US Tax Compliance For Foreign Trusts
When handling the US tax implications of trusts, particularly non-US trusts, there are a number of issues you must address:
- Is the entity a trust for US tax purposes?
- If the entity is a trust, is it a US (domestic) trust or a non-US (foreign) trust?
- If the entity is a trust, is it a “grantor” or “non-grantor” trust?
The answer to each of these questions will drive your analysis of the tax implications associated with the trust, the trustees, the grantor (settlor) and the beneficiaries.
This can seem, at first, to be an impenetrable minefield. However, by working through the process, step-by-step, the cloud of confusion can be overcome.
Step 1: Is the entity a trust for US tax purposes?
For US Federal income tax purposes, a trust is an arrangement where legal title to property is conveyed to trustees who are required to protect or conserve the property for the beneficiaries and not an arrangement for the conduct of a business. In this context, we look to the law of the jurisdiction that controls the trust to set forth the technical aspects that apply. We then analyze these aspects of the trust to determine if this is a trust for US tax purposes.
In some jurisdictions the rules governing trust arrangements have elements of both conservation of property as well as the conduct of business. We must then determine if the arrangement favors one aspect more than the other to decide if it should be treated as a trust or a company for US tax purposes.
Step 2: Is the entity a US (Domestic) or Non-US (Foreign) Trust?
US taxation of a trust’s income, gains, and distributions is determined principally by whether the trust is a US trust or a foreign trust. Under US law, a trust is classified as a foreign trust unless it satisfies both the “court test” and the “control test”.
A trust satisfies the court test if a US court can exercise primary supervision over the administration of the trust. A trust satisfies the control test if one or more US persons have the authority to control all substantial decisions of the trust.
In applying the court test, one must look to the deed or other documents which govern the trust and look to the clause(s) which define the jurisdiction and forum of the trust. If the authority to supervise the administration of the trust is not given to a US court, then the trust fails the court test.
As to the control test, the controlling or majority of trustee(s) (or members of a foundation council), who have the power to make substantial decisions of the trust, must be US persons, or the trust will also fail the control test.
What we find important from a practice perspective is that the court and control tests are not geographic in nature. Thus, a non-US situs trust, which provides a US court with primary supervision over its administration and vests control in a US trustee, could be a domestic trust for US tax law purposes.
Step 3: Is the trust a Grantor Trust or a Non-Grantor Trust?
US law essentially classifies trusts as either grantor or non-grantor. The term grantor refers to any person (or entity) who settles a trust or otherwise makes gratuitous contributions of property to a trust.
Generally, a grantor trust is a trust where the grantor retains a “reversionary interest,” “beneficial enjoyment,” “power to revoke,” or the right to the income of a trust, without the approval of an “adverse party.” The grantor is then attributed the taxable income/gain and credits of the portion of the trust they are deemed to own.
In contrast, a non-grantor trust is settled “irrevocably” – meaning that the grantor transfers property to the trust without the right to revoke the trust or request that the assets be revested in him or her.
Note: in this context, a transfer by a grantor to a grantor trust will usually not result in the transfer being treated as a taxable gift. On the other hand, an irrevocable transfer to a non-grantor trust will normally be treated as a taxable gift, subject to the US Gift Tax and reporting rules.
Now for a bit of complexity, just to keep you on your toes…
If a US person transfers property to a foreign trust with a US beneficiary (or if there is any possibility that a US person could become a beneficiary), the trust will be a grantor trust even if none of the rules for creating a grantor trust otherwise apply. Under this set of facts, the trust is a grantor trust, meaning the grantor is subject to tax on the income/gains realized by the trust, while the transfer to the trust is also treated as a completed gift for Gift Tax purposes. (This is not necessarily a situation that most grantors will like, although sometimes these rules can be advantageous to combine tax planning for the grantor and beneficiaries).
On a further note, the Grantor Trust rules generally only apply if the effect is to tax a US citizen or resident as a grantor under these rules. Where a trust has a foreign (non-US) grantor, the trust rather than the grantor will be taxable on the trust’s US source income unless at least one of the following exceptions applies:
- The grantor retains an absolute power to revest the trust property in themselves, such as by way of a power to revoke the trust, regardless of whether such power is actually exercised (the “Revesting Exception”); or
- The only amounts distributable from the trust during the lifetime of the grantor are amounts that are distributable to the grantor and/or the grantor’s spouse (the “Exclusive Benefit Exception”).
Taxation of a Grantor Trust
From a US federal income tax standpoint, a grantor trust is tax neutral (transparent) and its owner(s) must recognise the income, deductions and credits of the grantor trust for purposes of determining their US federal income tax liability.
In general, the status of a grantor trust terminates upon the death of the grantor and it becomes a non-grantor trust for US income tax purposes (subject to the terms of the trust that remain in existence). If it is a foreign trust, its income and gains earned after the death of the grantor will generally be subject to US income tax only if earned from US sources, or when distributed to its US beneficiaries, as discussed below.
Taxation of a Foreign Non-Grantor Trust
A non-grantor trust is treated as a separate taxpayer, distinct from the grantor for US tax purposes and generally calculates its taxable income in the same manner as a non-resident non-citizen (non-US) individual. This means that the trust is taxable by the US only on taxable income derived from US sources.
US source income generally includes income which is effectively connected with the conduct of a trade or business within the US, US sourced Fixed or Determinable Annual or Periodic (FDAP) Income, and income related to United States real property interests.
Taxation of US Beneficiaries of a Foreign Non-Grantor Trust
A distribution from a foreign trust includes any gratuitous transfer of money or property from a foreign trust, whether the trust is deemed to be owned by another US person. A distribution is normally taxable if it is either actually, constructively, or deemed received. For example, the payment by a foreign trust with respect to credit card charges of a US beneficiary is treated as a distribution to the US beneficiary for the year in which the payment occurs.
Likewise, a payment in exchange for property transferred or services rendered to the trust by a US beneficiary will be treated as a reportable distribution to the extent that the fair market value of the payment received exceeds the fair market value of the property transferred or services rendered.
Taxation of Distributions
US beneficiaries of a foreign non-grantor trust are taxed on any amounts required to be distributed to them, plus any amounts actually or deemed distributed to them. The determination of the tax treatment of such distribution depends on the nature of the income/gain treated (under US rules) as being distributed and whether the distribution is of current income (referred to as Distributable Net Income or DNI) or accumulated income (referred to as Undistributed Net Income or UNI).
Distributions of income/gains, up to the current year’s DNI, will be taxed as either ordinary income (subject to progressive tax rates) or capital gains (subject to capital gains tax rates), depending on the nature of the income/gains earned by the trust and the portion of such income/gains treated as distributed to the US beneficiary under US tax rules.
DNI not distributed during the current year becomes accumulated income or UNI and subject to taxation under what are often called the “throw-back” rules. The throw-back rules are designed to tax a distribution of UNI as if it had been distributed in prior years. Once a foreign non-grantor trust has UNI, it remains in the trust until it is distributed.
Accumulated income is taxed as ordinary income when distributed, and subject to an additional interest charge which is compounded over the length of time that the income accumulated in the trust. Thus, the longer the distribution of UNI is deferred, the larger that total tax plus interest charges becomes. As an additional punitive measure, capital gains are taxed at ordinary income tax rates if they are accumulated and distributed as UNI.
In this context distributions are allocated proportionately to all beneficiaries (including non-US persons) who receive a distribution.
Distributions in excess of DNI and UNI are treated as distributions of capital and are not taxable.
Additional actions that may be treated as distributions:
Loans to Beneficiaries
Trustees sometimes delay making a distribution to a beneficiary by loaning trust funds/assets to the beneficiary in exchange for some type of promissory note. For US tax purposes this flexibility is curtained as a loan is treated as a distribution unless the loan is a “qualified loan”.
To be a “qualified loan” 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, and the borrower must report the existence of the loan annually on IRS Form 3520. The US 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.
Use of Trust Property
The use of trust property is also treated as a distribution equal to the fair market value of the use of trust property, except to the extent that the trust is paid the fair market value of such use within a reasonable period of time.
From a practical perspective, establishing the fair market value for the use of trust property may prove difficult depending on the nature of the property being used. The IRS may require independent valuations of the fair market value of such use, thus adding to the administrative burden of a trustee.
Trusts often own interest in non-US corporations. Such corporations may be classified as Controlled Foreign Corporations (CFC), or Passive Foreign Investment Companies (PFICs). The tax treatment to beneficiaries of a foreign trust owning such entities is beyond the scope of this note. However, the US taxpayer/beneficiary should be aware that they may be deemed to own an interest in such companies and may be taxed on income related to such companies even though they may not receive a distribution from the trust. Such interest must be reported on Form 5471 (CFC) or Form 8621 (PFIC).
Beneficiaries and anyone receiving a distribution, loan, or use of trust property must file Form 3520. Failure to file either of these forms or filing the forms late or incomplete can result in sizable penalties.
Foreign Non-Grantor Trust Reporting & Appointing a US Agent
The Internal Revenue Code imposes various reporting obligations on foreign trusts and persons creating, making transfers to, or receiving distributions from such trusts.
The US grantor of a foreign grantor trust must ensure that such trust makes a return for such year which sets forth a full and complete accounting of all trust activities and operations for the year, the name of the United States agent for such trust, and furnishes such information as the Secretary may prescribe to each United States person who is treated as the owner of any portion of such trust or who receives (directly or indirectly) any distribution from the trust. This information is provided on Form 3520-A. If the Trustee does not file the form, the Grantor may file a substitute Form 3520-A.
US Income Tax Reporting Requirements
The US tax reporting requirements relevant to foreign trustees and US owners and beneficiaries of foreign trusts are outlined below:
Form 1040NR – (U.S. Nonresident Alien Income Tax Return). Nonresident aliens, including foreign trusts, engaged in a trade or business in the United States, who receive income from US sources or experience a gain or loss on the disposition of a US real property interest must file Form 1040NR. This Form must be filed by April 15 or the extension deadline.
Foreign Non-Grantor Trust Beneficiary Statement. A trustee who does not have a legal obligation to file tax returns in the US should assist any US beneficiary (citizen, green card holder or resident) by providing them a Foreign Non-Grantor Trust Beneficiary Statement for each tax year in which the US beneficiary receives a distribution, deemed distribution or loan from the Trust. This statement must be provided prior to the due date of the beneficiary’s tax return – April 15 or the extension deadline.
Form 3520-A (Annual Information Return of a Foreign Trust with a US Owner). This form provides information about the foreign trust, its US beneficiaries, and any US person who is treated as an owner of any portion of the foreign trust. The US person treated as the owner of the foreign trust is responsible for ensuring that the foreign trust files Form 3520-A and furnishes the required annual statements to its US owners and US beneficiaries. The due date for filing Form 3520-A is March 15. An extension may be granted but must be requested prior to the due date for filing the return.
Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts). A US person should file Form 3520 in any year they receive a distribution from a foreign trust. Thus, any US beneficiary who receives a distribution, deemed distribution or loan from the trust must file Form 3520 (general information and Part III). If the beneficiary is not provided with the Foreign Non-Grantor Trust Beneficiary Statement, then the beneficiary must calculate (and pay) the tax due under the applicable “default” rules. Form 3520 is due on the due date of the beneficiary’s income tax return – April 15 or the extension deadline.
FinCEN Form 114 Report of Foreign Bank and Financial Accounts (the “FBAR”). FinCEN Form 114 is required by any US person with a financial interest in or signature or other authority over at least one financial account located outside the United States if the aggregate value of those foreign financial accounts exceeds $10,000 at any time during the calendar. These rules apply to beneficiaries of a foreign trust who receive more than fifty percent of the trust’s current income during a tax year.
Form 8938 (Statement of Specified Foreign Financial). Form 8938 must be filed if the total value of all the specified foreign financial assets in which the US person has an interest is more than the appropriate reporting threshold (this varies depending on whether the taxpayer is married and whether the taxpayer lives in the US.)
If you have an interest in a foreign non-grantor trust you may have to include the value of your interest on Form 8938. A number of rules may apply here and are beyond the scope of this note. If you are considered the owner of any part of a foreign trust under the grantor trust rules, you do not have to report any of the specified foreign financial assets held by the part of the trust you are considered to own if you satisfy the following conditions:
- You report the trust on a Form 3520 that you timely file with the IRS for the same tax year.
- You ensure that the trust timely files Form 3520-A (or you timely file a substitute Form 3520-A) with the IRS for the same tax year.
- You report the filing of Form 3520 and 3520-A on Form 8938.
A foreign trust with US beneficiaries is subject to certain reporting requirements and IRS scrutiny, as is the US beneficiary. Trustees of such trusts must be mindful of their obligations, both under their fiduciary responsibilities, and because the IRS has increased its enforcement activities with regards foreign assets with US beneficial owners.
The trustee should then ensure that the trust meets all its US tax filing obligations (eg. Forms 1040NR or Form 3520-A where applicable, Trust Beneficiary Statements, etc.). As part of their fiduciary duties and proper relationship management, the trustee may also want to provide the US beneficiaries with assistance in their reporting obligations, including the preparation and filing of the various US tax Forms.
Grantor Trust – A trust where the grantor retains a “reversionary interest,” “beneficial enjoyment,” “power to revoke,” or the right to the income of a trust, without the approval of an “adverse party.” The grantor is then attributed the taxable income/gain and credits of the portion of the trust they are deemed to own.
Non Grantor Trust – Any trust that is not a Grantor Trust.
US (domestic) Trust – Is any trust that meets two tests. To meet the two tests the trust must be subject to the jurisdiction of a US court, and all major decisions must be controlled by US persons. Any trust that does not meet both tests is a Foreign Trusts.
FDAP – Fixed or Determinable Annual or Periodic Income, generally interest, dividends, royalties and rents.
DNI – Distributable Net Income current income
UNI – Undistributed Net Income or accumulated income is DNI that is not distributed during the current tax year.
CFC – Controlled Foreign Corporation is a foreign corporation where more than 50% is owned/controlled by 10% of greater US shareholders.
PFIC – Passive Foreign Investment Company is a foreign corporation where either at least 75% of its gross income is considered passive income or at least 50% of the company’s assets are investments that produce passive income. Passive income generally includes dividends, interest, rent, royalties and capital gains from the disposition of securities.