New IRS Guidance Regarding Certain Tax-Favored Foreign Trusts

In new IRS guidance, certain foreign trusts receive a significant break from information reporting and the potential refund of penalties.

The IRS will now exempt eligible U.S. persons from reporting transactions with, or ownership of, certain tax-favored foreign trusts that are operated exclusively (or nearly exclusively) to provide pension, retirement, medical, disability, or education benefits. Such foreign trusts are likely to include programs such as Canadian registered educational savings plans and registered disability savings plans (RESPs and RDSPs); and UK self-invested personal pensions (SIPPs).

I. Summary

Section 6048 of the Internal Revenue Code IRS generally requires annual information reporting by U.S. persons with respect to contributions to, ownership of, and distributions from, foreign trusts. The IRS treated many foreign retirement trusts as standard foreign trusts notwithstanding their tax-favored status in the foreign jurisdiction. Moreover, U.S. persons who fail to comply with Section 6048 reporting requirements are subject to penalties under Section 6677.

On March 2, 2020, the IRS issued Revenue Procedure 2020-17 (Rev. Proc. 2020-17) which exempted certain foreign retirement and nonretirement savings trusts from Section 6048 foreign trust reporting. Specifically, Rev. Proc. 2020-17:

(1) exempts U.S. persons from the information reporting requirements under Section 6048 for transactions with, and ownership of tax-favored foreign retirement trusts and certain tax-favored foreign nonretirement savings trusts; and

(2) establishes procedures for eligible U.S. persons to request abatement of penalties that have previously been assessed or a refund of penalties that have previously been paid pursuant to Section 6677 for the U.S. person’s prior failure to comply with the information reporting requirements of Section 6048 for applicable tax-favored foreign trusts.

The exemption is only for foreign trust information reporting; U.S. persons are still required to report the income and pay any tax associated with these trusts

II. Background of Section 6048 Requirements

Section 6048 is comprised of three reporting obligations:

First, U.S. persons must report certain events related to foreign trusts on Form 3520 (Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts) , including the creation of a foreign trust by a U.S. person; the direct or indirect transfer of money or other property by a U.S. person to a foreign trust; the death of a U.S. person treated as the owner of a foreign trust under the grantor trust rules; and the death of a U.S. person if any portion of a foreign trust was included in her gross estate.

Second, a U.S. person who is treated as owning a foreign trust under the grantor trust rules must ensure that the trust (1) files Form 3520-A (Annual Information Return of Foreign Trust With a U.S. Owner) each year to provide an accounting of all trust activities and operations for the year; and (2) furnishes certain information to each U.S. person who is treated as owning any portion of the trust and to each U.S. person who receives any direct or indirect distribution from the trust.

Third, any U.S. person who receives a distribution from a foreign trust during the taxable year must report information about that distribution on Form 3520.

III. Penalties

U.S. persons who fail to timely file Form 3520 or 3520-A, as required under Section 6048, or who fail to include all of the required information, are subject to penalties under Section 6677. For Form 3520, the initial penalty is equal to 35% of the amount required to be reported, and additional penalties may apply if the failure to file continues. For Form 3520-A, the initial penalty is 5% and also may increase if the failure to file continues.

There is a reasonable cause exception to the penalty provisions of Section 6677.

IV. Rev Proc. 2020-17

A. Exemption from Section 6048 Reporting Requirements

The Treasury Department and the IRS have exempted U.S. persons from the above-described filing requirements for tax-favored foreign retirement trusts and tax-favored foreign nonretirement savings trusts. The reason for this change is that these trusts generally are subject to written restrictions (such as contribution limitations, conditions for withdrawal, and information reporting) under the laws of the country in which the trust is established, and because U.S. persons with an interest in these trusts may be required to report their interests under other Internal Revenue Code provisions.

The exemption applies to U.S. persons who are, or at any time were, U.S. citizens or residents who have complied with all required U.S. federal income tax filings and, to the extent required under U.S. tax law, have properly reported as income any contributions to, earnings of, or distributions from, an applicable tax-favored foreign trust.

Tax-favored foreign retirement trusts are foreign trusts (for U.S. tax purposes) that are organized under the laws of a foreign jurisdiction to operate exclusively (or almost exclusively) to provide for retirement benefits. More specifically,

  1. Such a trust must be tax-favored in the foreign jurisdiction, in that (i) contributions to the trust that would otherwise be subject to tax are deductible or excluded from income, are taxed at a reduced rate, give rise to a tax credit, or are otherwise eligible for another tax benefit (such as a government subsidy or contribution); or (ii) taxation of investment income earned by the trust is deferred until distribution or the investment income is taxed at a reduced rate.
  2. Annual information reporting with respect to the trust is provided or available to the relevant tax authorities in the foreign jurisdiction.
  3. Contributions to the trust are limited by a percentage of the earned income of the participant; are subject to an annual limit of $50,000 or less to the trust; or are subject to a lifetime limit of $1,000,000 or less to the trust.
  4. Withdrawals and distributions from the trust are conditioned upon reaching a specified retirement age, disability, or death, or penalties must apply where withdrawals and distributions are made prior to the requisite conditions being met.
  5. In the case of an employer-maintained trust, (i) the trust must be nondiscriminatory insofar as a wide range of employees must be eligible to make contributions or accrue benefits under the terms of the trust; (ii) the trust must actually provide significant benefits for a substantial majority of eligible employees; and (iii) the benefits actually provided under the trust to eligible employees are nondiscriminatory.

Tax-favored foreign nonretirement savings trusts are foreign trusts (for U.S. tax purposes) that are organized under the laws of a foreign jurisdiction to operate exclusively (or almost exclusively) to provide for medical, disability, or education benefits. More specifically,

  1. Such a trust must be tax-favored, in that (i) contributions to the trust that would otherwise be subject to tax are deductible or excluded from income, are taxed at a reduced rate, give rise to a tax credit, or are otherwise eligible for another tax benefit (such as a government subsidy or contribution); or (ii) taxation of investment income earned by the trust is deferred until distribution or the investment income is taxed at a reduced rate.
  2. Annual information reporting with respect to the trust is provided or available to the relevant tax authorities in the foreign jurisdiction.
  3. Contributions to the trust are limited to $10,000 or less annually or $200,000 or less on a lifetime basis.
  4. Withdrawals and distributions from the trust are conditioned upon the provision of medical, disability, or educational benefits, or penalties must apply where withdrawals and distributions are made prior to the requisite conditions being met.


B. Procedures for Requesting Abatement or Refund of Section 6677 Penalties

Eligible U.S. persons who have been assessed a penalty under Section 6677 for failure to comply with Section 6048 reporting requirements may request abatement and/or a refund of the penalty. Rev. Proc. 2020-17 provides details on the specific procedures for requesting such relief.

V. Final Takeaways

The changes under the revenue procedure went into effect on March 16, 2020 and are applicable to all prior tax years that are open under Section 6511.

Based on preliminary analysis, it appears that some, but not all, retirement trusts in foreign countries may benefit from this relief. The Treasury Department and the IRS have requested comments about other types of foreign trusts that should be considered for an exemption from Section 6048 reporting.

While this change provides relief, U.S. persons with interests in tax-favored foreign trusts may not be entirely exempt from reporting such interests. For example, a U.S. person may still need to file a Form 8938 (of Specified Foreign Financial Assets) where the value of the interest in the tax-favored foreign trust meets the filing thresholds.

And, as noted above, regardless of the information reporting requirements, U.S. persons with tax-favored foreign trusts may still be liable for U.S. tax.

If you have any questions or would like to discuss these issues, please contact K&F at (212) 808-8100.