Welcome to “Lost in Translation: Blunders in International Estate Planning.” This blog series explores the rarified world of international estate planning, uncovering potential pitfalls and providing insights to navigate the complexities. Zach Weitz is our guest author for this blog article.

Blunder No. 3: Forgetting to File International Forms

There are many penalties imposed by the Internal Revenue Service (“IRS”). For example, the penalty for failing to file a tax return is 5% of the unpaid tax per month. The penalty for failure to file an informational return in which no tax is paid is typically a fixed dollar amount, such as the failure by an employer to issue a W-2, which ranges between $60.00 – $630.00. As one can see, while penalties for domestic tax returns can be potentially substantial, most of the time, the penalties are nominal amounts. Especially in the area of domestic informational forms, penalties tend to have little consequence for the average taxpayer.

The penalties for failure to file international informational returns, such as the 8938, 3520, 3520-A, Report of Foreign Bank and Financial Accounts (“FBARs”), and 5471, are far more burdensome than the penalties for domestic informational returns. In particular, the penalty for failure to file a Form 3520 is likely the most significant of any penalty issued by the IRS.

Understanding the 3520 and 3520-A

There are four instances in which a U.S. person is required to file a Form 3520:

1. A U.S. person transfers money or property to a foreign trust;
2. A U.S. person is treated as an owner of a foreign Trust under IRC §§671- 679;
3. A U.S. person received a distribution or used property of foreign trust without providing sufficient compensation;
4. A U.S. person received a gift or bequest from a foreign person.

The penalties for Form 3520 are as follows:

• The penalty for number 1 is 35% of the gross value of the property transferred to a foreign trust.
• The penalty for number 2 is 5% of the gross value of the portion of the foreign trust’s assets treated as being owned by a U.S. person.
• The penalty for number 3 is 35% of the gross value of the distribution received from a foreign trust.
• Finally, the penalty for number 4 is 5% of the amount of the foreign gift with a maximum penalty of 25%.

Potential Blunder

First, let’s give an example of the 25% penalty for failure to report receipt of a gift or bequest from a foreign person. Let’s say you are a U.S. person who received $50,000,000 as a gift from your father in 2016, who lives in Portugal and has never resided in the U.S.A. You did not know you needed to file a Form 3520 to report the gift. Fast forward to the present day, and the IRS sends you a notice for penalty and interest for failure to file a Form 3520 to report a gift from a foreign person. The penalty, not including interest, will be $12,500,000. Think about that penalty for a second. You did not do anything other than receive money, and now you will have to pay a penalty of at least 25% of the total gift! A disastrous result.

Next is an example of the 35% penalty for failure to report the transfer of property to a foreign Trust. Let’s say that you are a U.S. person, and in 2016, you transferred $50,000,000 to a trust established under the laws of the Cook Islands. Again, you did not know that you needed to report the transfer and interest in the foreign trust. The year is now 2024, and you receive a notice from the IRS for penalty and interest for failing to file a Form 3520 to report the transfer of property to a foreign trust. The penalty, not including interest, would be $17,500,000.

How to Avoid the Blunder and What to Do if You Could Not Avoid it?

It is hard to fathom the size of these penalties, especially because, most of the time, reporting items on the 3520 typically does not result in significant income to the taxpayer. Rather, they are merely informational returns. The easiest way to avoid the blunder is to remember the four instances in which a 3520 requires filing. Even if you or your accountant did not know that you were required to file this form, while the IRS has repeatedly stated that they would accept a reasonable cause defense in this situation, it has been reported that reasonable cause defenses in these cases have been routinely ignored.

Streamlined Domestic Offshore Procedures

U.S. taxpayers residing in the U.S. facing huge international tax form penalties may be eligible to enter into the Streamlined Domestic Offshore Procedures. If the taxpayer is eligible, rather than the 25% or 35% penalty outlined above, the penalty for the Streamlined Procedures is 5% of the highest aggregate balance/value of the taxpayer’s foreign financial assets that are subject to the miscellaneous offshore penalty during the years in the covered tax return period and the covered Report of Foreign Bank and Financial Accounts (“FBAR”) period.

In order to be eligible for the Streamlined Domestic Offshore Procedures, the taxpayer must:

1. Fail to meet the applicable non-residency requirement described in the “Eligibility for the Streamlined Offshore Procedures” (outlined on the IRS website);
2. Have previously filed a U.S. tax return for each of the most recent three (3) years for which the U.S. tax return due date has passed;
3. Have failed to report gross income from a foreign financial asset and pay tax as required by U.S. law, and may have failed to file one or more international information returns (e.g., Forms 3520, 3520-A, 5471, 5472, 8938, 926, and 8621) with respect to the foreign financial asset; and
4. Such failures resulted from non-willful conduct.

Note: You may be eligible for the Streamlined Foreign Offshore Procedures if you are considered a non-resident of the U.S. The Streamlined Foreign Offshore Procedures results in zero penalties as opposed to the 5% penalty for the domestic program.

Conclusion: Make sure you consult an attorney or accountant regarding your U.S. tax obligations

If you or one of your clients is a U.S. person who receives gifts from a foreign person, has interests in a foreign business entity, has an interest in a foreign trust, or has foreign bank accounts, make sure that you consult an international tax expert to determine whether you have a filing obligation. Especially in the area of foreign bank accounts, having merely signatory power over the account could result in substantial international tax penalties. Typically, in this area of tax law, the taxpayer is almost always non-willful in not filing an informational international tax form. However, the IRS has no sympathy and can embroil you in a never-ending fight.