Whether you are a professional looking to protect your assets from lawsuits or a parent looking to secure your children’s future, there are numerous strong arguments for utilizing an offshore trust. When you decide you are ready to set up an offshore trust for yourself and your family, you should be aware that IRS has strict reporting requirements for offshore trusts that need to be followed.
The administrative and reporting requirements are extensive and can be divided into three phases: preliminary paperwork, trust paperwork, and additional tax return paperwork. The penalties for failing to submit paperwork are punishing, and it is vital to follow all requirements, to ensure that you follow all reporting requirements every year.
Before you can comply with IRS reporting requirements, there are preliminary steps that need to be taken.
First, to streamline the administration of your trust in the US, you should appoint a “US Agent” for your offshore trust. A US Agent is an official designee for your trust who is authorized to give further information about your trust to the IRS. The US Agent for your offshore trust can be the grantor/settlor of the trust, your attorney, or your trustee.
IRS Instructions for Form 3520 define a US Agent as:
“a U.S. person . . . that has a binding contract with a foreign trust that allows the U.S. person to act as the trust’s authorized U.S. agent in applying sections 7602, 7603, and 7604 with respect to:
While it is not mandatory to have a US agent, drafting paperwork between yourself and the trustee of your offshore trust to appoint a US agent should be the first step you take after establishing your trust. Reporting requirements in the absence of a US agent are more onerous, and cause you to lose many of the privacy protections afforded by the offshore trust.
Once you have appointed your US agent, you will need to file for a US Tax Identification Number. Don’t worry – receiving a USTIN does not in and of itself subject your offshore trust to US taxation or change the tax structure of your offshore trust. It simply provides a unique identifier for your trust, which allows the IRS to track your trust throughout the various filings required.
Finally, if the creation of your offshore trust is treated as a gift for US tax purposes, you will need to file a gift tax return. Whether funding your trust is a taxable gift depends on your specific circumstances and is a topic you should discuss with your estate planning and tax attorney. If you do need to file a gift tax return, you will need to file an IRS form 709.
Once all the preliminary paperwork is completed, it is time to complete all the reporting requirements for your offshore trust. These requirements comprise Forms 3520-A, 3520, and FINCEN Form 114 (also known as FBAR).
The first form that must be submitted is IRS Form 3520-A. This form is filed by the trust itself, rather than the taxpayer. It cannot be filed electronically and must be physically mailed. The 3520-A provides information to the IRS about the trust, its investment structure, sub entities, assets held in trust, and income or loss on the trust’s investments. Generally, the first time you file a 3520-A, you should expect a time-consuming process – you will need a thorough understanding of your investment structure and all your legal documents. For this reason, it is highly recommended to consult a professional to assist in filing Form 3520-A.
The second form to be submitted is IRS Form 3520, the companion form to 3520-A. Unlike 3520-A, which is filed by the trust itself, Form 3520 is filed by each settlor/grantor and beneficiary of the trust. As part of preparing Form 3520-A, your offshore trust will provide a statement to you and each other grantor and beneficiary that outlines all income earned by the trust each year, and all distributions made by the Trust that year, as well as any other facts pertinent to the income and distributions of the trust. When you file Form 3520, you will attach this portion of your trust’s Form 3520-A to your Form 3520. Failure to attach this statement to your Form 3520 can cause issues with the IRS. This is one of the reasons why it’s important to appoint a US Agent, as the US Agent is authorized to sign the IRS Form 3520-A. It is crucial to ensure that this form gets completed on time and that the statement required for 3520 is distributed to the grantor(s) and beneficiaries on time.
The last required paperwork related to the trust to be filed is FINCEN Form 114 (FBAR). Form 114 (which is commonly called the Foreign Bank Account Report or FBAR) is only required if your trust structure includes a foreign financial account (such as a bank account or brokerage account) with a balance of at least $10,000. Since most trusts do include such a bank account, FINCEN Form 114 is considered an essential part of the trust reporting requirements. This form is filed separately from your tax return using a separate Treasury Department e-filing system.
CAUTION: Do not take the FBAR lightly. If you are unsure whether an account meets the threshold for reporting, err on the side of caution. The penalty for failing to timely file the FBAR starts at $10,000 and can be as high as 50% of the account balance if the IRS determines that the failure to file was “willful.” For best results, always consult your attorney.
All the forms we’ve covered so far are filed separately from your tax return. However, your offshore trust will affect your US federal income tax return itself as well. If you use a third party to prepare your taxes, you should make sure that your tax preparer is made aware of your offshore trust, and that they have the requisite knowledge and experience to prepare the proper forms.
If your offshore trust structure comprises a foreign financial account (such as a non-US bank or brokerage account), you may need to ensure that the questions at the end of Schedule B is filled out appropriately. This is the schedule on your tax returns that is used to report interest and dividend income. These questions must be answered correctly to report interest and dividend income in applicable foreign accounts.
If your offshore trust structure comprises non-US entities under the trust, you may need to file additional forms to report income of this entity, depending on the US tax treatment of the entity. If the entity is treated as a corporation for US tax purposes (the most common scenario for non-US entities held by trust), the appropriate form is Tax Form 5471. If the entity is treated as a disregarded entity for tax purposes, you may need to file Tax Form 8858. Your tax attorney can assist you in selecting the best entity classification for any entities owned by you or your trusts, and file Form 8832 to elect appropriate treatment if necessary.
If your offshore trust structure owns assets worth at least $50,000, and these assets include a non-US entity or a non-US bank or brokerage or other financial accounts, you may need to file IRS Form 8938. This form was introduced in 2011, and serves to collate relevant information included elsewhere in your return, essentially notifying the IRS that you own substantial offshore assets.
If your offshore trust invests in a U.S. business or an offshore corporation that does business in the United States, and such investment is equal to or greater than 25% of the business, the corporation may need to file Form 5472 to report U.S. source income.
Finally, if you transfer assets to a foreign corporation held by your offshore trust, you may need to file Form 926, and if you transfer assets to a foreign partnership held by your offshore trust, you may need to file Form 8865.
As outlined above, the reporting requirements for offshore trusts are extensive. A portion of the required paperwork must be filed by the trust itself, while the remainder is to be filed by the grantor(s) and/or beneficiaries. Naturally, with so many required forms come a variety of filing deadlines and timing issues. Generally speaking, all the forms required as part of tax returns share the same deadline as the tax return.
The 3520-A, which is filed by the offshore trust itself, must be submitted by March 31st, and cannot be filed electronically. The 3520 is must be submitted along with the tax return of the applicable party. The FINCEN Form 114, on the other hand, must be filed by April 15th, but the deadline can be automatically extended to October 15th.
There are compelling arguments for the use of offshore trusts to protect your assets and plan your estate. However, it is vital to ensure that you follow all IRS requirements for required paperwork when using offshore trusts in your estate plan. Failure to follow the reporting requirements can result in severe penalties.
Failure to file Form 3520-A, or filing an inaccurate or incomplete Form 3520-A is punishable by a penalty of the greater of $10,000 or 5% of the gross value of the trust assets held in trust for U.S. persons. The penalty is assessed for each applicable year, and the minimum penalty is $10,000.
Likewise, if any U.S. grantors or beneficiaries of an offshore trust fail to file Form 3520, they are assessed an additional penalty of the greater of $10,000 or 5% of the gross value of the trust assets owned by U.S. persons.
The most severe of all is the penalty for failing to file FINCEN Form 114. If the failure is found to be non-willful, the penalty is $10,000 per violation. If the failure is found to be willful, however, the penalty is greater of $100,000 or 50% of the amount in the account for each violation.
The reporting requirements outlined above apply to trusts and bank accounts holding cash or securities. However, one question that comes up often is whether the same applies to digital wallets containing cryptocurrency held in offshore trusts.
As of the writing of this article, FINCEN Form 114 is not required for financial accounts containing only cryptocurrency. FinCEN has responded to practitioner inquiries by stating that 31 C.F.R. §1010.350(c) does not define virtual currency held in an offshore account as a type of reportable account. Similarly, digital wallets containing cryptocurrency are not considered a reportable account. However, in case of accounts holding mixed assets (cryptocurrency and other securities or cash), it is presumed that the value of the cryptocurrency is considered when calculating the total value of the account to determine whether it meets the $10,000 reporting threshold.
In its most recent report, FinCEN published the following statement:
Currently, the Report of Foreign Bank and Financial Accounts (FBAR) regulations do not define a foreign account holding virtual currency as a type of reportable account. (See 31 CFR 1010.350(c)). For that reason, at this time, a foreign account holding virtual currency is not reportable on the FBAR (unless it is a reportable account under 31 C.F.R. 1010.350 because it holds reportable assets besides virtual currency). However, FinCEN intends to propose to amend the regulations implementing the Bank Secrecy Act (BSA) regarding reports of foreign financial accounts (FBAR) to include virtual currency as a type of reportable account under 31 CFR 1010.350. (emphasis added)
Additionally, it is unclear if Form 8938 requires reporting cryptocurrency held in foreign exchanges. The lack of clarity here comes from ambiguity regarding cryptocurrency’s status as either a commodity or a security, and the exact definition of a foreign exchange as it applies to crypto brokerages such as CoinBase, Bitmart, etc. As of this writing, it appears as if the letter of the law is unclear in regard to cryptocurrency held in foreign exchange wallets, but does not require reporting cryptocurrency held in private digital wallets. There is a strong indication that the IRS will make a ruling and publish new regulations on this topic in the near future.
Highlighting this shift in focus to regulating cryptocurrency, Form 1040 now includes questions about cryptocurrency as well. The IRS is sending strong signals that cryptocurrency’s tax status will soon be reevaluated and more tightly regulated, and it will be crucial to keep a keen eye on new developments.
If you are looking to set up an offshore trust or are looking for guidance with IRS offshore reporting requirements, please contact Mile High Estate Planning today.