Does a US Beneficiary of a Foreign Non-Grantor Trust Pay Taxes?

Does a US Beneficiary of a Foreign Non-Grantor Trust Pay Taxes?

Taxation of Beneficiary of a Foreign Non-Grantor Trust

One of the most complicated aspects of international tax law involves the US taxation of a beneficiary of a foreign non-grantor trust — and there are many reasons for the foreign trust complexities. From a baseline perspective, a foreign trust is not taxable in the U.S. unless the trust specifically has U.S. owners, U.S. beneficiaries, and/or if there are U.S.-based assets in the trust. From a tax perspective, a US person who is a beneficiary of a foreign trust is still required to pay tax on the distribution just as a US person pays tax on a distribution from a domestic trust. Depending on whether the income distributed is UNI or DNI, in conjunction with the throwback rule, accumulation distributions, and issues involving whether a beneficiary statement was issued, will all impact how a US person beneficiary can be taxed. Let’s walk through the basics of the taxation of a beneficiary of a foreign non-grantor trust, in conjunction with the recently published IRS Practice Unit of November 2023.

Foreign Non-Grantor Trust Income Distributed

The difference between a grantor trust and a non-grantor trust is very important for tax purposes. With a grantor trust, it is typically the grantor who is taxed on the income, and distributions made to the beneficiaries are non-taxable. Conversely, with a non-grantor trust, the rules are different and the beneficiary is taxed on income distributed to him. Many different types of distributions may be taxable when distributions are made from a foreign non-grantor trust.

      • Trust income
        • Foreign sourced income
        • U.S. or foreign source income effectively connected with the conduct of a U.S. trade or business (ECI)
        • Other U.S. sourced income
        • Gains from sale of U.S. real property.
      • Gift or bequest not paid from trust income, which includes:
        • Specific sum of money
        • Specific property.
      • Trust Corpus
        • Corpus is defined as the principal sum or capital of a trust.

DNI, UNI, and Throwback Tax Rule

DNI refers to Distributable Net Income and it is taxable to the beneficiary in the year that they received the distribution. This is commonplace, and in a typical example a trust will generate some income that income will be distributed to the beneficiary, and the beneficiary reports it on their tax return. With foreign trust, if the income is not DNI, then it is UNI and may involve accumulated distributions. The tax calculation for UNI is more complicated than DNI because it involves issues involving the throwback rule and accumulation distributions which are calculated on form 4970 and attached to form 3520 for reference at the IRS. Income that is distributed as UNI instead of DNI oftentimes loses its beneficial character and is taxed at the Beneficiaries’ ordinary income (OI) tax rates.

Trust Corpus and Gifts

A distinction should be made between trust income and gifts/corpus. Since gift foreign trust distributions of gifts and corpus are not income per se,  typically it is not taxable as income to the US beneficiary.

As provided by the IRS:

      • Generally, distributions of trust corpus and gifts or bequests of specific property as specified in the trust instrument are generally not taxable to a beneficiary. However, when a foreign non-grantor trust distributes trust income, the distribution may be taxable to the beneficiary. U.S. source income and ECI not distributed by a foreign non-grantor trust is taxed to the trust.

Foreign Non-Grantor Trust Beneficiary Statement

A foreign non-grantor trust beneficiary statement is similar to a K-1 in that it identifies certain aspects of the distribution received by the US beneficiary from the foreign non-grantor trust. It is important to note, that when taxpayers do not receive this statement, then they are at a disadvantage when it comes to the tax calculation (and schedules) in Form 3520.

Simple or Complex Foreign Non-Grantor Trusts

A simple trust is essentially a trust that is required to distribute its annual DNI without any holdover, charitable distributions, etc. A complex trust is different in that it is not required to distribute all of the current income each year. So with a Foreign Complex Trust, this can lead to complexities involving distributions which may include DNI, UNI, and Corpus. In other words, whether a trust is a simple or a complex trust affects the beneficiary’s taxable income from a trust distribution and the calculation of the trust’s distribution deduction.

      • The trust’s DNI limits the amount included in the gross income of the beneficiary and the corresponding deduction of the trust for a simple or complex trust.

Complex Trust

The tax rules are more complicated with a complex trust and generally require a much more comprehensive tax analysis.

      • As provided by the IRS: If the trust is a complex trust an examiner should determine if the income amounts reported on Form 3520, Part III, line 40 include the amounts the trust was required to distribute and any other amounts distributed, limited by the trust’s DNI. For example, if the examiner determines that the beneficiary incorrectly treated the trust as a complex trust when the trust was a simple trust, the examiner’s determination and resulting change to the Form 3520, Part III, will affect one or more of the Lines 40a – 46 and the income reported on the beneficiary’s income tax return depending upon the facts and circumstances.

Ordering Rules

When a foreign trust has accumulated distributions/UNI, the ordering rules are very important since it will impact the overall tax liability. As further provided by the IRS:

      • Taxable distributions of a foreign non-grantor trust are limited by the trust’s income. A distribution from a foreign non-grantor is comprised of, in order:
        • (1) DNI to extent of DNI, then
        • (2) UNI to the extent of UNI, and then
        • (3) trust principal.
      • Distributions of DNI are reflected directly in the U.S. beneficiary’s Form 1040 as items of income, and distributions of UNI are considered separately to arrive at an accumulation distribution tax amount.
      • A foreign trust’s DNI includes both U.S. and foreign-source income. DNI for a foreign trust is the taxable income of the trust with the following modifications:
          • No distribution deduction is taken.
          • No personal exemption is taken.
          • Capital gains are included, reduced by losses from sales or exchanges of capital assets, to the extent such losses do not exceed gains.
          • For simple trusts, which by definition do not distribute any amounts other than current income, extraordinary dividends or taxable stock dividends are not included, unless the dividends are allocable to corpus.
          • Tax-exempt interest is included, reduced by any amounts which would be deductible if not disallowed.
          • Plus or minus any adjustment needed related to abusive transactions.

Domestic Income in a Foreign Trust

When U.S. income is generated in a foreign trust, the rules are even more complicated and beyond the scope of this article.

An Example Provided by the IRS 

  • A trust’s DNI is $10,000. The current income required to be distributed currently is 60% of DNI. Total distributions other than gifts, bequests, and charitable contributions were $15,000.
        • Total distribution: $15,000
          • Less: Income required to be distributed currently: $6,000 ($10,000 x 60%)
          • Less: Gifts, bequests, and charitable contributions distributed currently: $0 ? Equals:
            • Total other distributions: $9,000 ($15,000 – $6,000)
              • Less: $4,000 (DNI of $10,000 less income required to be distributed currently of $6,000)
      • Equals:
            • Accumulation Distribution of $5,000 (Total other distributions of $9,000 less $4,000 of DNI subtracted by income required to be distributed currently)
            • When using Form 3520, Schedule B, the beneficiary must also calculate the foreign trust’s aggregate and weighted average UNI in respect of the distribution to the beneficiary. UNI is defined and calculated as follows:
              • UNI is the amount by which a trust’s DNI for the taxable year exceeds the sum of amounts distributed under IRC 661(a)(1) & (2) (amount of current income required to distributed currently and other amounts properly paid or credited or required to be distribute.

Foreign Tax Credit

A U.S. beneficiary of a foreign non-grantor trust may be able to claim foreign tax credits.

      • “A foreign non-grantor trust may credit any foreign taxes imposed on its foreign source income against its U.S. income tax liability. Additionally, a beneficiary may also credit against his or her U.S. tax liability a proportionate share of the taxes the trust paid to a foreign country. However, the applicable regulations do not provide a method for allocating the credit between a trust and a beneficiary.”

Forms 3520/3520-A Reporting

In addition to the tax implications of being a beneficiary of a foreign trust, the beneficiary must also file a Form 3520 in any year they receive a trust distribution. If they are considered an owner of the trust, more detailed Form 3520 and 3520-A requirements may be necessary.

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 of the Streamlined Procedures. 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

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