We covered a bit of an overview of foreign retirement plan reporting here: Foreign Retirement Plan Reporting: Form 3520-A, Form 3520, Form 8938, and FBARs, but I wanted to take a little more time to specifically discuss what makes your retirement account a foreign grantor trust, the associated reporting, and the potential impact of IRS revenue procedure 2020-17.
The two most common ways that individuals end up with foreign retirement plans that are classified as grantor trusts are 1. Contributing more to their retirement plans than their employer has or 2. Opening and funding a retirement plan that is separate from their employment.
If your retirement account has been funded through your employment, and you’ve contributed more than your employer, you need to be concerned with the account being ‘bifurcated’ for U.S. tax purposes. What this means is that part of your account (the part associated with employer contributions) will be treated as an employee’s trust and part of your account (the part associated with your contributions) will be treated as a grantor trust. As you can imagine, this creates quite a few accounting headaches as you try to divide one retirement account into two separate accounts for tax disclosure purposes.
What are the mechanics of this division? Well, that’s a great question and there isn’t much guidance on it. Generally we divide the assets ratably (i.e. if 60% is a grantor trust and 40% is an employees trust, we treat 60% of every asset as owned through the grantor trust).
When you consider the term, grantor trust, the word you want to focus in on is grantor. The grantor is the individual that transferred the funds to the trust, but it’s not quite that simple. There are a number of technical ‘grantor trust rules’ which can be found in the internal revenue code from section 671 through section 679. Some of the rights and actions that can convert a trust into a grantor trust are: maintaining reversionary interests (do the assets or the income potentially revert back to you?), the power to control the beneficial enjoyment of the trust corpus or the trust income, power to borrow against trust corpus without adequate interest payments, the power to revoke the trust (resuming direct control of trust assets), and having the benefit of the income generated by the trust. Most importantly, IRC 679, a catch-all provision, makes it such that when a U.S. person transfers assets to a foreign trust that has a U.S. beneficiary, he shall be treated as the owner of that trust for tax purposes.
Once you’ve determined that all or part of your retirement account is a ‘grantor trust’ for U.S. tax purposes, the next question is: what does this ‘grantor trust’ mean for your U.S. tax filings. This question became a lot more complicated during 2020 as the IRS has tried to create some relief for certain individuals with foreign retirement accounts meeting certain requirements. (IRS Revenue Procedure 2020-17).
Prior to 2020, having a grantor trust would have meant filing Form 3520, Form 3520-A, Form 8938, an FBAR, and including the underlying income of the retirement plan on your tax return annually. The assets of a grantor trust are treated as though you own them directly, the treatment isn’t just pass-through, the ownership is flow-through. This means that if you own shares in a foreign company, we have to treat it as though you own the shares directly. The most common issue that results from this treatment is the magnitude of PFIC reporting associated with the ownership of foreign mutual funds, by far the most common investment type in foreign retirement plans. PFIC reporting can balloon your tax return and the amount of tax owed with that return. I’ve seen PFIC reporting turn an otherwise 20 page tax return into an over 1,000 page tax return. I’ve also seen PFIC sales that result in an effective tax rate in excess of 50%.
Currently, whether or not you are afforded some of the ‘relief’ offered in 2020-17 (2020-17 Blog Article Here), you still have to include all of the income items associated with your foreign retirement plan annually. You also still have to report the account on your Form 8938 as well as your FBAR. The only reporting that this ‘relief’ extends to is the Form 3520 and the Form 3520-A reporting. The most important thing to remember here is that whether or not you have to include Form 3520 and Form 3520-A has NO BEARING on the income items that must be reported. The fact that the Form 3520-A income statement no longer has to be prepared or filed does not change the fact that you have to include all of that income on your return each year, and more importantly, failure to do so will forfeit the relief offered by 2020-17 and expose you to the Form 3520 and Form 3520-A penalties that you sought to avoid.