Tax rules affecting trusts are always complex, but once a foreign trust comes into the picture, there are many pitfalls for taxpayers in the United States to consider. These pitfalls can result in unexpected filings and high penalties for even small infractions.
The implications for U.S. tax purposes vary greatly depending on the classification of the trust and the tax residency of the parties involved. Solely having transactions with a foreign trust may result in U.S. income tax consequences and reporting requirements. Additionally, in the foreign jurisdictions where trusts exist, the requirements are often quite different from those in the U.S. and can include a unique set of terminology, structure and local legal and tax consequences.
SETTING THE STAGE: DEFINING A U.S. PERSON AND A TRUST
The tax consequences can apply to U.S. persons treated as owners of a foreign trust and U.S. persons treated as beneficiaries of a foreign trust and to the foreign trust itself.
A U.S. person is defined by the Internal Revenue Code as any of the following:
- A U.S. citizen
- Domestic partnership
- Domestic corporation
- Any domestic estate
- Any trust if a U.S. person exercises primary supervision over the administration of the trust or if one or more U.S. persons have the authority to control all substantial decisions of the trust
Often, it is obvious that a trust exists, but other times the existence of a trust may not be clear based on the legal arrangements.
It may be determined that a trust exists if it meets all of the following criteria:
- A written or oral arrangement exists.
- The arrangement was created either by a will or inter-vivos declaration.
- The arrangement provides trustees with the rights to take title to a property to maintain and preserve said property for beneficiaries.
- The beneficiaries do not possess the powers of a trustee.
Generally, an arrangement will be treated as a trust under the Internal Revenue Code if it can be shown that the purpose of the arrangement is to vest responsibility in trustees to protect and conserve property for beneficiaries who cannot share in the discharge of this responsibility. Therefore, a trust exists if the beneficiaries are not associates in a joint enterprise for the conduct of business for profit.
IDENTIFYING A FOREIGN TRUST
Now that U.S. persons and trusts have been defined, the next step is to determine whether the trust is considered domestic or foreign.
A trust will be treated as foreign if it fails either the court or control test.
Under the court test, a U.S. court must be able to exercise jurisdiction over the administration of the trust. U.S. Treasury regulations provide further guidance by stating that the court test will be satisfied under any of the following circumstances:
- The trust is registered by an authorized fiduciary or fiduciaries of the trust in a court within the U.S.
- The fiduciaries of a testamentary trust have been qualified as trustees by a U.S. court.
- The fiduciaries or beneficiaries of an inter-vivos trust take actions with a U.S. court that cause the trust to be under the primary supervision of the court.
- Both a U.S. court and a foreign court are able to exercise primary supervision over the administration of the trust.
The automatic migration clause offers further clarification on the court test: if the trust instrument states that any attempt by a U.S. court to assert jurisdiction would cause the trust to migrate from the U.S., then it does not pass the court test.
The safe harbor rule builds on this, however, explaining that a trust without an automatic migration clause will satisfy the court test if the administration of the trust is exclusively in the U.S. and there is no provision in the trust's instrument allowing for its administration elsewhere.
Under the control test, a U.S. fiduciary must have the power to control the substantial decisions of the trust. A substantial decision is any decision that a person is required/authorized to make under the trust arrangement.
GRANTOR VS. NON-GRANTOR TRUSTS
Once it has been determined that the trust is a foreign trust, the next step is to determine if the trust is a grantor or a non-grantor trust.
This determination is crucial because the filing obligations and U.S. tax implications vary greatly depending on what type of foreign trust was established.
A foreign trust is considered to be a grantor trust if it is revocable. It is also considered a grantor trust if it is irrevocable, but the settlor and the settlor’s spouse are the only ones receiving distributions during the life of the settlor. However, these are not the only instances in which a foreign trust can be a foreign grantor trust for U.S. tax purposes.
Foreign grantor trusts also exist if a U.S. grantor makes a gratuitous transfer to a foreign trust that has one or more U.S. beneficiaries or potential U.S. beneficiaries of any portion of the trust. Most likely, if a foreign trust is funded by a U.S. person, the trust will be treated as a grantor trust.
If the trust is irrevocable and persons other than the settlor or the settlor’s spouse are receiving distributions, the trust is considered a non-grantor trust, and it will always be treated as a non-grantor trust.
REPORTING REQUIREMENTS FOR FOREIGN TRUSTS
The U.S. requires reporting for most foreign investments, and foreign trusts are no exception.
Form 3520 is generally required to be filed for foreign trusts when a U.S. person:
- Creates or transfers money or property to a foreign trust or makes a loan to a foreign trust
- Receives any distributions from a foreign trust
- Is treated as the owner of a foreign trust under grantor trust rules
Form 3520 is due with the U.S. Individual income tax returns on April 15 and follows the extension for individual U.S. income tax returns.
U.S. owners of a foreign grantor trust must also file a complete Form 3520-A and furnish annual statements to its U.S. owners and beneficiaries.
If a foreign trust fails to file Form 3520-A, the U.S. owner must complete and attach a substitute Form 3520-A to a timely filed Form 3520 and furnish the required annual statements to the U.S. beneficiaries.
Form 3520-A is generally due on the 15th day of the third month after the year-end of the trust. For calendar year-ends, it would be due on March 15; for a June 30 year-end, it would be due on Sept. 15. An extension can be filed for Form 3520-A.
If the U.S. owner files a substitute Form 3520-A with their Form 3520, the deadline follows the Form 3520 deadline.
It is important to be aware of the different filing obligation deadlines as the forms carry extensive penalties.
Generally, failing to file Forms 3520 and 3520-A can lead to a penalty of $10,000 or one the following (whichever is greater):
- 35 percent of the gross value of any property transferred to a foreign trust for failure by a U.S. transferor to report the creation of or transfer to a foreign trust in Part I
- 35 percent of the gross value of distributions received from a foreign trust for failure by a U.S. person to report receipt of the distribution in Part III
- 5 percent of the gross value of the portion of the foreign trust's assets treated as owned by a U.S. person under the grantor trust rules, if the foreign trust (a) fails to file a timely Form 3520-A and furnish the required annual statements to its U.S. owners and U.S. beneficiaries or (b) does not furnish all of the information required or includes incorrect information
In addition to Forms 3520 and 3520-A, owners and beneficiaries of foreign trusts may also have to disclose the trust’s bank accounts on Forms FinCen 114 (FBAR) and the existence of the trust on Form 8938.
With these filing obligations in place, it is important to consider the U.S. tax consequences.
Income from a foreign grantor trust is generally taxed to the trust’s grantor rather than the trust itself or the beneficiaries.
A person who is treated as the U.S. owner of a foreign trust will be subject to U.S. income tax on their portion of their pro rata share of the trust’s income, regardless of whether the income is treated as a U.S. source or foreign source.
A foreign grantor trust with a foreign grantor will only be taxed on income from U.S. sources. This can be a great planning opportunity because the foreign grantor trust may be able to accumulate earnings from foreign sources, and these earnings may then be distributed tax-free to U.S. beneficiaries.
The above is very similar to the treatment of a foreign non-grantor trust. The foreign non-grantor trust is only subject to U.S. taxation on income derived from U.S. sources.
U.S. beneficiaries are then taxed on distributions received from the foreign non-grantor trust. The taxation of these distributions is governed by a complex set of rules, which include the following:
- A U.S. beneficiary will be taxed on distributions to the extent of the person's share of the trust's current-year distributable net income (DNI), which is equivalent to accumulated income.
- If a trust does not distribute all DNI in a year, the DNI will become classified as undistributed net income (UNI) in the next tax year.
- The throw-back rule provides that a beneficiary is treated as having received the income in the year in which it was earned by the trust. This may be avoided or minimized by a 65-day election, which puts the income in the prior year.
The establishment of foreign trusts requires careful planning to ensure the best outcome to U.S. and non-U.S. beneficiaries in order to avoid penalties for missed filings for already existing trusts.
Please contact GHJ’s International Tax Services Team for a more comprehensive discussion of the tax implications of foreign trusts and related tax planning considerations.