Offshore non-U.S. resident trusts are becoming a popular planning vehicle for U.S. citizens, residents, and domiciles for a variety of reasons. Indeed, foreign trusts are a bit of craze for U.S. persons and citizens seeking to diversify their investment portfolios outside the U.S. dollar and outside the physical confines of U.S. borders. Such trusts can facilitate inter-generational wealth transfer planning, marital planning, and provide to the settlor a degree of asset protection planning really unachievable in the domestic U.S. setting given the generous anti-creditor lawsuit statutes in most offshore foreign jurisdictions. Please note that all irrevocable foreign trusts of this type are "grantor" trusts (if they have a U.S. beneficiary) for U.S. income tax purposes meaning that all the income and gains of the trust will be imputed to the U.S. settlor for purposes of U.S. income tax even though the trust property will be outside of the settlor’s estate for U.S. transfer tax purposes and even if the U.S. settlor receives no actual distributions of income from said trust.

Such trusts (whether revocable or irrevocable or whether completed gifts or not) invest in a wide array of assets ranging from directly-held interests in a variety of offshore corporations (which in turn own assets like investments in real estate in foreign countries) to indirectly held marketable security portfolios and commodities. Trusts make ideal vehicles for the management of such investments due to the proliferation of professional offshore trust companies in the business of managing such portfolios. Such trusts are locally private, relatively low cost to administer, and provide a personalized platform to facilitate personal residential moves to foreign jurisdictions.

Given all of the above benefits, the U.S. based settlor is often times improperly advised as to the material, substantial, and increasingly expensive compliance regime that has been created in the last two decades by the U.S. Congress and the IRS. Indeed, many U.S. settlors of foreign trusts are simply unaware of these requirements or the penalties for failing to comply with the requirements. This is as tragic as it is unnecessary.

Commencing with the Small Business Job Protection Act of 1996, such trusts (and their grantor/settlors and beneficiaries) have been subject to an increasing variety of statutory and regulatory mandated compliance initiatives. This article will seek to summarize such compliance protocols and requirements. It is to be noted that the failure to comply with any one compliance or reporting requirement carries with it stiff fines and penalties. Indeed, the recent series of offshore voluntary disclosure initiatives instituted by the IRS has in some material sense been designed to bring forth U.S. persons who have failed to completely comply with this ever more burdensome foreign reporting regime.

Many such foreign trusts are designed to be completed gifts for U.S. federal gift tax purposes and will result in various additional tax reporting forms being filed with the IRS by your tax CPA or tax form preparer on your behalf. It can’t be emphasized enough that only experienced tax preparers should be retained to prepare and file these forms. These forms are fraught with pitfalls for the unwary, are complex, and are easily misfiled. The first question anyone should ask the individual intended to prepare these forms is: how many of these have you prepared? If the answer is none, run do not walk to the nearest exist and find yourself a new tax preparer.

Any settlor of a foreign trust should also immediately advise their drafting attorney and their foreign trustee of their CPA's name and firm so that the attorney and trustee may apprise them of the settlor’s actions in regards to the settlement of the foreign trust so that he or she may make timely disclosure of the required forms (and make any required elections and provide any required information) to the IRS on the settlors’ behalf. Further, prior to settling any offshore foreign trust, the settlor should ensure that the respective offshore foreign trustee will cooperate in the information downloads required to facilitate the settlor’s U.S. based compliance. If the foreign trustee refuses to cooperate, the settlor should rethink the propriety of the foreign trust or seek a more cooperative substitute foreign trustee.

Given the above background, we will now turn our attention to the myriad of forms required to be filed by a U.S. settlor relative to a foreign trust (and such trust’s trustees and beneficiaries). Such forms will include, amongst others, (and will need to be filed, signed, and reported as required by IRS regulations either initially in the year of creation and/or on an ongoing annual basis):

- Federal Form 709 Gift Tax Return is generally required for all irrevocable gift transfers by U.S. persons to anyone or any trust, including a foreign trust. Such returns can require professional valuations if you transfer assets without ready identifiable fair market values such as interests in closely held corporations. Settlors of foreign trusts making irrevocable gifts designed to facilitate inter-family generational wealth planning need to be aware that is this form because it allocates a settlor’s U.S. generation-skipping transfer tax exemption automatically to such irrevocable gifts unless the donor-settlor opts out of such allocation thereby saving such allocation exemption for other future transfers.

- Federal Form 3520 Annual Report to Report Certain Transactions With Foreign Trusts Is required to be filed for a whole series of reportable events such as the creation of a foreign trust by a U.S. person or a distribution being received from a foreign trust by a U.S. person. U.S. owners of such trusts are also required to file this form as all foreign trusts settled by U.S. persons with U.S. beneficiaries are considered U.S. “grantor trusts” (i.e., essentially disregarded entities for U.S. income tax reporting purposes). Any person who receives a foreign gift over a certain annually determined amount also files this form to report the gift. This form is due on the same date, including extensions, with the reporting person’s federal tax return. There are a whole host of penalties applicable for failing to file such a form including a) a 35% penalty of the gross fair market value of any transfers made by the transferor to such a foreign trust; b) a 35% penalty of the gross fair market value of any distributions received by a U.S. person from a foreign trust; and c) a 5% penalty of the gross value of the portion of the foreign trust assets considered as owned by a U.S. person.

- Federal Form 3520A Annual Information Return of a Foreign Trust with a U.S. Owner is required to report the settlor’s share of the trust's income. Confusion reigns over this form as it is to be filed by the foreign trustee and not the U.S. settlor, but it is the U.S. settlor/owner’s responsibility to ensure its timely filing. It essentially serves as a K-1 style form showing which portions of the offshore trust’s dividends, interest, and capital gains are reportable by the U.S. owner. This form is due to be filed, unless separately extended, by the 15th day of the third month following the close of the taxable year of the trust. Caution should be used by any and all U.S. settlors as to the filing of this form as many, if not most, foreign trustees are either unaware of this form or refuse to cooperate in its filing. This can cause dramatic consequences and penalties to the U.S. settlor. The usual penalty is 5% of the assets treated as owned by the U.S. owner/settlor. This form requires the disclosure of the trust’s assets and income thereby increasing the complete and total transparency of the foreign trust transaction.

- Federal Form TD F 90-22.1 Foreign Bank Account Reporting Form is required to report overseas bank accounts held or managed by U.S. persons and certain beneficiaries of certain trusts (e.g., a beneficiary that has a more than 50% present beneficial interest in the assets or income in a trust for the year). Generally, if one’s overseas accounts total (in the aggregate) more than $10,000 (at any time) such a report is required to be filed with the federal government separate and apart from one’s federal tax return. It must be received (note received) by June 30th of every year. It is the opinion of this firm that any and all U.S. settlor’s of foreign trusts which are treated as U.S. grantor trusts are responsible for filing this form on their own behalf if the $10,000 aggregate filing threshold is passed. This form is also required if a U.S. person has signatory authority over a financial foreign account such as being a director of a foreign corporation or domestic corporation that has foreign bank account. This is important inasmuch many settlors serve as directors of the companies their trusts own.

- Federal Form 8938 Statement of Specified Foreign Financial Assets is required for U.S. persons with overseas financial assets. Simply put, the vast majority of overseas foreign financial assets held by a U.S. person must be disclosed on this form. It can be duplicative with other forms required to be filed with shortcuts being allowed. Whether foreign assets such as gold or silver held directly by a U.S. person or foreign realty held by a U.S. person are subject to reporting is a matter of some debate amongst the professional tax compliance community.

IF AND ONLY IF YOUR FOREIGN TRUST OWNS A FOREIGN COMPANY OR A FOREIGN PARTNERSHIP OR A FOREIGN MUTUAL FUND OR OTHER SIMILAR OFFSHORE ENTITY THE FOLLOWING IRS FORMS WOULD OR COULD BE REQUIRED:

Federal Form 5471 "Information Return of U.S. Persons With Respect to Certain Foreign Corporations"; or

Federal Form 8865 "Returns Of U.S. Persons With Respect To Certain Foreign Partnerships"; or

Federal Form 8621 "Information Return Of A Shareholder In A Passive Foreign Investment Company."

A typical foreign trust may create a 100% owned foreign offshore subsidiary to purchase a rental condominium which does not qualify as an active business under IRS foreign regulations. The net rental income would be imputed via Form 5471 to the foreign trust even in the absence of any distributions. Alternatively, the foreign trust may invest in foreign mutual funds which generate passive income. Such income would usually be reported by way of a Form 8621 since the vast majority of foreign mutual funds are passive foreign investment companies (”PFICs”). A person with a PFIC generally makes a certain election on the Form 8621 to pass through the income of the PFIC annually to the U.S. person even in the absence of an actual distribution. This is generally done to avoid significant future penalties on distributions. Finally, trusts that own interest in foreign partnerships must file the Form 8865 (and fill in certain schedules based upon a variety of criteria) which reports the foreign partnership’s income, balance sheet, and partner’s share of partnership income.

In conclusion, foreign trusts are a viable and appropriate planning vehicle for the well-informed. However, the level of knowledge of the typical U.S. settlor as to the ever increasing and costly range of compliance responsibilities has been historically at a very low level. Further, the typical U.S. based CPA has a similar low level of knowledge in respect to the appropriate level of disclosure required in such circumstances. As a result, foreign trusts can be trap for the unwary.