Foreign Grantor Trust – Non-Grantor Foreign Trust | IRS Requirements
Foreign Grantor Trust: The Foreign Grantor Trust is a very complicated vehicle. In general, the IRS frowns upon foreign grantor trusts.
That is because many times these types of trusts are used for improper purposes, such as to hide or shield overseas income. Therefore, the IRS takes a hardline when it evaluates foreign trusts.
The Foreign Grantor Trust differs from a non-grantor trust, in that the grantor trust is not considered separate and distinct from the owner, whereas a non-grantor trust is considered a separate entity with different tax consequences.
Foreign Grantor Trusts
The Foreign Grantor Trust Rules have many complexities to it.
Since there is a significant amount of mis-information online, we wanted to provide you at least a basics understanding and framework of the two different types of trusts, how they work, and who they benefit.
There are various reasons why or why not a person would opt for a foreign or offshore trust, but it is important to be able to know whether your trust qualifies as a foreign trust or not.
In order to not be a foreign trust, the trust must meet two (both) of these tests.
First, What is a Trust?
At its most basic core, a Trust is an arrangement for the holding of money or assets.
One very common scenario is a revocable trust:
You may have been recommended to hold your personal residence in a revocable trust.
- With the revocable trust, the Grantor (owner of the home) creates the trust.
- The Trustee is in 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
This is just a very basic example.
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.
Sham Trusts Used for Improper Purposes
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.
Foreign Grantor Trust Example of What the IRS Wants 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 which he used to pay for each kid’s college.
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 school.
Compare: Dave would be taxed at a much higher tax rate, vs. the kids (some who are married and not “life-motivated”) at 10%-20% so that Dave would have to withdraw and pay tax on significantly more money to arrive at the same net income.
And, since Dave is really holding the purse-strings, and still exercises control over the trust – the IRS requires him to pay tax on the trust income.
Foreign vs. Domestic Trust
Once a determination is made that the entity is a trust (vs a business entity used to conduct business for example) the next step is to determine if the trust if foreign or domestic.
The IRS does not provide a bright-line test to determine if a trust is foreign.
Rather, a Trust is considered to be foreign when it does not meet either the court test or control test:
(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 United States person within the meaning of section 7701(a)(30). For example, a domestic corporation is a United States person, regardless of whether its shareholders are United States persons.
(ii) Substantial decisions. The term substantial decisions means those decisions that persons are 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 United States 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 United States person if the United States 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 United States persons 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.
Foreign Grantor Trust “Trustee”
The Trustee has a very important responsibility, which is to file Form 3520-A each year with the IRS.
Form 3520-A is the “Annual Information Return of Foreign Trust with U.S. Owner” form. The failure to file the form may result in significant fines and penalties.
*There are various rules and requirements that the trustee must follow, such as sending the Foreign Grantor Trust Owner Statement to each U.S. Owner of the foreign trust.
**An extension to file Form 3520-A may be requested.
Foreign Grantor Trust “Owner”
As mentioned above, the owner of the trust is subject to income tax on the foreign grantor trust. The U.S. Owner of the trust files the Form 3520 to show that he or she is the owner (or an owner) of the foreign trust, along with reporting any transfers to the foreign trust.
Form 3520 is due on the due date of the individual tax return.
*BE SURE your trustee files Form 3520-A, if not, then you should probably file it yourself.
Grantor Trust vs. Non-Grantor Trust
There are many different types of trusts, depending the nature and purpose of the arrangement. The two primary categories of trusts are grantor trusts (IRC 671-679) and non-grantor trusts (Form 1041)
With a Grantor Trust, the Grantor controls the assets and therefore, the income imputed to the trust is considered taxable to the grantor.
As provided by the IRS:
“A foreign trust that has, or is deemed to have, U.S. beneficiaries will generally be treated as a foreign grantor trust under IRC § 679 to the extent a USP has gratuitously transferred property to it. If a foreign trust is characterized as a grantor trust under IRC § 679, the trust is ignored for income tax purposes and the grantor is treated as owner of the trust in proportion to the value of the transferred property.
In general, any person treated as the owner of the trust is taxed directly on the income earned by the property placed in the trust. A USP treated as an owner of a trust is required to report his or her share of trust income, deductions, and credits as if those items were received or paid directly by the USP.”
“Where it is specified in this subpart that the grantor or another person shall be treated as the owner of any portion of a trust, there shall then be included in computing the taxable income and credits of the grantor or the other person those items of income, deductions, and credits against tax of the trust which are attributable to that portion of the trust to the extent that such items would be taken into account under this chapter in computing taxable income or credits against the tax of an individual.
Any remaining portion of the trust shall be subject to subparts A through D. No items of a trust shall be included in computing the taxable income and credits of the grantor or of any other person solely on the grounds of his dominion and control over the trust under section 61 (relating to definition of gross income) or any other provision of this title, except as specified in this subpart.”
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.
So far, we have learned that the Trust has 3 main components to it, and grantor and non-grantor trusts are taxed differently.
What if you Have a Foreign Trust?
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.
A typical grantor trust is reported on Form 3520 and 3520-A, such as a revocable trust. If the trust holds accounts, the accounts may be reported on the FBAR and Form 8938.
BUT, in accordance with Rev. Proc. 2020-17, the IRS has reduced the “duplicate” reporting required for Form 3520/3520-A – which can be significant, especially when compared to the reporting on Form 8938.
Here is what the IRS says in the new Rev. Proc. 2020-17:
- 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.
- Accordingly, pursuant to the authority granted under section 6048(d)(4), the Treasury Department and the IRS are exempting from section 6048 information reporting an eligible individual’s transactions with, or ownership of, an applicable 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 nonretirement savings trust as defined under section 5.04 of this revenue procedure.
Common Sources of Income for a Foreign Non-Grantor Trust
Here a few common sources of income:
ECI (Effectively Connected Income)
This analysis would go far beyond a basic introduction. Generally, ECI is taxed progressive at varying rates (vs. FDAP, described below, which is a standard 30% subject to U.S. Tax Treaty reductions).
ECI may be impacted by Permanent Establishment and many other complexities. And, while rental income is considered FDAP, an election to ECI may help reduce taxes (due to all the expenses generated from Real Estate Income)
FDAP (Fixed, Determinable, Annual, Periodical)
FDAP is taxed at 30%, subject to exceptions, exclusion, and limitations (especially by most treaties, which reduce the rate to 15%, 10%, 5% or waived)
Essentially, FDAP is passive income such as:
- Certain Gains
In determining whether there is an FDAP issue, it is important to assess whether the common exception of the Portfolio Interest exemption applies.
Examples of non-taxable U.S. income of a Foreign non-grantor trust:
- OID <183 days to maturity
- Interest from a U.S. Bank or similar (excluding ECI)
- Portfolio Interest (excluding ECI)
- Interest related to certain dividends/STCG involving Mutual Funds.
What is a Retirement Trust?
If you have a Superannuation in Australia – this is a retirement trust. If you have a CPF in Singapore, this is also a retirement trust.
But, how are they reported?
A foreign employment trust is not really what the IRS means by foreign trust. Whether it is a Superannuation in Australian, CPF in Singapore or other trust – these are employment/retirement trusts. And, if they were U.S. trusts would probably meet the requirements of a 401K – which receives tax deferred treatment in the U.S.
We generally recommended reporting limited these foreign retirement plans on the FBAR and Form 8938, but also reporting the form on 3520 (absent a +50% ownership stake by the employee) because anything more seems like duplicate or overreproting.
Many foreign based practitioners tended to report on 8938 and 3520, which was not necessarily incorrect —
Here is what the New Rev Procedure 2020-17 says:
“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.
(1) 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.
(2) Annual information reporting with respect to the trust (or of its participants or beneficiaries) is provided, or is otherwise available, to the relevant tax authorities in the trust’s jurisdiction.
(3) Only contributions with respect to income earned from the performance of personal services are permitted.
(4) Contributions to the trust are limited by a percentage of earned income of the participant, are subject to an annual limit of $50,000 or less to the trust, or are subject to a lifetime limit of $1,000,000 or less to the trust. These contribution limits are determined using the U.S. Treasury Bureau of Fiscal Service foreign currency conversion rate on the last day of the tax year (available at https://www.fiscal.treasury.gov/reports-statements/treasury-reporting-rates-exchange).
(5) Withdrawals, distributions, or payments from the trust are conditioned upon reaching a specified retirement age, disability, or death, or penalties apply to withdrawals, distributions, or payments made before such conditions are met. A trust that otherwise meets the requirements of this section 5.03(5), but that allows withdrawals, distributions, or payments for in-service loans or for reasons such as hardship, educational purposes, or the purchase of a primary residence, will be treated as meeting the requirements of this section 5.03(5).
(6) In the case of an employer-maintained trust,
(i) the trust is nondiscriminatory insofar as a wide range of employees, including rank and file employees, must be eligible to make or receive contributions or accrue benefits under the terms of the trust (alone or in combination with other comparable plans),
(ii) the trust (alone or in combination with other comparable plans) actually provides significant benefits for a substantial majority of eligible employees, and
(iii) the benefits actually provided under the trust to eligible employees are nondiscriminatory.
A trust that otherwise meets the requirements of this section 5.03 will not fail to be treated as a tax-favored foreign retirement trust within the meaning of this section solely because it may receive a rollover of assets or funds transferred from another tax favored foreign retirement trust established and operated under the laws of the same jurisdiction, provided that the trust transferring assets or funds also meets the requirements of this section 5.03.”
What is a Tax-Favored Foreign Non-Retirement Savings Trust?
The new revenue procedure is not limited to Foreign Retirement Savings Trusts. Rather, it also includes Tax-Favored Foreign Non-Retirement Savings Trusts.
Here is what the Rev Procedure Says about the 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.
(2) Annual information reporting with respect to the trust (or about the beneficiary or participant) is provided, or is otherwise available, to the relevant tax authorities in the trust’s jurisdiction.
(3) Contributions to the trust are limited to $10,000 or less annually or $200,000 or less on a lifetime basis, determined using the U.S. Treasury Bureau of Fiscal Service foreign currency conversion rate on the last day of the tax year (available at https://www.fiscal.treasury.gov/reports-statements/treasury-reporting-rates-exchange).
(4) Withdrawals, distributions, or payments from the trust are conditioned upon the provision of medical, disability, or educational benefits, or apply penalties to withdrawals, distributions, or payments made before such conditions are met. A trust that otherwise meets the requirements of this section 5.04 will not fail to be treated as a tax-favored foreign non-retirement savings trust within the meaning of this section 5.04 solely because it may receive a rollover of assets or funds transferred from another tax-favored foreign non-retirement savings trust established and operated under the laws of the same jurisdiction, provided that the trust transferring assets or funds also meets the requirements of this section 5.04.”
FBAR Reporting is Still Required
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) Reporting is Still Required
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.
Abatement or Refund of IRC 6677 Penalties
If you were recently assessed penalties, and/or paid the penalty – you may be able to obtain relief, or abate the penalties.
As provided in the new Revenue Procedure 2020-17
“Subject to the limitations of sections 6402 and 6511, eligible individuals who have been assessed a penalty under section 6677 for failing to comply with section 6048 with respect to an applicable tax-favored foreign trust (without regard to whether such failure was due to reasonable cause under section 6677(d)) and who wish to obtain relief under this revenue procedure may request an abatement of the penalty assessed, or a refund of the penalty paid, under section 6677 by filing Form 843, Claim for Refund and Request for Abatement.
Eligible individuals are not precluded from requesting relief under any other applicable relief provisions. Under section 6402(a), the Secretary is authorized to credit, within the applicable period of limitations, an overpayment against any liability in respect of an internal revenue tax of the person who made the overpayment, and must generally refund any balance to that person, subject to the requirements of section 6402(c), (d), (e), and (f) (providing for offset for past-due support and certain debts to federal and state governments). Section 6511(b)(1) provides that no credit or refund shall be allowed or made after the expiration of the period of limitation prescribed in section 6511(a), unless the taxpayer filed a claim for credit or refund within that period. .02 Where to File.
A Form 843 requesting relief under this revenue procedure should be mailed to Internal Revenue Service, Ogden, UT 84201-0027. .03 Filing Requirements for Form 843. Eligible individuals should complete the form and write the statement “Relief pursuant to Revenue Procedure 2020-17” on Line 7 of the form. In addition, Line 7 should include an explanation of how the eligible individual meets each relevant requirement under section 5.02 of this revenue procedure and how the foreign trust meets each relevant requirement under section 5.03 or 5.04 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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Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure.
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