Proposed Regulations On Loans Of Cash And Property From Foreign Trusts

On May 8, 2024, the Treasury Department issued proposed regulations regarding the classification, taxation, and reporting of foreign trusts. The proposed regulations were issued for sections 643(i)6796039F6048, and 6677 of the Internal Revenue Code. The proposed regulations would largely incorporate guidance that the IRS provided in Notice 97-34, with some modifications.[1]

In this post, we’ll take a look at the proposed regulations for section 643(i).

Original Enactment

As first enacted in 1996, section 643(i) of the Internal Revenue Code provides that if a non grantor foreign trust directly or indirectly makes a loan of cash or marketable securities to a United States person who is a grantor or beneficiary or who is related to a grantor or beneficiary of the foreign trust, then that loan is treated as a distribution by the foreign trust to that grantor or beneficiary (a “Section 643(i) distribution”).[2]

A Section 643(i) distribution is treated as having been made by a trust that doesn’t distribute only current income.[3] If adequate records are not provided to determine the proper treatment of a distribution from a foreign trust, then the distribution is treated as an accumulation distribution subject to taxation under subpart D of the trust provisions.[4]

Section 643(i) allows the Treasury Department to make exceptions to this treatment by regulation.[5] The legislative history for Section 643(i) indicates that Congress intended that the Treasury Department issue regulations providing an exception for loans of money or marketable securities with arm’s length terms.[6]

Notice 97-34

On June 23, 1997, the IRS issued Notice 97-34, which provided guidelines an exception to section 643(i) for loans of cash or marketable securities in the case of a “qualified obligation.” [7] The notice defined a “qualified obligation” and provided rules for additional loans between the same parties as well as for the distribution that would result when an obligation ceased to be a qualified obligation.[8] The notice also provided guidance on how to determine the tax consequences of a Section 643(i) distribution.[9]

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What Is A Foreign Trust?
Explaining a Foreign Trust In Easy-to-Understand Language

In this global economy, it’s becoming increasingly common for U.S. citizens and residents to have financial ties overseas. These financial ties often come in the form of foreign bank accounts, real estate holdings, and trusts.

Foreign trusts in particular are subject to special rules under the Internal Revenue Code (“IRC”).  However, understanding what constitutes a foreign trust and its treatment under the IRC can be difficult even for the most seasoned lawyer.

What Is A Trust?

The Internal Revenue Service (“IRS”) defines a trust as “an arrangement created either by a will or by an inter vivos declaration [in other words, a declaration during the life of the person setting up a trust] whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts.”[1]

In the United States, trusts are formed under state law. Thus, the law of the particular state in which the trust has been or will be formed must be consulted for any particulars regarding trust formation and administration. However, below are some general definitions that may prove helpful in the discussion that follows:

  • “Settlor” or “Grantor”: The “settlor” or “grantor” is the person who creates a trust;[2]
  • “Trustee”: The “trustee” is the person who holds title to the property in the trust;[3]

“Beneficiary”: The “beneficiary” is the person for whose benefit the trustee holds the property in the trust.[4]

Is A Trust Domestic Or Foreign?

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Court Deems A Foundation A Foreign Trust, Greenlighting Tax Penalties

Foreign assets are always tricky for U.S. tax reporting. A recent court decision also shows that differentiating a foundation from a trust is pivotal.

The levying of tax penalties stood in a recent federal appeals court decision on whether a private foundation was a foreign trust subject to such penalties.

In the Rost v. U.S., the U.S. Court of Appeals for the Fifth Circuit upheld tax penalties against U.S. citizen John Rebold, who failed to report his personal-use Liechtenstein “Stiftung” (a non-charitable private foundation) as a foreign trust.

The decedent Rebold formed the Enelre Foundation in 2005 for the general support and education of him and his children. He transferred $2 million to the foundation in 2005 and $1 million in 2007 and did not disclose the transactions to the IRS.

Rebold later learned that the IRS would consider his foundation a foreign trust with the associated reporting requirements. He filed the reports belatedly, in 2013, and the IRS assessed penalties.

Under IRC Sec. 6048, a U.S. person must report creation of a foreign trust, transfers to a foreign trust and distributions received by a foreign trust; ownership of the trust must also be disclosed. Annual filing forms are 3520 and 3520-A, and penalty for failing to file is the greater of $10,000 or 35% of the gross value of property contributed to a foreign trust.

Rebold paid the penalties and then filed a refund action, arguing that the penalties were improper because the reporting requirements for the private foundation were unclear, even though he’d been told as early as 2010 (a year before the IRS announced a new Offshore Voluntary Disclosure Initiative, aka OVDI) that his tax-reporting position was obvious.

He was assessed $1,380,252.35 in penalties and negotiated to reduce these penalties by half. He paid the reduced penalties and filed for an administrative refund claim, which was ultimately taken over by his estate after his death. The estate argued that the foundation wasn’t a foreign trust, claiming that the rules defining trusts are vague and that the IRS never designated that a Stiftung was a foreign trust.

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Failure To Report Foreign Trust Results In 35% Penalty Against The Owner/Beneficiary

The 35% penalty under I.R.C. section 6677 for failing to report a distribution from a foreign trust applies against a person who is both the beneficiary and grantor/owner of a foreign trust.  At least, that is now the rule for taxpayers in the second circuit.  This draconian penalty for failing to properly report a foreign trust is applicable even if the taxpayer and trust paid all required taxes, if any, with respect to the trust.

In the case before the court, the taxpayer (Wilson) was the sole owner and beneficiary of a foreign trust.  He received a distribution from the foreign trust.  He filed his tax return late.  The IRS assessed a penalty equal to 35% of the amount of the distribution for failing to timely disclose the distribution.

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Foreign Trusts - John Richardson

TaxConnections is posting this thoughtfully written comment on an article titled “Treasury Exempts Applicable “Tax-Favored Foreign Trusts” From The Form 3520… And Therefore Form 3520A Requirement” written by John Richardson. Here is a recommendation for Treasury to consider as posted by a David Johnstone.

Excellent post. Based on my reading of the Revenue Procedure, as well as feedback from practitioners in the UK or Australia, I have grave reservations about the claim that this Revenue Procedure will help “many” Americans abroad. Perhaps this is an example of an attempt to simplify things from a legal perspective that in practice – once one does the math – may lead to greater complexity and help a very small number of people at best.
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What are the requirements for an arrangement to qualify as a “trust” under the Internal Revenue Code?

1. Definitions are found in Internal Revenue Code 7701.

2. Treasury Reg. 301.7701-4(a) defines a trust as for Internal Revenue Code purposes as:

“an arrangement created either by will or inter vivos declaration whereby trustees take title to property for the purpose of protecting and conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts . . . . Generally speaking, an arrangement will be treated as a trust under the Internal Revenue Code if it can be shown that 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”

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Gary Carter Form 3520-A

Section 6048 of the Internal Revenue Code requires a United States person, as defined for FBAR reporting, (and the executor of the estate of a US decedent) to file Form 3520 to report:

  • Certain transactions with foreign trusts,
  • Ownership of foreign trusts, and
  • Receipt of certain large gifts or bequests from certain foreign persons.

Additionally, an owner of a foreign trust might be required to file a Substitute Form 3520-A if the foreign trust fails to file Form 3520-A (See SUBSTITUTE Form 3520-A below). Here is Form 3520 and Instructions.

What Is a Foreign Trust For Which Form 3520 Must Be Filed?

Although the Internal Revenue Code (IRC) refers to trusts in numerous sections, nowhere in the IRC is the term “trust” actually defined. There is a definition of foreign trust. IRC Section 7701(a)(31)(B) says: “The term ‘foreign trust’ means any trust other than a trust described in subparagraph (E) of paragraph (30).” Subparagraph (E) describes “any trust if (i) a court within the United States is able to exercise primary supervision over the administration of the trust, and (ii) one or more United States persons have the authority to control all substantial decisions of the trust.”

So a foreign trust is one that is not under the jurisdiction of United States courts or controlled by a United States person. But what is a “trust”?

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Future Developments

For the latest information about developments related to Form 3520-A and its instructions, such as legislation enacted after they were published, go to

Purpose of Form

Form 3520-A is the annual information return of a foreign trust with at least one U.S. owner. The form provides information about the foreign trust, its U.S. beneficiaries, and any U.S. person who is treated as an owner of any portion of the foreign trust under the grantor trust rules (sections 671 through 679).

Who Must File

A foreign trust with a U.S. owner must file Form 3520-A in order for the U.S. owner to satisfy its annual information reporting requirements under section 6048(b). Each U.S. person treated as an owner of any portion of a foreign trust under the grantor trust rules (sections 671 through 679) is responsible for ensuring that the foreign trust files Form 3520-A and furnishes the required annual statements to its U.S. owners and U.S. beneficiaries. If a foreign trust fails to file Form 3520-A, the U.S. owner must complete and attach a substitute Form 3520-A for the foreign trust to the U.S. owner’s Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. See Part II, line 22, of the Instructions for Form 3520. Otherwise, the U.S. owner may be liable for a penalty. See Penalties, later.

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Gary Carter

When I was a kid we lived across the street from the Wolfermans. The Wolfermans got a dog. One day I was in my yard, and their dog was barking. Mr. Wolferman came out, clapped his hands and called the dog. The dog joyfully bounded to Mr. Wolferman. Mr. Wolferman then proceeded to spank the dog, apparently for barking. I remember thinking what a fool Mr. Wolferman was for doing that – the dog would never come to him again when called.

A couple of weeks ago I described the traumatic experience of a client who had received a $10,000 penalty notice from the IRS for a completely invalid purpose. As the owner of a foreign trust, my client had done all she could have done to comply with the filing requirements of a foreign trust owner. She was compliant, yet was slapped with a $10,000 penalty. See Foreign Trusts: IRS Penalty Notices For Late Forms 3520-A Traumatize Many Innocent Taxpayers!

Since then, I have learned firsthand of dozens of similar notices, and I suspect there have been thousands issued for the same invalid purpose. Then, this week, another client contacted me about receiving the exact notice under the exact circumstances.

Below is the letter I wrote to the IRS on behalf of the client who received the latest notice. The recipients of these notices represent  foreign trust owners who are doing their best to obey the law (the Wolfermans’ dog) only to be punished by a formidable but misguided tax collection agency (Mr. Wolferman). Would one blame the dog for wandering off to find someone kinder and wiser to pledge allegiance to (as in expatriation)?

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