Do You Have to Pay US Taxes on Foreign Inheritance?

We get this question almost daily…A U.S. person owes no U.S income tax on the receipt of an inheritance or gift from an individual living outside the United States. However, there are important legal considerations to review, including the Foreign Account Tax Compliance Act (FATCA), which directly deals with foreign compliance matters.

This article summarizes international estate planning and tax issues that U.S. citizens, greencard holders, and other U.S. persons must consider if they are the beneficiary of a foreign gift.

Basics: Income Tax – Do I have to pay taxes on foreign inheritance to the IRS? No, the IRS does not impose taxes on foreign inheritance or gifts if the recipient is a U.S. citizen or resident alien. Although the IRS will not tax the actual inheritance, you will still have to submit one or more forms to report information about the inheritance; failure to do so could result in substantial penalties. Reporting a foreign inheritance is not a simple process and requires guidance from an experienced advisor. The following are the most common forms that must be filed when receiving a foreign inheritance:

IRS Form 3520

The main form is IRS Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts. This form applies in cases where a U.S. person receives more than $100,000 through a foreign inheritance or gift. However, because this is an information return and not a tax return, no payment needs to be submitted in relation to this form. Failure to fill out Form 3520 could result in a 25% penalty on your foreign inheritance or gift.

After satisfying the initial compliance obligations on Form 3520 when receiving a foreign inheritance, it must be assessed what type of IRS foreign asset reporting is required on an ongoing annual basis going forward. In the event that the inherited assets remain outside the US, there may be substantial income tax reporting requirements for foreign assets beyond the normal IRS Form 1040.

These reporting requirements include, but are not limited to, the timely filling of a FinCEN Report 114 (FBAR) and IRS Form 8938 (Statement of Specified Foreign Financial Assets) which merely report the existence of such assets. The IRS uses information reporting to determine potential tax noncompliance. 

Foreign inheritances come in many types and forms that require unique U.S. tax reporting:

Reporting Foreign Bank Accounts Holding Cash – Cash held in a foreign bank account is relatively simple to report. In addition to reporting the inheritance on Form 3520, there may be additional requirements on the FinCEN Report 114 (FBAR) or IRS Form 8938 (Statement of Specified Foreign Financial Assets). Interest earned must also be reported as income and is taxed like interest earned in a U.S. bank account.

Foreign Investment Accounts (Stocks, ETFs, Mutual Funds, and other pooled investments) – Foreign investment accounts and funds require more complex U.S. tax reporting. Commonly, foreign investment accounts hold foreign investment products such as foreign listed ETFs, mutual funds, and private investments. The IRS may classify these investments as passive foreign investment companies (PFICs). It is not a violation of U.S. tax law to own a foreign fund classified as a PFIC, but complicated and ongoing annual reporting is required, even if no investments are bought or sold. A PFIC requires complex reporting on Form 8621. In addition to the complex reporting of investments in these accounts, disclosure of these accounts is required on the FBAR and FATCA 8938 form.

Foreign Business Ownership – Inheriting ownership of a foreign business has significant U.S. tax reporting obligations. Extensive reporting on Form 5471 extends deep into the corporate structure and requires additional U.S. tax reporting by foreign owners.  U.S. tax laws related to controlled foreign corporations and global intangible low-taxed income (GILTI, Section 951A) are complex. Ownership in a foreign business requires legal assistance from an international tax attorney prior to the inheritance to create a more efficient ownership structure.

Foreign Real Estate – The reporting of foreign non-rental real estate owned directly is relatively simple. Apart from the initial Form 3520, there is no special ongoing reporting required of foreign real estate. This would change if the property is rented, which requires U.S. income tax reporting of rental income). A sale of property abroad would also need to be reported on U.S. tax filings.

Art and Collectibles – When inheriting paintings, collectibles, jewelry, or other tangible items of value, it is important to obtain a professional appraisal. An appraisal will document the current value which may be necessary for estate or inheritance tax purposes (filing Form 3520). No ongoing U.S. tax reporting is required of unsold tangible items located in another country.

Foreign Trust Structures – U.S. taxpayers may become beneficiaries of a foreign trust. A U.S. taxpayer who is a beneficiary of a foreign trust has complex tax reporting required by the trustee and beneficiary. Transfers to, distributions from, and annual income and expenses of foreign trusts must be reported and may be taxed in the U.S.  Individuals who are settlors, trustees, or beneficiaries of a foreign trust must obtain legal assistance from an international tax attorney (preferably prior to the foreign trust creation to create a more efficient tax structure).

It is important that no mistakes be made for a foreign inheritance because the IRS can impose very high penalties on those who fail to comply. If you have recently received a foreign inheritance or are likely to receive one soon, you should get specialized legal advice. Feel free to contact us today.

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