ESTATES AND TRUSTS

January 2000

REPORTING FOREIGN TRANSFERS: RECENT DEVELOPMENTS AFFECT U.S. DONEES

By Christopher J. Byrne, CPA, Arthur Andersen LLP

In recent years, U.S. tax law has been significantly modified to track the flow of funds received by U.S. persons from non-U.S. sources. Specifically, U.S. persons (citizens, green card holders, and residents) that receive property that they treat as gifts or bequests from foreign persons or entities must now report these transfers on an annual basis. Generally, even though there is no estate or gift tax levied upon the recipient of the gift or bequest, under U.S. law failure to comply with these new rules may result in significant penalties. Furthermore, if not properly reported, an otherwise tax-free transfer could be recharacterized as taxable income.

The relevant information must be reported to the IRS annually on Form 3520. The filing deadline is the due date for the recipient's U.S. income tax return.

What are these new rules intended to address? Why does the IRS want this information? From the following examples, it will be easy to conclude that these new rules are targeted at taxable transfers from foreign sources that are incorrectly characterized as tax free for U.S. purposes. Direct Transfers from Nonresident Alien Individuals and Estates

If a U.S. person receives a gift or bequest of more than $100,000 during a calendar year from a nonresident alien (NRA) individual or estate, the receipt of this property must be reported to the IRS on Form 3520 [IRC section 6039F(a), modified by Notice 97-34, section VI]. If transfers from several sources are received, the value of the transfers from each person must be aggregated if the recipient knows (or has reason to know) that the donors are related or are acting together. Once the $100,000 threshold has been met the recipient must separately identify each gift in excess of $5,000.

In the case of reportable transfers from NRA individuals or estates, the recipient is required to report the date of the transfer, a description of the property received, and the value of the property. The recipient is not required to disclose the identification of the donor on Form 3520; however, she may be required to provide additional information, including the identity of the donor, upon request.

Consider the following example:

Facts: Mr. and Mrs. Jones are non-U.S. persons. Their son has been living and working in the United States for the past several years with an L-1 visa. Mrs. Jones made a $60,000 gift of cash from her personal account at a non-U.S. bank during 1999 so that her son could buy a new home. Mr. Jones made a similar gift of $50,000.

Analysis: In this case, because Mr. and Mrs. Jones are considered related persons, the two gifts must be aggregated, resulting in reportable transfers exceeding $100,000. The son must report the date he received each gift, a description of the property received, and the fair market value of the property. He is not required to report any specific information about his parents. This reporting is required even if the money is transferred from the parents' non-U.S. accounts to the son's non-U.S. account.

A reportable gift to a U.S. person does not include certain amounts paid on behalf of that person to educational institutions for tuition or to health care providers for medical services [IRC section 6039F(b)]. If a gift from an NRA is expected for payment of any of these types of expenses during the calendar year, the reporting requirements may be circumvented by having the donor make the transfer directly to the educational institution or health care provider.

In the above example, the gift is a direct gift of non-U.S. property from NRA individuals. Accordingly, there are no U.S. income tax consequences to the son as a result of this transfer. If, however, the transfer was actually received from a foreign estate, a determination of the U.S. income tax consequences would require further analysis.

Consider the following example:

Facts: Mrs. Smith, a non-U.S. person, died in January 1999. Her estate consists of foreign marketable securities that generated dividends during 1999. In her last will and testament she provided for a specific bequest of $150,000 for her son, a U.S. person. The remainder of her estate, (after expenses) will pass to several individuals that live outside the United States. In December 1999, the estate transfers $150,000 to the son in full satisfaction of the bequest.

Analysis: The son must first determine whether or not he has received a "bequest" from his mother's estate. Under U.S. law, a bequest is generally defined as a specific sum of money or property paid to the beneficiary all at once or in no more than three installments [IRC section 663(a)(1)]. This direction could be accomplished pursuant to the decedent's last will and testament or local law.

In this fact pattern, the son inherited a specific sum of money pursuant to the terms of his mother's last will and testament. The property was paid all at once and therefore qualifies as a specific bequest. Because the bequest exceeds the $100,000 threshold, it is a reportable transfer. The son must report the date he received the bequest, a description of the property received, and the fair market value of the property. The bequest is not subject to U.S. income tax. The son is not required to report any specific information about his mother's estate; however, additional information may be requested at a later time.

Caution: Classification as a bequest is generally desired because it allows non-U.S. property to pass to the U.S. recipient without U.S. income tax consequences. This often leads to many incorrect classifications. Because of the complex nature of this area of the law, a detailed analysis of the decedent's last will and testament (or the local law where the decedent resided) will be necessary to make an accurate determination of the tax consequences.

The reporting requirements for transfers that are treated as gifts and bequests from NRA individuals or estates are effective for transfers after August 20, 1996. Reportable transfers from prior years that have not yet been reported may be assessed a penalty. However, no penalty will be imposed if the recipient can demonstrate that the failure to comply was due to reasonable cause and not willful neglect. Failure to comply may result in a penalty of five percent of the value of the property transferred for each month of noncompliance (to a maximum of 25%). In cases of noncompliance, the IRS is also authorized by statute to determine the treatment of the gift. This could result in an otherwise tax-free gift or bequest being reclassified as taxable income [IRC 6039 F(c)].

Gifts from Foreign Trusts

Suppose that instead of receiving a transfer of foreign property outright from an NRA individual or estate, the U.S. person received a transfer from an offshore (non-U.S.) trust previously established by an NRA. In this case, the reporting obligation applies to any transfer from the trust without regard to an annual threshold amount. The reporting obligations apply to transfers from foreign trusts made after August 20, 1996 [IRC section 6048(c); modified by Notice 97-34, section V].

Consider the following example:

Facts: Mr. and Mrs. Johnson, non-U.S. persons, create a trust in the Cayman Islands for the benefit of their children. All of their children are non-U.S. persons except their son, who lives in the United States on an L-1 visa. Mrs. Johnson wishes to help her son with the down payment on a home. During 1999, she directed the trustee to wire transfer $25,000 from the offshore trust account to her son's bank account in the United States.

Analysis: The son is required to report the date and amount of the trust distribution and to provide a description of the property (in this case, currency) on Form 3520 for the year of the transfer. In the case of distributions from foreign trusts, all distributions must be reported, irrespective of the amounts involved and irrespective of the fact that the distribution does not create any gift or estate tax liability (See below for a discussion of the income tax consequences). The term "distribution" means any gratuitous transfer from a trust and includes gifts, bequests, and even, in some instances, loans from a foreign trust. If you contributed property to the trust in exchange for the distribution, this must also be reported.

If a distribution is received from more than one offshore trust, a separate Form 3520 must be filed for each trust. As in the case of foreign gifts and bequests, compliance with the information reporting requirements is important. The penalty for noncompliance is 35% of the value of the property in question [IRC section 6677(a)]. Additional penalties may be assessed in the case of continued noncompliance. The date of distribution, a description of the property, and the value on the date of transfer must be reported. In the case of distributions from foreign trusts, certain details about the trust must also be disclosed, to the extent this information is available to the beneficiary.

It is important to note that the term "distribution" is quite broad. In some instances, a loan from a foreign trust will be considered a distribution (IRC section 643i; Notice 97-34 section V, A). Furthermore, indirect distributions must also be reported. For example, if an offshore trustee pays credit card charges incurred by a U.S. person, this payment would be considered a reportable indirect transfer. The same would apply for checks written on a foreign trust's bank account.

The U.S. income tax consequences to the U.S. recipient of a foreign trust are often difficult to ascertain. The taxation issues facing the U.S. beneficiary will depend upon the terms of the trust.

The first step is to distinguish between "grantor" and "nongrantor" trust status. A grantor trust is a trust whose assets and income are considered to be owned by another person, usually the grantor (or settlor). Since the income is deemed owned by the grantor, a distribution to a U.S. person is treated as a tax-free gift from the grantor to the beneficiary.

A nongrantor trust is a trust that is not owned by an individual but is instead viewed as a taxable entity. When a distribution is made to a U.S. person, it is likely that the distribution will be taxable to the U.S. beneficiary. However, the actual tax consequences will require a detailed analysis of the terms of the trust, as well as the financial history of the trust investments.

Consider the following example:

Facts: Mr. and Mrs. Adams are non-U.S. persons. They have several children that live in various countries around the world. Mr. and Mrs. Adams established a trust several years ago in the Cayman Islands as a way to manage their international investments. They retain the right to revoke the trust during their lifetime. After their deaths, the trust will stay in existence for several generations and be administered for the benefit of their lineal descendents. The trust currently has $1 million in corpus and accumulated interest and dividends of $300,000. In 1999, Mrs. Adams directs the trustee to make a $50,000 distribution to their son (a U.S. resident).

Analysis: The power to revoke the trust retained gives it grantor trust status. As a grantor trust, all corpus and income is deemed owned by Mr. and Mrs. Adams. Any distribution to the son is a reportable transfer, but there are no U.S. income tax consequences to him.

After the deaths of Mr. and Mrs. Adams, the status of the trust will change to nongrantor. Any income earned by an offshore nongrantor trust that is distributed to a U.S. person will be taxed to that person. If the trust is used to accumulate income in one year and distribute it to a U.S. person in a subsequent year, the distribution will be taxed in an unfavorable manner.

The rules governing the U.S. taxation of an offshore trust are complex. Due care should be exercised in this area.

Gifts from Foreign Corporations or Partnerships

Some U.S. individuals receive transfers from foreign corporations and foreign partnerships, even though they do not have any ownership interest in the entities. Information reports must be filed for property received from a foreign corporation or foreign partnership and treated as a gift (Notice 97-34, section VI, B, 2). The threshold for these transfers is $10,735 for calendar year 1999, adjusted annually for inflation. The threshold was $10,000 for 1996, $10,276 for 1997, and $10,557 for 1998. Gifts from more than one foreign corporation or partnership must be aggregated to determine whether the threshold has been met if the taxpayer knows or has reason to believe that the transfers are related.

Under current U.S. law, when a gift is made directly from a foreign corporation to a nonshareholder, such a transfer will be treated as taxable income for U.S. income tax purposes [Final Regulations section 1, 672(f)-4]. Furthermore, the amount of information that must be disclosed on the information report is expanded.

Consider the following example:

Facts: Ms. Lee is an NRA residing in a tax-free jurisdiction. Her son is a resident of the United States. Ms. Lee owns 100% of the shares of XYZ Corporation, a Cayman Islands corporation that she uses to manage her passive investments. During 1999, intending to make a gift to her son, she transferred $15,000 from the XYZ Corporation's bank account to his account in the United States.

Analysis: The son is required to file a Form 3520 for 1999. Furthermore, since the transfer was made directly to him from a foreign corporation, it is likely that the entire amount will be taxed as ordinary income to the son.

The son will not only be required to disclose the date, amount, and description of the property received, but he will also be required to disclose the name and address of the donor entity as well as its status as a corporation or partnership and its identification number (if any). If this information is not provided, the form may be considered incomplete, leaving the son exposed to possible penalties.

If Ms. Lee, an actual shareholder in the corporation, first took a corporate distribution in her name and subsequently made a direct gift to her son, the transfer would be deemed a gift from an individual (not a foreign corporation). As such, it would be under the $100,000 reporting threshold and would also retain its tax-free characteristic. *