IRC 684: Deemed Sale, Exceptions, and Form 3520 Reporting

Under Internal Revenue Code Section 684, when a U.S. person transfers appreciated property to a foreign trust or foreign estate, the transfer is treated as a sale at fair market value and the transferor owes U.S. tax on the built-in gain. The rule fires before the property leaves U.S. tax jurisdiction, and it applies whether the transfer is a gift, a bequest, or a contribution. Several exceptions can defer or eliminate the tax, but each one carries conditions that can fail later, and when they fail the deferred gain comes due.¹

What Triggers the Deemed Sale

Three conditions have to line up. The transferor must be a U.S. person, the recipient must be a foreign trust or foreign estate, and the property must have appreciated above the transferor’s adjusted basis.

“U.S. person” is defined broadly: U.S. citizens, U.S. residents, domestic corporations, domestic partnerships, and estates that are not foreign estates all qualify.

Whether a trust is foreign turns on a two-part test. A trust is domestic only if a U.S. court exercises primary supervision over its administration and one or more U.S. persons control all substantial decisions. Fail either prong and the trust is foreign.² A trust that loses its U.S. trustee or shifts decision-making authority abroad can flip from domestic to foreign quickly.

Appreciation is the third piece. If the property’s fair market value equals or is below basis, there is no gain, and Section 684 has nothing to trigger. There is no actual buyer and no cash proceeds; the statute simply treats the transfer as if a sale had happened at fair market value.¹

How the Gain Is Calculated

The recognized gain equals fair market value on the transfer date minus the transferor’s adjusted basis. Character follows the normal rules: property held more than one year produces long-term capital gain at preferential rates, and property held one year or less produces short-term capital gain at ordinary rates.³⁴⁵

Section 684 is a one-way ratchet. Losses are never recognized, and a loss on one asset cannot offset a gain on another asset in the same transfer. If you move ten assets to a foreign trust and five have appreciated while five have depreciated, you owe tax on the five gains and get nothing for the five losses.⁶

The trust takes a basis in each asset equal to the fair market value used to compute the deemed sale. That prevents double taxation on appreciation that has already been taxed once at the transfer.

Indirect and Constructive Transfers

The regulations define “transfer” to reach direct, indirect, and constructive transfers, borrowing the anti-abuse framework built for Section 679.⁷ Routing property through a third party who then hands it to a foreign trust does not sidestep the rule. If a U.S. person cannot show to the IRS’s satisfaction that the intermediary acted independently, the transfer is attributed back to the U.S. person and the intermediary is treated as that person’s agent.

Look-through rules also reach entity transfers. If a domestic trust, partnership, or other entity partly owned by a U.S. person contributes appreciated property to a foreign trust, the U.S. owners are treated as transferors of their proportionate share, and the gain rolls through to them.

Exceptions That Can Defer or Eliminate the Tax

The regulations carve out several situations where a transfer to a foreign trust or estate does not trigger gain. Each is narrower than it looks.

Grantor Trust Status

If any person is treated as the owner of the foreign trust under the grantor trust rules of Subpart E, Section 684 stands down. The rationale is that the U.S. grantor is already reporting the trust’s income, so the anti-avoidance purpose is already served.¹

Section 679 makes this exception practical for most foreign trusts with U.S. connections. A U.S. person who transfers property to a foreign trust with at least one U.S. beneficiary is automatically treated as the owner of the trust’s assets for income tax purposes, which means the initial contribution does not trigger Section 684 gain.⁸⁹ This is a deferral, not a permanent pass. If grantor trust status later ends, the deferred gain is recognized then.

Transfers at Death with a Stepped-Up Basis

When property passes to a foreign trust or foreign estate at the death of a U.S. person and the recipient’s basis is determined under Section 1014, there is no deemed sale. The step-up resets basis to fair market value on the date of death, so there is no built-in gain left to capture.⁹

The exception is tied to the step-up mechanism. Lifetime transfers to a foreign estate are still subject to Section 684 if the property is appreciated, because the statute covers both foreign trusts and foreign estates.

Sales for Fair Market Value to Unrelated Trusts

A U.S. person who sells appreciated property to an unrelated foreign trust for its full fair market value is already paying tax on the appreciation through the sale itself. Section 684 does not double up on that. The exception is limited to unrelated trusts; a sale to a related foreign trust at fair market value may draw scrutiny under other provisions.⁹

Charitable Trusts and Nonrecognition Stock Transfers

Two narrower carve-outs also exist. Transfers to a foreign trust that qualifies as a Section 501(c)(3) charitable organization are exempt, and transfers of stock where the domestic corporation does not recognize gain under Section 1032 are also excluded.⁹

When Deferred Gain Comes Due

Because the grantor trust exception is a deferral, the events that end grantor trust status are also the events that trigger Section 684 gain on the full built-in appreciation as of that date. The regulations treat the U.S. person as having transferred all of the trust’s assets to a foreign trust immediately before the status change.⁷

Common triggers include:

Death of the grantor. Grantor trust status typically ends at the grantor’s death, and the gain is recognized on the grantor’s final income tax return. The Section 1014 stepped-up basis rule may absorb the gain if the property qualifies.
Loss of U.S. beneficiaries. Under Section 679, a trust is treated as owned by the U.S. transferor only while at least one U.S. beneficiary exists. If all U.S. beneficiaries are removed or lose their U.S. status, grantor treatment ends and the deemed sale occurs as of the first day of the following tax year.
Release of a retained power. If the grantor voluntarily releases the power that produced grantor trust treatment, the trust becomes a non-grantor trust and the deemed transfer is triggered.

After the deemed sale, the trust takes a stepped-up basis equal to fair market value, so the same appreciation is not taxed twice.

Domestic Trust Becoming a Foreign Trust

Section 684(c) covers a different path to the same result. If a trust that was domestic becomes a foreign trust, all of its assets are treated as transferred to a foreign trust immediately before the change takes effect, and the trust itself recognizes gain on the built-in appreciation unless the grantor trust exception or another carve-out applies.¹¹⁰

Everyday events can cause the migration. Replacing a U.S. trustee with a foreign trustee, or a U.S. person with substantial decision-making authority moving abroad, can break the court-and-control test and turn the trust foreign as of that date.²

There is a safety valve for inadvertent shifts. If residency changes because of an unplanned event like the death, incapacity, or resignation of the person controlling substantial decisions, the trust has 12 months to fix the problem by replacing that person or changing their residence. If the fix is timely, the trust is treated as having kept its original residency the whole time and there is no deemed transfer. If reasonable steps were taken but circumstances prevented a timely fix, the trust can ask the IRS for an extension, though approval is discretionary.²

The reverse migration does not trigger Section 684. A foreign trust becoming domestic brings assets back into U.S. tax jurisdiction rather than sending them out, and the statute is only concerned with the outbound direction.

Form 3520, Form 3520-A, and the Open Statute of Limitations

Every transfer of property to a foreign trust by a U.S. person must be reported on Form 3520, even if an exception eliminates the gain.¹¹ The form requires the trust’s identifying information, the transfer date, and the fair market value. A transferor recognizing Section 684 gain must attach a statement showing the deemed sale calculation.

Penalties are steep. For transfers to foreign trusts, the penalty is the greater of $10,000 or 35% of the gross value of the property transferred. Once the IRS sends a notice about the missing form, additional $10,000 penalties accrue every 30 days the failure continues, capped at the total reportable amount.¹² Reasonable cause relief exists, but the IRS will not accept the argument that a foreign country’s disclosure penalty is reasonable cause.

If a U.S. person is treated as the owner of the foreign trust under the grantor trust rules, the trust must also file Form 3520-A annually, and the U.S. owner is on the hook for making sure it gets filed.¹³

The reporting rules connect to a trap that is easy to miss. Under Section 6501(c)(8), when a taxpayer fails to report information required by Section 6048, which is the statute mandating Form 3520 reporting, the normal three-year assessment period does not start until three years after the required information is actually provided to the IRS.¹⁴ Skip Form 3520 and the IRS can assess related tax indefinitely. If the failure is due to reasonable cause rather than willful neglect, the open assessment window is limited to the items tied to the missing information rather than the entire return. Intentional non-filing gets no such limit.

1
Office of the Law Revision Counsel. 26 U.S. Code 684 – Recognition of Gain on Certain Transfers to Certain Foreign Trusts and Estates
2
eCFR. 26 CFR 301.7701-7 – Trusts, Domestic and Foreign
3
Internal Revenue Service. Topic No. 409 – Capital Gains and Losses
4
Office of the Law Revision Counsel. 26 U.S. Code 1245 – Gain From Dispositions of Certain Depreciable Property
5
Office of the Law Revision Counsel. 26 U.S. Code 1 – Tax Imposed
6
eCFR. 26 CFR 1.684-1 – Recognition of Gain on Transfers to Certain Foreign Trusts and Estates
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eCFR. 26 CFR 1.684-2 – Transfers
8
Office of the Law Revision Counsel. 26 U.S. Code 679 – Foreign Trusts Having One or More United States Beneficiaries
9
GovInfo. 26 CFR 1.684-3 – Exceptions to General Rule of Gain Recognition
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eCFR. 26 CFR 1.684-4 – Outbound Migrations of Domestic Trusts
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Internal Revenue Service. About Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts
12
Internal Revenue Service. Failure to File Form 3520/3520-A Penalties
13
Internal Revenue Service. Instructions for Form 3520
14
Office of the Law Revision Counsel. 26 USC 6501 – Limitations on Assessment and Collection