How a nongrantor, nonbeneficiary of a foreign trust can be required to file Form 3520

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The Proposed Foreign Trust Regulations Create Unnecessary Paperwork

The proposed regulations related to foreign trusts, published in May, 2024, will significantly increase the paperwork load for foreign trusts and U.S. persons associated with those foreign trusts.

Let me give you a ridiculous example.

A foreign trust owns a Vail condominium. The settlor and all of the beneficiaries are nonresident aliens. The condo is never rented.
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As it happens, the settlor went to college in the United States. He tells his college roommate and long-time friend (a U.S. citizen) to use the Vail condo for a couple of weeks—no charge.
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The college roommate must file Form 3520 to report use of the Vail condominium.

The college roommate must file Form 3520

The college roommate is a United States person. Prop. Reg. Sec. 1.6048-1(b)(7).

The college roommate received a distribution from the foreign trust when he used the Vail condominium for two weeks. Prop. Reg. Sec. 1.6048-4(b)(6)(i) says:

A distribution includes the fair market value of the direct or indirect use of any property of a foreign trust by a U.S. person.

“Any” United States person who receives a distribution from a foreign trust (grantor trust or nongrantor trust, it doesn’t matter) must file Form 3520. Prop. Reg. Sec. 1.6048-4(a) says:

Unless an exception in § 1.6048-5 applies, any U.S. person who receives directly or indirectly any distribution from a foreign trust (without regard to whether any person is treated as the owner of the foreign trust under the rules of subpart E of part I of subchapter J of chapter 1) must file Part III of Form 3520. . . .

None of the exceptions in Prop. Reg. Sec. 1.6048-5 will apply (these exceptions relate to edge cases like compensation trusts, distributions to 501(c)(3) organizations, etc.). As a result, the college roommate will have a Form 3520 filing obligation.

No tax liability for the college roommate

Fortunately, the college roommate won’t have taxable income from his use of the Vail condo.

Prop. Reg. Sec. 1.6048-4(d)(1) gives the general rule for taxation of trust distributions:

Subject to paragraph (e) of this section, a U.S. person (other than a U.S. person described in § 1.6048-4(c)(1)(i)) who receives a distribution (other than a distribution described in § 1.6048-4(b)(5) or (6) that is not treated as a section 643(i) distribution under § 1.643(i)-1) from a foreign trust must determine the tax consequences of the distribution as follows, unless the distribution is received in a year that the foreign trust terminates.

What a dreadful, awkward sentence!

What it says is that we compute the tax consequences of a trust distribution for people who are NOT owners of foreign grantor trusts according to the rules of Prop. Reg. Sec. 1.6048-4(d)(1) – but only for certain types of distributions. The college roommate is the right kind of person—he is a U.S. person who isn’t the owner of the foreign trust.

But it’s the wrong type of distribution to trigger the tax liability calculation rules of Prop. Reg. Sec. 1.6048-4(d)(1). The specific types of distributions that you do NOT use calculate tax consequences using Prop. Reg. Sec. 1.6048-4(d)(1) are:

• Loans of cash and marketable securities that are not section 643(i) distributions; and
• Use of trust-owned property that is not a section 643(i) distribution.

A distribution is an IRC sec. 643(i) distribution only if the distribution is to a U.S. grantor or beneficiary or a person related to a U.S. grantor or beneficiary. The college roommate doesn’t fit into that category, and anyway in my example the grantor and all beneficiaries of the trust are nonresident aliens.

So, even though the college roommate is the right kind of U.S. person to compute his tax liability under Prop. Reg. Sec. 1.6048-4(d)(1), he received the wrong kind of distribution. He received a distribution that is use of trust-owned property that is not a section 643(i) distribution.

Therefore, there is no rule that creates income tax liability for the college roommate on account of his use of the Vail condominium.

Conclusion

What we see is a requirement under the Proposed Regulations that imposes a Form 3520 filing obligation on a random U.S. person who can never have any income tax liability arising from the transaction.

Seems like useless busywork to me.

Furthermore, consider the practical aspects of this filing obligation. How in the world would the college roommate even know that the Vail condominium was owned by a foreign trust?

There are other examples I can give you.

E.g., Form 3520 filing requirements that apply to a normal family living in a normal family home that happens to be owned by a foreign trust. What happens if mom, dad, and one kid are nonresident aliens, and another kid is a U.S. citizen? They’re all living in a home owned by a (foreign) family trust—created for normal estate planning purposes. That U.S. child has a Form 3520 filing obligation. Imagine preparing Form 3520 for a five-year old child!

I’m not a fan of the Proposed Regulations. Overkill.