In 1996, Congress enacted Section 6048.[1] Under that provision, certain persons are responsible for reporting transactions or relationships with foreign trusts on IRS Form 3520 and/or IRS Form 3520-A. The failure to timely file an IRS Form 3520 and/or IRS Form 3520-A can result in significant civil penalties and potential criminal referrals.
However, until recently, there has been significant debate among tax professionals regarding whether certain foreign trusts funded through employer and employee contributions were subject to the above reporting requirements. On March 2, 2020, the IRS issued guidance on these types of compensation arrangements (and certain savings trusts) through the release of Revenue Procedure 2020-17.
In sum, Revenue Procedure 2020-17 concludes that the reporting requirements of IRS Form 3520 and IRS Form 3520-A are not required in these circumstances, provided the foreign trusts and taxpayers meet specified criteria under the Revenue Procedure. Moreover, the Revenue Procedure provides helpful guidance to taxpayers who have been assessed civil penalties for failure to file IRS Forms 3520 and IRS Forms 3520-A in these circumstances and who wish to file a claim for abatement or refund of the civil penalty.
Summary of Foreign Trust Reporting Requirements
Section 6048 contains the reporting requirements applicable to foreign trusts. Under Section 6048(a), a “responsible party” must file an IRS Form 3520 if a “reportable event” occurs. For these purposes, a reportable event includes: (1) the creation of a foreign trust by a U.S. person; (2) the transfer of money or property to a foreign trust by a U.S. person; and (3) the death of a U.S. person 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. Generally, the responsible party is the grantor of the trust, the transferor of assets or property to the trust, or the executor of the decedent’s estate.
Section 6048(c) generally imposes reporting requirements on foreign trust beneficiaries. Under that provision, U.S. persons are required to file IRS Form 3520 if they receive a distribution from the foreign trust during the tax year.
Section 6048(b) imposes reporting obligations on foreign trusts or certain U.S. persons. This reporting obligation is the IRS Form 3520-A, which must be filed by any U.S. person treated as the owner of any portion of a trust under the grantor trust rules unless the foreign trust files the IRS Form 3520-A.
Failures to file IRS Forms 3520 and/or IRS Forms 3520-A can result in steep civil penalties. For example, for violations under Section 6048(a) or Section 6048(c), the IRS can impose a civil penalty equal to the greater of $10,000 or 35% of the “gross reportable amount” under Section 6677. Moreover, for violations under Section 6048(b), the IRS can assert a civil penalty equal to the greater of $10,000 or 5% of the gross reportable amount. For these purposes, the gross reportable amount is:
- In the case of Section 6048(a) violations, the gross value of the property involved in the event;
- In the case of Section 6048(b) violations, the gross value of the portion of the trust’s assets at the close of the tax year that are treated as owned by the U.S. person under the grantor trust rules; and
- In the case of Section 6048(c) violations, the gross amount of the distributions.
Section 6048 has some statutory exceptions. Specifically, Section 6048(a)(3)(B)(ii) provides an exception from the foreign trust reporting requirements under Section 6048(a) for transfers to foreign compensatory trusts described in Sections 402(b), 404(a), or 404A.[2] Moreover, Section 6048(d)(4) permits the IRS to suspend or modify reporting requirements under Section 6048 if the United States has no significant tax interest in obtaining the required information.
Previously, the IRS has relied on either of these provisions to modify the reporting obligations under Section 6048. Specifically, in prior guidance, the IRS has held:
- No IRS Form 3520 must be filed under Section 6048(c) for distributions from certain foreign compensatory trusts, provided that the recipient of the distribution reports it as compensation income on a federal tax return, and
- No IRS Form 3520 or IRS Form 3520-A must be filed under Section 6048(a), (b), and (c) for certain Canadian retirement plans.
Revenue Procedure 2020-17
On March 2, 2020, the IRS issued Revenue Procedure 2020-17. A summary of the Revenue Procedure follows:
- Under its authority in Section 6048(d)(4), the IRS will no longer require IRS Forms 3520 and IRS Forms 3520-A for “eligible individuals” with “applicable tax-favored foreign trusts.”
- An eligible individual means an individual who is, or at any time was, a U.S. citizen or resident and who, for any period during which an amount of tax may be assessed under Section 6501 (without regard to Section 6501(c)(8))[3] is compliant (or comes into compliance) with all requirements for filing a U.S. federal income tax return (or returns) covering the period such individual was a U.S. citizen or resident, and to the extent required under U.S. tax law, has reported as income any contributions to, earnings of, or distributions from, an applicable tax-favored foreign trust on the applicable return (including on an amended return).
- For these purposes, “applicable tax-favored foreign trusts” include “tax-favored foreign retirement trusts” (“Retirement Trusts”) or “tax-favored foreign non-retirement savings trusts” (“Savings Trusts”).
- To qualify, a Retirement Trust must, in addition to the applicable requirements below, be a foreign trust for U.S. tax purposes that is created, organized, or otherwise established under the laws of the foreign jurisdiction as a trust, plan, fund, scheme, or other arrangements to operate exclusively or almost exclusively to provide, or to earn income from the provision of, pension or retirement benefits and ancillary or incidental benefits.
- To qualify, a Savings Trust must, in addition to the applicable requirements below, be a foreign trust for U.S. tax purposes that is created, organized, or otherwise established under the laws of a foreign jurisdiction as a trust, fund, scheme, or other arrangements to operate exclusively or almost exclusively to provide, or to earn income for the provision of medical, disability, or educational benefits.
- Generally, qualifying Retirement Trusts and Savings Trusts must: (1) be exempt from income tax or otherwise tax-favored under the laws of the trust’s jurisdiction; (2) require annual information reporting to the relevant tax authorities in the trust’s jurisdiction; and (3) meet certain contribution limits as further specified in the Revenue Procedure.
- In addition, Retirement Trusts must have the following other unique factors: (1) contributions are made only with respect to income earned from the performance of personal services; (2) withdrawals, distributions, or payments from the trust are conditioned upon reaching a specified retirement age, disability, or death, or penalties apply to early withdrawals and distributions; (3) if the trust is maintained by the employer, the trust must be nondiscriminatory as to participating employees, the trust must actually provide significant benefits for a substantial majority of eligible employees, and the benefits actually provided under the trust to eligible employees must be nondiscriminatory.
- Conversely, Savings Trusts must require withdrawals, distributions, or payments from the trust to be conditioned upon the provision of medical, disability, or educational benefits, or apply penalties for early withdrawals and distributions.
Procedures for Requesting Abatement or Refund of Section 6677 Penalties
Because the IRS no longer believes that civil penalties are appropriate in the above circumstances, the Revenue Procedure also provides that eligible individuals who have been assessed civil penalties under Section 6677 for failing to file IRS Forms 3520 and IRS Forms 3520-A with respect to applicable tax-favored foreign trusts may request an abatement of the penalty or a refund of the penalty paid.
To do so, taxpayers should file an IRS Form 843, Claim for Refund and Request for Abatement. However, to qualify for refund, the taxpayer must meet the requirements of Section 6402 and Section 6511.[4] Significantly, Section 6511 limits the ability of the IRS to refund taxes and civil penalties unless the taxpayer files the claim for refund within 3 years from the date the return was filed or 2 years from the time the tax was paid, whichever expires later.
To request abatement and refund, the taxpayer should mail the Form 843 to the Internal Revenue Service office in Ogden, Utah. In addition, the taxpayer should write on Line 7 of Form 843 “Relief Pursuant to Revenue Procedure 2020-17.” Moreover, the taxpayer should explain on Line 7 how the taxpayer and the foreign trust meet each relevant requirement under the Revenue Procedure.
Takeaway
The Revenue Procedure provides some welcome reporting relief for taxpayers who find themselves squarely within its parameters. However, taxpayers should ensure the foreign trust at issue meets the applicable requirements of the Revenue Procedure if they intend not to file an IRS Form 3520 and/or IRS Form 3520-A.
Moreover, taxpayers should be cognizant of the Revenue Procedure’s specific warning regarding other reporting requirements which may apply and are not exempt from reporting under the Revenue Procedure, such as FinCEN Form 114, Report of Foreign Bank and Financial Accounts (“FBARs”) and Form 8938, Statement of Specified Foreign Financial Assets.
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[1] All “Section” references are to the Internal Revenue Code of 1986, as amended (the “Code”).
[2] These Sections of the Code generally refer to so-called employees’ trusts or deferred compensation plans.
[3] Generally, Section 6501 of the Code requires the IRS to assess tax within 3 years after the tax return was filed unless the return is false or fraudulent or no return is filed. Section 6501(c)(8) provides an extension of the statute of limitations where the taxpayer fails to file certain foreign information reporting returns, such as IRS Form 3520, IRS Form 3520-A, IRS Form 5471, etc.
[4] Section 6402 permits the IRS to credit, within the applicable statute of limitations period, any overpayment against other liabilities, such as past-due support and certain debts to federal and state governments.
