Foreign Grantor Trusts vs Non-Grantor Trust
Foreign Grantor Trust: A Trust is simply an arrangement for the holding of money or assets. When a U.S. Person has a trust, and the trust fails the court or control test, the trust may be considered a foreign trust. If it is foreign trust, the IRS has certain reporting requirements on various international reporting forms, such as Form 3520-A. Some of the requirements may be exempted or excluded.
A Foreign Grantor Trust is a common type of trust that the grantor controls on behalf of the beneficiary.
This is in comparison to a non-grantor trust, in which the original grantor may no longer have control over the trust (direct or indirect), absent some very creative planning.
We will summarize what a Foreign Grantor Trust is.
Understanding the Basics
One very common scenario is a revocable grantor trust.
A simple example may be a revocable grantor trust you were recommended to create in order to hold your personal residence.
- With the revocable trust, the Grantor (owner of the home) creates the trust.
- The Trustee administers the trust; and
- The Beneficiary will receive the trust property.
Therefore, the three (3) main components to a basic, revocable grantor trust.
- Grantor or Settlor
How Does the IRS Define a Trust?
Treas. Reg. §301.7701-4:
- The Regulations define a “trust” as an arrangement created either by a will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries.
- In a legitimate trust, the grantor transfers property to a trustee to hold and protect for the benefit of the trust beneficiaries, often pursuant to the terms of a written trust agreement.
- A trust is a separate legal entity or arrangement typically used for family and estate planning purposes. Trusts allow assets to be held by an entity, other than a natural person, with an indeterminate life. Accordingly, trusts are often used to hold property and facilitate a transfer of such property to beneficiaries without the need for probate proceedings.
- An arrangement will be treated as a trust if it can be shown that its purpose is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.
Foreign vs Domestic
There are two main tests to determine U.S. vs Foreign Trust:
(1) Safe harbor. A trust satisfies the court test if –
(i) The trust instrument does not direct that the trust be administered outside of the United States;
(ii) The trust in fact is administered exclusively in the United States; and
(iii) The trust is not subject to an automatic migration provision described in paragraph (c)(4)(ii) of this section.
(1) Definitions –
(i) United States person. The term United States person means a U.S. Person within the meaning of section 7701(a)(30). For example, a domestic corporation is a U.S. Person, regardless of whether its shareholders are U.S. Persons.
(ii) Substantial decisions. The term substantial decisions means those decisions that persons re authorized or required to make under the terms of the trust instrument and applicable law and that are not ministerial. Decisions that are ministerial include decisions regarding details such as the bookkeeping, the collection of rents, and the execution of investment decisions. Substantial decisions include, but are not limited to, decisions concerning –
(A) Whether and when to distribute income or corpus;
(B) The amount of any distributions;
(C) The selection of a beneficiary;
(D) Whether a receipt is allocable to income or principal;
(E) Whether to terminate the trust;
(F) Whether to compromise, arbitrate, or abandon claims of the trust;
(G) Whether to sue on behalf of the trust or to defend suits against the trust;
(H) Whether to remove, add, or replace a trustee;
(I) Whether to appoint a successor trustee to succeed a trustee who has died, resigned, or otherwise ceased to act as a trustee, even if the power to make such a decision is not accompanied by an unrestricted power to remove a trustee, unless the power to make such a decision is limited such that it cannot be exercised in a manner that would change the trust’s residency from foreign to domestic, or vice versa; and
(J) Investment decisions; however, if a U.S. Person under section 7701(a)(30) hires an investment advisor for the trust, investment decisions made by the investment advisor will be considered substantial decisions controlled by the U.S. Person if the U.S. Person can terminate the investment advisor’s power to make investment decisions at will.
(iii) Control. The term control means having the power, by vote or otherwise, to make all of the substantial decisions of the trust, with no other person having the power to veto any of the substantial decisions. To determine whether U.S. Person have control, it is necessary to consider all persons who have authority to make a substantial decision of the trust, not only the trust fiduciaries.
IRS is Very “Concerned” About Sham Trusts
As a quick aside, the IRS has a serious aversion to Sham Trusts, Income Assigning, etc.
As provided by the IRS:
Where a trust exists solely for tax avoidance purposes, it is an “abusive trust arrangement” or “sham” whereby the IRS may ignore the purported form for U.S. tax purposes.
Factors you should consider in a sham analysis (not an exclusive list):
- Lack of Change: The relationship between the grantor and property conveyed to the trust does not materially change after conveyance to the trust.
- Retained Control: A grantor continues to use and/or exercise dominion and control over trust property as if it was his/her own.
- Retained Benefit: Property and/or income of the trust are used to benefit the Grantor
- Lack of Independent Trustee: Trustee’s failure to exercise fiduciary responsibilities. The trustee merely approves actions directed by grantor, and is trustee “in name only”, often due to family relationships or grantor’s position of control over trustee.
Example of What the IRS Seeks to Avoid
Dave had 5 kids. None of them work (Why would they, Dave is “mega-rich.”)
Dave forms a foreign grantor trust because he believes he can reduce his U.S. tax liability.
Why a Grantor Trust?
Because Dave loves (but doesn’t trust) his spoiled kids. He wants to gift them money, but wants half of it to go their schooling.
So, if each kid receives an annual distribution of $100,000 (as opposed to Dave taking a $500,000 distribution), then the distributed amounts to the kids would be taxed at a lower rate than Dave – who is in the highest tax bracket.
Then, each kid gifts dad back $50,000.
As a result, the U.S lost out on tax money, since the kids were each taxed at a lower rate than Dave. And, Dave is able to use part of the money that was taxed at a reduced rate to pay for each kid’s extra-curricular school activities (not otherwise deductible education expenses.)
Compare: If Dave took the full distribution, he would be taxed at a much higher tax rate, vs. the lower-income earning children, so that Dave would have to withdraw and pay tax on significantly more money to arrive at the same net income.
That is why Dave (the Grantor) is taxed on the income that is distributed to his Kids.
Non-Grantor Trust vs. Grantor Trust
A Non-Grantor Trust is different, and generally more complicated.
With a non-grantor trust, the grantor no longer retains power of the administration of trust, such as revoking the trust.
Rather, the trustee has the control of the trust.
The trust is taxed as a separate entity, so that the original “grantor,” may not be necessarily taxed at all. And, the trust is taxed at the trust rate(s), which can be higher.
The trust files its own tax return, using Form 1041 and the benficiaries are taxed on the income.
How to Report Foreign Trusts to IRS
When it comes to reporting foreign trusts, it is very complicated – but it doesn’t have to be, especially with the new Revenue Procedure 2020-17.
The general rule, is that a foreign trust is reported on Forms 3520 and 3520-A. The failure to report the foreign trust may result in significant fines and penalties.
The key is understanding how and when to report the foreign trust.
FBAR & FATCA Filing
When a foreign grantor trust has foreign accounts associated with, the trust will file an FBAR, and usually a Form 8938 to report accounts.
The primary IRS reporting vehicle for a foreign grantor trust is a Form 3520-A. Recently, the IRS issued Rev. Proc. 2020-17, which limits duplicate reporting for certain foreign trusts.
Rev Procedure 2020-17
The Rev. Proc. 2020-17 refers to foreign trust reporting rules and requirements:
As provided by the IRS:
“This revenue procedure provides an exemption from the information reporting requirements under section 6048 of the Internal Revenue Code for certain U.S. citizen and resident individuals (U.S. individuals) with respect to their transactions with, and ownership of, certain tax-favored foreign retirement trusts and certain tax-favored foreign nonretirement savings trusts, as described in sections 5.03 and 5.04 of this revenue procedure (collectively, applicable tax-favored foreign trusts).
Only eligible individuals described in section 5.02 of this revenue procedure (generally U.S. individuals who have been compliant with respect to their income tax obligations related to such trusts) may rely on this revenue procedure.
In addition, this revenue procedure establishes procedures for eligible individuals to request abatement of penalties that have been assessed or a refund of penalties that have been paid pursuant to section 6677 for the individuals’ failure to comply with the information reporting requirements of section 6048 with respect to an applicable tax-favored foreign trust.
Eligible individuals may request relief from section 6677 penalties, subject to the limitations of sections 6402 and 6511, in accordance with section 6 of this revenue procedure.”
What does Rev. Proc 2020-17 Mean?
Rev. Proc. 2020-17 means that the IRS is going to reel in some of the reporting requirements of foreign trusts, which oftentimes results in duplicate reporting for Taxpayers. The emphasis on the exception will be certain tax-favored foreign retirement trusts and tax favored foreign nonretirement savings trusts.
IRC 6048 Foreign Grantor Trust
Notice of certain events:
(1) General rule
On or before the 90th day (or such later day as the Secretary may prescribe) after any reportable event, the responsible party shall provide written notice of such event to the Secretary in accordance with paragraph (2).
(2) Contents of notice
The notice required by paragraph
(1) shall contain such information as the Secretary may prescribe, including—
(A) the amount of money or other property (if any) transferred to the trust in connection with the reportable event, and
(B) the identity of the trust and of each trustee and beneficiary (or class of beneficiaries) of the trust.
(3) Reportable event
For purposes of this subsection —
(A) In general
The term “reportable event” means—
(i) the creation of any foreign trust by a United States person,
(ii) the transfer of any money or property (directly or indirectly) to a foreign trust by a United States person, including a transfer by reason of death, and
(iii) the death of a citizen or resident of the United States if—
(I) the decedent was treated as the owner of any portion of a foreign trust under the rules of subpart E of part I of subchapter J of chapter 1, or
(II) any portion of a foreign trust was included in the gross estate of the decedent.
FBAR is Still Required for a Foreign Grantor Trust Account
As further provided by the Revenue Procedure:
“This revenue procedure does not affect any reporting obligations under section 6038D or under any other provision of U.S. law, including the requirement to file FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), imposed by 31 U.S.C. section 5314 and the regulations thereunder.
This revenue procedure does not affect previously issued guidance providing an exception from section 6048 reporting with respect to distributions from certain foreign compensatory trusts under Section V of Notice 97-34, and an exception from all information reporting requirements under section 6048 with respect to certain Canadian retirement plans under Revenue Procedure 2014-55.
See also section 6048(a)(3)(B)(ii) (providing an exception from reporting with respect to transfers to foreign compensatory trusts described in section 402(b), 404(a)(4), or 404A).”
FATCA (Form 8938) is Still Required for a Foreign Grantor Trust Account
As further provided by the Revenue Procedure:
Section 6038D, enacted in 2010, and the regulations thereunder generally require a specified person, which includes a U.S. citizen or resident alien, to report any interest in a specified foreign financial asset provided that the aggregate value of all such assets exceeds certain thresholds. See §1.6038D-2(a).
Section 6038D(d) imposes a penalty for failing to comply. A specified foreign financial asset includes interests in certain foreign retirement, pension, and non-retirement savings funds or accounts. See §§1.6038D-3.
Section 6038D information reporting is provided on Form 8938, Statement of Specified Foreign Financial Assets. A specified person who is required to report information under section 6038D on Form 8938 may also be required to report similar identifying information under section 6048 on Form 3520 or Form 3520-A.
What is a Tax-Favored Foreign Trust?
“For purposes of this revenue procedure, an applicable tax-favored foreign trust means a tax-favored foreign retirement trust as defined under section 5.03 of this revenue procedure or a tax-favored foreign non-retirement savings trust as defined under section 5.04 of this revenue procedure.”
What is a Tax-Favored Foreign Retirement Trust?
“For purposes of this revenue procedure, a tax-favored foreign retirement trust means a foreign trust for U.S. tax purposes that is created, organized, or otherwise established under the laws of a foreign jurisdiction (the trust’s jurisdiction) as a trust, plan, fund, scheme, or other arrangement (collectively, a trust) to operate exclusively or almost exclusively to provide, or to earn income for the provision of, pension or retirement benefits and ancillary or incidental benefits, and that meets the following requirements established by the laws of the trust’s jurisdiction.”
“The trust is generally exempt from income tax or is otherwise tax-favored under the laws of the trust’s jurisdiction. For purposes of this revenue procedure, a trust is tax-favored if it meets any one or more of the following conditions:
(i) contributions to the trust that would otherwise be subject to tax are deductible or excluded from income, are taxed at a reduced rate, give rise to a tax credit, or are otherwise eligible for another tax benefit (such as a government subsidy or contribution); and
(ii) taxation of investment income earned by the trust is deferred until distribution or the investment income is taxed at a reduced rate.”
What is a Tax-Favored Foreign Non-Retirement Savings Trust?
“For purposes of this revenue procedure, a tax-favored foreign non-retirement savings trust means a foreign trust for U.S. tax purposes that is created, organized, or otherwise established under the laws of a foreign jurisdiction (the trust’s jurisdiction) as a trust, plan, fund, scheme, or other arrangement (collectively, a trust) to operate exclusively or almost exclusively to provide, or to earn income for the provision of, medical, disability, or educational benefits, and that meets the following requirements established by the laws of the trust’s jurisdiction.
(1) The trust is generally exempt from income tax or is otherwise tax-favored under the laws of the trust’s jurisdiction as defined in section 5.03(1) of this revenue procedure.”
The Full Text of the Revenue Procedure 2020-17 can be found here (subscription may be required).
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