How a Nongrantor, Nonbeneficiary of a Foreign Trust can be Required to File Form 3520

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.

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:

“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:

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:

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.

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