Over the past few decades, the Internal Revenue Service (IRS) has made an effort to raise awareness of reporting regulations and file for foreign trusts. As such, if you are among the U.S. taxpayers with financial ties to a foreign state, you may have a foreign trust that requires U.S. tax filing.
The United States federal income taxation of foreign trusts and their owners and beneficiaries depends upon whether they are classified as “grantor” or “non-grantor” trusts. If you want to learn more about the different types of foreign trusts and how these trusts will tax you, here’s a quick guide to help you understand foreign trust taxation.
What is a Foreign Trust?
To further understand the in-depth content of foreign trust taxation, you should know what a trust is and when you can say it’s a foreign trust. Generally, a trust is a fiduciary relationship between a trustor, trustee, and beneficiary.
It is an arrangement wherein the property’s legal title is transferred from one party, known as the trustor, to another party, the trustee, who will then manage the asset for the benefit of a third party, known as the beneficiary. So when can you say trust is a foreign trust? Well, according to U.S. law, a trust that was arranged in a foreign state and subject to that state’s courts and laws is considered as a foreign trust.
For U.S. tax purposes, trusts for the U.S. are taxed as grantor or non-grantor. However, when the grantor retains ownership of the assets transferred to a trust, it will be considered a grantor trust under IRC Section 671-679.
As such, the income and capital gains from a foreign grantor trust are taxed to the trust’s grantor instead of the trust’s beneficiaries or the trust itself. On the contrary, when the grantors give all the ownership over properties or assets to a trust and are distributed to their U.S. beneficiaries, it is generally taxed as a non-grantor trust. In this case, the non-grantor trust will pay U.S. income tax for the year where the income is earned. Pro-tip: If you hold crypto investments in a foreign trust, things might be a bit more complicated for you.
If a foreign trust was established by a U.S. person who has complete control over the trust’s income, it would be considered a grantor trust. In addition, even if the U.S. grantor does not hold any control over the trust, they will still be treated as the trust’s owner for U.S. tax purposes as long as it has a U.S. beneficiary.
On the other hand, if a foreign trust has a grantor who is not a U.S. person, there will be more limited applied rules to identify whether the trust is under the grantor trust category. Generally, a trust will be treated as a grantor trust only if:
a.) it is revocable by the grantor (either alone or with the consent of a subordinate or related party who is subservient to the benefactor)
b.) distributions (whether of corpus or income) may be made only to the grantors or their spouses during their lifetime.
Furthermore, the income generated from a foreign grantor trust is taxed to the grantor and not to the trust’s beneficiaries or the trust itself. Thus, for U.S. trust owners, the worldwide income of their trust would be subject to U.S. tax as if such income was earned by themselves.
On the other hand, for non-U.S. trust owners, only the trust’s U.S. source Fixed, Determinable, Annual, or Periodical (FDAP) passive income (such as interest and dividends) and those revenues directly connected to a U.S. business or trade will be subject to U.S. tax.
All the trust that is not treated as a grantor trust is considered to be a non-grantor trust. This classification of trust is an arrangement in which the grantors take out their control over the trust and give it to their beneficiaries.
One of the good things about non-grantor trust is that it allows a foreign national to give a significant amount of wealth to their beneficiaries which may be free from applicable taxes. However, the beneficiaries and the trust itself should report any capital gains and income on their tax returns. Thus, remember that a non-grantor trust is another taxing entity liable for filing its annual income tax return.
What is a Foreign Trust for U.S. Tax Purposes?
Under prior law, certain factors are to consider to determine whether a trust is foreign or domestic. These factors include:
- The residence of the trustee;
- The principal place of administration;
- The governing law of the trust;
- The nationality of the trust settlors and beneficiaries; and
- The situs of trust assets.
But, the 1996 Small Business Act changed this subjective test, comprising the above facts and circumstances, with an objective test to differentiate domestic trust from a foreign trust. Here are some of its considerations:
- A trust will be treated as a domestic trust if a U.S. court can work with principal supervision over trust administration (the “court test.”)
- A trust will be treated as a domestic trust if a U.S. person has control over all the essential trust decisions (the “control tests.”)
- A trust will be considered foreign unless it satisfies both the above “U.S. Court Test” and “Control Test.” According to treasury regulations, a foreign trust must compute its taxable income for U.S. income tax purposes the same way as a nonresident alien.
The rules provide that a U.S. court comprises any local, state, or federal court within the 50 states and the District of Columbia for the court test’s purposes. Hence, a court inside a U.S. possession or territory is not a U.S. court. As such, a U.S. court is considered to have primary supervision if it possesses the power to determine all the issues regarding the entire trust’s administration, i.e., the fiduciary decisions concerning the trust as a whole significantly.
On the other hand, the control test will be satisfied if a U.S. person controls all substantial decisions that may affect the entire trust and no other representative can overpower them. These significant decisions include:
- The amount and timing of distribution and whether to make them from corpus or income;
- The Investment decisions;
- The selection of beneficiaries;
- Whether to terminate the trust or not; and
- The decisions regarding trustee changes.
Take note that the regulation affords 12 months to replace the authorized person to make all the important decisions affecting a trust if there’s an unintentional change in control, causing the trust’s residency to change. For this purpose, an accidental change includes the death, resignation, incapacity, or change of residence of the person who has the control to make the trust’s substantial decisions that weren’t anticipated nor intended to cause a shift of trust’s residency.
As such, if changes of control are made within 12 months of inadvertent change, the trust will maintain its pre-changed residency during the 12 months. If not, the change of trust residency will be considered to have occurred on the day when the inadvertent change has been made.
How is Foreign Trust Taxed?
To have more profound knowledge about foreign trust taxation, let’s know how these trusts are taxed. As mentioned earlier, foreign trust has two types, the grantor trust, and the non-grantor trust. For the foreign grantor trust, the income generated from this trust is taxed to its grantor.
In contrast, the foreign non-grantor trust is taxed when distributed to U.S. beneficiaries only if the income is retained and earned by the trust. In this case, the non-grantor trust would have to pay U.S. income tax for the year such income is earned.
Are Foreign Trusts Subject to U.S. Estate Tax?
Foreign trusts established in the United States for U.S.income tax purposes won’t protect trust’s settlor from U.S. estate taxation if:
- The settlor is a trust’s beneficiary; and
- The trust owns properties and assets deemed to be present in the United States.
Furthermore, according to “Estate tax U.S. situs assets,” a U.S. trust qualifying as a foreign grantor trust is liable for estate tax at 40% with only $60,000 de minimus (as an aversion to $5.3 million for U.S. person).
On top of that, here are some of the special tax rules applicable to Foreign Trusts:
The throwback rule is the hook upon the distinction between distributable net income (DNI) and undistributed net income (UNI). As such, all the income earned by a foreign non-grantor trust with some modification is noted as DNI (under Sec. 643). Thus, as the income is distributed to a U.S. beneficiary, the trust is subject to income taxation.
However, based on this special tax rule, yearly DNI that is not distributed to beneficiaries within 65 days before the year-end will be reclassified as UNI. Moreover, after the accumulation of UNI from the later years, any distributions beyond the amount of DNI attributable to the foreign trust will be referred to as distribution of UNI until any undistributed net comes from the trust is exhausted.
As stated in Section 684 of the Internal Revenue Code of 1986, any transfer of assets or property by a U.S. person to a foreign trust is regarded as a taxable exchange of the property (except for some circumstances). This section also provides that when a domestic trust becomes a foreign trust, it will be treated as taxable effective immediately before the trust changes its residence status.
Loans from Foreign Trusts; Intermediary Transfers
One of the special rules added to the 1996 Small Business Act Code is the treatment of loans from foreign trusts and distributions through intermediaries.
As provided in regulations, cash loans or marketing securities by a foreign trust to a beneficiary, grantor, or other U.S. person related to the beneficiary or grantor is regarded as trust distribution that is taxable under standard trust rules. However, suppose the loan is made to people other than a beneficiary or grantor. In that case, it will be regarded as a distribution to the beneficiary or grantor to whom the person is related.
How to File Foreign Trust Tax Return
A U.S. person who has certain transactions with a foreign trust must file Form 3520, “Annual Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts.”
Besides that, a U.S. person is also required to file the same form when:
- They are treated as owners of foreign trusts under the rules of IRC Sec. 671-679;
- They receive certain bequests or large gifts from a foreign person;
- They transfer or create property or money to a foreign trust;
- They receive uncompensated use of the property of a foreign trust;
- They receive distributions from a foreign trust; and
- They receive a loan from a foreign trust.
When filing Form 3520, you will encounter more information regarding:
- Who must file a Form 3520;
- Where and when a U.S. person must file Form 3520;
- Possible penalties for untimely filing of Form 3520 or proving inaccurate details when filling out the form.
In addition to Form 3520, a U.S person who owns a foreign trust under the grantor trust rules must also secure and file a Form 3520-A, “Annual Information Return of Foreign Trust With a U.S. Owner.” However, if U.S. owners fail to file Form 3520-A, they must:
- Attach a complete substitute Form 3520-A to a timely filed Form 3520; and
- Provide the required annual statements to avoid penalties for the failure of timely filing of Form 3520-A.
What are the Penalties for Failure to File
When a U.S. person fails to file necessary forms for their foreign trust filings on time, they will undoubtedly face significant penalties that may hurt their pockets. In addition, the amounts assessed due to late filings can devastate the clients and be a crucial challenge to CPAs trying to explain and eliminate them.
The discussion of penalties below focuses on the context of individual taxpayers. However, the reporting obligations are applicable for all U.S. person taxpayers that have filing obligations.
Calendar-year taxpayers must file Form 3520-A every the 15th of March and every the 15th of April for Form 3520, though they may obtain a six-month extension of time to file either form. In addition, only a U.S. person residing outside the United States is eligible for the 15th of June due date when filing for Form 3520.
As such, below are the corresponding penalties for failure to timely file Forms 3520-A and 3520:
- 5% of the end-of-tax-year value of the gross assets of a foreign grantor trust (Forms 3520 and 3520-A);
- 35% of contributions to a foreign trust (Form 3520);
- 35% of distributions received from a foreign trust (Form 3520); and
- Up to 25% when beneficiaries failed to report the receipt of a gift or inheritance from a foreign person (Sec. 6039F(c)(1)(B)) (Form 3520).
Moreover, if the percentage amount is less than $10,000, with respect to the foreign trust reporting, the penalty will be $10,000. Plus, if reporting failure continues more than 90 days after notice of failure has been served by the IRS, another $10,000 will be set for every 30 days. However, this additional penalty amount won’t go beyond the reportable amount as per Form 3520.
Hence, the imposed penalties for such a failure of timely reporting cannot exceed 100%. On a side note, these penalties have no relationship to unreported gifts or income. The U.S person may have paid all income taxes connected to the activities of the foreign trust. Above all, if the taxpayer failed to file form 3520 and form 3520-A on the given time due to reasonable cause and not because of willful negligence, no penalty shall be imposed.
What Tax Form does a Foreign Trust file?
When a U.S. citizen transfers property or money to a foreign trust, they should file Form 3520. Furthermore, they are also required to file the same form when they are considered the U.S. owner of a foreign trust under the grantor trust rules. Moreover, the trustee of a grantor trust with a U.S. owner must file Form 3520-A with the IRS every year.
Is a TFSA Considered a Foreign Trust?
Generally, the Tax-Free Savings Account or TFSA is offered as annuity contracts, deposits, or trust type arrangements. It is a way for people of legal age and a valid Social Insurance Number (SIN) to set aside tax-free money throughout their lifetime. As such, TFSA is assumed to be a foreign trust for U.S. tax purposes and thus, requires the filing of Form 3520 and 3520-A.
If a U.S. person makes a transfer to a foreign trust how will it be treated for U.S. income tax purposes?
A foreign trust will be considered as a grantor trust when a U.S grantor transfers to a foreign trust that has U.S. beneficiaries or potential beneficiaries who will have a portion of the trust. Thus, it would be best to note that in most cases, when a U.S. person funds a foreign trust, the trust will be treated as a grantor trust.
If I have an interest in a foreign trust, do I need to file an FBAR?
The Foreign Bank Account Report (FBAR) exists to battle tax evasion, specifically reporting assets and money in foreign banks. If you are a U.S. trustee of a foreign trust, you will have signature authority over and a financial interest in the trust’s foreign account, and thus, you must file the FBAR form. If you fail to file such a form, you may face the imposition of civil and criminal penalties.
Who are considered US Owners and US Beneficiaries of foreign trust?
All the U.S. owners and U.S. beneficiaries of foreign trusts refer to the individual who is U.S. persons or residents for income tax purposes. With that said, these people include a green card holder, U.S. citizen, or a person who meets the significant presence test in any tax year.
How is the tax residence of trust determined?
For tax purposes, a trust may be taxed in a country for which it is identified as a resident trust under the governing state’s definition of residency. It could be based on the location of:
- The grantor;
- The trust administrator or trustee; and
- The beneficiaries.
What is the Safe Harbour Rule?
A safe harbor rule states that a trust will be a U.S. trust if :
- the trust instrument doesn’t direct the trust to be managed outside the United States;
- the trust is administered exclusively in the U.S.; and
- the trust is not subject to an automatic migration provision.
Suppose you are a U.S. person who owns a foreign trust, whether a grantor or a non-grantor trust; it is necessary to know the general and special rules regarding foreign trust taxation. In addition, having knowledge on how these trusts are taxed and the necessary forms to file when it comes to reporting distribution and net income may help you avoid penalties that may give you headaches in the future.