IRS Foreign Trust Reporting Plan Offers Rare Chance to Influence

Taxpayers and their advisers have a rare chance to influence how the IRS should regulate foreign trusts and large foreign gifts, and they shouldn’t let that chance go to waste. Such an opportunity hasn’t arisen for several years because the IRS had relied on nonbinding guidance or form instructions to communicate requirements without prior public notice.

The proposed regulations would replace guidance last provided almost 30 years ago in Notice 97-34. They also incorporate legislative updates to federal tax and reporting requirements for foreign trusts and foreign gifts, intended to combat abusive offshore tax schemes. The IRS is accepting comments on the proposal until July 8, 2024.

The IRS doesn’t always recognize or acknowledge the legitimate reasons behind certain foreign arrangements and transactions. Public feedback should be provided on the impact of new requirements on taxpayers and whether they further advance the IRS’s objectives. The IRS also would benefit from public insight on whether proposed reporting exemptions effectively reduce taxpayers’ burdens where information collected wouldn’t necessarily assist the IRS in its enforcement goals.

For example, the proposed regulations provide a new anti-abuse rule addressing noncitizens and nonresidents who receive loans from a foreign nongrantor trust within two years before becoming a US citizen or resident. The outstanding amount of such a loan may be treated as a taxable distribution, as of the day these individuals acquire their US status, unless the loan satisfies requirements set forth in the proposed regulations when first made.

Noncitizens and nonresidents don’t pay federal tax on actual distributions from a foreign nongrantor trust unless the distributions consist of US source income. Thus, significant federal tax consequences may apply just because a taxpayer received a loan from a foreign trust before becoming a US citizen or resident that doesn’t satisfy the IRS’s requirements—rather than receiving an actual distribution.

The IRS needs examples of foreign retirement plans that warrant exemption from reporting. Tax professionals have noted the proposed regulations’ modifications to Rev. Proc. 2020-17, which contains restrictive requirements for obtaining reporting relief for foreign retirement plans, don’t sufficiently broaden the criteria for relief.

This is the case even though they may be highly regulated in their home jurisdictions and don’t easily serve as vehicles for abuse. Additionally, unlike Canadian retirement plans, other foreign retirement plans with similar benefits under a US tax treaty (such as UK self-invested personal pensions) don’t qualify for a reporting exemption based on such treaty protection.

Comments also should be provided on reporting requirements the IRS imposed in updates to Form 3520 and Form 3520-A, which are used by taxpayers to report ownership of or transactions with foreign trusts. The imposition raised questions about the agency’s authority to require certain information through forms and instructions.

For example, without prior guidance, the IRS began requiring with the 2020 Form 3520-A and its instructions that US owners of foreign trusts obtain employer identification numbers for these trusts. The IRS also removed taxpayers’ option, available up to that point, to identify foreign trusts with reference ID numbers.

US owners of foreign trusts must enter a foreign trust’s employer identification number on both Form 3520-A and Form 7004, used to request an extension. Otherwise, the IRS may not process the forms, exposing taxpayers to penalties of up to 5% of the gross value of their foreign trusts. The penalty risks are further exacerbated by the IRS’s practice of automatically imposing penalties (highlighted by the National Taxpayer Advocate’s January report) for failure to timely file without first reviewing taxpayers’ statements explaining the untimely filing.

The proposed regulations don’t address the requirement to obtain employer identification numbers for foreign trusts. Taxpayers and advisers should provide comments on their experiences in satisfying this requirement, such as completion of the Form SS-4 used to obtain the employer identification number.

Current IRS audit goals, coupled with potential taxpayer challenges to existing guidance, provide the agency with incentives to formalize the foreign trust and foreign gift requirements through the regulatory process.

Taxpayers and their advisers must use this opportunity to provide the IRS with feedback on the proposed regulations’ implications for taxpayers. Comments on existing IRS guidance and practice relating to the enforcement of foreign trust and foreign gift requirements also should be provided, as courts are increasingly holding the IRS accountable on the way it issues rules and imposes requirements on taxpayers.

A public hearing on the proposed regulations is scheduled for Aug. 21.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Rosy L. Lor is managing director in the BDO USA Private Client Services National Tax Office, specializing in cross-border tax matters affecting high-net-worth individuals.

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