IRS Notice 97-60: Foreign Trusts and Deferred Compensation

IRS Notice 97-60 has nothing to do with foreign trusts or deferred compensation. Published in November 1997, it is a question-and-answer document explaining the education tax breaks added by the Taxpayer Relief Act of 1997: the Hope Scholarship Credit, the Lifetime Learning Credit, the student loan interest deduction, and Education IRAs.¹ The federal tax rules that apply when a foreign trust is used to fund nonqualified deferred compensation come from a different place entirely: IRC Section 409A(b) and Section 402(b). Those rules are aggressive. They trigger immediate income inclusion at vesting, a flat 20 percent additional tax, and interest running back to the year of the original deferral.

What Notice 97-60 Actually Covers

The Notice addresses higher education tax incentives and nothing else. If you have seen 97-60 cited in connection with offshore trusts or executive compensation, the citation is wrong. The confusion may stem from Notice 97-34, which does address foreign trust reporting, or from Section 409A, enacted years later in 2004. Notice 97-60 itself contains no provisions on trusts, deferred compensation, or offshore arrangements.¹

The Statutes That Actually Govern Offshore Deferred Compensation

The primary statute is IRC Section 409A(b)(1). When assets are set aside in a trust located outside the United States to pay nonqualified deferred compensation, those assets are treated as property transferred in connection with services under Section 83. That treatment applies regardless of whether the trust assets remain available to the employer’s general creditors.² The creditor-access point is what makes the rule bite. A domestic “rabbi trust” typically escapes immediate taxation because the assets can be reached by the employer’s creditors, keeping the arrangement effectively unfunded. Moving the same assets offshore removes that protection.

The IRS confirms this in its Nonqualified Deferred Compensation Audit Technique Guide, which states that an offshore rabbi trust causes the deferred compensation to become subject to taxation and additional taxes under Section 409A once it vests, treating the assets as a taxable property transfer under Section 83 even if creditor-access language appears in the trust document.³

IRC Section 402(b) provides an overlapping basis for taxation. It governs employees who are beneficiaries of employee trusts that do not qualify for tax-exempt status under Section 501(a). Employer contributions to a nonexempt trust are included in the employee’s gross income following Section 83 principles, valued by the employee’s interest in the trust rather than the fair market value of specific property.⁴ Both provisions can apply to the same arrangement, but Section 409A(b) carries the harsher penalty structure.

When the Tax Hits: Vesting, Not Payment

Under both Section 409A(b)(1) and Section 402(b), income inclusion is tied to vesting, not to 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 a substantial risk of forfeiture as a condition where your rights to the property depend on performing substantial future services.⁵

The practical effect: if your employer places $500,000 in an offshore trust for you and you must work three more years to earn full rights, no tax is due now. When the three-year requirement lapses, or when your interest becomes transferable, the full vested value hits your gross income for that year. Tax is owed even though you have received no distribution and may not be eligible for one for years.

The 20 Percent Additional Tax and Interest

Section 409A does more than accelerate the timing. When amounts must be included in gross income under Section 409A(b), the tax for that year increases by a flat 20 percent additional tax on the included amount, plus interest calculated at the underpayment rate plus one percentage point. Interest runs from the year the compensation was first deferred, or the year it vested if later, through the year of inclusion.⁶

An example: an employer sets aside $200,000 in an offshore trust in 2020, and the amount vests in 2026. You include the $200,000 (plus growth) in your 2026 gross income, pay your regular marginal rate, then owe an additional 20 percent tax on the same amount, plus interest running back to 2020. Combined effective rates well above 50 percent of the deferred amount are common.

Annual Taxation of Trust Earnings

The exposure continues after vesting. Under Section 409A(b)(4), for each year that assets remain set aside in an offshore trust, any increase in value or earnings on those assets is treated as an additional 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. Those annual inclusions carry the same 20 percent surcharge and interest charge.

Your basis in the plan increases by amounts already included in income, so distributions eventually recover the previously taxed amounts tax-free. You will not pay tax twice on the same dollars, but the forced annual inclusion erases any compounding advantage the arrangement was meant to create.

Employer Deductions and Withholding

The employer’s deduction timing follows IRC Section 404(a)(5), which permits a deduction for nonqualified deferred compensation only in the year the amount is includible in the employee’s gross income.⁷ Because the offshore trust accelerates the employee’s inclusion to vesting, the employer’s deduction accelerates to match.

FICA follows a similar rule. Under IRC Section 3121(v)(2), deferred compensation under a nonqualified plan is taken into account for Social Security and Medicare purposes 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 vesting event pushing a large lump sum into wages can produce a substantial single-year FICA bill.

Withholding creates a cash-flow problem for both sides, since income and employment taxes are due on wages the employee has not received in cash. Employers commonly handle this by reducing regular paychecks, requiring the employee to fund the withholding separately, or netting it against other compensation. Failure to withhold correctly exposes the employer to penalties and can create personal liability for responsible officers.

Information Reporting Obligations

Foreign trusts trigger a stack of reporting forms. The specific requirements 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 must file Form 3520 to report the trust relationship and any contributions or distributions. Form 3520 is due on the same day as your individual return, with an automatic extension to October 15 if your income tax return is extended.¹⁰ The trust or the U.S. owner must also file Form 3520-A, detailing the trust’s income, assets, and operations.¹¹

The Form 3520 instructions exempt transfers to funded nonqualified deferred compensation arrangements described in Section 402(b) from the Form 3520 filing requirement.¹² Whether the exemption applies depends on the exact structure. If the arrangement creates ownership interests under Section 679’s grantor trust rules, reporting may still be required under a different provision.

Form 8938

An interest in a foreign trust is a specified foreign financial asset under FATCA. Taxpayers living in the United States must file Form 8938 if aggregate specified foreign financial assets exceed:

$50,000 on the last day of the year or $75,000 at any point during the year, for single or married-filing-separately taxpayers.
$100,000 on the last day of the year or $150,000 at any point during the year, for married filing jointly.

These are aggregate thresholds, not per-asset limits.¹³ Deferred compensation balances routinely clear them.

FBAR

If you have a financial interest in or signature authority over foreign financial accounts with an aggregate value exceeding $10,000 at any point during the calendar year, you must file an FBAR through FinCEN’s BSA E-Filing System.¹⁴ The FBAR deadline is April 15, with an automatic extension to October 15. A foreign trust account 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 or independent contractors. The form reflects both the income and the taxes withheld.

Penalties for Missed Reporting

The penalties for missing foreign trust reporting are large and largely automatic. Under IRC Section 6677, failing to file Form 3520 or Form 3520-A on time, or filing incomplete or incorrect information, carries a penalty equal to the greater of $10,000 or 35 percent of the gross reportable amount for transfers and distributions. For annual ownership reporting under Form 3520-A, the rate drops to 5 percent of the gross value of assets treated as owned by the U.S. person.¹⁵ If the failure continues more than 90 days after IRS notice, an additional $10,000 accrues for each 30-day period. A reasonable cause exception exists, but the IRS has stated that the risk of civil or criminal penalties in a foreign jurisdiction for disclosing the information does not qualify.

FBAR penalties are separate. In 2026, non-willful violations carry a penalty of up to $16,536 per report, and willful violations reach the greater of $165,353 or 50 percent of the unreported balance. Following Bittner v. United States, non-willful penalties apply per report rather than per account.

The Narrow Exception for Services Performed Abroad

Section 409A(b)(1) contains one carve-out. The offshore trust rules do not apply to assets located in a foreign jurisdiction if substantially all of the services to which the deferred compensation relates are performed in that jurisdiction.² “Substantially all” is generally read as at least 85 percent. Time split between the United States and a foreign country does not automatically qualify.

Overlap With Section 679

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 of the trust attributable to that transfer, provided the trust has any U.S. beneficiary.¹⁶ As deemed owner, the person reports all income from that portion of the trust annually.

In employer-funded deferred compensation, the employer is technically the transferor. But if the arrangement causes the employee to be treated as a trust owner under the grantor trust rules, whether through Section 679 by imputation or through the Section 409A deemed-transfer framework, the employee picks up the annual income. Each U.S. owner of a foreign trust should receive a Foreign Grantor Trust Owner Statement detailing the income to report.¹⁷ The overlap between Sections 409A(b), 402(b), and 679 can capture the same income under multiple provisions, though the rules generally prevent double taxation of the same dollars.

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