Corporate Taxation | Tax Stringer

Reporting Foreign Assets and Activities: Requirements and Challenges

Complex annual U.S. federal information reporting requirements apply to U.S. citizens and resident aliens who own foreign assets or engage in cross-border activities. These U.S. taxpayers and their tax advisors must be proactive in identifying their foreign assets or transactions and understanding the reporting requirements that may apply. Failure to timely submit accurately completed information returns to the IRS can result in harsh consequences, including significant monetary penalties, extension of the general three-year statute of limitations for the IRS to assess additional tax with respect to the related U.S. federal tax return under Section 6501 (c)(8), or in certain circumstances, criminal penalties and imprisonment.  

The following discussion summarizes reporting requirements that may apply to U.S. citizens and resident aliens with foreign assets or cross-border activities. 

Transfers of Property to Foreign Corporations

Generally, U.S. citizens and resident aliens must file Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation, as required by Section 6038B, with their U.S. federal income tax returns to report transfers of property to a foreign corporation in nonrecognition transactions under Sections 332, 351, 354, 355, 356, and 361. Transfers of cash to a foreign corporation also must be reported on Form 926 if (1) immediately after the transfer, a U.S. citizen or resident alien directly, indirectly, or constructively [under Section 318(a), as modified by Section 6038(e)(2)] owns 10% or more of the total vote or value of the foreign corporation; or (2) the amount of cash transferred to the foreign corporation during the 12-month period ending on the date of the transfer exceeds $100,000. Spouses may file a joint Form 926 if they file a joint U.S. federal income tax return. The IRS may impose a penalty equal to 10% of the fair market value of property transferred (capped at $100,000) for failure to timely file an accurate Form 926. A penalty may be imposed for each late or inaccurate Form 926 required for each tax year.

Foreign Trusts and Foreign Gifts

U.S. grantors or beneficiaries of foreign trusts are required under Section 6048 to file Form 3520-A, Annual Information Return of Foreign Trust with U.S. Owner, and/or Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, to report:

  • Ownership of a foreign trust under Sections 671-679;
  • Transfers of property to the trust; and
  • Distributions from the trust. 

Additionally, they must report gifts or bequests from foreign persons on Form 3520 under Section 6039F as follows:

  • Gifts or bequests from a nonresident alien or foreign estate exceeding $100,000; and
  • Gifts from foreign corporations or partnerships exceeding $18,567 (2023 figure, IRS Revenue Procedure 2022-38).  

The IRS intensified scrutiny of Forms 3520-A and Forms 3520 following its May 21, 2018, announcement of a campaign focusing on these forms. The IRS has retired the official campaign but continues to impose penalties for late or inaccurate Forms 3520-A and Forms 3520 pursuant to procedures in the IRS Penalty Handbook.

Form 3520-A is due for calendar-year trusts on March 15; a six-month extension to September 15 may be requested for calendar-year trusts by filing Form 7004, Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns, on or before March 15. Both Form 3520-A and Form 7004 must include the foreign trust's employer identification number, which may be obtained by phone with a Form SS-4, Application for Employer Identification Number (EIN). 

If Form 3520-A is not submitted by the original or extended due date, it will be treated as timely filed if submitted as a “substitute Form 3250-A” with the U.S. owner’s timely filed Form 3520. A U.S. citizen or resident alien required to file Form 3520 to report foreign trust ownership, transfers to such a trust, distributions from the trust or foreign gifts or bequests generally must submit the form by April 15 of the tax year following the end of the individual’s prior tax year. Individuals may extend the Form 3520 due date to October 15 by filing Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return, on or before April 15. Both Form 3520-A and Form 3520 are filed separately from an individual’s tax return and at a different IRS location. 

With respect to failure to report foreign trust ownership on Form 3520-A and Form 3520, Section 6677(b) allows the IRS to assess two separate penalties against the U.S. owner of up to 5% of the U.S. owner’s portion of the foreign trust (with a minimum penalty of $10,000) for each missed form for each year they are required. However, the IRS indicates in Internal Revenue Manual Section 20.1.9.13.4(3) that it will pursue only one penalty for each tax year, imposing a penalty for failure to file Form 3520-A rather than Form 3520. Because Form 3520 is used to satisfy four different reporting requirements, other penalties may apply if a U.S. person fails to file Form 3520 for one tax year. Section 6677 provides separate penalties of up to 35% of a contribution to a foreign trust or 35% of a distribution from such a trust (both with a minimum penalty of $10,000) for failure to report foreign trust contributions or distributions on Form 3520. Additionally, Section 6039F imposes a penalty of up to 25% of the value of a gift or bequest from a foreign person that is not timely and accurately reported on Form 3520 as required for the tax year in which the gift or bequest is received.

The IRS has provided limited guidance on specific foreign arrangements it views as foreign trusts; for example, certain Liechtenstein stiftungs (foundations) are treated as trusts (AM-2009-012), whereas certain Mexican land trusts are not (Revenue Ruling 2013-14). A foreign tax-free savings account, retirement plan, or entity may be treated as a foreign trust for U.S. federal tax purposes, and require reporting, regardless of its treatment under foreign law. The IRS provides Form 3520-A and Form 3520 filing exemptions for a narrow range of foreign arrangements, such as Canadian retirement plans under IRS Revenue Procedure 2014-55 and certain foreign tax-favored retirement and non-retirement savings trusts under IRS Revenue Procedure 2020-17. Careful attention should be paid to the forms’ annual instructions, where the IRS may update requirements.

Controlled Foreign Corporations/Acquisitions and Dispositions of Foreign Stock

Ownership of a foreign corporation may result in a Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations, filing requirement if a U.S. citizen or resident alien falls within one or more of the five main categories of U.S. persons required to file. With respect to individual filers, categories 1 and 5 generally require disclosure of information about a foreign corporation when the individual, with other U.S. persons, controls the corporation (defined as owning more than 50% of the vote or value). Category 4 requires information about a foreign corporation if the filer, alone, controls the corporation. Category 2 filers are U.S. officers or directors of a foreign corporation who must report information relating to a U.S. person’s acquisition of the corporation’s stock. Category 3 filers generally are U.S. persons required to report their own acquisition or disposition of stock of a foreign corporation.  The Form 5471 instructions provide a detailed summary of the filing criteria for each of the five filing categories and the information required. 

For purposes of each of the five filing categories, the requisite percentage of stock ownership triggering the reporting requirement is determined by factoring in direct, indirect and constructive ownership.  Category 1 and 5 filers apply the rules in Section 318(a), as modified by Section 958. Category 4 filers apply the rules in Section 318(a), as modified by Section 6038(e). U.S. citizen and resident alien category 1, 4 and 5 filers can be attributed stock ownership from family members (spouse, parents, children and grandchildren), corporations, estates, partnerships and trusts. However, attribution from nonresident alien family members applies for category 4 but not categories 1 and 5. For category 2 and 3 filers, attribution rules under Section 6046 apply.

In contrast to category 1, 4 and 5 filers, category 2 and 3 individual filers are attributed ownership from a broader range of family members and narrower range of entities. Notably, category 2 and 3 filers are attributed ownership from siblings, as well as spouses, ancestors (grandparents, parents) and lineal descendants (children, grandchildren). Category 2 and 3 filers who own foreign corporations or partnerships with underlying foreign corporations are treated as owning their proportionate share of the stock of those underlying corporations’ stock. Attribution from other entities does not apply.

A filer may fall under more than one Form 5471 filing category with respect to a foreign corporation. The IRS may impose a $10,000 penalty for each required Form 5471 for each tax year an accurate form is not timely filed. The Form 5471 must be filed with the individual’s U.S. federal income tax return.   

Foreign-owned U.S. Corporations or Disregarded Entities/Foreign Corporation with U.S. Trade or Business

While Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, applies to corporations (or disregarded entities treated as corporations), U.S. citizens and resident aliens who own interests in such entities, notably closely held ones, should be aware of Form 5472. Section 6038A requires that a “reporting corporation” disclose any “reportable transaction” with a foreign or domestic “related party,” which is stated on Form 5472. 

A reporting corporation includes:

  • A U.S. corporation that is at least 25%-owned by foreign persons;

  • A foreign-owned U.S. disregarded entity (U.S. DRE); and

  • A foreign corporation with a U.S. trade or business.

Reportable transactions include:

  • Transactions listed in Part IV of Form 5472 for which monetary consideration (including U.S. and foreign currency) was the sole consideration paid or received, such as sales and rents);

  • Transactions listed in Part V; and

  • Any transaction or group of transactions listed in Part VI. 

A related party includes:

A related person does not include any corporation filing a consolidated U.S. federal income tax return with the reporting corporation.

Generally, Form 5472 is filed with the corporation’s U.S. federal income tax return. In the case of a foreign-owned U.S. DRE, special filing procedures apply, as discussed in the Form 5472 instructions. Failure to timely file Form 5472 can result in the imposition of a $25,000 penalty for each required form for each tax year.

Passive Foreign Investment Companies

U.S. citizens and resident aliens who directly or indirectly own passive foreign investment companies (PFICs) must file Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, with their U.S. federal income tax returns each year to report ownership of each PFIC and any distributions from the PFIC, as well as make any election relating to the PFIC and report income resulting from such an election.

A foreign corporation is a PFIC if either (1) 75% or more of its gross income for the taxable year is passive income (e.g., interests, dividends, and royalties— the “income test”) or (2) the average percentage of assets held by such corporation during the taxable year, which produce passive income or which are held for the production of passive income, is at least 50% (the “asset test”). PFIC status, once acquired, cannot be lost in subsequent years even if the foreign corporation no longer satisfies the income test or the asset test. Examples of foreign corporations that may be treated as PFICs include, but are not limited to, foreign mutual funds and private holding companies. 

The PFIC rules provide a punitive tax regime intended to discourage U.S. persons from investing in offshore structures to defer U.S. federal income tax on investment income (such as interest, dividends, and royalties) earned outside of the United States. The default PFIC “excess distribution” tax regime under Section 1291 applies unless a U.S. person files a timely Form 8621 with the relevant tax return to make an election for the first year the PFIC investment was made to annually treat the PFIC as a “qualified electing fund” (QEF) under Section 1295 or to apply the “mark-to-market” (MTM) rules under Section 1296. The excess distribution regime results in U.S. federal income taxation of U.S. citizens and resident aliens at the highest ordinary income rates (current maximum, 37%) on distributions from PFICs and gains from the sale of PFIC stock, rather than at the lower preferential rates (current maximum, 20%). An interest charge is also imposed based generally on how long the individual has held the PFIC stock.

The QEF election enables a U.S. person to include annually in gross income for U.S. federal income tax purposes the U.S. person’s pro rata share of the PFIC’s ordinary earnings and net capital gain, which must be provided to the U.S. person annually by the foreign corporation. The MTM election allows a U.S. person to include in gross income the excess of the fair market value of the foreign corporation’s stock at the close of a tax year over its adjusted basis.

Although a monetary penalty does not apply for the late filing of Form 8621, a significant consequence of the failure to timely file Form 8621 for the first year of PFIC ownership is the inability to apply the QEF or MTM election from that year forward. Limited relief is available for making a retroactive QEF or MTM election as provided in Treas. Reg. § 1.1295-3 and Treas. Reg. § 1.1296-1, respectively. A prospective QEF or MTM election may be made, but U.S. federal income tax under the default excess distribution regime may be required for the tax year a QEF or MTM election is made as part of the process of removing a PFIC from the default regime to the QEF or MTM regime.

Foreign Partnerships/Transfers/Acquisitions and Dispositions of Partnership Interests

Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships, is the analogue to Form 5471 for reporting ownership of a foreign partnership and acquisitions or dispositions of such interests. A U.S. citizen or resident alien must file Form 8865 with their U.S. federal income tax return if the individual falls within one or more of the four categories of U.S. persons required to file with respect to a foreign partnership. Category 1 requires information about a foreign partnership if a U.S. person, alone, controls the partnership, that is, has more than a 50% interest in the foreign partnership’s capital, profits, deductions or losses at any time during the partnership’s tax year. A category 2 filer reports information regarding the partnership if the filer, with other U.S. persons, controls the partnership. Category 3 filers provide information regarding transfers of property or cash to a foreign partnership. Category 4 requires information relating to a U.S. person’s acquisition or disposition of interests in a foreign partnership.

For purposes of categories 1 through 3, the requisite percentage of ownership interest generating each of the Form 8865 reporting requirements is determined by factoring in direct, indirect and constructive ownership [applying Section 267(c), except (c)(3), as modified by Section 6038(e)]. With respect to category 4, ownership must be direct to trigger the reporting requirement. A $10,000 penalty may apply for a late or inaccurate Form 8865 requiring information under category 1, 2 or 4. A penalty equal to 10% of the fair market value of the transferred property (capped at $100,000) may apply for a late or inaccurate Form 8865 requiring information under category 3.

Foreign Disregarded Entities/Foreign Branches

A U.S. citizen or resident alien files Form 8858, Information Return of U.S. Persons With Respect to Foreign Disregarded Entities (FDEs) and Foreign Branches (FBs), to report information related to an FDE or FB if the individual falls within certain parameters. Notably, an individual is required to file Form 8858 if the individual:

  • Is a tax owner of an FDE or operates an FB at any time during the individual’s tax year;
  • Directly (or indirectly through a tier of FDEs or partnerships) is a tax owner of an FDE or operates an FB; 
  • Files Form 5471, under category 4 or 5, with respect to a controlled foreign corporation (CFC) that is a tax owner of an FDE or operates an FB during any time during the CFC’s annual accounting period; or
  • Files Form 8865, under category 1 or 2, with respect to a controlled foreign partnership (CFP) that is a tax owner of an FDE or operates an FB during any time during the CFP’s annual accounting period. 

A “tax owner” of an FDE is the person treated as owning the assets and liabilities of the FDE for purposes of U.S. income tax law.

Generally, Form 8858 is filed with an individual’s U.S. federal income tax return. Form 5471 and Form 8865 filers are required to attach Form 8858 to their Form 5471 or Form 8865, respectively. A specific monetary penalty is not imposed for failure to timely file an accurate Form 8858. However, Form 5471 and Form 8865 filers who are also required to file Form 8858 may be subject to a $10,000 penalty for failure to file Form 8858 as discussed in its instructions. 

Foreign Financial Accounts and Assets

FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), is filed to report foreign financial accounts over which a U.S. person has signature authority or in which the U.S. person has a “financial interest” if the aggregate value of all accounts exceeds $10,000 at any time during a calendar year. A U.S. citizen or resident alien has a financial interest in a foreign financial account if the individual is the owner of record, has legal title over the account if held for the individual’s or another person’s benefit or owns entities that in turn own the accounts as provided in 31 C.F.R. § 1010.350 (e.g., the individual owns more than 50% of the voting power or the total value of the shares of the corporation that owns the account). Examples of foreign financial accounts that may require reporting include, but are not limited to, foreign mutual funds, life insurance with cash value and foreign retirement accounts.

While the IRS enforces compliance with the FBAR, the form itself is filed with the Financial Crimes Enforcement Network within the U.S. Department of the Treasury. The FBAR is generally due April 15 for the prior calendar year being reported. Filers receive an automatic extension to October 15 without the need to request it, as explained in IRS Publication 5569, Report of Foreign Bank & Financial Accounts (FBAR) Reference Guide.

For individuals, failure to timely file the FBAR can result in a civil penalty of up to $14,489 for a non-willful violation, as provided by 31 U.S.C. § 5321(a)(5)(B) and 31 C.F.R. § 1010.821. A case pending before the U.S. Supreme Court — Bittner v. United States, No. 21-1195 —involves whether the penalty for a non-willful violation applies for each account that is not timely reported on an FBAR or for each FBAR that is not timely filed to report all the accounts. A willful violation can trigger a civil penalty of up to 50% of the amount in the account at the time of the violation under 31 U.S.C. § 5321(a)(5)(C). Criminal penalties and imprisonment for knowingly and willfully filing a false FBAR and other violations also may apply, as summarized in IRS Publication 5569.

Foreign financial accounts are also “specified foreign financial assets” (SFFAs) under Section 6038D and must be reported on Form 8938, Disclosure of specified foreign financial assets (SFFA), if certain criteria apply. In contrast to the FBAR reporting requirements, the Form 8938 reporting requirement encompasses a broader variety of foreign assets (not limited to accounts). For purposes of Form 8938, SFFAs include, but are not limited to, foreign accounts, stocks, partnership interests, pension plans and certain interests in trusts. 

Generally, U.S. persons must file Form 8938 with their U.S. federal income tax returns for a tax year if the value of their SFFAs exceeds $50,000 on the last day of the tax year, or $75,000 at any time during the tax year. For individuals, different asset values trigger a Form 8938 filing requirement, depending on their return filing status (e.g., single vs. married, filing joint) and whether they reside in or outside the United States as summarized in the Form 8938 instructions. An individual is not required to file a Form 8938 for a tax year if not required to file a U.S. federal income tax return for that year. With respect to an SFFA reported on Form 3520-A, Form 3520, Form 5471, Form 8621 or Form 8865, a taxpayer need only indicate on Form 8938 that one of those forms was filed. The IRS may impose a $10,000 penalty for each failure to timely file an accurate Form 8938.

Compliance Options and Penalty Relief

The IRS Streamlined Filing Compliance Procedures offer eligible U.S. citizens and resident aliens two pathways for submitting delinquent or amended U.S. federal income tax returns and information returns without incurring the monetary penalties that normally would apply. The Streamlined Foreign Offshore (SFO) procedures provide eligible individuals residing outside the United States the opportunity to file delinquent returns and information returns without paying any penalties. The Streamlined Domestic Offshore (SDO) procedures provide eligible individuals residing in the United States a process for submitting amended returns and delinquent information returns with the payment of a 5% miscellaneous offshore penalty rather than the potentially higher penalties that would apply outside of SDO. 

The Delinquent International Information Return Submission Procedures (DIIRSP) provide a process for filing late information returns with a “reasonable cause statement.” However, the DIIRSP is not a particularly useful option, because the IRS acknowledges that it may assess late filing penalties without reviewing reasonable cause statements, which may require taxpayers to resubmit statements and respond to IRS correspondence. The Delinquent FBAR Submission Procedures allow eligible individuals to file late FBARs without the imposition of penalties. If the IRS has already assessed a penalty for failure to timely file a particular form, an individual’s general remedy is to request abatement of the penalty if there was reasonable cause for the failure to file, as discussed in the IRS Penalty Handbook. The IRS First Time Abate procedures described in Internal Revenue Manual Section 20.1.1.3.3.2.1 do not provide individuals relief for penalties assessed for failure to timely file the information returns discussed above. It is critical to respond to a penalty notice within the period provided in the notice to avoid the imposition of continuation penalties.

Conclusion

Given the potential risks posed by the failure to timely file any of the forms discussed and the limited relief available, taxpayers and their tax advisors must be vigilant in ensuring reporting requirements are timely satisfied.

Rosy L. Lor is a managing director in the National Tax Office, Private Client Services, of BDO USA, LLP. She also has served as a senior technical reviewer in the IRS Office of Associate Chief Counsel (International).  She can be reached at  rlor@bdo.com or 443.471.2063.