U.S. Expats and Foreign Trusts: A Guide to Reporting, Tax Rules, and Penalties 937

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Living abroad as a U.S. citizen comes with unique tax challenges, especially when you own or are a beneficiary of a foreign trust. The IRS has strict reporting rules to prevent tax evasion and ensure all foreign financial assets are properly disclosed.

This guide will walk you through what a foreign trust is, the difference between grantor and non-grantor trusts, how they are taxed, and the critical reporting requirements for Forms 3520 and 3520-A.

What Is a Foreign Trust?

A trust is considered foreign if it fails either of two key tests:

  • The Court Test: A U.S. court cannot exercise primary supervision over the trust’s administration.
  • The Control Test: U.S. persons do not control all significant trust decisions.

If a trust fails either test, it’s classified as foreign. For example, a pension plan in another country administered exclusively abroad is considered a foreign trust. This is a crucial distinction, as many expats discover they’ve unknowingly inherited or hold foreign assets that are treated as part of a foreign trust.

Grantor vs. Non-Grantor Trusts: What’s the Difference?

The main difference between these two types of trusts is how they are controlled and taxed.

Grantor Trusts

A grantor trust exists when the U.S. owner (the grantor) retains control over the trust. This can include the ability to revoke or amend the trust, change beneficiaries, or direct investment decisions.

  • Taxation: The trust is disregarded as a separate tax entity. All income and capital gains are taxed directly to the U.S. owner on their personal tax return.
  • Example: A U.S. citizen sets up a revocable trust in Canada to hold a foreign bank account, but they maintain the right to manage or withdraw funds. The IRS treats this as a foreign grantor trust, and the U.S. person must report all income and file both Form 3520 and Form 3520-A.

Non-Grantor Trusts

A non-grantor trust is created when the grantor gives up control of the assets they transfer to the trust.

  • Taxation: The trust is treated as its own separate entity. It pays U.S. tax only on U.S.-sourced income. The U.S. beneficiary is taxed on any distributions of income they receive. Distributions of the trust’s principal are generally not taxable.
  • Example: A U.S. person establishes a trust in Switzerland where an independent trustee makes all decisions. Since the grantor no longer has control, it becomes a non-grantor trust. Any U.S. beneficiary who receives a distribution must file Form 3520 to report it.

How Foreign Trusts Are Taxed

The taxation of a foreign trust depends on whether it’s a grantor or non-grantor trust.

Foreign Grantor Trust

  • Taxation: The U.S. owner is taxed on all of the trust’s income and capital gains.
  • Filing Obligations:
    • Form 3520-A: Filed annually by the trustee (or by the U.S. owner if the trustee does not). This form provides an accounting of the trust’s assets.
    • Form 3520: Filed with the owner’s personal tax return to report their ownership and transactions.

Foreign Non-Grantor Trust

  • Taxation: The trust is its own taxpayer, paying U.S. tax only on U.S.-sourced income. A U.S. beneficiary pays tax on any distributions of income they receive.
  • Filing Obligations:
    • Form 3520-A: Not required.
    • Form 3520: Must be filed by a U.S. beneficiary to report any distributions they receive.

Key Reporting Requirements for U.S. Expats

Foreign trusts trigger a number of reporting requirements for U.S. expats.

  1. Form 3520 – Annual Return to Report Transactions With a Foreign Trust: This form is required for any U.S. person who:
    • Creates or transfers assets to a foreign trust.
    • Is treated as the U.S. owner of a foreign trust.
    • Receives distributions or gifts from a foreign trust.
  2. Form 3520-A – Annual Information Return of Foreign Trust With a U.S. Owner: This form must be filed annually by the trustee of a grantor trust (or the U.S. owner if the trustee doesn’t). It provides a full accounting of the trust’s assets and administration.
  3. FBAR (FinCEN Form 114): If the foreign trust holds bank accounts or other financial accounts with an aggregate balance of over $10,000, you may need to file an FBAR. This applies if you have a financial interest or signature authority over the account, even if the trust has legal title.
  4. Form 8938 – Statement of Specified Foreign Financial Assets: This form is required if you meet reporting thresholds for specified foreign financial assets, which include interests in foreign trusts.
  5. U.S. Income Tax Return (Form 1040): Any taxable income from a foreign trust must be reported on your Form 1040. For a grantor trust, you report all income as if you earned it directly. For a non-grantor trust, you report any taxable distributions you receive.

Penalties and Due Dates

The IRS imposes steep penalties for failing to comply with foreign trust reporting requirements.

  • Form 3520: The penalty is the greater of $10,000 or 35% of the gross value of the property transferred or distributions received.
  • Form 3520-A: The penalty is the greater of $10,000 or 5% of the total value of trust assets owned by the U.S. person.

The due date for Form 3520 is the same as your personal income tax return (April 15, or June 15 for expats, with extensions). However, the due date for Form 3520-A is March 15 (or September 15 with an extension). The penalty for late filing Form 3520-A is automatic and rarely abated, so it’s critical to meet this deadline.

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