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Foreign Grantor Trust Tax Rules
With the recent uptick by the Internal Revenue Service in enforcing compliance for accurate and timely reporting of foreign trusts — much of the focus has been on the filing of Forms 3520/3520-A. but, one of the most important aspects of foreign trusts, and especially foreign grantor trusts, is how the income generated from the trust is taxed. When it comes to Foreign Grantor Trusts, in many respects, they operate the same as a Domestic Grantor Trust in terms of how the owner/settler or other transferors move property into the trust, generate income, and are taxed under US tax law. In general, foreign trust taxation is very complicated. But, let’s go through the basics of how a foreign grantor trust is taxed under US tax law.
Foreign Grantor Trust Taxation
When a trust is a grantor trust — instead of a non-grantor trust — it typically means that the person who created the trust still maintains control over the assets in the trust and how the trust operates (For example, who serves as a trustee). As a result, based on that control, it is typically the grantor of the grantor trust who is responsible for paying income tax generated from the trust. That is the same, whether or not there are beneficiaries who receive distributions as well. In other words, when a trust is a grantor trust so that the trust is still owned by the grantor, the grantor pays tax on the income.
IRC 671
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Where it is specified in this subpart that the grantor or another person shall be treated as the owner of any portion of a trust, there shall then be included in computing the taxable income and credits of the grantor or the other person those items of income, deductions, and credits against tax of the trust which are attributable to that portion of the trust to the extent that such items would be taken into account under this chapter in computing taxable income or credits against the tax of an individual.
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Any remaining portion of the trust shall be subject to subparts A through D. No items of a trust shall be included in computing the taxable income and credits of the grantor or of any other person solely on the grounds of his dominion and control over the trust under section 61 (relating to definition of gross income) or any other provision of this title, except as specified in this subpart.
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Examples from IRC 1.671-2
- 1.671-2 Applicable principles.
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(a) Under section 671 a grantor or another person includes in computing his taxable income and credits those items of income, deduction, and credit against tax which are attributable to or included in any portion of a trust of which he is treated as the owner. Sections 673 through 678 set forth the rules for determining when the grantor or another person is treated as the owner of any portion of a trust. The rules for determining the items of income, deduction, and credit against tax that are attributable to or included in a portion of the trust are set forth in § 1.671-3.
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- 1.671-3 Attribution or inclusion of income, deductions, and credits against tax.
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(a) When a grantor or another person is treated under subpart E (section 671 and following) as the owner of any portion of a trust, there are included in computing his tax liability those items of income, deduction, and credit against tax attributable to or included in that portion.
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For example:
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(1) If a grantor or another person is treated as the owner of an entire trust (corpus as well as ordinary income), he takes into account in computing his income tax liability all items of income, deduction, and credit (including capital gains and losses) to which he would have been entitled had the trust not been in existence during the period he is treated as owner.
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(2) If the portion treated as owned consists of specific trust property and its income, all items directly related to that property are attributable to the portion. Items directly related to trust property not included in the portion treated as owned by the grantor or other person are governed by the provisions of subparts A through D (section 641 and following), part I, subchapter J, chapter 1 of the Code. Items that relate both to the portion treated as owned by the grantor and to the balance of the trust must be apportioned in a manner that is reasonable in the light of all the circumstances of each case, including the terms of the governing instrument, local law, and the practice of the trustee if it is reasonable and consistent.
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(3) If the portion of a trust treated as owned by a grantor or another person consists of an undivided fractional interest in the trust, or of an interest represented by a dollar amount, a pro rata share of each item of income, deduction, and credit is normally allocated to the portion. Thus, where the portion owned consists of an interest in or a right to an amount of corpus only, a fraction of each item (including items allocated to corpus, such as capital gains) is attributed to the portion. The numerator of this fraction is the amount which is subject to the control of the grantor or other person and the denominator is normally the fair market value of the trust corpus at the beginning of the taxable year in question. The share not treated as owned by the grantor or other person is governed by the provisions of subparts A through D. See the last three sentences of paragraph (c) of this section for the principles applicable if the portion treated as owned consists of an interest in part of the ordinary income in contrast to an interest in corpus alone.
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Current Year vs Prior Year Non-Compliance
Once a taxpayer has missed the timely tax and reporting (such as FBAR and FATCA) requirements for foreign trusts 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 that 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. 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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