A Primer to the Foreign Trust Tax & Reporting Requirements

A Primer to the Foreign Trust Tax & Reporting Requirements

Foreign Trust Tax & Reporting Requirements

When it comes to international tax law and the IRS, one of the most complicated aspects of taxation and reporting is the annual disclosure of foreign trusts. That is because each foreign country has its own version of a trust –– and the trust is not considered a “foreign trust” for that particular country. In other words, a trust formed in the UK is not considered a foreign trust in the UK or under UK tax rules — but it is considered a foreign trust under US tax law.  Foreign trusts have very complicated tax implications under US law — depending on whether it is a grantor trust or non-grantor trust, and whether the foreign trust also has US assets, which will impact the annual reporting requirements.  In a common situation, a non-US person who is either an owner or beneficiary – – or both – – of the foreign trust becomes a US person, which opens the floodgates for foreign trust reporting, taxation, and overall compliance. Let’s walk through the basics of the foreign trust tax rules.

Is it a Domestic or Foreign Trust?

The first question is to determine whether the trust is a foreign trust or a domestic trust. Unfortunately, neither the Internal Revenue Service nor the Internal Revenue Code are helpful when it comes to determining whether a trust is domestic or foreign. Essentially, the IRS defines as foreign trust as any trust that is not considered a domestic trust. While not the most helpful guidance, there are various tests the taxpayers per form in order to determine if it qualifies as foreign or domestic — including the court test and control test. For purposes of this analysis, let’s presume that the trust is foreign.

Definition of a Foreign Trust (26 U.S.C. 7701)

      • (30) United States person

        • The term “United States person” means—

          • (A) a citizen or resident of the United States,

          • (B) a domestic partnership,

          • (C) a domestic corporation,

          • (D) any estate (other than a foreign estate, within the meaning of paragraph (31)), and

          • (E) any trust if—

            • (i) a court within the United States is able to exercise primary supervision over the administration of the trust, and (ii)one or more United States persons have the authority to control all substantial decisions of the trust.

      • (31) Foreign estate or trust

        • (A) Foreign estate

          • The term “foreign estate” means an estate the income of which, from sources without the United States which is not effectively connected with the conduct of a trade or business within the United States, is not includible in gross income under subtitle A.

        • (B) Foreign trust

          • The term “foreign trust” means any trust other than a trust described in subparagraph (E) of paragraph (30).

Simple or Complex Trust

One of the first important concepts involving trusts, including foreign trusts, is to determine whether or not it is a simple trust or a complex trust. When it is a simple trust, essentially all of the income is distributed annually — and there is no accumulation of income within the trust. A complex trust is essentially any trust that does not meet the requirements for qualifying as a simple trust — and unlike the simple trust, a complex trust may accumulate income, assets, etc.

As provided by the IRS

      • Simple Trust

        • A simple trust must distribute all its income currently. Generally, it cannot accumulate income, distribute out of corpus, or pay money for charitable purposes. If a trust distributes corpus during a year, as in the year it terminates, the trust becomes a complex trust for that year. Whether a trust is simple or complex determines the amount of the personal exemption ($300 for simple trusts and $100 for complex trusts), that applies in calculating the tax owed

      • Complex Trust

        • A complex trust is any trust that does not meet the requirements for a simple trust. Complex trusts may accumulate income, distribute amounts other than current income and, make deductible payments for charitable purposes under section 642(c) of the Code.

Revocable or Irrevocable Trust

Another very important aspect of a foreign trust is to determine whether it is revocable or irrevocable. With a grantor revocable trust, the idea of the revocable trust is the concept that the owner or grantor has control — and can modify or revoke/cancel the trust. Once the trust becomes irrevocable, then the trust cannot be revoked. It is common for a trust to begin as revocable and then once the grantor passes away or another triggering event occurs, the trust then becomes irrevocable.

As provided by the IRS:

      • Revocable Trust

        • If the grantor retains the ability to revoke the trust and revest the trust assets in the grantor, the trust is revocable and the income is taxable to the grantor under the grantor trust rules. Assets in a revocable trust are included in the grantor’s gross estate for federal estate tax purposes. Revocable trusts also called living trusts, are one of the more frequently misunderstood trust concepts. They are used primarily as a will substitute. Assets in trust avoid the cost, time, expense, and publicity of probate. Because a revocable trust may be a will substitute, it may provide for direct gifts to charity as well as establishing a split interest trust, a charitable remainder trust, or a charitable lead trust. For example, a revocable trust may establish a charitable remainder trust upon the grantor’s death to benefit a surviving spouse or child. The noncharitable beneficiary can receive an income payment for life, or for a term of years. The remainder will pass to charity at the death of the noncharitable income recipient or the end of the term. Similarly, a grantor may use a will or a revocable trust to establish a charitable lead trust, with an interest for charity during a term of years or for the life of certain individuals, and the remainder to the grantor’s spouse, child or other heir.

      • Irrevocable Trust

        • An irrevocable trust is one that, by its terms, cannot be revoked.

Grantor Trust (IRC Sections 671-679)

Grantor trust rules can be found in Internal Revenue Code section 671-679. More specifically, section 671-678 refers to both domestic and foreign trusts, whereas section 679 refers exclusively to foreign trusts. The tax rules involving grantor trusts are contained in these code sections and it can be a dense read, so it is important that taxpayers really take a look at the language of therefore I trust determine whether or not it is a grantor or nongrantor trust.

Distributions to US Beneficiaries

Where the US beneficiary receives a distribution from a foreign trust, the key ingredient is whether or not it’s a grantor trust or nongrantor trust. When the trust is a grantor trust then generally it is the grantor and not the beneficiary who is taxed on the distributed income. Conversely, when the trust is considered a non-grantor trust, then it is the beneficiary who has to report the income on the US tax return. There are various requirements involving issues such as beneficiary statement and whether or not to throw back tax rules have been met properly, but the baseline position is that a beneficiary of a non-grantor for interest has to report to distribution as income.

Grantor vs Non-Grantor Trust

From a baseline perspective, the grantor trust means that the grantor is taxed on the income, and not the beneficiary who receives the distributions. The purpose of this is to avoid a grantor from assigning and transferring their income to lower tax bracket beneficiaries — who then turn around and give the money back to the (usually deep-pocket) grantor.

Grantor Trust Rules

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.

Non-Grantor Trust

When it is a non-grantor trust, the tax rules are different. With a foreign non-grantor trust, the US beneficiaries of that foreign trust are subject to tax on the distributions. Therefore, if a US beneficiary of a foreign trust receives a distribution from that trust, then the baseline position is that the distribution is taxable as income reported on the US taxpayer’s tax return as income.

Reporting Requirements (Form 3520 & Form 3520-A)

Foreign trusts may be required to be reported on Form 3520 and 3520-A. The failure to timely report these forms may result in significant fines and penalties — but they may be avoided or removed (abated) with reasonable cause or offshore tax amnesty.

Golding & Golding: International Tax Law Firm Specialist Team

Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure.

Contact our firm for assistance.