, a “United States person” includes U.S. citizens and residents.[ii]  These disclosures are required on IRS Form 3520.  If a U.S. person has an IRS Form 3520 filing obligation and fails to timely file a Form 3520, the IRS can impose a “penalty equal to the grater of $10,000 or 35 percent of the gross reportable amount.”[iii] Generally, the “gross reportable amount” is the amount that should have been disclosed—e.g., the amount of funds transferred to the foreign trust.

Federal law also requires the disclosure of certain ownership in foreign trusts.  Under section 6048(b), anyone treated as the owner of a foreign trust under the grantor trust rules must ensure that the foreign trust annually files a Form 3520-A with the IRS.  If the foreign trust fails to file a Form 3520-A (which can be common), the grantor must file a substitute Form 3520-A with the IRS.  If a U.S. person has an IRS Form 3520-A filing obligation and fails to timely file a Form 3520-A, the IRS may impose “a penalty equal to the greater of $10,000 or 5% of the gross reportable amount.”[iv]  In these instances, the “gross reportable amount” is “the gross value of the portion of the trust’s assets at the close of the year treated as owned by the United States person.”[v]

The Facts of Rost

The taxpayer in Rost (Mr. Rebold, a U.S. citizen) invested in a Stiftung under the laws of Liechtenstein.  For those unfamiliar with these arrangements, the term “Stiftung” means, roughly, “foundation” or “endowment” in German  They are commonly used by U.S. taxpayers as Liechtenstein (roughly the size of Washington, D.C.) has historically been known as a tax haven.

Mr. Rebold named his Stiftung “Enelre Foundation” (the “Foundation”).  According to the Foundation’s organizational documents, it was formed to provide education and general support for Mr. Rebold and his children and was prohibited from engaging in “commercial trade”.  The Foundation’s documents also did not provide for any allocation of profits. Finally, the Foundation’s organizational documents provided for trustees and the payment of trustee fees.

After the Foundation was formed, Mr. Rebold transferred $2 million to its foreign banks in 2005 and $1 million to its foreign banks in 2007.  In 2010, one of the foreign banks notified Mr. Rebold that it intended to turn over the Foundation’s account records to the IRS.  Several years later in 2013, Mr. Rebold’s daughter, Daphne Rost (Ms. Rost), filed Forms 3520 and 3520-A on behalf of her father for the years 2005, 2006, and 2007, reporting year-end balances of approximately $1.68 million to $3.1 million throughout those years.

In 2014, the IRS assessed approximately $1.4 million of civil penalties against Mr. Rebold for his failure to file Forms 3520 and Forms 3520-A for 2005, 2006, and 2007.  After the IRS sought to levy the civil penalties from him, Mr. Rebold filed for a Collection Due Process (CDP) hearing.  The IRS Settlement Officer reduced the penalties by half but sustained the levy for the remaining amounts.  In 2017, Mr. Rebold paid the penalties in full and later filed an administrative claim for refund with the IRS.  When the IRS failed to provide a decision on his administrative claim for refund, Mr. Rebold filed a complaint in federal district court.  He passed away in June 2019, and his daughter, Ms. Rost, took over his estate’s claim as the executrix of his estate.

The Parties’ Arguments

During the district court proceedings and on appeal, the parties’ central dispute was whether the Foundation qualified as a foreign trust.  According to Ms. Rost, it was not a foreign trust because the IRS had never characterized a Stiftung as a trust, among other arguments.  According to the IRS, the facts and circumstances (its organizational documents, its structure, etc.) relating to the Foundation showed that it was a foreign trust for federal income tax purposes.  The district court agreed with the IRS, and Mr. Rost filed an appeal with the Fifth Circuit.

The Fifth Circuit’s Decision

As indicated above, the primary issue before the Fifth Circuit was whether the Foundation was a “foreign trust” for federal income tax purposes.  To determine whether the Foundation was a foreign trust, the Fifth Circuit engaged in a two-step inquiry:  (1) First, whether it was a trust under the regulations and case law; and (2) Second, if it was a trust, whether it was foreign or domestic.

Step One:  What is a Trust? 

For federal income tax purposes, an entity is a trust if “trustees take title to property for the purpose of protecting or conserving it for beneficiaries.”[vi]  Thus, an arrangement generally qualifies as a trust if “the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.”[vii]  Conversely, any entity not characterized as a trust for federal income tax purposes is generally characterized as a “business entity.”[viii]   Significantly, trusts can constitute “business trusts,” which are not treated as ordinary trusts for federal income tax purposes.

Although all of the facts and circumstances must be analyzed to determine whether an entity is a “trust” or a “business entity” including a “business trust,” various factors carry more weight than others.  For example, in Rost, the Fifth Circuit recognized that “the arrangement’s organizing documents” are significant because the party establishing the entity is generally not permitted to argue that the entity’s purpose was for anything other than what is described in those documents.

Step Two:  If a Trust, is it Foreign?

If an entity is deemed a trust for federal income tax purposes, the next inquiry is whether the trust is foreign or domestic. A foreign trust is defined in the negative:  it is any trust other than a trust that is a U.S. person.  And for these purposes, a trust is domestic (i.e., not foreign) if:  (1) a court within the U.S. is able to exercise primary supervision over the administration of the trust (referred to as “the court test”); and (2) one or more U.S. persons have the authority to control all substantial decisions of the trust (referred to as the “control test”).  See I.R.C. § 7701(a)(30)(E); Treas. Reg. § 301.7701-7(a)(1).

Is the Foundation a Foreign Trust?

In light of the above governing factors and tests, the Fifth Circuit had no trouble concluding that the Foundation in Rost was a foreign trust for federal income tax purposes.  First, the Foundation’s organizing documents indicated that the Foundation was established to support its beneficiaries; moreover, they limited the Foundation from pursuing any commercial trade.  Second, because the Foundation was subject to Lichtenstein laws, its board members functionally served as independent trustees and it had beneficiaries. Because the Foundation was a “trust,” it was also foreign in that:  (1) any disputes regarding the Foundation had to be resolved under Liechtensteinian arbitration proceedings; and (2) Mr. Rebold waived control over the Foundation.

Notably, the Fifth Circuit correctly acknowledged that not all Stiftungs are trusts as a matter of law.  Rather, under certain facts and circumstances, a Stiftung could be treated as a corporation, partnership, or other entity.

In sum, the Fifth Circuit sustained over $600,000 of civil penalties against Mr. Rebold’s estate for failure to file Forms 3520/3520-A.

The Takeaway  

The Rost decision demonstrates how easily a foreign entity may be characterized by the IRS as a foreign trust for purposes of requiring a Form 3520/3520-A.  Taxpayers with foreign interests in entities, particularly those with certain trust-like features, should ensure that they are timely and properly filing Forms 3520/3520-A to avoid the significant civil penalties that were sustained in Rost.  Taxpayers involved in IRS examinations regarding Form 3520/3520-A non-filings should remember that many arguments may be raised to potentially negate the civil penalties associated with those forms, including that the entity in question is not a foreign trust at all.

For more on Forms 3520/3520-A, see our other Insights below:

 

Probate, Trust, and Fiduciary Litigation

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[i] Id. at 6048(a)(1), (3)(A)(i)-(ii).

[ii] See I.R.C. § 7701(a)(30)(A).

[iii] See I.R.C. § 6677(a).

[iv] Id. § 6677(a)-(b).

[v] Id. § 6677(c)(2).

[vi] Treas. Reg. § 301.7701-4(a).

[vii] Id.

[viii] See Treas. Reg. § 301.7701-2(a).