Loans to or from a foreign trust
Loans to or from a foreign trust by US persons may be treated as either a contribution to the trust, or a distribution from the trust.
To avoid this treatment the loan must be a “Qualified Loan”.
To be a “Qualified Loan” the following requirements must be met:
- The obligation must be in writing,
- The term of the loan may not exceed five years,
- The interest rate must fall within a prescribed range (see below),
- The lender or borrower must report the existence of the loan annually on IRS Form 3520, and
- The lender or borrower must also agree to extend the period of assessment for any income tax attributable to the loan to a date not earlier than three years after the maturity date of the obligation.
Required interest rate
The prescribed interest rate must be between 100% and 130% of the appropriate Applicable Federal Rate. The AFR is published monthly by the IRS and depends on whether the loan is “short-term”, “mid-term” or “long term”. In this context a loan for not over three (3) years is a short-term loan; a loan over three (3) years (but not over nine (9) years is a mid-term loan; a loan over 9 years is long-term.
Treatment of a non-qualified loan
If the loan fails to meet the requirements above during its five-year period, it will lose its “Qualified” status and will then be treated as a contribution to or distribution from the foreign trust.
Non-Qualified Loan – Contribution
A loan made by a grantor, beneficiary or a party related to the grantor or beneficiary will be disregarded and thus treated as a contribution to the foreign trust.
Depending on the status of the person making the loan, the person may be treated as a grantor of the foreign trust, potentially making the trust a grantor trust with respect to that person.
Careful and complete records must be kept ensuring that the relevant tax and information returns are completed with respect to the transferor.
Non-Qualified Loan – Distribution
If a loan is non-qualified (at inception or during the five-year period, it will be treated as a distribution from the trust, subject to the normal tax rules applicable to a distribution from a foreign trust.
The issue arises how to treat the “repayment” of the loan? The Internal Revenue Code addresses this issue and provides that:
If any loan (or use of property) is taken into account … (as a distribution) … any subsequent transaction between the trust and the original borrower regarding the principal of the loan (by way of complete or partial repayment, satisfaction, cancellation, discharge, or otherwise) … shall be disregarded for purposes of this title.
Careful records must be taken to assure that the repayment is properly recorded.
Person resident in countries other than the United States
If the person making or receiving the loan is a tax resident outside of the United States, they should carefully consider the tax implications in their country of residence of either making or receiving a loan from a trust.
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