The IRS issued proposed foreign trust regulations on May 7, 2024, which offer certain taxpayers additional relief from burdensome foreign pension reporting requirements. But they don’t come without risk.
On the positive side, if you have an interest in a foreign pension, and your foreign pension(s) meet certain criteria, you may:
- Be able to skip annual in-depth reporting of your foreign pension details on IRS Forms 3520 and 3520-A, sparing you from the annual headaches of gathering difficult-to-obtain information, as well as from the hefty tax preparation costs related to annual filings. This could result in thousands of dollars’ worth of savings per year.
On the negative side, taking advantage of the relief in the proposed regulations carries risks:
- The proposed regulations do not bear the force of law, yet opting to use them locks you in to certain positions.
- The proposed regulations are subject to change or revocation by political parties or figures who do not agree with their provisions.
- Changes in your pension balances may mean your pensions qualify for relief one year but not the next, and the proposed regulations are silent as to how to handle the intervening periods.
- If you need to resume reporting (either because the regulations are revoked or superseded, or because your pension no longer falls within the value limits), it is unclear whether you will need to go back and reconstruct data and calculations for the intervening periods and possibly be left to fight the typical $10,000 penalties that Forms 3520 and 3520-A carry for failure to file (or for late or incomplete filing).
In this blog post, we will delve into these matters to give you a better understanding of the proposed changes to the US classification, reporting, and taxation of foreign pensions in the context of the proposed foreign trust regulations.
Background on Foreign Pension Reporting and Earlier Relief
If you have an interest in a foreign pension, the US tax treatments and reporting requirements are burdensome (even if you don’t currently receive distributions). For an explanation of why this is the case, see Part 1 of our August 2020 blog post series on US Taxpayers with Pensions and Retirement Accounts outside the US.
In March 2020, the IRS issued Revenue Procedure 2020-17, which offered rare relief to taxpayers whose foreign pensions met certain requirements. It was the first attempt by the IRS to provide relief to taxpayers who had to file Forms 3520 and 3520-A to report certain foreign pensions (not just a specific pension or pensions in a singular foreign country – see Rev. Proc. 2014-55). See Part 2 of our August 2020 blog post series on foreign pensions, Do Your Foreign Retirement Accounts Qualify for Better US Tax Treatment?
Although Rev. Proc. 2020-17 offered relief, it also generated confusion. In addition, the IRS later clarified that its scope was narrower than taxpayers and practitioners understood.
The Proposed Foreign Trust Regulations Issued in 2024 Give Taxpayers More Options
On May 7, 2024, the IRS issued proposed foreign trust regulations, which clarified and expanded the relief available to taxpayers with an interest in foreign pensions reported on Forms 3520 and 3520-A.
The IRS received a high volume of comments (1,575 comments) on the regulations, and a public hearing was conducted on August 21, 2024.
Taxpayers now have the option of following the proposed regulations (and skipping Forms 3520 and 3520-A, if they qualify), beginning with 2024 tax year. Since preparation of these forms is burdensome, both to gather the requisite information and to complete the forms, opting out of filing is very attractive. It may indeed be a good option for some filers, saving significant time and compliance costs. As outlined above, however, this approach also carries risks. The position to take depends largely on your risk tolerance.
Below, we outline the nature of the new regulations, what they entail, and other factors to consider when weighing your options.
Implications of Proposed Regulations (vs. Final Regulations)
First, it is important to understand the differences between proposed and final regulations.
Proposed regulations are not legally binding. They are draft rules or guidelines in an attempt by the IRS to clarify, interpret, and implement the Internal Revenue Code (IRC). They are open to the general public for feedback.
Final regulations are legally binding and carry the force of law. They are definitive guidance (although they may be subject to new legal challenges under the Administrative Procedures Act and the Loper Bright Supreme Court case). They must be published in the Federal Register. In some cases, final regulations can apply retroactively, they are typically prospective.
One important item to note is that taxpayers can rely on proposed regulations until they become final regulations. The reliance must be in total. This means that taxpayers cannot cherry-pick sections in the proposed regulations that help their tax position while ignoring other sections that they find burdensome, inefficient, or unhelpful to their tax position.
Furthermore, once a taxpayer takes a position on a tax return to rely on a proposed regulation, the taxpayer must continue to do so on all future tax returns until the final regulations come into effect. This aspect is particularly important to understand as, on January 20, 2025, the US President issued a “Regulatory Freeze Pending Review.” This is an Executive Order to all executive departments and agencies instructing them not propose or issue any new rules or regulations. Therefore, it is unknown how long it will be before the IRS will be able to work on and issue final regulations.
How the Proposed Foreign Trust Regulations Affect Prior IRS Guidance on Foreign Pension Reporting (Rev. Proc. 2020-17)
Prior IRS Guidance under Rev. Proc. 2020-17
When Rev. Proc. 2020-17, Section 5.03 – “Tax-Favored Foreign Retirement Trust” was released in 2020, it outlined a series of requirements that foreign pensions must meet to be considered “tax-favored.” The Rev. Proc. offered relief to taxpayers who hold an interest in foreign pensions that meet these qualifications, waiving the taxpayer’s requirement to file IRS Forms 3520 and 3520-A (as well as other tie-in international informational returns).
Instead of filing Forms 3520 and 3520-A, the taxpayer would be subject to the less extensive reporting requirements that apply to foreign pensions categorized as IRC 402(b) pensions under US tax law, namely reporting on FinCEN Form 114 (FBAR) and IRS Form 8938, Part VI. Note that taxpayers must take great care to note potential income inclusions of employer contributions and earnings/accretions (assuming no tax treaty relief is available).
Rev. Proc. 2020-17, Section 5.03(4) specifically outlined two potential requirements to qualify for this relief:
- First, the foreign jurisdiction must have rules that limit the amount of the annual contributions to $50,000 USD or less.
- Second, the foreign jurisdiction must have rules that limit the lifetime amount of contributions to $1,000,000 or less.
Many taxpayers (and tax practitioners) misinterpreted this guidance to be a “value threshold.” Their understanding was that if the taxpayer’s actual contributions and pension values were below these amounts, they could qualify for the relief provisions and cease reporting on Forms 3520/3520-A.
The IRS later clarified these amounts were not a “value threshold” but instead depended on the contribution limits imposed by the type of pension plan in the foreign jurisdiction.
Updates Made in the Proposed Regulations
Due to the confusion and the numerous comments made over the years since Rev. Proc. 2020-17 was issued, when the IRS issued the proposed foreign trust regulations, they included the following updates:
- Section 5.03(4) now includes a value threshold.
- The value threshold is $600,000 USD.
- The value threshold is based on the total aggregate value of all foreign pensions in the foreign trust’s jurisdiction.
- The value threshold is calculated using the US Treasury Bureau of Fiscal Service foreign currency conversion rate on July 1 of the tax year.
- Taxpayers need only meet the value threshold for the foreign pension(s) to be classified as tax-favored foreign retirement trusts (assuming all other points of Section 5.03(4) are met).
- Reliance on the proposed regulations is limited to tax years 2024 and any future years until the final regulations are released (i.e., this update to Rev. Proc. 2020-17 cannot be used for retroactive compliance).
Example 1
Taxpayer A is a US citizen living and residing in Foreign Country 1 (FC1). FC1 does not have an income tax treaty with the US. Taxpayer A’s filing status is single. Taxpayer A has three pensions in FC1. Taxpayer A sought tax consulting advice from a qualified tax professional. Based on Taxpayer A’s specific facts and circumstances, all three pensions were classified as “foreign grantor trusts” for US tax reporting purposes. Taxpayer A has been filing IRS Forms 3520, 3520-A, 8621, 8938 Part IV, and the FBAR for each pension through tax year 2023. For tax year 2024, Taxpayer A uses the US Treasury Exchange Rate as of July 1, 2024, and determines the value in USD of each pension to be as follows:
- Pension 1 – $200,000
- Pension 2 – $195,000
- Pension 3 – $200,000
- Total Aggregate Value – $595,000
For tax year 2024, Taxpayer A can make the decision to rely on the proposed foreign trust regulations and classify the foreign pensions (all three) as “tax-favored foreign retirement trusts.” In doing so, Taxpayer A will no longer be required to file IRS Forms 3520 and 3520-A. Taxpayer A may still be required to file IRS Form(s) 8621. Taxpayer A must file IRS Form 8938 Part VI (see reporting thresholds for unmarried taxpayers living outside of the US) and FinCEN Form 114 (FBAR).
Note: The new proposed foreign trust regulations also reduce the reporting obligations for taxpayers who own certain other types of foreign savings accounts (other than pensions) that are deemed foreign trusts for US tax purposes. See Part II of this blog post for information on which trusts qualify for the additional relief and what the relief entails.
Issues with the Proposed Regulations’ Updates to Rev. Proc. 2020-17
Although the proposed regulations clarify and broaden Rev. Proc. 2020-17 by adding in the value threshold, they do not specify that once a foreign pension or pensions have been classified as a “tax-favored foreign retirement trust” that they will always retain that classification for future years.
In fact, the opposite is true based on the wording of the update. Taxpayers will have to reanalyze the aggregate value threshold (updated for inflation each year) to determine if their foreign pensions qualify or not.
Example 2
Same facts as Example 1. Assume in calendar year 2025 the value threshold is now $650,000 (adjusted for inflation). Assume Taxpayer A calculates the July 1, 2025, values for the pensions as follows:
- Pension 1 – $250,000
- Pension 2 – $250,000
- Pension 3 – $200,000
- Total Aggregate Value – $700,000
Taxpayer A is now over the allowed aggregate value threshold. Assuming the pensions do not meet any of the contribution limits, Taxpayer A must file IRS Forms 3520 and 3520-A for tax year 2025. The proposed foreign trust regulations do not make any mention as to how the IRS will view the interceding gap year (2024) if Forms 3520 and 3520-A are filed for 2023 and 2025. Nor is there any commentary on how to deal with includable income that may have been treated differently under IRC 402(b) for 2024 versus 2023 and 2025.
Example 3
Same facts as Example 1. Assume Taxpayer A is the owner of an actual foreign grantor trust (FT) located in FC 1. The trust holds foreign real property. Taxpayer B is a US citizen and nephew of Taxpayer A. Taxpayer B receives a loan of cash from FT that is not in exchange for a qualified obligation. The loan is treated as paid or accumulated for the benefit of a US person under the proposed foreign trust regulations. Since Taxpayer A is relying on the proposed foreign trust regulations to exempt reporting for Taxpayer A’s foreign pension, Taxpayer A must also follow the proposed foreign trust regulations for FT. As such, Taxpayer B is now considered a beneficiary of FT.
Additional Requirements To Take Advantage of the Proposed Regulations
Taxpayers who have previously needed to file Forms 3520 and 3520-A to report their foreign pensions and who would like to take advantage of the proposed regulations to forego 3520/3520-A reporting must also meet another requirement: You must have fully and properly reported your foreign pension for prior years.
The proposed regulations apply to tax years 2024 and later. To take advantage of them, you must have correctly reported your foreign pension for prior years on Forms 3520 and 3520-A, as well as any related forms, such as Forms 8621 and 8938, if required.
Because many taxpayers miss these forms or their related forms, many use IRS amnesty programs, such as the Foreign or Domestic Streamlined Filing Programs to fix their prior-year issues without facing the regular steep penalties. If you have used one of these programs in the past, then you should use extra caution going forward. The IRS can re-impose the penalties waived under the Streamlined Filing amnesty programs if it deems you have not remained in compliance.
Wolf Group Recommendations
The best approach depends largely on your risk tolerance and your particular facts and circumstances. The Wolf Group recommends that taxpayers who are considering relying on the proposed foreign trust regulations in order to exempt your reporting for Forms 3520 and 3520-A conduct a thorough investigation and analysis as to potential impacts of taking this position not only on the current-year tax return but future tax returns.
The Wolf Group also recommends that you document the analysis under the proposed foreign trust regulations’ update to Rev. Proc. 2020-17 in case of any audit or examination or other type of inquiry by the IRS related to associated noncompliance issues. This analysis should be conducted by a qualified tax practitioner who regularly practices in the area of US International Tax compliance.