IRS Notice 97-60: Foreign Trusts and Deferred Compensation

IRS Notice 97-60 has nothing to do with foreign trusts or deferred compensation. It is a 1997 question-and-answer notice explaining the education tax breaks created by the Taxpayer Relief Act of 1997, including the Hope Scholarship Credit, the Lifetime Learning Credit, the student loan interest deduction, and Education IRAs.¹ The rules that actually govern what happens when a foreign trust is used to fund nonqualified deferred compensation come from IRC Section 409A(b), Section 402(b), and Section 679, and they are punishing: immediate income at vesting, a 20 percent additional tax, interest charges dating to the year of deferral, and annual tax on trust earnings.

If you landed here because a source cited Notice 97-60 in a foreign trust context, that citation is wrong. The likely confusion is with Notice 97-34, which addresses foreign trust reporting, or with the Section 409A regime enacted in 2004. The rest of this article walks through the rules that do apply.

What Notice 97-60 Actually Says

Notice 97-60 was published in November 1997 to explain the new education tax incentives. It contains no provision touching foreign trusts, nonqualified deferred compensation, offshore funding, or employee benefit trusts.¹ If you need authority on the tax treatment of an offshore deferred compensation arrangement, do not look here.

How Section 409A(b) Treats Offshore-Funded Deferred Compensation

The statute aimed squarely at offshore trusts used to fund deferred compensation is IRC Section 409A(b)(1). When assets are set aside in a trust located outside the United States to pay nonqualified deferred compensation, the statute treats those assets as property transferred in connection with services under Section 83. That treatment applies whether or not the assets remain reachable by the employer’s general creditors.²

That last point is why offshore funding fails as a deferral strategy. A domestic rabbi trust normally avoids current tax because its assets remain exposed to the employer’s creditors, so the arrangement is treated as unfunded. Move the same assets offshore and that shield disappears. The IRS’s own Nonqualified Deferred Compensation Audit Technique Guide confirms this: an offshore rabbi trust produces current taxation and additional taxes under Section 409A once the compensation vests, even if the trust document recites that assets remain available to creditors.³

Section 402(b) runs on a parallel track. It governs employees who are beneficiaries of employee trusts that do not qualify for tax exemption under Section 501(a), including foreign trusts. Employer contributions to a nonexempt trust are included in the employee’s gross income under Section 83 principles, measured by the value of the employee’s interest in the trust.⁴ Offshore arrangements can be captured by both provisions at once, though Section 409A(b) carries the harsher penalty layer.

When the Tax Hits and What It Costs

Income inclusion is tied to vesting, not to actual receipt of cash. The compensation becomes taxable in the first year it is either transferable or no longer subject to a substantial risk of forfeiture. Section 83 defines that risk as a condition where your rights depend on performing substantial future services.⁵

Say your employer places $500,000 into an offshore trust on your behalf, subject to a three-year service requirement. You owe nothing while the risk of forfeiture is real. The moment the requirement lapses, the full vested value hits your gross income for that tax year, even though you cannot yet touch the money.

Then come the additional taxes. When amounts are required to be included under Section 409A(b), the tax for that year increases by a flat 20 percent additional tax on the included amount, plus interest at the underpayment rate plus one percentage point. The interest runs from the year the compensation was first deferred (or the year of vesting, if later) through the year of inclusion.⁶

A worked example makes the arithmetic concrete. If your employer sets aside $200,000 offshore in 2020 and it vests in 2026, you include $200,000 plus any growth in your 2026 gross income, pay regular marginal rates, add a 20 percent surtax on top, and pay interest running back to 2020. The combined effective rate frequently exceeds 50 percent of the deferred amount. The penalty structure is designed to make offshore deferral economically pointless.

Annual Tax on Trust Earnings

Under Section 409A(b)(4), for each year assets remain set aside in the offshore trust, any increase in value or earnings on those assets is treated as a further property transfer and included in your gross income.⁶ Dividends, interest, and capital gains inside the trust are taxed to you every year, whether or not any cash is distributed.

The 20 percent surcharge and interest apply to those annual inclusions as well. The compounding benefit that deferral was meant to capture is eliminated. Your basis rises by amounts already included in income, so distributions eventually come out tax-free to the extent of that basis, which prevents literal double taxation but does nothing to offset the year-by-year drag.

Employer Deduction and Payroll Tax Timing

IRC Section 404(a)(5) allows the employer a deduction for nonqualified deferred compensation only in the year the amount is includible in the employee’s income.⁷ Because Section 409A(b) accelerates the employee’s inclusion to vesting, the employer’s deduction accelerates to match.

FICA follows a similar path. Section 3121(v)(2) takes nonqualified deferred compensation into account for Social Security and Medicare at the later of when services are performed or when the substantial risk of forfeiture lapses.⁸ In 2026, Social Security tax applies to earnings up to $184,500; Medicare tax at 1.45 percent has no wage cap.⁹ A single vesting event can push a large lump sum through payroll in one year.

Both parties then face a cash-flow problem. The employer must withhold income and employment taxes on wages the employee never actually received. Employers typically handle the mismatch by reducing regular paychecks, collecting a separate payment from the employee, or netting against other compensation. Missing the withholding exposes the employer to penalties and can create personal liability for responsible officers.

Reporting the Trust

Offshore deferred compensation drags a stack of information returns along with it. The specific forms depend on how your interest is classified.

Form 3520 and Form 3520-A

A U.S. person treated as the owner of a foreign trust files Form 3520 to report the trust relationship, contributions, and distributions. It is due when your individual return is due, with an automatic extension to October 15 if your income tax return is extended.¹⁰ The trust (or the U.S. owner acting for it) also files Form 3520-A, reporting the trust’s income, assets, and activity.¹¹

The Form 3520 instructions carve out transfers to funded nonqualified deferred compensation arrangements described in Section 402(b) from the filing requirement.¹² Whether the exemption reaches a particular arrangement depends on how it is structured, and Section 679 grantor trust treatment can pull reporting back in through a different door. Get this analyzed before relying on the carve-out.

Form 8938

An interest in a foreign trust is a specified foreign financial asset under FATCA. Form 8938 attaches to your return once your total specified foreign financial assets exceed the applicable threshold, which starts at $50,000 for single filers living in the United States and rises for joint filers and taxpayers living abroad.¹³ Deferred compensation balances usually clear the threshold without effort.

FBAR

If you have a financial interest in or signature authority over foreign financial accounts whose aggregate value exceeds $10,000 at any point in the year, you file an FBAR through FinCEN’s BSA E-Filing System.¹⁴ The deadline is April 15 with an automatic extension to October 15. Trust accounts can qualify.

Employer Reporting

The employer reports the income inclusion on the employee’s Form W-2 in the year the amount is includible, or on Form 1099 for non-employee directors and independent contractors. Withheld taxes are reported alongside the income.

Penalties for Missed Reporting

The information return penalties are large and largely automatic. Under IRC Section 6677, failure to file Form 3520 or Form 3520-A on time, or filing incomplete or incorrect information, triggers the greater of $10,000 or 35 percent of the gross reportable amount for transfers and distributions. For annual ownership reporting on Form 3520-A, the percentage is 5 percent of the gross value of assets treated as owned. If the failure continues more than 90 days after the IRS mails a notice, an additional $10,000 accrues for each 30-day period the failure persists.¹⁵ Reasonable cause relief exists but the bar is high, and the IRS has explicitly stated that fear of civil or criminal penalties in a foreign jurisdiction for disclosing the information does not count as reasonable cause.

FBAR penalties in 2026 reach up to $16,536 per report for non-willful violations and the greater of $165,353 or 50 percent of the unreported balance for willful violations.

The Narrow Foreign-Services Exception

Section 409A(b)(1) contains one carve-out. The offshore trust rules do not apply to assets in a foreign jurisdiction if substantially all of the services to which the deferred compensation relates are performed in that jurisdiction.² If a U.S. employee works almost entirely in Germany and the employer funds a German trust for that employee’s deferred compensation, the punitive treatment may not apply. “Substantially all” is generally read to mean at least 85 percent. Split assignments do not qualify without a careful look at the allocation of services.

Section 679 and Grantor Trust Overlap

Section 679 provides an independent basis for taxing U.S. persons who transfer property to a foreign trust. A U.S. person who directly or indirectly transfers property to a foreign trust is treated as the owner of the portion attributable to that transfer, as long as the trust has any U.S. beneficiary, and the deemed owner reports all income on that portion each year.¹⁶

In an employer-funded arrangement, the employer is technically the transferor. But when the structure treats the employee as an owner under grantor trust principles, whether through Section 679 by imputation or through the Section 409A deemed-transfer framework, the employee picks up the annual income.¹⁷ The overlap among Sections 409A(b), 402(b), and 679 means the same income can be reached through more than one provision, though the rules prevent taxing the same dollars twice.

Put together, funding nonqualified deferred compensation through an offshore trust does not produce deferral. It produces immediate taxation at vesting, a 20 percent surtax, back-interest to the year of deferral, annual tax on earnings inside the trust, and a reporting regime whose penalties dwarf most other information return failures. For anyone still sitting inside one of these structures, unwinding it with professional advice is almost always cheaper than continuing.

1
Internal Revenue Service. IRS Notice 97-60 – Education Tax Incentives Guidance
2
Office of the Law Revision Counsel. 26 USC 409A – Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans
3
Internal Revenue Service. Nonqualified Deferred Compensation Audit Technique Guide
4
Office of the Law Revision Counsel. 26 U.S. Code 402 – Taxability of Beneficiary of Employees Trust
5
Office of the Law Revision Counsel. 26 U.S. Code 83 – Property Transferred in Connection with Performance of Services
6
Office of the Law Revision Counsel. 26 U.S. Code 409A – Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans
7
Office of the Law Revision Counsel. 26 USC 404 – Deduction for Contributions of an Employer to an Employees Trust or Annuity Plan and Compensation Under a Deferred-Payment Plan
8
Office of the Law Revision Counsel. 26 U.S. Code 3121 – Definitions
9
Internal Revenue Service. Social Security and Medicare Withholding Rates
10
Internal Revenue Service. Instructions for Form 3520
11
Internal Revenue Service. About Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts
12
Internal Revenue Service. Instructions for Form 3520
13
Internal Revenue Service. Do I Need to File Form 8938, Statement of Specified Foreign Financial Assets
14
FinCEN. Report Foreign Bank and Financial Accounts
15
Office of the Law Revision Counsel. 26 USC 6677 – Failure to File Information with Respect to Certain Foreign Trusts
16
Office of the Law Revision Counsel. 26 USC 679 – Foreign Trusts Having One or More United States Beneficiaries
17
Internal Revenue Service. Foreign Trust Reporting Requirements and Tax Consequences