How a Foreign Grantor Trust is Taxed & Reported, IRC 679

How a Foreign Grantor Trust is Taxed & Reported, IRC 679

A Foreign Grantor Trust U.S. Tax Overview 

When it comes to international tax and offshore reporting, foreign grantor trust filing is one of the most complicated aspects of offshore disclosure. That is because the rules involving IRS foreign grantor trusts can be different than the rules involving domestic grantor trusts. It can become even more complicated in situations where the foreign grantor or beneficiary is a non-US person, but the beneficiaries are US persons — especially if there is a hybrid of foreign and domestic assets within the trust. In general, the United States owner of a foreign trust is required to file Form 3520 and 3520-A. Let’s walk through the basics of foreign grant or trust taxation with some common examples.

This is an update to the original article published by Golding & Golding back in 8/2020.

What is a Foreign Grantor Trust?

A foreign trust is a trust that does not qualify as a domestic trust. In addition, if the trust is foreign, then there are other components to consider because depending on the assets owned within the trust will impact how the trust is taxed. Some preliminary questions include:

• • • Is the foreign trust owned by US persons? (Form 3520/3520-A)

    • Are there foreign accounts and assets held in the trust? (FBAR or Form 8938)

    • Are there foreign investment funds held in the trust? (Form 8621)

    • Is the trust a shell for a foreign entity such as the PTY LTD owned within the trust? (Form 5471)

How is a Foreign Grantor Trust Taxed?

The baseline position is that the owner of a foreign grantor trust is taxed on the income. For example, if Joe is a US person and he owns a foreign grant or trust because the trust does not qualify as a domestic trust, then Joe is taxed on the income. This is true, even in situations in which Joe may distribute income to beneficiaries. That is because the IRS wants to avoid any artificial transferring of income from higher-income earners to lower-income earners to manipulate the tax implications.

• • • Example: Joe is a US person who owns a foreign trust. In the current year, the trust accumulates $300,000 and Joe distributes $50,000 to each of six beneficiaries. Even though Joe had the trust distribute the money to the beneficiaries, since Joe is the owner of the trust, he is still taxed on the income.

What does Internal Revenue Code 679 Provide?

IRC 679 refers to Foreign trusts having one or more United States beneficiaries: (a) Transferor treated as owner

• In general

  • • • “A United States person who directly or indirectly transfers property to a foreign trust (other than a trust described in section 6048(a)(3)(B)(ii)) shall be treated as the owner for his taxable year of the portion of such trust attributable to such property if for such year there is a United States beneficiary of any portion of such trust.

      • Exceptions Paragraph (1) shall not apply— (A)Transfers by reason of death To any transfer by reason of the death of the transferor. (B)Transfers at fair market value To any transfer of property to a trust in exchange for consideration of at least the fair market value of the transferred property. For purposes of the preceding sentence, consideration other than cash shall be taken into account at its fair market value.”

What does this mean? It means that if a US person transfers money to a foreign trust, then they will be deemed the owner of the trust proportionate to the amount of assets they contribute, subject to any exceptions in Paragraph (1)

• • • Example: Jeffrey is a US person who has family members that own a Grantor trust. Jeffrey decides he wants to relocate overseas to be closer to his family and wants to invest money into a foreign trust so that his ownership share is about 20%. In general, this means that under U.S. tax law, Jeffrey is now a 20% owner of the foreign trust.

Foreign Persons Who Become U.S. Persons

A very common situation occurs when a person who is a non-US person becomes a US person as either a lawful permanent resident or meets the substantial presence test — and has ownership of a foreign trust before they became a US person. In this type of situation, the US person is not considered the owner of a foreign trust: As further provided by Section 679:

• • • “(4) SPECIAL RULES APPLICABLE TO FOREIGN GRANTOR WHO LATER BECOMES A UNITED STATES PERSON

      • (A) In general If a nonresident alien individual has a residency starting date within 5 years after directly or indirectly transferring property to a foreign trust, this section and section 6048 shall be applied as if such individual transferred to such trust on the residency starting date an amount equal to the portion of such trust attributable to the property transferred by such individual to such trust in such transfer.

      • (B) Treatment of undistributed income: For purposes of this section, undistributed net income for periods before such individual’s residency starting date shall be taken into account in determining the portion of the trust which is attributable to property transferred by such individual to such trust but shall not otherwise be taken into account.

      • (C) Residency: starting date For purposes of this paragraph, an individual’s residency starting date is the residency starting date determined under section 7701(b)(2)(A).”

What does this mean? It means that taxpayers must be careful that when they decide to become a US person, if they own a foreign trust, they may become subject to the onerous foreign grant or trust rules by default comma simply by becoming a US person for tax purposes.

• • • Example: Michelle is a foreign national who relocated to the United states for school and then decided to remain in the United States and obtained her green card. For several years she has been the owner of a foreign trust with other family members who are all non-US persons. Since Michelle is considered to be an owner of the foreign trust relative to her percentage ownership and must report this information on her US tax return and corresponding international reporting forms.

Late Filing Penalties May be Reduced or Avoided

For Taxpayers who did not timely file their FBAR and/or 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.

Late-Filing Disclosure Options

If a Taxpayer is out of compliance, there are various international offshore tax amnesty programs that they can apply to safely get into compliance. Depending on the specific facts and circumstances of the Taxpayers’ noncompliance, they can determine which program will work best for them.

*Below please find separate links to each program with extensive details about the reporting requirements and examples.

Streamlined Filing Compliance Procedures (SFCP, Non-Willful)

The Streamlined Filing Compliance Procedures is one of the most common programs used by Taxpayers who are non-willful and qualify for either the Streamlined Domestic Offshore Procedures or Streamlined Foreign Offshore Procedures.

Streamlined Domestic Offshore Procedures (SDOP, Non-Willful)

Taxpayers who are considered U.S. residents and file timely tax returns each year but fail to report foreign income and/or assets may consider the Streamlined Domestic Offshore Procedures.

Streamlined Foreign Offshore Procedures (SFOP, Non-Willful)

Taxpayers who are foreign residents may consider the Streamlined Foreign Offshore Procedures which is typically the preferred program of the two streamlined procedures. That is because under this program, Taxpayers can file original returns, and the 5% Title 26 miscellaneous offshore penalty is waived.

Delinquent FBAR Submission Procedures (DFSP, Non-Willful/Reasonable Cause)

Taxpayers who only missed the FBAR reporting and do not have any unreported income or other international information reporting forms to file may consider the Delinquent FBAR Submission Procedures — which may include a penalty waiver.

Delinquent International Information Returns Submission Procedures (DIIRSP, Reasonable Cause)

Taxpayers who have undisclosed foreign accounts and assets beyond just the FBAR — but have no unreported income — may consider the Delinquent International Information Return Submission Procedures. Before November 2020, the IRS was more inclined to issue a penalty waiver, but since then this type of delinquency procedure submission has morphed into a reasonable cause request to waive or abate penalties.

IRS Voluntary Disclosure Procedures (VDP, Willful)

For Taxpayers who are considered willful, the IRS offers a separate program referred to as the IRS Voluntary Disclosure Program (VDP). This program is used by Taxpayers to disclose both unreported domestic and offshore assets and income (before 2018, there was a separate program that only dealt with offshore assets (OVDP), but that program merged back into the traditional voluntary disclosure program (VDP).

Quiet Disclosure

Quiet disclosure is when a Taxpayer submits information to the IRS regarding the undisclosed foreign accounts, assets, and income but they do not go through one of the approved offshore disclosure programs. This is illegal and the IRS has indicated they have every intention of investigating Taxpayers who they discover intentionally sought to file delinquent forms to avoid the penalty instead of submitting to one of the approved methods identified above.

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. 

*This resource may help Taxpayers seeking to hire offshore tax counsel: How to Hire an Offshore Disclosure Lawyer.

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.