U.S. beneficiaries of foreign trusts must comply with new disclosure rules
The Hiring Incentives to Restore Employment Act (the HIRE Act)1 of 2010, found in Internal Revenue Code Section 6038D, enacted foreign asset disclosure rules that apply to most U.S. taxpayers for the first time this tax filing season. Here's an overview of those rules and how they apply to U.S. beneficiaries of foreign trusts.
IRC Section 6038D imposes self-reporting on U.S. taxpayers with respect to their foreign financial assets and is effective for tax years beginning after March 18, 2010. For calendar year taxpayers, this is the tax return due April 17, 2012.2 Section 6038D has its genesis in The Foreign Account Tax Compliance Act of 2009 (FATCA), a bill proposed by Senator Max Baucus (D.-Mont.), the provisions of which were incorporated into the HIRE Act. FATCA purports to give the Internal Revenue Service significant new tools to find and prosecute U.S. individuals who hide assets overseas in foreign accounts or foreign entities, including trusts and corporations. Among other things, it requires: (1) foreign financial institutions to provide certain information to the IRS about financial accounts held by U.S. taxpayers or by foreign entities in which U.S. taxpayers have a substantial ownership interest, and (2) U.S. taxpayers with foreign assets to provide detailed information about them. At the same time, FATCA broadens the foreign trust rules applicable to U.S. taxpayers who transfer assets to or receive distributions from foreign trusts and creates annual reporting obligations for U.S. shareholders of passive foreign investment companies (PFICs).
Section 6038D requires certain U.S. individuals who hold an interest in “specified foreign financial assets” that exceed, in aggregate, $50,000 on the last day of the tax year (or, as provided in temporary regulations, more than $75,000 at any time during the year), to report them on a statement attached to their income tax returns. The statement is made on Form 8938 (Statement of Specified Foreign Financial Assets), which was finalized in December 2011, with accompanying instructions, following the issuance of temporary and proposed regulations earlier that month. Individuals subject to this reporting include U.S. citizens, U.S. residents for income tax purposes3 (including dual resident taxpayers electing treaty benefits) and nonresidents who elect to be treated as U.S. residents.
Importantly, the reporting applies to individuals, not to entities, but the statute gives the IRS authority to issue regulations that require a domestic entity to file as if it were an individual, if it was formed or availed of to hold specified foreign financial assets. On Dec. 14, 2011, the IRS issued a proposed regulation, Treasury Regulations Section 1.6038D-6, which discusses the instances in which specified domestic entities, including certain domestic corporations, partnerships and trusts (but not domestic estates) will be subject to these reporting rules.4 A discussion of the proposed regulation is beyond the scope of this article, because there's no filing requirement imposed on domestic entities at this time.
The IRS issued temporary regulations, Treas. Regs. Sections 1.6038D-1T through 1.6038D-8T, with an effective date of Dec. 19, 2011,5 which, together with the instructions to the final Form 8938, provide guidance on the new filing requirement. The temporary regulations address: (1) how to determine what constitutes a specified foreign financial asset and if a U.S. taxpayer has an interest in it, (2) how to value an interest in the relevant asset for purposes of reporting it, and (3) which assets are exempt from reporting or otherwise qualify for “short-form” reporting, as discussed below. The temporary regulations also create increased filing thresholds for married taxpayers filing jointly and for U.S. taxpayers living outside the United States. More specifically, married taxpayers who file jointly and reside in the United States need only report if the total value of their specified foreign assets is more than $100,000 on the last day of the tax year or more than $150,000 at any time during the tax year. Likewise, those U.S. taxpayers residing abroad who file: (1) separately, must report if the total value of their specified foreign assets is more than $200,000 on the last day of the tax year or more than $300,000 at any time during the year, or (2) jointly, must report if the total value of their specified foreign assets is more than $400,000 on the last day of the tax year or more than $600,000 at any time during the year. These thresholds apply even if only one spouse resides abroad.
“Specified foreign financial assets” are defined by statute to include depository or custodial accounts at foreign financial institutions (but the regulations provide that underlying assets held in such accounts aren't required to be reported separately). To the extent not held in such accounts, they also include: (1) stock or securities issued by foreign persons, (2) any other financial instrument in which the counterparty isn't a U.S. person, and (3) any interest in a foreign entity. Importantly, a financial account maintained at a U.S. branch of a foreign financial institution isn't a specified foreign financial asset. Exceptions exist for assets used in the conduct of a trade or business (notably, stock is never considered to be used or held for a trade or business), for assets that are marked-to-market under IRC Section 475 and for an interest in a social security, social insurance or similar program of a foreign government.
An individual has an interest in a specified foreign financial asset if potential tax attributes and transactions related to the asset would be reported on his income tax return. The asset must be reported even if it doesn't affect tax liability for the particular year. The only exception is if the individual isn't otherwise required to file an income tax return.
The information required to be disclosed on Form 8938 includes: (1) in the case of an account, the name and address of the financial institution and the account number; (2) in the case of a stock or security, the name and address of the issuer and the identification of the class or issue of which the stock or security is a part, (3) in the case of any other instrument, such information as is necessary to identify the contract or interest and the names of the issuer or contracting parties, (4) the maximum value of each asset during the year, and (5) the amount of income, loss, deduction or credit recognized in connection with the asset, including the schedule, form or return on which it's reported. Formal valuations aren't required; reasonable estimates based on periodic account statements are sufficient. Year-end values are acceptable for assets other than financial accounts, if they reasonably represent maximum value for the year. In addition, there are special rules for valuing interests in foreign trusts and estates, described below.
Non-compliance can lead to a $10,000 penalty, which increases to $50,000 for continued failure after receipt of IRS notification. The statute creates a presumption that the filing threshold is met for purposes of assessing the penalty if the taxpayer doesn't provide sufficient information to demonstrate value. The statute of limitations for the tax return is tolled until the Form 8938 is properly filed. If there's an omission of gross income in excess of $5,000 attributable to an undisclosed foreign financial asset, the statute is extended to six years. In addition, there's an accuracy-related penalty of 40 percent for underpayments of tax associated with undisclosed foreign financial assets.
Section 6038D doesn't remove the requirement to file a Form TDF 90-22.1 (Report of Foreign Bank and Financial Accounts or FBAR), which requires disclosure of foreign financial accounts in which the filer has a financial interest, signatory or other authority, which exceeds, in aggregate, $10,000 in a calendar year. This is because the FBAR filing is imposed by the Bank Secrecy Act (Title 31 of the United States Code), not by the IRC (Title 26 of the United States Code) and has other law enforcement purposes in addition to tax administration. Therefore, different policy considerations apply.6 For purposes of Title 26, the FBAR isn't considered “return information,” and its distribution to other law enforcement agencies isn't limited by the nondisclosure rules of Title 26. “Comparing Filing Requirements” (p. 45), illustrates some key differences between the FBAR and Form 8938 filing requirements with respect to foreign financial accounts.
In contrast, a U.S. taxpayer who files one of the following forms may avoid providing detailed information on Form 8938 (so-called “short-form reporting”):
- Form 3520 (Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts);
- Form 3520-A (Annual Information Return of Foreign Trust With a U.S. Owner);
- Form 5471 (Information Return of U.S. Persons With Respect To Certain Foreign Corporations);
- Form 8865 (Return of U.S. Persons With Respect to Certain Foreign Partnerships); and
- Form 8621 (Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund).
U.S. Beneficiary of Foreign Trusts
As indicated, an interest in a foreign entity is a specified foreign financial asset. A foreign entity includes a foreign trust. A foreign trust is any trust other than a U.S. trust. A U.S. trust must meet two requirements: (1) a court within the United States must be able to exercise primary supervision over the administration of the trust, and (2) one or more U.S. persons must have authority to control all substantial decisions of the trust, with no other person having power to veto such decisions. A trust that doesn't meet either requirement defaults to foreign status. A U.S. individual who's treated as the owner of a U.S. or foreign trust under the grantor trust rules of IRC Sections 671 through 679, has an interest in the specified foreign financial assets held by the portion of the trust he's treated as owning.
The rules are different with respect to a U.S. beneficiary of a foreign trust who isn't treated as an owner under the grantor trust rules. Prior to the issuance of the Treasury regulations, there was some question as to whether the reporting threshold applied to the value of: (1) a U.S. beneficiary's interest in a foreign trust, (2) the trust's interest in its foreign financial assets, (3) the trust, or (4) a U.S. beneficiary's interest in the foreign trust's financial assets.
Treas. Regs. Section 1.6038 D-3T(c) clarifies that the reporting threshold applies to a U.S. beneficiary's interest in a foreign trust and Treas. Regs. Section 1.6038D-5T(g) provides valuation rules. Thus, an interest in a foreign trust is reportable to the extent that, when valued and combined with other categories of reportable assets, it exceeds the reporting thresholds. This is, in fact, consistent with the Joint Committee on Taxation's report issued on Feb. 23, 2010, which says:
For example a beneficiary of a foreign trust who is not within the scope of the FBAR reporting requirements because his interest in the trust is less than 50 percent may nonetheless be required to disclose his interest in the trust with his tax return under [Section 6038D] if the value of his interest in the trust together with the value of other specified foreign financial assets exceeds the aggregate value threshold [emphasis added].
Under the valuation rules, a beneficial interest in a foreign trust or foreign estate isn't a specified foreign financial asset unless the U.S. individual knows or has reason to know of it based on readily accessible information. Receipt of a distribution from the foreign trust or foreign estate is deemed to be actual knowledge of the interest. Once established as a specified foreign financial asset, the value is the sum of: (1) the fair market value of all property distributed to the beneficiary during the year, plus (2) the value of the beneficiary's right to receive mandatory distributions from the foreign trust as determined under IRC Section 7520. Section 7520 requires the use of a set of actuarial tables for valuing annuities, life estates, remainders and reversions, but most foreign trusts don't provide for fixed interests. Here are some outcomes with a discretionary trust:
- A U.S. beneficiary of a discretionary foreign trust who doesn't receive a distribution nor knows of his interest. He doesn't have a specified foreign financial asset and hence, no reporting.
- A U.S. beneficiary of a discretionary foreign trust who doesn't receive a distribution but who knows of his interest has a specified foreign financial asset with a zero value. He doesn't have to report his specified foreign financial asset.
- A U.S. beneficiary of a discretionary foreign trust who receives a distribution that's below the filing threshold and who has no other specified foreign financial assets. He doesn't have to report his specified foreign asset.
- A U.S. beneficiary of a discretionary trust who receives a distribution that exceeds the filing threshold. He must report his specified foreign asset.
- A U.S. beneficiary of a discretionary foreign trust who receives a distribution that doesn't exceed the filing threshold by itself, but when combined with his other specified foreign financial assets exceeds the filing threshold. He must report his specified foreign asset.
- A U.S. beneficiary of a discretionary foreign trust who doesn't receive a distribution but who knows of his interest and whose other specified foreign financial assets exceed the filing threshold. This is different from the second situation above, in which the U.S. beneficiary wasn't otherwise required to file. In this case, he's required to report his specified foreign asset with a zero value.
A typical holding structure for a nonresident alien with U.S. beneficiaries involves the use of a foreign corporation to hold the underlying assets. The stock of the corporation is owned, in turn, by a foreign grantor trust.7 In most cases, the trust is revocable for a broad class of beneficiaries that includes the grantor and his family and is wholly discretionary as to principal distributions. However, to position the assets for a basis step-up on his death under IRC Section 1014(b)(2),8 the grantor will usually have reserved the power to direct income distributions, in addition to the power to revoke and revest the trust assets, in himself. Suppose the grantor directs that all the income be paid to a U.S. beneficiary. The U.S. beneficiary has the following reporting requirements, despite the fact that the distribution isn't taxable,9 assuming the relevant filing thresholds are met (where applicable). He must file:
- Form 3520 to report the distribution of income from the trust;
- An FBAR to report his interest in the foreign financial accounts of the trust (since he receives more than 50 percent of its current income) and of the corporation (owned 100 percent by the trust); and
- Form 8938 to report his beneficial interest in the trust, but this is “short-form” reporting since he's already filing a Form 3520.
Notably, had the grantor directed the income be paid to his personal account and made gifts from it to the U.S. beneficiary, all reporting could be avoided with the exception of Form 3520 if the gifts exceeded $100,000 annually (but it wouldn't require disclosure of the trust in that event). The same is true for principal distributions that are made to the U.S. beneficiary through the grantor, rather than from the trust itself. The grantor is never an intermediary for purposes of the trust taxation rules.10
After the grantor's death, the trust will cease to be a grantor trust. If all income continues to be paid to the U.S. beneficiary, the foreign corporation will become a controlled foreign corporation11 as to him, resulting in potential tax and reporting on Form 5471, in addition to the Form 3520, FBAR and Form 8938 filings above. If the corporation or trust is then invested in foreign funds, which could be PFICs,12 the U.S. beneficiary may have to report them as well on Form 8621, irrespective of whether a taxable event has occurred with respect to them.13
Focus on Offshore Compliance
With increased focus on offshore compliance in the wake of several high profile scandals involving U.S. taxpayers hiding assets in foreign financial institutions, the close scrutiny given to FBAR filings and the 2012 Offshore Voluntary Disclosure Program announced on Jan. 9, 2012 (the third such program over the past three years designed specifically to bring U.S. taxpayers with unreported foreign income back into the fold), Form 8938 is sure to generate a lot of attention. Taxpayers with foreign assets can no longer afford to be ignorant of their filing obligations.
— The author would like to thank Davidson T. Gordon, Special Counsel at Day Pitney LLP in New York, for his contributions to this article.
- Pub. L. No. 111-147, 124 Stat. 71.
- The provision is effective for tax years beginning after March 18, 2010, but was temporarily suspended by Internal Revenue Notice 2011-55, 2011-29 IRB, pending the issuance of a final Form 8938. The final Form 8938, with accompanying instructions, was issued on Dec. 19, 2011.
- A U.S. resident for income tax purposes is an individual who: (1) is a lawful permanent resident (that is, a green card holder), or (2) meets the physical presence requirements of the substantial presence test. The substantial presence test requires presence of 183 days or more over three consecutive years under a statutory formula.
- Proposed Treasury Regulations Section 1.6038D-6, 76 Fed. Reg. 78594 (Dec. 14, 2011).
- Treas. Regs. Sections 1.6038D-1T through 1.603D-8T, 76 Fed. Reg. 78553 (Dec. 19, 2011).
- See Joint Committee on Taxation issued on Feb. 23, 2010, discussing the Hiring Incentives to Restore Employment Act revenue provisions JCX-4-10.
- A grantor of a grantor trust is deemed to be the “tax owner” of the income of the trust for U.S. tax purposes and is disregarded as a separate taxable entity. Generally, a nonresident can be treated as the owner of a trust if one of the two requirements of Internal Revenue Code Section 672(f)(2)(A) are met: (1) the grantor reserves the power to revoke and revest absolutely in himself the portion of the trust attributable to his contributions either alone or with the consent of a related or subordinate party subservient to him, or (2) the only amounts distributable from such portion (whether income or principal) during the grantor's lifetime are amounts distributable to him or his spouse.
- See Dina Kapur Sanna, “Save U.S. Beneficiaries from Tax Disaster,” Trusts & Estates (November 2007) at p. 48. IRC Section 1014(b)(2) provides a basis step-up for property transferred in trust during the lifetime of the decedent when the income is paid or applied to or on his order or direction, with the right reserved at all times before death to revoke the trust.
- See Revenue Ruling 85-13, 1985 C.B. 184.
- See Dina Kapur Sanna, “When U.S. Clients Receive Money from Foreign Family Members,” Trusts & Estates (November 2008) at p. 56.
- In general, if a majority in interest of the trust beneficiaries are U.S. persons, the corporation may be a controlled foreign corporation (CFC) (defined, generally, as a foreign corporation in which more than 50 percent is owned, by vote or value, by U.S. shareholders who each own at least 10 percent of the voting shares). If a corporation is a CFC for an uninterrupted period of 30 days in a given taxable year and a U.S. shareholder owns, directly or indirectly (for example, through a trust), stock on the last day of such taxable year, the U.S. shareholder must include his proportionate share of the corporation's “Subpart F” income in gross income as a deemed dividend. Subpart F income includes virtually all categories of investment income.
- A foreign corporation is a passive foreign investment company (PFIC) if 75 percent or more of its gross income for the taxable year is passive income or the average percentage of assets held by the corporation during the taxable year that produce, or are held for the production of, passive income is at least 50 percent. Unless U.S. shareholders of a PFIC make an election to be subject to U.S. tax currently on PFIC income or gain, U.S. shareholders of a PFIC are taxed on: (1) gains on the direct or indirect disposition of PFIC stock, and (2) direct or indirect “excess distributions” from the PFIC (that is, distributions exceeding 125 percent of the annual average distributions made to the shareholder over the prior three-year period). The amount taxable under these rules is allocated ratably over the U.S. shareholder's holding period in the PFIC stock (which doesn't include any period during which the trust holding the stock was a grantor trust). Amounts allocated to prior years are taxed as ordinary income and draw an interest charge.
- See Section 1298(f) enacted by The Foreign Account Tax Compliance Act of 2009. But see Notice 2011-55, which presently suspends the filing obligation.
Dina Kapur Sanna is a partner in the individual clients department at Day Pitney LLP in New York
Comparing Filing Requirements
Key differences between Report of Foreign Bank and Financial Accounts (FBAR) and Form 8938
Filing threshold is $10,000.
Required if U.S. taxpayer has a financial interest or signatory or other authority.
Due date is June 30th and filed with the Internal Revenue Service in Detroit.
Financial interest is based on whether the person is the owner of record for or holds legal title to the account or is the indirect beneficial owner.
Required by persons who don't have a direct financial interest in a foreign financial account, for example, an individual is required to report the foreign financial account of his wholly owned domestic or foreign corporation. If a domestic corporation has a direct or indirect financial interest in the foreign account, it will also be required to report the account, as would any individuals, such as employees, who have signatory authority over the financial account.
Doesn't toll or extend statute of limitations on assessment of tax if not filed.
Civil penalties range from $10,000 to greater of $100,000 or 50 percent of account.
Filing threshold is $50,000.
Required if U.S. taxpayer has an interest (not signatory or other authority).
Due date is tied to income tax return and filed with applicable IRS service center.
Financial interest is based on potential tax attributes or transactions related to the account that would be reported on the individual's tax return.
If a foreign financial account is reported by a specific individual, the foreign account won't also be reported by a specified domestic entity and vice-versa.
Tolls statute of limitations on assessment of tax for relevant year until filed; can extend statute to six years if omission attributable to unreported financial account exceeds $5,000.
Civil penalties range from $10,000 to $50,000, plus accuracy-related penalty of 40 percent if underpayment of tax is attributable to undisclosed account.
— Dina Kapur Sanna
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