On May 7, 2024, the U.S. Treasury and Internal Revenue Service issued proposed regulations providing guidance regarding the reporting of ownership information, transfers, and receipt of distributions by foreign trusts; receiving large foreign gifts; and loans from, and uses of, assets of foreign trusts. The proposed rules also seek to amend existing regulations regarding foreign trusts that have one or more U.S. beneficiaries.

Applicability

The proposed rules affect US persons who engage in transactions with or are treated as owners of foreign trusts and US persons who receive large gifts or inheritances from foreign persons. These rules should also concern 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 US persons owned an interest in such trusts and whether such persons reported and paid the required taxes on their income. from such trusts.

Many foreign trusts were created in tax haven jurisdictions with bank secrecy laws, which limited transparency of holdings, income earned, or distributions made, since there was previously no requirement for a US person to disclose distributions from the trusts. the foreigner.

Changes and updates to the legislation over the years have resulted in expanded reporting requirements for US taxpayers. However, these newly proposed rules provide relief from these onerous foreign trust reporting requirements with a more substantial list of exceptions.

Dual resident taxpayers

The proposed rules provide for special rules for “dual resident taxpayers.” A dual resident taxpayer is a non-U.S. individual who is considered to be a resident of the United States and a resident of a treaty country (income tax), but, because of the “offending” provision of the relevant treaty, is treated as a nonresident alien for US income tax purposes.

Although dual resident taxpayers are generally treated as nonresident 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 in Reporting 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 regulations, dual resident taxpayers will not be treated as a US person for any part of the year in which they are treated as a nonresident alien for purposes of computing their US tax liability. As such, there would be no international information reporting requirement for dual resident taxpayers.

Foreigner Gloans against loans

Section 6038F of the Internal Revenue Code requires US persons to disclose the receipt of large gifts from foreigners or nonresident estates. Currently, the threshold for reporting these gifts is $100,000. Many taxpayers have tried to avoid this reporting by arguing that the transfer is a loan and not a gift. To combat this underreporting, the proposed rules 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 does not treat the amount received as a gift; AND
• The recipient does not treat the amount received as taxable income.

In practice, these anti-avoidance rules require the payee to have information/documentation to prove the debit, such as a loan agreement, note or principal/interest payment history.

Reporting threshold

The proposed rules also update the $100,000 reporting threshold noted above. Threshold amount of $100,000 issued in 1997 (Notice 97-34, Section VI-B.1) has not increased and is not currently indexed for inflation. As such, more gifts and inheritances are required to be reported as inflation increases.

The proposed regulations would index the $100,000 threshold annually for inflation.

Gift wrap

Under the proposed regulations, if the aggregate amount of foreign gifts received exceeds the reporting threshold, the US person would be required to separately identify each foreign gift of more than $5,000 and provide identifying information about the transferor, including the name and his address. It does not appear that the $5,000 will be adjusted annually for inflation., The full extent of the identifying information was not provided in detail, although the IRS believes that additional identifying information would help determine whether amounts received are property treated as gifts.

Currently, the transferor's identifying information is not required to be disclosed on Form 3520.

exception

Foreign gifts received by IRC Section 501(c) charities are exempt from reporting since the entity itself is exempt from taxation under Section 501(a).

Foreign gifts received by transferors who renounce U.S. citizenship, thereby becoming covered expatriates within the meaning of IRC section 877A(g)(1), but the amount of which does not exceed the exclusion for each applicable provision under IRC Section 2503(b), are exempt from reporting.

Transfers to Foreign Trusts and Ownership

Under the proposed rules, a transferor of U.S. property to a foreign trust would be considered the owner of the trust portion attributable to the transferred property during each tax year that the trust has a U.S. beneficiary. This proposed rule would apply regardless of whether the transferor retains any power under Sections 673 through 677 of the IRC. Further, the settlor must take into account all income, deductions and credits attributable to the portion of the trust he owns when calculating his tax liability.

In addition, a foreign trust that has received property from a U.S. transferor is treated as a U.S. beneficiary unless no portion of the trust's income or corpus is payable or accrued to or for the benefit of an American person. If the trust is terminated at any time during the tax year, no income or corpus of the trust may be paid to or for the benefit of a US person. The rules provide a very narrow exception: persons who are not named as potential beneficiaries and are not members of a class of beneficiaries as defined in the trust will not be considered if the settlor shows to the satisfaction of the IRS that their contingent interest in the trust is so distant as to be negligible.

Finally, the proposed rules provide that if a nonresident alien individual becomes a U.S. person and has a residency commencement date within five years of the transfer of property to a foreign trust, the individual will be deemed to have transferred the property to the trust as of date residency start 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 residence commencement date.

Loan from or use of property for a foreign Trust

The proposed rules generally incorporate the guidance provided in Notice 97-34 with some modifications regarding IRC section 643(i). The proposed rules provide that any loan of cash or marketable securities made by a foreign trust (of principal or income is immaterial) directly or indirectly to a U.S. grantor or beneficiary or any U.S. person related to the U.S. grantor or payee is treated as a distribution under section 643(i) as of the date the loan is made.

There are exceptions to this general rule – that is, it will not apply to:

• Cash loan in exchange or a qualified obligation within the meaning of Treasury Regulations Section 1.643(i)-2(b)(2)(iii);
• Use of trust property if the foreign trust receives the fair market value of such use within 60 days of the commencement of the use;
• De minimis use of trust property, which is noted as 14 days or less; OR
• Loans of money made by foreign corporations to a U.S. beneficiary of a foreign trust to the extent that the aggregate amount of all loans does not exceed the profits and retained earnings of the foreign corporation attributable to and included in the gross income of the foreign corporation. the beneficiaries.

Tax-advantaged foreign pension trusts

The proposed rules would expand on the initial relief provided for “tax-advantaged foreign pension trusts” by Revenue Procedure 2020-17 for certain qualified foreign trusts. In Rev. Proc. 2020-17, the exemption applies only if the plan meets certain criteria, ie – contribution limits based on a percentage of the participant's earned income, subject to an annual limit.

The proposed rules expand the initial relief provided in 2020 by allowing limited contributions from unemployed individuals and requiring the foreign trust to meet either a new value threshold or a contribution limit.

For the value threshold, the total value of the trust is limited to no more than $600,000 during the taxable year, 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.

Fines

The proposed rules under section 6677 provide for three separate civil penalties that may be assessed for each separate reporting requirement under Trea. The rules. Sections 1.6048-2, 1.6048-3, and 1.6048-4. They also provide that:

• The penalty initially imposed on persons who fail to timely file a required notice or return or fail to provide complete and accurate information is the greater of $10,000 or 5% of the applicable gross reportable amount (defined in Treas. Regs Section 1.6677-1(c)) for any such failure. 5% is a significant reduction from the 35% penalty currently imposed.
• The American owner, rather than the foreign trust, must pay the penalty.

A step in the right direction

The proposed regulations provide clarity in a very complicated and complex area of ​​international information reporting. However limited in scope these proposed updates are, they are still a step in the right direction and the expectation is that, particularly in the tax-advantaged foreign pension trust space, expanding the exemptions will result in fewer filings .

The AICPA and other organizations continue to provide feedback as practitioners feel that broader exemptions are needed as tax footprints continue to expand. Additionally, penalties in this space continue to be a hotly debated topic and I note that while the reduction of a 35% penalty to a 5% penalty is a big step in the right direction, ongoing discussion and updates are still needed.

Practitioners should continue to monitor these rules for updates and changes as they progress toward completion, as well as continue to question and educate clients about their foreign holdings.