- 1 Form 4970
- 2 Form 3520/3520-A and Form 4970
- 3 Who Files Form 4970 with Foreign Trusts
- 4 Foreign Trust Beneficiaries
- 5 Undistributed Net Income (UNI)
- 6 Accumulation distribution
- 7 Form 3520/3520-A Trust Distributions are Complex
- 8 Late Filing Penalties May be Reduced or Avoided
- 9 Current Year vs Prior Year Non-Compliance
- 10 Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)
- 11 Need Help Finding an Experienced Offshore Tax Attorney?
- 12 Golding & Golding: About Our International Tax Law Firm
When it comes to foreign trusts, not only is the reporting aspect complicated, but the U.S. tax calculation can be extremely complex as well — especially in situations in which there are accumulated trust distributions for prior years. In a common situation, a U.S. taxpayer is a beneficiary of a foreign non-grantor trust. When a current distribution is made to the beneficiary — and depending on how much the distribution is actually income that has been accumulated within the trust in prior years — can impact whether there will be additional tax or interest based on the accumulated income that was not previously distributed. This impacts the throwback rule and the concept of UNI/DNI. Let’s look at the basics.
Form 3520/3520-A and Form 4970
Form 3520 is used by U.S. persons who receive large gifts from foreign persons who are considered non-resident aliens – as well as distributions from foreign trusts (along with Form 3520-A). The main reason behind the U.S. person having to report the distributions is that the foreign national, non-resident alien or foreign trust does not have to file Form 709 to report the gift. If part of the distribution from the trust to the US beneficiary includes an accumulation distribution, then Form 4970 may be required.
Who Files Form 4970 with Foreign Trusts
In a common example, the taxpayer is a US person and receives a distribution from a foreign non-grantor trust, and the taxpayer does not have any ownership of the trust. Likewise, all of the assets are located outside of the United States so there is no issue with a foreign trust distributing income generated from domestic assets.
As provided by Form 4970:
Foreign Trust Beneficiaries
If you received an accumulation distribution from a foreign trust, you must report the distribution and the partial tax on a 2022 Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. Don’t file Form 4970 for distributions from any foreign trusts, except to attach it as a worksheet to Form 3520 if those instructions direct you to. Note: If the accumulation distributions are from a domestic trust that used to be a foreign trust, see Rev. Rul. 91-6, 1991-1 C.B. 89.”
Why Does this Apply to Foreign Trust Beneficiaries?
The Form 4970 is primarily for domestic trusts but applies to foreign trusts as well. So if the distribution that the taxpayer receives in the current year is not income from the current year, but rather accumulated income from prior years, there may be an additional tax/interest implication to the beneficiary. That is because, from the IRS’s perspective, the income that is sitting in the trust and was not previously distributed does not mean that the taxpayer can now receive it in the current year and avoid having to pay interest or other taxes for the time it was sitting in the trust and ‘should have’ been distributed to the beneficiary.
Undistributed Net Income (UNI)
“UNI is the distributable net income (DNI) of the trust for any tax year less (1) the amount of income required to be distributed currently and any other amounts properly paid or credited or required to be distributed to beneficiaries in the tax year and (2) the taxes imposed on the trust attributable to such DNI.”
What is Undistributed Net Income?
Each year, a trust is able to deduct or exclude certain income and typically this is referred to as DNI or Distributable Net Income. Sometimes that income is not actually distributed. Then it becomes UNI (Undistributed Net Income) in the trust, which essentially means it was otherwise considered DNI in the year it was generated only instead of being distributed, it is undistributed.
“An accumulation distribution is the excess of amounts properly paid, credited, or required to be distributed (other than income required to be distributed currently) over the DNI of the trust reduced by income required to be distributed currently. Generally, except for tax-exempt interest, the distribution loses its character upon distribution to the beneficiary. See section 667(d) for special rules for foreign trusts.”
What is an Accumulation Distribution?
An accumulation distribution refers to a distribution that exceeds the amount that is supposed to be distributed in the current year as DNI. One very important aspect of an accumulation distribution is that the distribution will oftentimes lose its character upon distribution to the beneficiary, for example, if it might have been long-term capital gain or qualified dividends and tax at a lower tax rate, it is instead taxed to the beneficiary as ordinary income — which is taxed at the taxpayer’s progressive tax rate — instead of a preferred rate.
Form 3520/3520-A Trust Distributions are Complex
For taxpayers who are receiving distributions from foreign trusts, it is important to try to obtain a foreign grantor trust beneficiary statement or foreign non-grantor trust beneficiary statement which can help minimize the tax implications. If this is not possible, then taxpayers should try to get an understanding of what type of distribution they’re receiving and whether it is from the current year or prior year income in the foreign trust to help determine what kind of filing requirements will be necessary for their U.S. tax returns. Since the Form 3520/3520-A penalty has become more common taxpayers should remain cognizant of what their filing requirements are.
Late Filing Penalties May be Reduced or Avoided
For Taxpayers who did not timely file their FBAR and other international information-related reporting forms, the IRS has developed many different offshore amnesty programs to assist taxpayers with safely getting into compliance. These programs may reduce or even eliminate international reporting penalties.
Current Year vs Prior Year Non-Compliance
Once a taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist who specializes exclusively in these types of offshore disclosure matters.
Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)
In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties.
Need Help Finding an Experienced Offshore Tax Attorney?
When it comes to hiring an experienced international tax attorney to represent you for unreported foreign and offshore account reporting, it can become overwhelming for taxpayers trying to trek through all the false information and nonsense they will find in their online research. There are only a handful of attorneys worldwide who are Board-Certified Tax Specialists and who specialize exclusively in offshore disclosure and international tax amnesty reporting.
Golding & Golding: About Our International Tax Law Firm
Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure.
Contact our firm today for assistance.