Many U.S. taxpayers have established offshore trusts for asset and lifestyle protection reasons. Generally, offshore asset protection trusts (APTs) are set up to be “tax neutral,” such that the settlor pays a fixed amount of income tax on the income earned inside the APT. Often, these trusts contain assets such as boats, planes, and other luxury items, including substantial cash and securities. The trustee of an APT can make the APT assets available for use or loan to U.S. persons not otherwise designated as beneficiaries of the trust.
Despite contrary beliefs, going offshore is legal so long as you inform the IRS about your offshore planning and transactions. Thus, U.S. taxpayers who establish a foreign trust for asset protection purposes know that there are certain prescribed tax reporting requirements. Failure to file specific returns can result in draconian civil and criminal penalties. In an attempt to reign in the tax abuses of using offshore structures to evade income taxes, President Obama recently signed into law the Hiring Incentives to Restore Employment (HIRE) Act, which contains some important changes to existing law regarding foreign trusts and who must file these reports.
The HIRE Act has expanded the definition of a “distribution” and created a new class of persons who will be deemed “U.S. Beneficiaries of a Foreign Trust” and therefore must comply with certain reporting requirements. This new law will effectively ensnare persons not otherwise thought to be required to file the mandatory forms, subjecting these unknowing persons to significant penalties.
Specifically, the HIRE Act amended IRC section 643(i)’s guidelines involving loans made by foreign trusts to U.S. persons and the use of trust property by U.S. persons. Now, except as provided in IRS regulations, loans to a U.S. person grantor or beneficiary or a “related” U.S. person are treated as trust distributions. In addition, such U.S. persons who merely “use” trust property without compensating the trust for the fair market value of the use will be deemed to have received a distribution from the trust. Each of these “distributions” must be reported to the IRS.
The HIRE Act has also broadened the definition of a U.S. beneficiary under IRC section 679(c). Where a U.S. person receives a loan of cash or marketable securities, or the use of property held in a foreign trust, and does not pay the trust the market rate of interest for the loan, nor the fair market value of the use of such property within a reasonable period of time, the recipient will now be deemed a U.S. beneficiary of that foreign trust. Such a result exists regardless of whether the trust’s terms designate that person as a beneficiary.
Once a U.S. person is deemed to have received a distribution from a foreign trust and thus considered a U.S. beneficiary, the trustee of the trust and the U.S. beneficiary are required to file certain forms with the U.S. Treasury, namely, forms 3520 (the U.S. beneficiary) and 3520-A (the trustee, if the trust is treated as having a “U.S. owner” for U.S. income tax purposes).
A failure to file or to report all distributions will result in a penalty of up to the greater of $10,000 or 35% of the distribution (Form 3520) along with 5% of the gross value of the portion of the trust’s assets considered to be owned by the U.S. person (Form 3520-A). Furthermore, U.S. owners must now be mindful to include the uncompensated use of the trust’s assets in his or her income for the tax year.
The HIRE Act will affect U.S. persons unaware of its application until the dates for the tax compliance have lapsed, leaving that person with substantial civil and possibly criminal sanctions. If you have a foreign trust and your situation happens to fit the fact pattern described above, be sure to consult with your tax preparer or other qualified professional without delay.
For more information about any of the information discussed in this Client Alert, or any other income or estate tax planning or asset protection planning assistance, please contact Jeffrey M. Verdon Law Group, LLP at firstname.lastname@example.org or (800) 521-0464.