Written by Max Reed Canadian residents who aren’t U.S. citizens may be surprised to know that U.S. estate tax can apply to them. That’s because U.S. estate tax applies to...
Recently, the IRS has significantly increased in the number of penalties issued for late or incorrectly filed Form 3250 (“Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts”) and Form 3520-A (“Annual Information Return of Foreign Trust With a U.S. Owner”). The penalties for filing these forms late or incorrectly are significant. The penalty for failing to file Form 3520 on time or incorrectly is the greater of $10,000 or 35% of the value of the property transferred to a foreign trust that was not reported properly. Similarly, the penalty for incorrectly or late filing Form 3520-A is the higher of 5% of the value of the trust assets or USD $10,000. Those penalties would hurt the wallet. They are also often disproportionate to the offense.
To minimize the risk of penalties or offset them if they are imposed, we suggest the following.
1. Make sure the forms are actually required
Under the US tax code, there cannot be a penalty imposed if there was no form required. Thus, the first step is to make sure either form is specifically required. Here are some common reasons for which either form is required:
- A US taxpayer receives a distribution from a foreign trust;
- A US taxpayer receives over USD $100,000 as a gift or inheritance from a foreign estate or individual;
- A US taxpayer contributes property to a foreign trust;
- A US taxpayer is considered the owner of a foreign trust.
However, there are some circumstances where it is not clear that Form 3250 or 3520-A is required. For instance, a Canadian TFSA or Canadian RESP may not require either form each year. Because of the penalty exposure, caution should be taken prior to filing either form. If there is any doubt whether the form is required or not, a US taxpayer should get some advice.
2. Make sure they are filed on a timely basis and correctly
If either form is required, make sure they are filed correctly and on a timely basis. We have seen penalties imposed where the forms are simply not filled out correctly. Due to the complexity of the forms, we generally recommend that people get professional assistance.
The due date for Form 3520 is April 15 of the year following the tax year. This was changed in 2015. Specifically, the language in the 2015 law is that “the due date of Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts, for calendar year filers shall be April 15 with a maximum extension for a 6-month period ending on October 15,” referring to calendar year filers generally with no distinction based on residency. Unfortunately, the 2018 instructions to Form 3520 state that taxpayers residing outside of the US have a due date of June 15 if you live outside the United States. This is not correct.
The due date of Form 3520-A is also confusing. The Form 3520-A is due March 15 of each year. To get an extension you have to file Form 7004. There is no automatic extension if you live outside the US. Further, extending the Form 1040 will not extend the Form 3520-A.
3. If filing late or penalties are imposed, send a letter explaining why
If you realize that the Form 3520/A is late, you should send a letter explaining why. You may be able to rely on the doctrine of reasonable cause to excuse the penalty or prevent the penalty from being applied. The doctrine of reasonable cause is both at once expansive but narrow. Generally, a taxpayer has reasonable cause such that penalty relief should be granted, where the taxpayer has exercised ordinary care and prudence in determining his tax obligations, but nevertheless was unable to comply with those obligations. Any reason that establishes that the taxpayer has exercised ordinary business care and prudence may be considered in making the determination. However, what the courts have actually accepted as reasonable cause is all over the map. Ignorance of the law, the classic “I didn’t know I had to file this form”, is a hard case to make.
The best case for reasonable cause you can make is reliance on a qualified tax advisor. Unfortunately, the IRS’ view echoed by some US courts, is that the deadlines remain the responsibility of the taxpayer. That means that if your accountant failed to file an extension or failed to file the form on a timely basis you can’t necessarily rely on that to excuse the penalty. Some courts have been more forgiving; others less.
Mistakes related to Form 3520 and Form 3520-A carry nasty penalties that IRS routinely imposes. Figuring out when they are required probably requires a degree in US tax. They have illogical due dates. They are brutally complicated to fill out. The IRS will only seemingly accept specific and well-documented reasons to excuse the penalty. If you find yourself with a late Form 3520 or Form 3520-A, we would suggest getting professional advice before you file it or you might wind up with a nasty IRS penalty to deal with instead.