Insights

Most tax practitioners are generally familiar with the U.S. federal gift tax, the federal estate tax and even the federal generation-skipping transfer (GST) tax. They are aware that when someone makes a gift, the donor may be required to file a federal gift tax return, and when someone dies, the decedent's estate may be required to file a federal estate tax return. However, many U.S. taxpayers and tax professionals are not aware that Form 3520 or Form 3520-A must be filed when certain gifts or inheritances are received by a U.S. person from individuals who are not U.S. citizens or U.S. residents (non-U.S. persons), or when certain transactions occur with foreign estates or trusts. It is extremely important to understand these filing requirements because the IRS, reversing long-standing practice, has recently been extremely aggressive in asserting substantial penalties for the failure to timely file these returns.

A full discussion of the transactions that require filing Form 3520 or Form 3520-A is beyond the scope of this article. The following are the most common situations in which Form 3520 or Form 3520-A must be filed:

• Receipt of Large Foreign Gifts. Form 3520 must be filed by any U.S. person who receives a gift in excess of $100,000 from a non-U.S. person.
• Receipt of Large Foreign Bequests. Form 3520 must be filed by any U.S. person who receives a bequest in excess of $100,000 from a foreign estate.
• Receipt of Distributions From Foreign Trusts or Use of Trust Property. Form 3520 must be filed by a U.S. person who receives a distribution from a foreign trust. There is no value threshold applicable to this category of reporting. Additionally, if a U.S. person is allowed to use property held within a foreign trust without paying fair value for that use—even as a beneficiary of the trust—Form 3520 must be filed.
• Existence of a Foreign Grantor Trust. Form 3520 or Form 3520-A must be filed to report the income and assets of a foreign trust if a U.S. person is treated as the "owner" of the trust under the grantor trust rules.
• Certain Transactions With Foreign Trusts. Form 3520 must be filed by (i) a U.S. grantor of a foreign trust to report the creation of the trust; (ii) a U.S. grantor to report certain transfers to a foreign trust; or (iii) the executor of a U.S. person's estate where the decedent was treated as (a) the owner of a foreign trust under the grantor trust rules, (b) in whose estate the foreign trust is included for estate tax purposes or (c) who makes a transfer to a foreign trust at death.

If Form 3520 or Form 3520-A is not timely filed, the following penalties can apply:

• A penalty of 35 percent of the total distributions received from a foreign trust
• A penalty of up to 25 percent of the total amount received as a foreign gift or foreign bequest (inheritance)
• A penalty of 35 percent of the total amount contributed to a foreign trust
• A penalty of 5 percent of the year-end value of the assets of a foreign grantor trust

The following examples illustrate these penalties:

• If a U.S. person fails to file Form 3520 to report receiving a $1 million distribution as a beneficiary of a foreign trust, the penalty is $350,000.
• If a U.S. person fails to file Form 3520 to report receiving a $1 million gift or bequest from a non-U.S. person, the penalty can be up to $250,000.
• If a U.S. person fails to file Form 3520 to report a $1 million contribution of property to a foreign trust, the penalty is $350,000.
• If a U.S. person is the grantor of a foreign grantor trust and the trust fails to file Form 3520-A to report the existence of a $1 million trust, the penalty is $50,000 (per year).

The penalties above each apply independently and are in addition to any other U.S. federal taxes or penalties that may be due.

The Form 3520 is due at the same time as the U.S. person's income tax return for the year in which the reportable event occurs, including extensions, but it is filed separately from the income tax return.

It is also important to mention that the U.S. tax rules may operate to inadvertently classify a trust as a "foreign trust" without the knowledge of the relevant parties. Even a trust created under U.S. law can be considered a "foreign trust" for U.S. federal tax purposes, which often results if non-U.S. persons control any of the substantial decisions of the trust.

Recently—especially during the past three to four years—the IRS has been extremely aggressive in imposing penalties on U.S. persons who fail to timely file Form 3520 or Form 3520-A. The tax law allows the IRS to waive penalties on a showing of "reasonable cause." In the past, the IRS was fairly tolerant of noncompliance in this area where there was no evidence of tax avoidance, the taxpayer self-corrected the problem before the IRS discovered it, and the taxpayer otherwise had a good record of tax compliance. There was a recognition that not all taxpayers or tax professionals were aware of these special filing requirements and that the significant penalties imposed by the statute were intended only for circumstances where a taxpayer was willfully attempting to evade a tax liability. However, the IRS seems to have instituted a "get tough" policy regarding these filings and is now asserting substantial penalties in situations it had routinely excused in the past. Moreover, the IRS is drawing a very hard line during appeals of these penalties, forcing taxpayers to take their cases to court or settle their cases by paying very large sums (even if less than the penalty that was originally assessed).

These developments make it even more important to be aware of these filing requirements and to pay careful attention to the deadlines. Taxpayers who have transactions with non-U.S. persons, foreign estates or foreign trusts should be sure to engage a qualified tax return preparer who is experienced in U.S. international tax and related reporting obligations. This is clearly an area where an ounce of prevention is worth a pound of cure.

If a taxpayer finds that he or she has missed a deadline to file Form 3520 or Form 3520-A, the taxpayer should immediately consult with a qualified U.S. tax practitioner. Even if the taxpayer has a strong case for penalty relief, the taxpayer should, under current IRS policy, expect a long and difficult road ahead to get the penalty abated or reduced.

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