IRS seeks to bolster foreign trust, gift transactions rules

An IRS rule proposal could give tax professionals and clients who receive assets through foreign trusts and gifts answers to technical questions they've been posing for decades.

Last month, the agency held a public hearing on a proposal the IRS released in May that would alter the guidelines for the reporting of transactions involving foreign trusts and gifts reflected on Forms 3520 and 3520-A. 

The proposal is less controversial than another IRS proposal that would enforce new rules for donor-advised funds or the agency's audit crackdown on tax avoidance methods used by wealthy households and won't make as much of an impact as the expiration of many provisions of the Tax Cuts and Jobs Act at the end of next year. Still, financial advisors whose clients have offshore holdings may soon be dealing with new guidelines.

The IRS proposal would bring "more clarity or certainty on needing to report transactions," said Brian Harvel, an Atlanta-based partner with the Alston & Bird law firm. 

"The key takeaway for me is that the IRS and Treasury want people to report more rather than less," Harvel said in an email. "That is in line with what other countries are doing around the world, except that the U.S. places more emphasis on privacy and recognizes that there are a lot of legal and beneficial uses for trusts — asset protection, privacy, personal safety — compared to other countries who are gathering information on trusts and making it public or semi-public. Those types of disclosures defeat the purpose of a trust in the first place."

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The proposal stems largely from a 1996 law, the Small Business Job Protection Act, which targeted "abusive tax schemes" that included that use of foreign trusts, according to a legislative history in the proposal. 

"In these schemes, foreign trusts were used to transfer large amounts of assets offshore, where it was much more difficult for the IRS to identify whether U.S. persons owned an interest in such trusts, and whether such persons were reporting and paying the required taxes on their income from such trusts," the rule said. "Many of the foreign trusts were established in tax haven jurisdictions with bank secrecy laws."

In rolling out the proposal earlier this year, the agency's statement cited stakeholders who informed the IRS of "potential opportunities for improvement" of the penalty process relating to the forms and a new working group seeking to identify further changes that would reduce taxpayer burdens and "incentivize voluntary compliance."

"The proposed regulations address potential uncertainty under current law, including the necessary requirements for complying with the foreign trust and gift provisions, and the relevant tax consequences and potential penalties for compliance failures," according to the preamble to the rule.

The proposal would alter the regulatory definition of the terms "U.S. persons" and loans known as "qualified obligations," and the treatment of indirect loans from foreign trusts that some taxpayers have used to bypass the rules, according to a guide to the potential rule written earlier this year by Ian Weinstock and Heather Fincher of the Kostelanetz law firm. 

In addition, the proposal expands reporting requirements to more kinds of transactions known as "constructive" transfers and distributions from trusts while filling in more details about exceptions to those guidelines and spelling out more rules for how to legally accept foreign gifts with proper notification to the IRS.

"For nearly thirty years, taxpayers have been waiting for the IRS to issue regulations related to foreign trusts and foreign gifts," Weinstock and Fincher wrote. "Since 1996, when Congress enacted a myriad of provisions to prevent tax avoidance through the use of foreign trusts and gifts, taxpayers have had to rely on less formal guidance (e.g., Notice 97-34, Revenue Procedures 2014-55 and 2020-17) on those provisions."

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In other words, tax professionals welcomed the codification of some highly specific policies, but they still asked the agency through more than 1,500 public comments and testimony at the Aug. 21 hearing to tweak the proposal further, according to a summary of the proceedings by Thomson Reuters Tax & Accounting.

For example, the American Institute of CPAs praised the May rule proposal, even as the organization called in July for shifts in at least 13 different sections of the guidelines.

"Practitioners have needed guidance in this area for more than 25 years," Eileen Sherr, AICPA's director of tax policy and advocacy, said in a statement at the time.