Notice 94-47: Foreign Trust Loans, Reporting, and Penalties

A loan from a foreign trust to a U.S. person is usually not treated as a loan at all. Under Internal Revenue Code Section 643(i), if a foreign trust lends cash or marketable securities (or lets someone use other trust property) to the trust’s U.S. grantor, a U.S. beneficiary, or a U.S. person related to either, the full amount is recharacterized as a distribution and taxed to the recipient. A narrow “qualified obligation” exception exists, but it has seven strict conditions and one misstep collapses it. Paying the money back does not undo the tax.

How Section 643(i) Recharacterizes the Loan

Section 643(i) applies to any loan of cash or marketable securities from a foreign trust, and to the fair market value of the use of any other trust property, when the borrower is a U.S. grantor or U.S. beneficiary of the trust. It also reaches loans made to U.S. persons who are related to the grantor or beneficiary, using the related-party definitions from Sections 267 and 707(b) expanded to include spouses of family members. A loan routed to a grantor’s sibling, child, or in-law can trigger a taxable distribution to the grantor or beneficiary.¹

The provision’s harshest feature involves repayment. Once a loan is recharacterized as a distribution and taxed, any later repayment is disregarded for all tax purposes.¹ You pay tax on the full amount when you receive it, and sending the money back to the trust does not reverse that result. The repayment is simply invisible to the tax code. Most people assume repaying fixes the problem. It does not.

Congress codified this rule in 1996, building on IRS guidance from Notice 94-47 that had targeted arrangements where U.S. taxpayers used offshore trusts to receive tax-free “loans” of what was really trust income. The signals were familiar: no fixed repayment schedule, no market-rate interest, no collateral, no meaningful obligation to repay.

The Qualified Obligation Exception

A loan can avoid recharacterization only if it satisfies every element of a “qualified obligation.” The requirements come from Notice 97-34 and later proposed regulations, and they are cumulative:

The obligation is documented in a written instrument.
The repayment term does not exceed five years.
All principal and interest payments are made in cash, denominated in U.S. dollars.
The yield to maturity is between 100 and 130 percent of the applicable federal rate on the issue date.
The borrower agrees to extend the statute of limitations on assessment for tax related to the loan to at least three years after the obligation matures.
The borrower reports the loan’s status each year on Form 3520.
All payments of principal and interest are made on schedule.

Violating any one of these conditions while the loan is outstanding causes the entire remaining principal plus accrued unpaid interest to be treated immediately as a taxable distribution. Rolling the debt into a new loan from the same trust does not extend the runway either: the original obligation is retested using the new obligation’s maturity date, so a chain of short-term loans designed to stretch past five years disqualifies the arrangement.

Loans Routed Through Someone Else

Section 643(h) and its regulations reach transfers that pass through an intermediary before landing with a U.S. person. If the intermediary received the property under a plan with a principal purpose of avoiding U.S. tax, the transfer is treated as a direct distribution from the foreign trust to the U.S. person. Tax avoidance is presumed when the U.S. recipient is related to the grantor or has a relationship that would ordinarily prompt a gratuitous transfer from the grantor.² Sending the money through a foreign corporation, a second trust, or a family member does not change the tax result.

What the Tax Bill Actually Looks Like

When a loan is recharacterized as a distribution, the analysis does not stop at reporting the amount as income. Two other layers of the foreign trust regime typically apply on top.

The first is the throwback rule. Foreign trusts that have accumulated undistributed income across multiple years are subject to Sections 667 and 668, which allocate the distribution back to the years the trust actually earned the income and add an interest charge computed at the IRS underpayment rate for the whole accumulation period.³ If the trust accumulated income for 15 or 20 years before the recharacterized loan, the interest charge alone can approach or match the underlying tax. The combined interest and partial tax cannot exceed the accumulation distribution itself, but that ceiling still allows the IRS to claim most of the amount received. The interest charge is not deductible.

The second layer is Section 679. A U.S. person who transfers property to a foreign trust that has any U.S. beneficiary is treated as the owner of the trust’s assets for income tax purposes and must report and pay tax on all trust income each year, distributions or no distributions.⁴ The deferral that offshore trusts were once used to achieve is gone. A grantor in this position owes tax on trust income as it accrues, and a purported loan is then taxed a second time as a distribution.

Reporting Obligations That Come With the Loan

A loan from a foreign trust triggers multiple overlapping information returns. Each one carries its own penalty regime, separate from the tax on the recharacterized distribution.

Form 3520

Any U.S. person who creates a foreign trust, transfers property to one, or receives a distribution (including a recharacterized loan) files Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts.⁵ The form is due with the filer’s income tax return, including extensions. Loans structured as qualified obligations are reported each year on Schedule C.

Form 3520-A

The foreign trust itself must file Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner, by the 15th day of the third month after the trust’s tax year ends.⁶ For a calendar-year trust, that is March 15. If the foreign trustee does not file, the U.S. owner must complete a substitute Form 3520-A and attach it to their own Form 3520.⁷

FBAR and Form 8938

Foreign accounts associated with the trust may also require the FBAR and Form 8938. FinCEN Form 114 is required when a U.S. person has a financial interest in or signature authority over foreign financial accounts exceeding $10,000 in aggregate at any point during the year.⁸ Form 8938 attaches to the income tax return when specified foreign financial assets exceed $50,000 on the last day of the year or $75,000 at any point during the year for unmarried U.S.-resident filers; the thresholds rise to $200,000 and $300,000 for single filers living abroad.⁹

Penalties for Failing to Report

Section 6677 sets the penalties, and they are large enough to function as their own deterrent.

Failing to file Form 3520 on time, or filing it incomplete or incorrect, triggers a penalty equal to the greater of $10,000 or 35 percent of the gross reportable amount.¹⁰ For a distribution (which is what a recharacterized loan is), the 35 percent is measured against the gross amount of the distribution.¹¹ For a transfer to the trust, it is 35 percent of the gross value of the property transferred. After the IRS sends a failure notice, an additional $10,000 accrues for each 30-day period, or fraction of one, past the 90-day mark. Total penalties are capped at the gross reportable amount.

The Form 3520-A penalty for a U.S. owner is the greater of $10,000 or 5 percent of the gross value of the trust assets treated as owned by that person, with the same 30-day continuation penalty structure.¹²

The only defense is reasonable cause and absence of willful neglect. The statute specifically forecloses one common argument: the fact that a foreign country would penalize the disclosure of the required information is not reasonable cause.¹⁰ Taxpayers typically need to show good-faith reliance on a qualified tax professional who had all the facts. Not knowing about the filing requirement, by itself, rarely works.

Fixing Prior Unreported Loans

Taxpayers who realize a past loan from a foreign trust was never reported have two main routes back into compliance before the IRS finds it first.

If the failure was not willful and the taxpayer is not already under IRS examination or criminal investigation, the Delinquent International Information Return Submission Procedures allow the late Form 3520 or 3520-A to be filed directly with a reasonable cause statement attached. The IRS notes that penalties may still be assessed in initial processing without weighing the reasonable cause statement, so a follow-up response to any penalty notice is often part of the process.¹³

Where there is also unreported foreign income tied to the trust, the Streamlined Filing Compliance Procedures are the more comprehensive path. The taxpayer certifies that the failures were due to non-willful conduct, meaning negligence, inadvertence, mistake, or a good-faith misunderstanding of the law. Anyone under civil examination or criminal investigation is ineligible.¹⁴ The certification is not casual paperwork; the willful-versus-non-willful line drives the whole result, and professional advice before filing anything is worth having.

A Note on Canadian RRSPs and RRIFs

Not every foreign retirement vehicle triggers the foreign trust regime. Under Revenue Procedure 2014-55, U.S. citizens and residents who hold Canadian Registered Retirement Savings Plans or Registered Retirement Income Funds and elect treaty deferral are exempt from the Section 6048 reporting rules that would otherwise apply.¹⁵ The election is claimed with a statement attached to the timely filed U.S. return identifying the plan, trustee, account number, and opening balance, carried forward each year through the year of final distribution. Without the election, an RRSP or RRIF can trigger the same Form 3520 and 3520-A obligations as any other foreign trust arrangement.

1
Office of the Law Revision Counsel. 26 USC 643 – Definitions Applicable to Subparts A, B, C, and D
2
eCFR. 26 CFR 1.643(h)-1 – Distributions by Certain Foreign Trusts Through Intermediaries
3
Office of the Law Revision Counsel. 26 U.S. Code 668 – Interest Charge on Accumulation Distributions
4
Office of the Law Revision Counsel. 26 U.S. Code 679 – Foreign Trusts Having One or More United States Beneficiaries
5
Internal Revenue Service. About Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts
6
Internal Revenue Service. Instructions for Form 3520-A
7
Internal Revenue Service. Reminder to U.S. Owners of a Foreign Trust
8
Financial Crimes Enforcement Network. Report Foreign Bank and Financial Accounts
9
Internal Revenue Service. Do I Need to File Form 8938, Statement of Specified Foreign Financial Assets
10
Office of the Law Revision Counsel. 26 USC 6677 – Failure to File Information With Respect to Certain Foreign Trusts
11
Internal Revenue Service. Instructions for Form 3520
12
Internal Revenue Service. Failure to File the Form 3520/3520-A Penalties
13
Internal Revenue Service. Delinquent International Information Return Submission Procedures
14
Internal Revenue Service. Streamlined Filing Compliance Procedures
15
Internal Revenue Service. Election Procedures and Information Reporting With Respect to Interests in Certain Canadian Retirement Plans (Rev. Proc. 2014-55)