If it is a foreign grantor trust, grantor trust will be taxed on the income and not the beneficiaries. So if you are a beneficiary of a foreign trust and receive a distribution, the baseline perspective is that you will not be taxed — but there are various hurdles to jump through, exceptions and exclusions to consider.
As provided by the IRS:
- Grantor trust” is a term used in the Internal Revenue Code to describe any trust over which the grantor or other owner retains the power to control or direct the trust’s income or assets. If a grantor retains certain powers over or benefits in a trust, the income of the trust will be taxed to the grantor, rather than to the trust. (Examples, the power to decide who receives income, the power to vote or to direct the vote of the stock held by the trust or to control the investment of the trust funds, the power to revoke the trust, etc.) All “revocable trusts” are by definition grantor trusts. An “irrevocable trust” can be treated as a grantor trust if any of the grantor trust definitions contained in Internal Code §§ 671, 673, 674, 675, 676, or 677 are met. If a trust is a grantor trust, then the grantor is treated as the owner of the assets, the trust is disregarded as a separate tax entity, and all income is taxed to the grantor.
Foreign Grantor Trusts with U.S. Owners
If a trust is a grantor trust, a particular person is treated as the owner of the trust, and the income, deductions, and credits against tax of the trust will be attributed to that person and, therefore, included in computing that person’s taxable income and credits. There are a number of sections of the tax law that result in a trust being considered a grantor trust as to a U.S. person. One such section is Code § 679. Under Code § 679, a U.S. person is generally is treated as the owner of a foreign trust, and such a trust is therefore considered a foreign grantor trust, if
(i) the U.S. person transfers property to the foreign trust, and
(ii) the trust could benefit a U.S. person
If a nonresident alien of the U.S. (“NRA”) has a residency starting date within five years after directly or indirectly transferring property to a foreign trust, such person is treated as if he or she transferred to such trust on the residency starting date an amount equal to the portion of such trust attributable to the property transferred by him or her to such trust in such transfer. Therefore, the trust will be treated as a grantor trust as to such an individual once he or she migrated to the U.S., thereby preventing him or her from sheltering assets from the income tax by transferring them to a foreign trust prior to his or her arrival in the U.S. All foreign trusts are presumed by the IRS to benefit a U.S. person unless the transferor can establish that
(i) under the terms of the trust, no part of the income or corpus of the trust may be paid or accumulated during the taxable year to or for the benefit of a U.S. person, and
(ii) no part of the income or corpus of such trust could be paid to or for the benefit of a U.S. person if the trust were to terminate at any time during the taxable year.
Pursuant to flush language added to Code § 679(c)(1) by the For- eign Account Tax Compliance Act (“FATCA”), which was enacted on 18 March 2010 as part of the Hiring Incentives to Restore Employment (“HIRE”) Act, trust income is deemed to be accumulated during the taxable year to or for the benefit of a U.S. person, even if the U.S. person’s interest in the trust is merely contingent on a future event.
FATCA added three more new rules that make it more likely that a foreign trust will be deemed to have a beneficiary who is a U.S. person, therefore causing a U.S. person who transferred property to that trust to be considered the owner of the trust income under Code § 679(a).
- The first rule is that if any person has the discretion to make a distribution from the trust to any person, the trust will be treated as having a beneficiary who is a U.S. person, unless the trust terms identify the class of persons to whom distributions may be made, and none of those persons is a U.S. person.
- The second new rule enacted by FATCA is that if the U.S. person who transferred property to a foreign trust is directly or indirectly involved in any agreement (written or oral) that may result in trust assets being paid to or accumulated for the benefit of a U.S. person, such agreement will be treated as a term of the trust, making the trust a grantor trust as to the transferor urider Code § 679(a).9
- Thirdly, FATCA provides that if a U.S. person transfers property to a foreign trust, the trust may be treated as having a U.S. beneficiary unless the U.S. person submits information to the IRS as the IRS requires or demonstrates that under the terms of the trust, no part of the income or corpus of the trust may be paid or accumulated during the taxable year to or for the benefit of a U.S. person, and no part of the income or corpus of such trust could be paid to or for the benefit of a U.S. person if the trust were to terminate at any time during the taxable year.’
In essence, this provision says that even if the taxpayer complies with all of the other requirements of Code § 679, the IRS can still require that further information be submitted before it is determined that the trust does not have any U.S. beneficiaries.
A beneficiary shall not be treated as a U.S. person for the purpose of the above rules with respect to any transfer of property to a foreign trust, if such beneficiary first became a U.S. person more than five years after the date of such transfer
Foreign Trust with US Beneficiaries
A U.S. transferor who transfers property to a foreign trust is treated as the owner of the portion of the trust attributable to the property transferred if there is a U.S. beneficiary of any portion of the trust, unless an exception applies to the transfer.
The foreign trust rules apply without regard to whether the U.S. transferor retains any power or interest described in sections 673 through 677. If a U.S. transferor would be treated as the owner of a portion of a foreign trust pursuant to the foreign trust rules and another person would be treated as the owner of the same portion of the trust pursuant to section 678, then the U.S. transferor is treated as the owner and the other person is not treated as the owner.
A foreign trust is treated as having a U.S. beneficiary unless during the taxable year of the U.S. transferor—
(i) No part of the income or corpus of the trust may be paid or accumulated to or for the benefit of, directly or indirectly, a U.S. person; and
(ii) If the trust is terminated at any time during the taxable year, no part of the income or corpus of the trust could be paid to or for the benefit of, directly or indirectly, a U.S. person.
However, there is also a backup rule. Even if, based on the terms of the trust instrument, a foreign trust is not treated as having a U.S. beneficiary within the meaning of the test above, the trust may nevertheless be treated as having a U.S. beneficiary based on the following:
- All written and oral agreements and understandings relating to the trust;
- Memoranda or letters of wishes;
- All records that relate to the actual distribution of income and corpus; and
- All other documents that relate to the trust, whether or not of any purported legal effect.
For purposes of determining whether a foreign trust is treated as having a U.S. beneficiary, the IRS looks to the following additional factors as well:
- If the terms of the trust instrument allow the trust to be amended to benefit a U.S. person, all potential benefits that could be provided to a U.S. person pursuant to an amendment must be taken into account;
- If the terms of the trust instrument do not allow the trust to be amended to benefit a U.S. person, but the law applicable to a foreign trust may require payments or accumulations of income or corpus to or for the benefit of a U.S. person (by judicial reformation or otherwise), all potential benefits that could be provided to a U.S. person pursuant to the law must be taken into account, unless the U.S. transferor demonstrates to the satisfaction of the Commissioner that the law is not reasonably expected to be applied or invoked under the facts and circumstances; and
- If the parties to the trust ignore the terms of the trust instrument, or if it is reasonably expected that they will do so, all benefits that have been, or are reasonably expected to be, provided to a U.S. person must be taken into account.
For these purposes, an amount is treated as paid or accumulated to or for the benefit of a U.S. person if the amount is paid to or accumulated for the benefit of:
(i) A controlled foreign corporation, as defined in section 957(a);
(ii) A foreign partnership, if a U.S. person is a partner of such partnership; or
(iii) A foreign trust or estate, if such trust or estate has a U.S. beneficiary (within the meaning of paragraph (a)(1) of this section).
Finally, an amount is treated as paid or accumulated to or for the benefit of a U.S. person if the amount is paid to or accumulated for the benefit of a U.S. person through an intermediary, such as an agent or nominee, or by any other means where a U.S. person may obtain an actual or constructive benefit.
Who is a Grantor?
A grantor includes any person to the extent such person either creates a trust, or directly or indirectly makes a gratuitous transfer of property to a trust. The grantor often establishes in the trust instrument the terms and provisions of the trust relationship between the grantor, the trustee, and the beneficiary.
If a person creates or funds a trust on behalf of another person, both persons are treated as grantors of the trust. However, a person who creates a trust but makes no gratuitous transfers to the trust is not treated as an owner of any portion of the trust under sections 671 through 677 or 679. Also, a person who funds a trust with an amount that is directly reimbursed to such person within a reasonable period of time and who makes no other transfers to the trust that constitute gratuitous transfers is not treated as an owner of any portion of the trust under sections 671 through 677 or 679.
In addition, a grantor includes any person who acquires an interest in a trust from a grantor of the trust if the interest acquired is an interest in certain investment trusts described in § 301.7701–4(c), liquidating trusts described in § 301.7701–4(d), or environmental remediation trusts described in § 301.7701–4(e).
If a trust makes a gratuitous transfer of property to another trust, the grantor of the transferor trust generally will be treated as the grantor of the transferee trust. However, if a person with a general power of appointment over the transferor trust exercises that power in favor of another trust, then such person will be treated as the grantor of the transferee trust, even if the grantor of the transferor trust is treated as the owner of the transferor trust under subpart E of part I, subchapter J, chapter 1 of the Internal Revenue Code.
Grantor Trusts with Non-U.S. Owners
All “revocable trusts,” are treated as grantor trusts. An “irrevocable trust,” however, may or may not qualify as a grantor trust. An irrevocable trust may be treated as a grantor trust if one or more of the grantor trust conditions set out in §§ 671 – 678 are met.
Under those rules, a grantor trust is any trust in which the grantor retains one or more of the following powers:
- A reversionary interest of more than 5% of the trust property or income;
- The power to revoke the trust and/or to return the trust’s corpus/principle to the grantor;
- The power to distribute income to the grantor or grantor’s spouse;
- Power over the beneficial interests in the trust;
- Administrative powers over the trust allowing the grantor to benefit.
A trust will also be deemed to be a grantor trust under either of the following circumstances:
- A trustee, beneficiary, or other person a power exercisable solely by himself to vest the corpus or the income therefrom in himself;
- A United States person who directly or indirectly transfers property to a foreign trust.
In the case of trusts having a foreign grantor—so- called “inbound grantor trusts with foreign grantors”— Code § 672(f) applies special rules that make it difficult for a foreign person to be treated as the owner of a trust for income tax purposes under the grantor trust rules. This, in many instances, prevents a foreign person from creating a foreign trust for U.S. beneficiaries and taking the position that he or she is the owner of the trust for income tax purposes.
A trust, be it foreign or domestic, is treated as a grantor trust with respect to transfers after 19 August 1996, only if the person deemed to own the trust is a U.S. person or a domestic corporation.’ This rule applies whether the trust income would be imputed to the foreign person either “directly or through 1 or more entities.”’ Prior to the enactment of Code § 672(f), a foreign grantor could use a foreign trust to convert into a tax-free distribution a gift to U.S. beneficiaries of assets—say, foreign securities— producing taxable income. This is because, if such income were taxable only to the grantor, and the grantor were a foreign grantor receiving foreign-source income, then no person would wind up being taxed in the United States on the trust’s income.’
There are some important exceptions to the above rule that prohibits grantor trust status unless the person deemed to own the trust is a U.S. person or domestic corporation.
The first exception is when an NRA funds the trust and “the power to revest absolutely in the grantor title to the trust property to which such portion is attributable is exercisable solely by the grantor without the approval or consent of any other person or with the consent of a related or subordinate party who is subservient to the grantor. In such a case the NRA grantor will be deemed the owner of the trust income and the trust will be treated as a grantor trust for U.S. income tax purposes. A related or subordinate party is presumed to be subservient to the grantor unless the presumption “is rebutted by a preponderance of the evidence. The power to revest, however, must be exercisable for at least 183 days during the taxable year of the trust. If the first or last taxable year of the trust (including the year of the grantor’s death) is less than 183 days, the grantor is treated as having a power to revest if the grantor has such power for each day of such first or last taxable year. But if the trust fails to qualify for this exception in any particular year, it may not qualify in any subsequent year, even if the requirements otherwise would be satisfied.’
The second exception is when an NRA funds a trust and “the only amounts distributable from such portion (whether income or corpus) during the lifetime of the grantor are amounts distributable to the grantor or the spouse of the grantor. ’ Again, in such a case the non- resident alien will be treated as the owner of the trust in- come for U.S. income tax purposes. For purposes of Code § 672, amounts distributable from a trust in discharge of a legal obligation of the grantor or the grantor’s spouse that are enforceable under the local law of the jurisdiction in which the grantor or the grantor’s spouse resides are treated as distributable to the grantor or the grantor’s spouse. Code § 672(I)(5) adds a further layer of protection against tax avoidance by preventing NRAs planning to adopt U.S. residency from circumventing the grantor trust rules. It provides that if an NRA would be treated as the owner of any portion of a trust (without regard to the provisions of section 672(f)), and such trust has a beneficiary who is a U.S. person, such beneficiary shall be treated as the grantor of such portion to the extent such beneficiary has made (directly or indirectly) transfers of property (other than a nongratuitous transfer or a gift that would be excluded from taxable gifts under §2503(b)) to such NRA. Before the enactment of Code § 672(I)(5), a wealthy NRA could avoid U.S. tax on his or her wealth by transferring property by gift to another NRA who could, in turn, contribute the property to a trust of which the initial NRA grantor was a discretionary income beneficiary and over which the intermediary NRA retained grantor powers over the trust. Upon becoming a U.S. resident, the former NRA could claim that he or she was not the grantor of the trust. Under Code § 672(I), the former NRA will be deemed the grantor of the trust. Certain trusts in existence on 19 September 1995 are not subject to Code § 672(I): those treated as owned by the grantor under Code § 676 (powers to revoke and re- vest) or Code § 677 (income paid to or accumulated for the benefit of the grantor or the grantor’s spouse). Code § 672(I) will apply, however, with regard to any portion of the trust attributable to transfers to the trust made after 19 September 1995
Foreign Nongrantor Trusts
While the income of a foreign grantor trust (like that of all grantor trusts) is attributed to the owner of the trust, resulting in the trust effectively being ignored for income tax purposes as a separate taxpayer, the income of a foreign nongrantor trust (like the income of a domestic nongrantor trust) is taxed to the trust, to the beneficiaries, or partly to each. Income is allocated between a foreign nongrantor trust and its beneficiaries through the concept of distributable net income (“DNI”) and its limitation on the trust’s distribution deduction. DNI for a foreign trust is, generally speaking, the taxable income of the trust, including capital gains (for domestic trusts, DNI does not include capital gains). “A complex foreign nongrantor trust receives a deduction for thot portion of its current income thot the trust is required to distribute plus that portion of its current income that the trustee actually distributes to the beneficiaries pursuant to the governing instrument.”
A foreign nongrantor trust, like a domestic nongrantor trust, can be either a “simple trust” or a “complex trust.” A foreign nongrantor trust is a simple trust if: (i) all income must be distributed currently; (ii) no amounts may be paid, permanently set aside for, or used for a charitable beneficiary; and (iii) no distributions are made other than of current income (i.e., no distributions are made of accumulated income or corpus). All of the income of a foreign nongrantor trust that is classified as a simple trust will be taxed to the beneficiaries, and the trust will receive a deduction for its current income that it must pay to the beneficiaries, whether or not that income is actually distributed.° The amount included in the beneficiaries’ gross income and the amount of the trust’s deduction are both limited by the trust’s DNI.
A foreign nongrantor trust that is not required to distribute all of its income currently, that distributes accumulated income or principal, or that has a charitable beneficiary is a “complex” trust. A complex foreign nongrantor trust receives a deduction for that portion of its current income that the trust is required to distribute plus that portion of its current income that the trustee actually distributes to the beneficiaries pursuant to the governing instrument.°’ The trust’s deduction is limited to the amount of its DNI.°
The beneficiaries of a complex foreign nongrantor trust include in their gross income all income that the trust is required to distribute, and all income actually distributed to the beneficiaries pursuant to the governing instrument. If and to the extent that a complex nongrantor trust does not distribute (and is not required to distribute) DNI, such DNI is taxable to the trust. Each beneficiary must include in his or her gross income an amount equal to that beneficiary’s pro-rata share of the trust’s DNI’ A distribution in excess of the trust’s DNI is treated either as a nontaxable distribution of principal or as a distribution of income accumulated from prior years taxable under the so-called “throwback rules.”. The purpose of the throwback rules is to prevent U.S. persons from using foreign nongrantor trusts to accumulate income without current tax. Under the throwback rules, if a foreign nongrantor trust accumulates DNI in one year, the accumulation becomes undistributed net income (“UNI”) for the following year. Since DNI for a foreign trust includes gains allocable to corpus, UNI will include any accumulated gains. An “accumulation distribution” is a distribution of any amount from the trust, other than income that is required to be distributed from the trust, to the extent that the amount distributed exceeds the trust’s DNI for the year, reduced by income that is required to be distributed. The throwback rules apply only to foreign trusts, since distributions from domestic trusts are calculated without regard to UNI. Under the throwback rules, the U.S. taxes a U.S. beneficiary of a foreign nongrantor trust that makes an accumulation distribution in the same manner that the U.S. would have taxed the beneficiary if the trust had distributed all of its income on a current basis. U.S. beneficiaries who receive distributions of UNI from a foreign nongrantor trust may be subject to onerous U.S. income tax treatment on the distribution in the form of two types of penalties.
First, the distribution of UNI is taxed to the U.S. beneficiary as ordinary income (taxable at marginal rates up to 37%), even if the UNI represents gains accumulated in a prior year (long-term capital gains are generally taxable to U.S. persons at a flat 23.8% rate, when accounting for the Medicare tax under Code Section 1411). The throwback tax is determined by averaging the distributions over a number of years equal to that over which the income was earned, and by including a fraction of the income received from the trust in the beneficiary’s income for each of the five preceding years, excluding the years with the highest taxable income and the lowest taxable income. The fraction of income included in the five years is based on the number of years the income was accumulated.
Second, the U.S. income tax on the distribution is subject to an interest surcharge, calculated on a compounding basis, that is intended (in a rough manner) to charge the U.S. beneficiary as if he or she had owed the U.S. tax for the prior year in which the UNI was earned in the foreign nongrantor trust. The interest surcharge imposed on the throwback tax is equal to the rate of interest applicable to underpayments of tax (which is the Federal short-term rate as determined monthly, plus three percent).
The combination of the above two penalties can result in a confiscatory tax as large as the distribution itself, because the longer UNI accumulates in a trust, the higher the interest charge. In order to determine whether a distribution from a foreign nongrantor trust carries out UNI, certain ordering rules apply. To apply the ordering rules, one must understand the definitions of DNI and UNI discussed above and must understand the definition of fiduciary accounting income (“FAI”). FAI is the amount of the trust’s income determined under the terms of the governing instrument and applicable local trust law. FAI can be, and often is, different in both timing and amount from DNI. To the extent there is any FAI exceeding DNI, it is not subject to U.S. tax but may be subject to local tax. When the total distributions from a foreign nongrantor trust during the year at issue do not exceed FAI for the year, the distribution will be deemed to carry out the trust’s current-year DNI. Once DNI is exhausted, FAI is carried out and no UNI is carried out, so the throwback rules will not apply.
When the total distributions from a foreign non-grantor trust during the year at issue exceed FAI for the year, the distribution will be deemed to carry out the trust’s current-year DNI and once DNI is exhausted, UNI carried forward from prior years is carried out. Once all DNI and UNI have been carried out, the balance of any distributions from the trust is deemed to be trust capital.
The Partnership Blocker Solution to the Throwback Rules for Foreign Non-Grantor Trusts
Generally speaking, if a U.S. person is a beneficiary of a foreign nongrantor trust, the solution to avoid the throwback rules is to distribute all of the income on an annual basis (either to the U.S. person beneficiary or to another non-U.S. person beneficiary). Another solution is to decant the trust assets to a domestic trust where the income can be accumulated without being subject to the throwback rules. If annual distributions from the foreign trust or decanting to a domestic trust are not possible or are not appropriate in the given circumstances, another solution that may be useful is the so-called “partnership blocker solution.” The partnership blocker solution is intended to take advantage of the ordering rules discussed above for DNI, UNI, and FAI. The partnership blocker solution’s objective is to control when the trust receives FAI. With the partnership blocker solution, the foreign trust owns an interest as a ninety-nine percent partner in a partnership. The other one percent partner can be a corporation, all of the stock of which is owned by the trust. The assets that would have otherwise been held by the trust are held by the partnership. The partnership is transparent for tax purposes and, therefore, the DNI/ UNI of the trust will be determined by the income of the partnership and the distributions from the trust. The partnership will nevertheless serve as a blocker for purposes of the trust’s FAI. FAI will only be provided to the trust when an actual distribution is made by the partnership to the trust. In most cases when the partnership makes a distribution to the trust, the trust will also have a DNI amount for the current year. Under the above ordering rules, a distribution from the trust will be first treated as taxable DNI to the extent of any current year DNI and, if the distribution does not exceed the current year FAI, the remainder of the distribution should be treated as FAI, which is not subject to taxation.
The partnership blocker allows the trustee to accumulate income in the underlying partnership without triggering the adverse effects of the accumulation distribution rules once a distribution to a U.S. beneficiary is made. Because the income generated by the underlying investments passes through the partnership directly to the trust for U.S. income tax purposes as DNI, UNI will gradually accumulate in the trust. However, the UNI will not be deemed distributed out of the Trust, and thus a U.S. beneficiary will not be taxed on such UNI as long as the trust’s total distributions for the year do not exceed its FAI (the distributions will likely not exceed FAI, since the distributions will equal exactly what was distributed to the trust by the partnership).
Tax on Contribution of Assets to a Foreign Trust
If a U.S. citizen or U.S. resident transfers property to a foreign trust, the transfer is treated as a sale or exchange of the transferred property for an amount equal to the fair market value of the property, and the transferor recognizes gain on the excess of the fair market value of the property over its adjusted basis. Such a transfer essentially is taxed at the capital gains tax rates (which is currently twenty percent plus a 3.8% Medicare surcharge). The tax on contribution to the foreign trust is not imposed, however, if the foreign trust is treated as a grantor trust for U.S. income tax purposes. There would, however, still be IRS reporting requirements.
Reporting Requirements for Contributions to and Distributions from a Foreign Trust and Receipts of Foreign Gifts
When a U.S. person makes a contribution to a foreign trust or receives a distribution from a foreign trust, in addition to complying with any required income tax reporting requirements and payments, he or she is required to file a report with the IRS for the year of the contribution or distribution reporting the same. Contributions by U.S. persons to foreign trusts and distributions to U.S. persons from foreign trusts must be reported annually on IRS Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts. If a U.S. person is an owner of a foreign trust, IRS Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner, also must be filed. It should be noted that “distributions from foreign trusts” also may include distributions that are constructively received, such as the payment of the beneficiary’s debts by the trust, payments to the beneficiary in exchange for property or services of the beneficiary if the payments exceed the fair market value of the property or the value of the services, and direct or indirect loans received by the beneficiary from the trust, unless the loan is in exchange for a so-called “qualified obligation.
IRS Form 3520 must be filed by a U.S. person for each year that he or she makes a contribution to or receives a distribution from a foreign trust. The form is due on the date the U.S. person’s individual income tax return, IRS Form 1040, is due (including extensions). With respect to contributions to a foreign trust, IRS Form 3520 requires the U.S. person who contributed the assets to report the name of the trust and the property contributed and value thereof. The U.S. person may also be required to report the names of the trustees or other persons in control of the trust and the names of the beneficiaries thereof, and may be required to attach a copy of the trust documents and other agreements and letters of understanding that control the trust relationship. Among other things, IRS Form 3520 requires the U.S. beneficiary of a foreign trust to report the name of the trust and its address, the amount of the distributions received from the trust during the tax year, whether any loans were received from the trust during the tax year—
If a Foreign Grantor Trust Beneficiary Statement is received from the Trust, meaning that it is a grantor trust, the entire distribution to the U.S. beneficiary will be treated as a nontaxable gift. If a Foreign Nongrantor Trust Beneficiary Statement is received from the trust, meaning that the trust is not a grantor trust, the distribution will be taxed to the beneficiary under ordinary U.S. income tax rules (which may or may not result in accumulation distribution treatment). If the U.S. beneficiary does not receive any such statement, he or she may be able to avoid treating the entire distribution as an accumulation distribution if he or she can provide certain information with respect to the distributions to the IRS
Foreign Grantor Trust: Reporting Requirements
In addition to the income of a grantor trust being taxed to the grantor under U.S. tax law, there are specific reporting requirements with which the trust and the grantor must comply, above and beyond reporting the income on the grantor’s annual income tax return.
If adequate records are not provided to the IRS to determine the proper treatment of a distribution from a foreign trust, the U.S. beneficiary will be required to treat the distribution as an accumulation distribution (discussed above) includible in the income of the beneficiary. (This is so even if the trust is a grantor trust, the income of which is usually only taxable to the grantor with the distribution otherwise being treated as a gift, if adequate records are not provided to the IRS.) The beneficiary will not be required to treat the entire distribution as an accumulation distribution if he or she receives from the foreign trust either a Foreign Grantor Trust Beneficiary Statement or a Foreign Nongrantor Trust Beneficiary Statement with respect to the distribution and attaches the statement to Form 3520 and further inquiries by the IRS are answered to its satisfaction.
Foreign Nongrantor Trust: Reporting Requirements
If a foreign trust does not fall within the definition of a foreign grantor trust under Code § 679, it is deemed a foreign nongrantor trust for U.S. tax purposes. Under U.S. tax law, distributions by a foreign nongrantor trust to a U.S. beneficiary are taxed to such beneficiary.
If the U.S. Taxpayer Receives a Foreign Nongrantor Trust Beneficiary Statement
Part III of Form 3520 covers distributions to a U.S. person from a foreign trust. Part III, Line 30, asks whether the taxpayer has received a Foreign Nongrantor Trust Beneficiary Statement with respect to any such distribu- tion. If the taxpayer has received a Foreign Nongrantor Trust Beneficiary Statement, he or she must attach it to Form 3520 and enter the pertinent information on Schedule B of IRS Form 3520
The Foreign Nongrantor Trust Beneficiary Statement is not part of a return and must, therefore, be prepared independently by the trustee. Pursuant to IRS Notice 97- 34 and the Instructions for IRS Form 3520, a Foreign Nongrantor Trust Beneficiary Statement should contain the following information:
Foreign Trust Background Information, including:
– the name, address, and EIN (if available) of the trust;
– the name, address, and TIN (if applicable) of the trustee furnishing the statement;
– the method of accounting used by the trust (cash or accrual);
– the taxable year to which the statement applies; and
– a statement identifying whether any of the grantors are partnerships or corporations.
U.S. Beneficiary Information, including:
- the name, address, and TIN of the U.S. beneficiary; and
- a description of the property (including cash) distributed or deemed distributed to the U.S. person, and the fair market value of said distribution.
- Sufficient information to enable the U.S. beneficiary to establish the appropriate treatment of any distribution or deemed distribution for U.S. tax purposes. According to Notice 97-34, information similar to that presented in an IRS Form K-1 would be sufficient. The trustee has the opportunity here to report what the components of the distribution represent (e.g., interest, dividends, etc.), so that the beneficiary can report the proper information on the beneficiary’s own tax return. Income, deductions, etc., need to be reported using U.S. tax concepts, which may require significant recharacterization of amounts shown on the financials of the foreign trust.
- A statement that, upon request, the trust will permit either the IRS or the beneficiary to inspect and copy the trust’s permanent books of account, records, and such other documents that are neces- sary to establish the appropriate treatment of any distribution. This statement is not necessary if the trust has appointed a U.S. agent.
- The name, address, and EIN of the trust’s U.S. agent, if applicable.
If the U.S. Taxpayer Does Not Receive a Foreign Nongrantor Trust Beneficiary Statement
Part III, Line 30, of IRS Form 3520 also provides for the case in which the taxpayer does not receive a Foreign Nongrantor Trust Beneficiary Statement from a foreign trust with respect to distributions received. In such a case, the taxpayer is asked to complete Schedule A of Part III of Form 3520. This schedule requires only that the taxpayer inform the IRS of the amounts received from the foreign trust and the number of years the trust has been a foreign trust. The taxpayer is not asked on this schedule to provide identifying information with regard to the trust in question or to its trustee. The disadvantage to the taxpayer of not procuring a Foreign Nongrantor Trust Beneficiary Statement is that the IRS, pursuant to IRS Notice 97-34, may deem (unless a U.S. agent is appointed) the entire distribution made by any foreign nongrantor trust an accumulation distribution, which would subject the amount of the distribution to unfavorable tax treatment and the imposition of the interest charge under the throwback rules. If a U.S. beneficiary cannot obtain a Foreign Nongrantor Trust Beneficiary Statement, however, Schedule A of Part III of Form 3520 allows the U.S. beneficiary to avoid treating the entire amount as an accumulation distribution
A Foreign Nongrantor Trust Beneficiary Statement must include the following items.
- An explanation of the appropriate U.S. tax treatment of any distribution or deemed distribution for U.S. tax purposes, or sufficient information to enable the U.S. beneficiary to establish the appropriate treatment of any distribution or deemed distribution for U.S. tax purposes.
- A statement identifying whether any grantor of the trust is a partnership or a foreign corporation. If so, attach an explanation of the relevant facts.
- A statement that the trust will permit either the IRS or the U.S. beneficiary to inspect and copy the trust’s permanent books of account, records, and such other documents that are necessary to establish the appropriate treatment of any distribution or deemed distribution for U.S. tax purposes. This statement is not necessary if the trust has appointed a U.S. agent.
- The Foreign Nongrantor Trust Beneficiary Statement must also include items (1), (4), and (6), as listed in the line 29 instructions, as well as basic identifying information (for example, name, address, TIN, etc.) about the foreign trust and its trustee.
Important Aspects of the Beneficiary Statement
- The most important aspect of the Foreign Non-Grantor Trust Beneficiary Statement is that the beneficiary is able to ascertain the amount of income and category of income. The trustee should be sure to provide:
- Total Amount of Distribution: Income vs. Non-Income
- Is the income Current Year, Prior Year, or Corpus
- Was any of the income US-sourced?
Prepare and Submit Forms 3520/3520-A on behalf of the Beneficiary if the U.S. beneficiary can provide certain information regarding actual distributions from the trust for the prior three years. Under this “default treatment,” the U.S. beneficiary is allowed to treat a portion of the distribution as a distribution of current income based on the average of distributions from the prior’three years, with only the excess amount of the distribution treated as an accumulation distribution. In making the calculation, the prior three years’ distributions are added together. The total is then multiplied by a factor of 1.25. This amount is then divided by three, with only the excess amount of the distribution treated as an accumulation distribution. This formula, in effect, assumes that current income increases by twenty- five percent each year before the excess is treated as an accumulation distribution.
The information needed in order to qualify for default treatment is as follows:
- the number of years the trust has been a foreign trust (with any portion of a year to be considered a complete year);
- the total distributions received from the foreign trust during the current year, including loans from a “related foreign trust” (a “related foreign trust” is a trust of which the U.S. taxpayer is a grantor or beneficiary of which a “related person” is a grantor or beneficiary; a “related person” is
(i) a sibling of the whole or half blood, an ancestor, a lineal descendant, or a spouse of the U.S. taxpayer or of any related person, or
(ii) a corporation of which the U.S. taxpayer owns directly or indirectly more than fifty percent in value of the outstanding stock); and
- the total distributions received from the foreign trust during the preceding three years.
Reporting of Accumulation Distributions Under the Throwback Rules
Once the amount of an accumulation distribution is determined on Schedule A or B of Part III of IRS Form 3520, the throwback tax on the accumulation distribution must be calculated using IRS Form 4970, Tax on Accumulation Distribution of Trusts (a copy of which is attached). As discussed above, the tax is determined by averaging the distributions over a number of years equal to that over which the income was earned and by including a fraction of the income received from the trust in the beneficiary’s income for each of the five preceding years, excluding the years with the highest taxable income and the lowest tax- able income. The fraction of income included in the five years is based on the number of years the income was accumulated. The interest surcharge imposed on the throwback tax is entered on Line 52 of Schedule C of Part III of IRS Form 3520.
Appointment of U.S. Agent
Any foreign trust (grantor or nongrantor) may appoint a limited agent (a “U.S. Agent”) for purposes of responding to
(i) IRS requests to examine records or produce testimony with respect to any items included on IRS Form 3520 or 3520-A or
(ii) an IRS summons regarding such records or testimony.
A U.S. Agent is a U.S. person (including a U.S. grantor, a U.S. beneficiary, or a domestic corporation controlled by the grantor) that has a binding contract with a foreign trust that allows such person to act as the trust’s authorized U.S. agent for the purposes mentioned above. The format of the contract is contained in the IRS Form 3520-A Instructions.
If a foreign grantor trust does not choose to appoint a U.S. agent, then the IRS can determine unilaterally the amounts to be included in income by the owner of the foreign trust. Also, if no agent is appointed, various attachments must be filed along with IRS Form 3520-A, including
(i) a summary of the terms of the trust and all written and oral agreements and understandings with the trustee that are related to the trust (whether or not legally enforceable) and
(ii) copies of all trust documents, including the trust agreement and amendments, memoranda or letters of wishes, and the like.’
If the U.S. agent of a foreign grantor trust resigns or liquidates, or the U.S. agent’s responsibility as an agent of the foreign grantor trust is terminated, the U.S. owner of the foreign trust must ensure that the foreign trust notifies the Commissioner of Internal Revenue within ninety days of such event by filing an amended IRS Form 3520- A. This notification must contain the name, address and taxpayer identification number of the new U.S. agent (if any). If a foreign nongrantor trust does not choose to appoint a U.S. agent, then the IRS can determine unilaterally the amounts to be included in income by the beneficiary of the foreign trust, unless “adequate records” are provided to the IRS. Presumably this means that it would be enough to complete Schedule A of Part III of Form 3520.
Even if a U.S. agent of a foreign trust—be it nongrantor or grantor—is identified on IRS Form 3520 or 3520-A, the U.S. beneficiary or owner of the foreign trust may be treated as providing incorrect information and thus may be subject to the penalty described in Code § 6677 (see below) if either the U.S. agent or the foreign trust does not comply with its obligations under the agency agree- ment (e.g., if the foreign trust fails to produce records re-quested by the IRS in reliance on the bank secrecy laws of the country where the trust’s thank accounts are located). This is the case even if the U.S. beneficiary has attached to the IRS Form 3520 a Foreign Grantor Trust Beneficiary Statement or a Foreign Nongrantor Trust Beneficiary Statement.
Receipts of Foreign Gifts
If the value of the aggregate “foreign gifts” received by a U.S. citizen or resident during any taxable year ex- ceeds $10,000, the recipient must provide such information as the IRS prescribes. The term “foreign gift” is any amount received from a person other than a U.S. citizen or resident that the recipient treats as a gift or bequest.
A U.S. citizen or resident is required to report the receipt of a foreign gift only if the aggregate amount of gifts from a particular foreign person or estate exceeds $100,000 during the taxable year, and is required to report the receipt of a gift from a foreign corporation or partner- ship if the aggregate amount of gifts from all such entities exceeds $10,000 during the taxable year. For purposes of determining these thresholds, the gifts from related persons are aggregated. Note that gifts made by foreign persons (whether to U.S. persons or non-U.S. persons) are not subject to the U.S. gift tax, unless the gift is of U.S. situs real or tangible property. Nevertheless, the gifts may be reportable if received by a U.S. person under the above rules. Foreign gifts are reported on IRS Form 3520, which is the same form used for reporting transactions with foreign trusts.
Does SECTION 679(A)(4) APPLY TO SUBTITLE B (U.S. ESTATE, GIFT AND GENERATION SKIPPING TRANSFER TAXES) ?
In almost every article or discussion about pre-immigration tax planning, inevitably some statement similar to the following is said: “. . . for a nonresident alien contemplating immigration to the United States, careful trust planning is required at least five years prior to the time of the immigration.”
The determination of whether a foreign trust has U.S. beneficiaries (making the trust disregarded as “grantor” under IRC Section 679) is made annually. A foreign trust created by a U.S. resident as nongrantor (with no U.S. beneficiaries) may become grantor if a beneficiary obtains U.S. residency within five years of the grantor funding the trust. The U.S. grantor must recognize all accumulated trust income in the taxable year the NRNC beneficiary becomes a U.S. resident.7 The U.S. grantor recognizes all income of the foreign trust for each subsequent year the foreign trust remains grantor.
If a foreign trust ceases to have a U.S. beneficiary, the U.S. grantor is treated as having made a taxable transfer to the foreign trust. Tax is recognized on the first day of the first taxable year following the last taxable year the trust had a U.S. beneficiary. The gain triggered by deemed sale of trust assets (under Section 684) includes appreciation since contribution to the trust.8
Deemed grantor status (avoiding the deemed sale) does not apply to foreign trusts without U.S. beneficiaries. Potential U.S. beneficiaries and future beneficiaries are, however, counted. If a foreign trust may be amended to add a U.S. person as a beneficiary, trust assets will be deemed recontributed upon U.S. residency of a beneficiary. The trust is then deemed a foreign grantor trust.9 However, if a foreign beneficiary first becomes a U.S. resident more than five years after the trust is funded, the trust is not treated as having a U.S. beneficiary for the purposes of IRC Section 679. The exception also is not available if the beneficiary was previously a U.S. resident.
Is there a difference for income taxes versus transfer taxes (estate gift and GSTT)? Why is this “5 year” statement so frequently made by investment advisors and many tax practitioners? To be sure, I.R.C. Section 679(a)(4) and the 2001 Treasury Regulation Section 1.679-52 (Pre-Immigration Trusts) have caused much confusion Section 679 (and its deemed ownership rule) does not apply for purposes of the estate and gift tax provisions of Subtitle B of the Code. Therefore, provided the grantor retains no rights or powers in the Assets held by the Pre-Immigration Trust that would require the Assets to be included in his gross estate under Sections 2031 through 2044 of Subtitle B, the Assets will not be so included, irrespective of the deemed ownership rule and income tax consequences under Section 679.