Foreign Non Grantor Trusts as a Pre Immigration Tax Planning Tool to those migrating to the US

A Foreign Non-Grantor Trust (FNGT) is a type of trust established under the laws of a foreign (non-U.S.) jurisdiction, where the person creating the trust (the grantor or settlor) does not maintain control over the trust’s assets or income for U.S. tax purposes.

This means that the grantor is not treated as the owner of the trust’s income or assets under U.S. tax law.

Foreign Non-Grantor Trusts can be used for various purposes, including estate planning, asset protection, and tax planning.

In considering emigration (especially into the United States), one has to pay sufficient regard a priori to the tax ramifications with being a resident of the country emigrated to. There are various tax planning tools which can considerably reduce tax liabilities which have to be deployed before the change of residency. In this regard, a carefully-planned tax-minimisation framework should be adopted before emigration to maximise tax efficiency

In this article, we discuss the use of the FNGT is pre immigration tax planning for those moving into the US from abroad

Moving to the USA

To obtain US citizenship, one has to first apply for permanent residency and the Lawful Permanent Resident Card, commonly known as the “green card”, before applying for naturalization after having held the “green card” for five years and satisfied other requirements.

For a resident alien, meaning a person who holds a “green card” or anyone who has stayed in the country for at least 31 days in one calendar year and 183 days over the past three years are subject to worldwide income tax, like US citizens.

• Clients, their children, and sometimes their parents or their business interests continue to move to, or invest in, the U.S. for the following reasons (among others):
  • Employment – Clients Coming to the U.S.: Clients seek advice for both short-term and long-term employment obligations and U.S. pre-immigration planning both from income and transfer tax perspectives
  • Family – Members of Clients’ Family Coming to (or Already in) the U.S.: Clients’ children establish residency in the U.S. and need to plan for assets passing to them (during life or at death of their parents)
  • Business – Clients’ Business Moving Into the U.S. or Want to Invest in U.S. Situs Assets: Clients need assistance with tax and entity planning for their businesses, whether this is portfolio investment into the U.S. or in an active business enterprise.

1. Lawful Permanent Resident (Green Card Holders) = RA (Actual physical presence in U.S. is irrelevant)
2. Substantial Presence Test (“SPT”) = RA (Consider Impact of Special Visa Classifications Where Days Do Not Count)
   • Individuals meet this objective test if physically present in the U.S. for at least 31 days in the current year AND at least 183 days for the 3-year period ending on the last day of the current year using a weighted average formula.
   • Generally, any day of physical presence counts as a U.S. day regardless of how much time during that day the individual is in the U.S.
   • Example:  2018: 100 Days x 1 day     =   100.00 Days
                   2017: 170 Days x 1/3 days =   56.61   Days
                   2016: 170 Days x 1/6 days =   28.33  Days
                           Total =                         184.94 Days = FLUNK
   • General “121 Day” Rule: If the individual does not have a green card and is not on a preferred visa classification, then if the individual stays in U.S. for at most 121 days each year, the individual will avoid becoming a  U.S. income tax resident under the Substantial Presence Test 

***Consider Closer Connection Exception (or Applicable Treaty)

***Consider residency election if married to U.S. Citizen/GC Holder

• Closer Connection Exception
  • Less than 183 days in the current year, but whose 3-year average is greater than 121 days, but can demonstrate tax home in/closer connection to foreign country
• Special Visa Classification Exceptions
  • i.e., Student Visas (F and M) and G visas
• Always Consider Treaties- including the protocols.

3. First Year Residency Election

Foreign Grantor Trust vs Foreign non grantor trust

• Foreign Grantor Trust (IRC 672(f)(2))
  • A foreign trust with a foreign grantor which is either:
    • Grantor can revoke or revest during grantor’s life; or
    • The only amounts distributable from the trust (income or corpus) during the grantor’s lifetime  are to the grantor or the grantor’s spouse during the grantor’s lifetime
  • IRC 672(f)(5) treats a U.S. person (rather than a foreign person) as the grantor of a trust if before he became a U.S. person, he gifted assets to another foreign person who subsequently used the assets to create a trust of which the U.S. person is a beneficiary
• Foreign Nongrantor Trust (essentially the default)
  • A foreign trust which is not a foreign grantor trust 
  • Caveat: Beware of the potential application of the 5 Year Drop Off Trust Rules (IRC 679(a)(4)). 
  • If a U.S. person gratuitously transfers property to the trust either directly or indirectly, that portion of the trust will not qualify as a foreign non-grantor trust

Pre-emigration Tax Planning, FGT and FNGT

As could be imagined, one would face a drastic change in his/ her tax position by moving from a low tax regime to the US. There are a number of taxation tools available which can potentially mitigate the impacts.

 (1) Setting up a Trust

A Foreign non-grantor trust (the “FNGT”), on the other hand, with appropriate structure in place, can achieve favourable tax results for US persons, especially in the context of inheritance. 

(2) Existing Trust

It is not uncommon that some people who wish to become a US person are already beneficiaries of a trust.  In light of any forthcoming US residency, the trust structure shall be revisited to avoid any adverse tax implications.

To minimise US taxes, generally speaking, the trust should prior to the beneficiary becoming a US person (1) make as much distributions as possible to the beneficiaries, (2) distribute all unpaid retained earnings and in which case the personal financials have to be revised to reflect that the beneficiary has already received the same and such distribution has now converted into the beneficiary’s personal assets which is not subject to US tax, (3) re-valuate the trust assets reflecting the mark-to-market adjustments in the financial accounts of the trust; and/or (4) “step up” in basis of the assets to minimise capital gain taxes.

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.

PFIC’s and Foreign Non-Grantor Trusts

Passive Foreign Investment Companies, or PFICs, are a specific type of foreign corporation. They meet one of two conditions in a year: 75% or more of the corporation’s gross income is “passive income”, or 2. At least 50% of the corporation’s assets (averaged over each quarter) are held for the purpose of generating “passive income” or are already producing such income.

The taxation rules for PFICs are unique: Taxation only happens when there are actual distributions or when the PFIC shares are sold. However, there’s an exception if the corporation is elected to be treated as a “Qualified Electing Fund”.

There are strict rules for “excess distributions” and when PFIC shares are sold:

• These are subject to an interest charge due to tax deferral.
• The deferred income is taxed at the highest tax rates, no matter what the underlying character is. This is similar to how distributions from foreign non-grantor trusts are handled.

Let’s Talk About the Beneficiary Statement of a Foreign Non-Grantor Trust.

The Foreign Non-Grantor Trust Beneficiary Statement is not a formal document of the Internal Revenue Service. The items that the Beneficiary Statement must contain are listed in the Form 3520 Instructions and include:

1. The trust’s basic identifying information and the first and last day of the tax year to which the statement applies.
2. A description and fair market value of the property distributed.
3. A statement regarding whether the trust appointed a U.S. agent. If the trust did not appoint a U.S. agent, there must be a statement that the trust will permit either the IRS or the U.S. beneficiary to inspect and copy the trust’s books and records to determine the U.S. tax treatment of any distribution or deemed distribution.
4. An explanation or sufficient information regarding the appropriate U.S. tax treatment of any distribution or deemed distribution.
5. A statement identifying whether any grantor of the trust is a partnership or a foreign corporation.

If the beneficiary used or was required to use the default calculation for trust distributions, as per Form 3520, Part III, Schedule A, it must be ensured that the beneficiary’s income tax return reported the amount on Schedule A, line 36 of Form 3520 as income. For instance, on Form 1040, the income would be reported on Schedule E, Part III, under Income or Loss from Estates and Trusts.

Efficient Tax Planning with Foreign Grantor Trusts

Foreign Grantor Trust Planning

If the requirements of Section 672(f) are satisfied, there are substantial opportunities for efficient tax planning for U.S. beneficiaries.

Since all income is considered taxable income of the foreign grantor, U.S. beneficiaries can receive distributions free of tax.

The foreign grantor is only taxed on Effectively Connected Income (ECI) or U.S. source Fixed, Determinable, Annual, or Periodical (FDAP) income. Therefore, the trust can invest in the U.S., generate capital gains (excluding Foreign Investment in Real Property Tax Act (FIRPTA) gains) and interest income, as well as non-U.S. income, without incurring an income tax burden in the U.S. If properly structured, it can be free from U.S. transfer tax.

Indirect Distributions from FNGTs

Foreign Non-Grantor Trusts: Distributions to U.S. Beneficiaries

Indirect Distributions: Distributions made to a U.S. person through an intermediary are treated as if they were made directly from the foreign trust to the U.S. beneficiary, if the principal purpose is tax avoidance.

Use of Property: The use of personal property (such as residences, jewelry, and artwork) is deemed to be a distribution unless it is rented for fair market value.

Loans to a U.S. Person: Loans of cash or securities to a U.S. beneficiary, U.S. grantor, or U.S. persons related or subordinate to the beneficiary or grantor are treated as distributions.

Exception: This rule does not apply to loans that satisfy certain requirements of IRS Notice 97-34