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.
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.
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.
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”
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”?
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)?