The Internal Revenue Service introduced a few years ago significant changes that offer much-needed relief to U.S. citizens and residents dealing with foreign trust reporting obligations. This development addresses longstanding compliance burdens and hefty penalties that have plagued taxpayers with certain foreign financial arrangements, and is welcome news for those affected by the onerous requirements.
Revenue Procedure 2020-17, released by the IRS, provides exemptions from information reporting requirements for specific types of foreign trusts. More importantly, it allows eligible individuals to request abatement or refunds of penalties previously assessed for failing to file Forms 3520 and 3520-A. For many taxpayers, particularly those with Canadian retirement and education savings plans such as registered education savings plans (RESPs) and registered disability savings plans (RDSPs), this represents a watershed moment in cross-border tax compliance.
The relief came into place after years of taxpayer advocacy highlighting the disproportionate penalty structure that often exceeded the actual tax liability. Understanding these changes and their implications is crucial for anyone navigating the complex landscape of foreign trust reporting.
Understanding the Previous Penalty Structure
Before this relief, the penalty system for foreign trust reporting was notably harsh. Taxpayers faced a $10,000 penalty for each late, incomplete, or erroneous Form 3520 or 3520-A filing. Taxpayers must timely file Forms 3520 and 3520-A to avoid penalties, as failure to timely file can result in significant civil penalties. This meant that a married couple who were both subscribers to a Canadian Registered Education Savings Plan (RESP) could face $20,000 in penalties for a single tax year, even without any underlying tax owed.
The severity of these penalties created a chilling effect on legitimate tax-favored savings arrangements. Many U.S. citizens living in Canada or maintaining Canadian financial accounts avoided participating in beneficial programs like RESPs entirely, solely due to the compliance costs and penalty risks.
Tax practitioners consistently reported cases where penalties far exceeded any tax benefits or account values, creating situations where compliance was more punitive than the underlying income would warrant. Many taxpayers have previously paid penalties under the old system, and the new relief aims to address these previously paid penalties by providing a path for abatement or refund.
Qualifying for Tax-Favored Retirement Trust Relief
The new revenue procedure establishes specific criteria for tax-favored foreign retirement trusts to qualify for reporting relief. These arrangements must meet several stringent requirements that ensure they genuinely serve retirement planning purposes. An employer-maintained trust must provide significant benefits to a substantial majority of eligible employees to qualify for relief. Additionally, the trust must allow participants to accrue benefits based on employment or service, in accordance with the plan’s terms.
Such trusts must also be exempt from income tax in the trust’s jurisdiction to qualify for relief. Furthermore, annual information reporting must be provided or available to the relevant tax authorities in the trust’s jurisdiction. These requirements help ensure that the trust complies with both local and US regulations and maintains its tax-favored status.
Essential Requirements for Retirement Trusts
To qualify, a foreign retirement trust must be created under foreign law exclusively or almost exclusively for pension or retirement benefits. The trust must enjoy tax-exempt or tax-deferred status in its home jurisdiction, with annual information reporting available to local tax authorities.
Contribution limitations play a crucial role in qualification. The trust may receive contributions from both employer and employee contributions, but only contributions derived from personal services income and income earned are permitted. These contributions must be capped either by a percentage of earned income or by dollar limits.
Distribution restrictions further define qualifying trusts. Withdrawals, distributions, or payments are generally allowed only upon reaching a specified retirement age, death, or disability, and penalties apply if distributions are made before the specified retirement age or qualifying event. Limited exceptions may include payments for a primary residence, in-service loans, hardship situations, or educational expenses.
Non-Retirement Trust Qualification Standards
Tax-favored foreign non-retirement trusts face different but equally specific qualification criteria. These trusts typically serve educational, medical, or other specific beneficial purposes while maintaining favorable tax treatment. Depending on the jurisdiction’s laws, such trusts may also qualify for a government subsidy, tax credit, or other tax benefit. Only tax favored foreign trusts that meet these standards are eligible for the reporting relief.
Key Qualification Elements
Non-retirement trusts must be tax-exempt or tax-favored under their jurisdiction’s laws, with information reporting available to local authorities.
Distribution conditions focus on the trust’s specific purpose. Withdrawals must be conditioned upon providing medical, disability, or educational benefits. Alternatively, the trust must impose penalties on distributions that don’t meet specified conditions.
These requirements ensure that only genuine tax-favored arrangements designed for specific beneficial purposes receive the reporting relief.
Qualifying non-retirement trusts are generally exempt from certain US trust reporting requirements and may benefit from a reporting exemption if they are classified as certain foreign gifts under IRS rules.
Eligibility Requirements for Individual Taxpayers
Individual taxpayers must meet specific compliance standards to benefit from this relief. Eligible taxpayers and eligible individuals, including persons living outside the United States, must meet these compliance standards to qualify for relief. The IRS requires that eligible individuals be current with all U.S. federal income tax return filing obligations covering their entire period as U.S. citizens or residents.
This compliance requirement serves as both a prerequisite and an ongoing obligation. Taxpayers seeking relief must demonstrate good faith efforts to meet their overall U.S. tax obligations, not merely the foreign trust reporting requirements.
The eligibility standards reflect the IRS’s approach of providing relief to compliant taxpayers while maintaining oversight of the broader tax system.
Continuing Reporting Obligations
While this revenue procedure provides significant relief from Forms 3520 and 3520-A requirements, other reporting obligations remain intact. Taxpayers must continue to comply with Foreign Bank Account Report (FBAR) requirements for accounts exceeding $10,000 in aggregate value. In addition, there are filing requirements for specified foreign financial assets, and U.S. persons may need to report foreign financial assets for U.S. tax purposes.
The Foreign Account Tax Compliance Act (FATCA) reporting requirements also continue to apply where relevant. Form 8938 filings may still be necessary depending on account values, filing status, and whether the assets qualify as specified foreign financial assets.
Income inclusions remain subject to normal tax rules. Distributions from these trusts continue to be taxable events requiring proper reporting on individual tax returns. The relief specifically addresses information reporting burdens, not the underlying tax treatment of trust income and distributions. Taxpayers may still be required to file an annual return for certain foreign trusts or accounts, depending on their tax purposes and reporting status.
Penalty Abatement and Refund Opportunities
One of the most significant aspects of this revenue procedure is its retroactive relief provisions. Taxpayers can request abatement of previously assessed penalties related to Forms 3520 and 3520-A filing failures for qualifying trusts. Penalty relief is available by requesting relief pursuant to the applicable statute and IRS guidance, such as Revenue Procedure 2020-17.
Even more notably, the procedure allows for refund requests for penalties already paid. This provision acknowledges that many taxpayers have already suffered financial harm from the previous penalty structure and provides a mechanism for recovery. Taxpayers must use the appropriate IRS form, such as IRS Form 843, when requesting relief, and may need to submit a late filing form as part of the process.
The refund provision requires specific documentation and procedures, but represents genuine relief for taxpayers who have already incurred these substantial penalties. Tax practitioners report significant interest from clients who paid substantial penalties in prior years. The limitations period for requesting relief is governed by the applicable statute, so taxpayers should ensure their requests are submitted within the required timeframe.
Moving Forward with Compliance
This relief represents a meaningful step toward more proportionate foreign trust reporting requirements. Taxpayers with qualifying arrangements should review their situations with qualified tax professionals to determine eligibility and appropriate action steps. In addition, taxpayers should consider the implications for Canadian tax purposes and be aware of potential tax issues that may arise from cross-border reporting requirements.
For those who have avoided certain foreign arrangements due to reporting burdens, this relief may open new planning opportunities. Canadian RESPs, in particular, may now be viable options for U.S. taxpayers who previously avoided them. Taxpayers should understand when they are required to report transactions or may benefit from a reporting exemption under the new rules.
The key to benefiting from this relief lies in careful analysis of the specific requirements and proper documentation of qualification. Working with experienced cross-border tax professionals ensures proper application of these new provisions while maintaining overall compliance with continuing obligations.
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The views expressed in this article are those of the author and should not be relied on to make decisions. Consider discussing your specific circumstances with an appropriate specialist.