On May 7, 2024, the U.S. Treasury and Internal Revenue Service issued proposed regulations that provide guidance regarding information reporting of ownership, transfers to and receipt of distributions from foreign trusts; receipt of large foreign gifts; and loans from, and uses of property of, foreign trusts. The proposed regs also seek to amend the existing regulations relating to foreign trusts having one or more U.S. beneficiaries.
Applicability
The proposed regs affect U.S. persons who engage in transactions with or are treated as the owners of, foreign trusts and U.S. persons who receive large gifts or bequests from foreign persons. These regs should also interest taxpayers with an interest in a foreign retirement arrangement classified as a foreign trust for U.S. purposes and those who receive gifts or bequests from non-U.S. foreign individuals.
Background
As discussed in the IRS’ release, abusive tax schemes, including offshore schemes involving foreign trusts, have re-emerged in the United States after last peaking in the 1980s. In the 1980s, foreign trusts were used to transfer large amounts of assets offshore, where it was much more difficult for the IRS to identify whether U.S. persons owned an interest in such trusts and whether such persons were reporting and paying the required taxes on their income from such trusts.
Many foreign trusts were established in tax haven jurisdictions with bank secrecy laws, which limited transparency into the holdings, income earned or distributions made, as there was previously no requirement for a U.S. person to disclose distributions from foreign trusts.
Legislation changes and updates over the years have resulted in expanded reporting requirements for U.S. taxpayers. However, these newly proposed regs provide some relief from these onerous foreign trust reporting requirements with a more substantial list of exceptions.
Dual-Resident Taxpayers
The proposed regs provide special rules for “dual-resident taxpayers.” A dual-resident taxpayer is a non-U.S. individual who’s considered to be a resident of the United States and a resident of a treaty country (income tax) but, due to the “tie-breaker” provision of the relevant treaty, is treated as a non-resident alien for U.S. income tax purposes.
Although dual-resident taxpayers are generally treated as non-resident aliens for purposes of computing their U.S. income tax liability, they may be treated as U.S. persons for certain international information reporting requirements (such as Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts and Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner).
Under the proposed regs, dual-resident taxpayers wouldn’t be treated as a U.S. person for any portion of the year in which they’re treated as nonresident aliens for purposes of computing their U.S. income tax liability. As such, there would be no international information reporting requirement for the dual-resident taxpayer either.
Foreign Gifts Versus Loans
Internal Revenue Code Section 6038F requires U.S. persons to disclose the receipt of large gifts from non-resident aliens or estates. Currently, the threshold for reporting these gifts is $100,000. Many taxpayers have attempted to avoid this reporting by arguing that the transfer is a loan, not a gift. To combat this non-reporting, the proposed regs include an anti-avoidance rule that would require gift treatment if all of the following requirements are met:
- The IRS concludes that the amount received is, in substance, a gift based on the facts and circumstances;
- The recipient doesn’t treat the amount received as a gift; and
- The recipient doesn’t treat the amount received as taxable income.
In practicality, these anti-avoidance rules require the recipient to have information/documentation to substantiate the debit, such as a loan agreement, note or principal/interest payment history.
Reporting Threshold
The proposed regs also update the $100,000 reporting threshold noted above. The $100,000 threshold amount released in 1997 (Notice 97-34, Section VI-B.1) hasn’t been increased and isn’t currently indexed for inflation. As such, more gifts and bequests are required to be reported as inflation rises.
The proposed regulations would annually index for inflation the $100,000 threshold.
Itemization of Gifts
Under the proposed regs, if the aggregate amount of foreign gifts received exceeds the reporting threshold, the U.S. person would be required to separately identify each foreign gift of over $5,000 and provide identifying information about the transferor, including their name and address. It doesn’t appear that the $5,000 is to be annually adjusted for inflation., The full extent of the identifying information isn’t provided in detail, though the IRS feels that additional identifying information would assist in the determination of whether amounts received are property treated as gifts.
Currently, identifying information of the transferor isn’t required to be disclosed on Form 3520.
Exceptions
Foreign gifts received by IRC Section 501(c) charitable organizations are exempt from reporting as the entity itself is exempt from tax under Section 501(a).
Foreign gifts received from transferors who relinquish U.S. citizenship, thereby becoming covered expatriates within the meaning of IRC Section 877A(g)(1) but whose amount doesn’t exceed the per donee exclusion in effect under IRC Section 2503(b) are exempt from reporting.
Transfers to Foreign Trusts and Ownership
Under the proposed regs, a U.S. transferor of property to a foreign trust will be considered the owner of the portion of the trust attributable to the property transferred during each tax year that the trust has a U.S. beneficiary. This proposed rule will apply regardless of whether the transferor retains any power under IRC Sections 673 through 677. Further, the transferor must take into account all income, deductions and credits attributable to the portion of the trust it owns when computing its tax liability.
Additionally, a foreign trust that’s received property from a U.S. transferor is treated as having a U.S. beneficiary unless no part of the income or corpus of the trust may be paid or accumulated to or for the benefit of a U.S. person. If the trust is terminated at any time during the tax year, no income or corpus of the trust could be paid to or for the benefit of a U.S. person. The regs provide for a very narrow exception: persons who aren’t named as possible beneficiaries and aren’t members of a class of beneficiaries as defined in the trust won’t be taken into consideration if the transferor demonstrates to the satisfaction of the IRS that their contingent interest in the trust is so remote as to be negligible.
Finally, the proposed regs provide that if a non-resident alien individual becomes a U.S. person and has a residency starting date within five years after transferring property to a foreign trust, the individual will be deemed to have transferred the property to the trust as of the residency starting date. If an individual is deemed to have made a transfer, the reporting requirements of IRC Section 6048 will apply to the deemed transfer on the taxpayer’s residency starting date.
Loans by or Uses of Property for a Foreign Trust
The proposed regs generally incorporate the guidance provided in Notice 97-34 with certain modifications with regard to IRC Section 643(i). The proposed regs provide that any loan of cash or marketable securities made from a foreign trust (from principal or income is irrelevant) directly or indirectly to a U.S. grantor or beneficiary or any U.S. person related to the U.S. grantor or beneficiary is treated as a distribution under Section 643(i) as of the date the loan is made.
There are exceptions to this general rule—namely, it won’t apply to:
- Loans of cash in exchange or a qualified obligation within the meaning of Treasury Regulations Section 1.643(i)-2(b)(2)(iii);
- The use of trust property if the foreign trust receives the fair market value of such use within 60 days from the start of the use;
- The de minimis use of trust property, which is noted as being 14 days or less; or
- Cash loans made by foreign corporations to a U.S. beneficiary of a foreign trust to the extent that the aggregate amount of all loans doesn’t exceed the undistributed earnings and profits of the foreign corporation attributable to and included in the beneficiary’s gross income.
Tax-Favored Foreign Retirement Trusts
The proposed regs would expand upon the initial relief provided for “tax-favored foreign retirement trusts” by Revenue Procedure 2020-17 for certain qualified foreign trusts. In Rev. Proc. 2020-17, the exemption only applied if the plan met certain criteria, that is, - contributions limits based on a percentage of the participant’s earned income, subject to an annual limit.
The proposed regs expand on the initial relief provided in 2020 by allowing limited contributions by unemployed individuals and requiring that the foreign trust meet either a new value threshold or a contribution limit.
For the value threshold, the aggregate value of the trust is limited to no more than $600,000 during the taxable year, as adjusted for inflation. For the contribution limit, contributions to the trust must either be limited by a percentage of earned income, an annual limit of $75,000 or a lifetime limit of $1 million, as adjusted for inflation.
Penalties
The proposed regs under Section 6677 provide for three separate civil penalties that may be assessed for each separate reporting requirement under Treas. Regs. Sections 1.6048-2, 1.6048-3 and 1.6048-4. They also provide that:
- The penalty initially imposed for persons who fail to timely file a required notice or return or fail to provide complete and correct information is the greater of $10,000 or 5% of the applicable gross reportable amount (defined in proposed Treas. Regs. Section 1.6677-1(c)) for each such failure. The 5% is a substantial reduction from the 35% penalty currently imposed.
- The U.S. owner, rather than the foreign trust, must pay the penalty.
A Step in the Right Direction
The proposed regulations provide clarity to a very complicated and complex area of international information reporting. However limited in scope these proposed updates are, they’re still a step in the right direction, and expectations are that, especially in the tax-favored foreign retirement trust space, the broadening of exceptions will result in fewer filings.
The AICPA and other organizations continue to provide their feedback, as practitioners feel broader exceptions are required as tax footprints continue to expand. Additionally, penalties in this space continue to be a much-discussed topic, and I note that while reducing a 35% penalty to a 5% penalty is a great step in the right direction, continued discussion and updates are still necessary.
Practitioners should continue to monitor these regs for updates and changes as they progress to finalization, as well as continue to ask and educate clients about their foreign holdings.