Foreign Trust Tax & Reporting Rules
What is a Foreign Trust: One of the most complicated issues involving the IRS and international tax is whether or not your overseas trust is considered a foreign trust or domestic trust. This is because the tax rules and reporting requirements for a foreign trust are much more onerous then a U.S. trust. And, when there is a U.S. beneficiary of a foreign trust, they must properly report the trust to the IRS.
Even though it is technically the Trustee who is supposed to report, the IRS will still penalize the U.S. beneficiary for failing to report.
The failure to properly report a foreign trust to the Internal Revenue Service may result in significant fines and penalties under Internal Revenue Code 6048.
As far as offshore penalties go, penalties for noncompliance a foreign trust tax and reporting are routinely issued.
Therefore, we will take some time to discuss the basics before and trust, how a Foreign Grantor Trust differs from a Non-Grantor Trust, and whether it is taxable or reportable in the US.
What is a Trust?
At its most basic level, a foreign trust is simply a trust that is not considered a US trust.
Stated another way, unless it is considered a US trust under US tax law, it is deemed a foreign trust.
Once it is deemed a foreign trust, the next question is whether it is a grantor trust for non-grantor trust. That is because the different types of trusts have different reporting and tax requirements.
The Internal Revenue Service relies on treasury regulation 301. 77014 when it comes to defining what a trust is.
a) Ordinary Trusts
“In general, the term “trust” as used in the Internal Revenue Code refers to an arrangement created either by a will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts.
Usually the beneficiaries of such a trust do no more than accept the benefits thereof and are not the voluntary planners or creators of the trust arrangement.
However, the beneficiaries of such a trust may be the persons who create it and it will be recognized as a trust under the Internal Revenue Code if it was created for the purpose of protecting or conserving the trust property for beneficiaries who stand in the same relation to the trust as they would if the trust had been created by others for them.
Generally speaking, 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 in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.”
What makes the Trust a U.S. Trust?
Under Treas. Reg. §301.7701-7, a Foreign Trust is defined as follows:
(1) A trust is a United States person if –
(i) A court within the United States is able to exercise primary supervision over the administration of the trust (court test); and
(ii) One or more United States persons have the authority to control all substantial decisions of the trust (control test)
(2) A trust is a United States person for purposes of the Internal Revenue Code (Code) on any day that the trust meets both the court test and the control test. For purposes of the regulations in this chapter, the term domestic trust means a trust that is a United States person.
What about a Foreign Trust?
The term foreign trust means any trust other than a domestic trust.
(3) Except as otherwise provided in part I, subchapter J, chapter 1 of the Code, the taxable income of a foreign trust is computed in the same manner as the taxable income of a nonresident alien individual who is not present in the United States at any time. Section 641(b). Section 7701(b) is not applicable to trusts because it only applies to individuals.
In addition, a foreign trust is not considered to be present in the United States at any time for purposes of section 871(a)(2), which deals with capital gains of nonresident aliens present in the United States for 183 days or more.
(b) Applicable law. The terms of the trust instrument and applicable law must be applied to determine whether the court test and the control test are met.
(c) The court test –
(1) Safe harbor. A trust satisfies the court test if –
(i) The trust instrument does not direct that the trust be administered outside of the United States;
(ii) The trust in fact is administered exclusively in the United States; and
(iii) The trust is not subject to an automatic migration provision described in paragraph (c)(4)(ii) of this section.
The following example illustrates the rule of paragraph (c)(1) of this section:
A creates a trust for the equal benefit of A’s two children, B and C. The trust instrument provides that DC, a State Y corporation, is the trustee of the trust. State Y is a state within the United States. DC administers the trust exclusively in State Y and the trust instrument is silent as to where the trust is to be administered. The trust is not subject to an automatic migration provision described in paragraph (c)(4)(ii) of this section. The trust satisfies the safe harbor of paragraph (c)(1) of this section and the court test.
(d) Control test –
(i) United States person.
The term United States person means a United States person within the meaning of section 7701(a)(30). For example, a domestic corporation is a United States person, regardless of whether its shareholders are United States persons.
(ii) Substantial decisions. The term substantial decisions means those decisions that persons are authorized or required to make under the terms of the trust instrument and applicable law and that are not ministerial. Decisions that are ministerial include decisions regarding details such as the bookkeeping, the collection of rents, and the execution of investment decisions. Substantial decisions include, but are not limited to, decisions concerning –
(A) Whether and when to distribute income or corpus;
(B) The amount of any distributions;
(C) The selection of a beneficiary;
(D) Whether a receipt is allocable to income or principal;
(E) Whether to terminate the trust;
(F) Whether to compromise, arbitrate, or abandon claims of the trust;
(G) Whether to sue on behalf of the trust or to defend suits against the trust;
(H) Whether to remove, add, or replace a trustee;
(I) Whether to appoint a successor trustee to succeed a trustee who has died, resigned, or otherwise ceased to act as a trustee, even if the power to make such a decision is not accompanied by an unrestricted power to remove a trustee, unless the power to make such a decision is limited such that it cannot be exercised in a manner that would change the trust’s residency from foreign to domestic, or vice versa; and
(J) Investment decisions; however, if a United States person under section 7701(a)(30) hires an investment advisor for the trust, investment decisions made by the investment advisor will be considered substantial decisions controlled by the United States person if the United States person can terminate the investment advisor’s power to make investment decisions at will.
The term control means having the power, by vote or otherwise, to make all of the substantial decisions of the trust, with no other person having the power to veto any of the substantial decisions. To determine whether United States persons have control, it is necessary to consider all persons who have authority to make a substantial decision of the trust, not only the trust fiduciaries.
(iv) Safe harbor for certain employee benefit trusts and investment trusts.
Notwithstanding the provisions of this paragraph (d), the trusts listed in this paragraph (d)(1)(iv) are deemed to satisfy the control test set forth in paragraph (a)(1)(ii) of this section, provided that United States trustees control all of the substantial decisions made by the trustees of the trust
(A) A qualified trust described in section 401(a)
(B) A trust described in section 457(g);
(C) A trust that is an individual retirement account described in section 408(a);
(D) A trust that is an individual retirement account described in section 408(k) or 408(p);
(E) A trust that is a Roth IRA described in section 408A;
(F) A trust that is an education individual retirement account described in section 530;
(G) A trust that is a voluntary employees’ beneficiary association described in section 501(c)(9); (H) A group trust described in Rev. Rul. 81-100 (1981-1 C.B. 326) (See § 601.601(d)(2) of this chapter);
(I) An investment trust classified as a trust under § 301.7701-4(c), provided that the following conditions are satisfied –
(1) All trustees are United States persons and at least one of the trustees is a bank, as defined in section 581, or a United States Government-owned agency or United States Government-sponsored enterprise;
(2) All sponsors (persons who exchange investment assets for beneficial interests with a view to selling the beneficial interests) are United States persons; and
(3) The beneficial interests are widely offered for sale primarily in the United States to United States persons; (J) Such additional categories of trusts as the Commissioner may designate in revenue procedures, notices, or other guidance published in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii)(b)).
Grantor vs. Non-Grantor
Since the Grantor Trust is the most common type of foreign trust, we will start there:
The Grantor Trust is generally the more common type of trust.
It is a trust in which the Grantor retains or has the ability to exercise control or dominion over the trust.
A simple common example is when a person owns a home, and places the home in a revocable trust, in which they are also the trustee.
With a Foreign Grantor Trust, the Owner of the trust is attributed income equal to the share ownership of the trust. So, if the grantor owns 50% of the trust, and it earns $100,000 of income – the grantor will report $50,000 in income.
In addition, the owners must file a Form 3520.
If the Trustee does not file the Form 3520-A, then the Owner must also file that form as well, to avoid fines and penalties
The Trustee of a foreign Trust is required to file the For 3520-A. Unlike the Form 3520, which is due at the time the tax return is filed, the 3520-A is filed
“ by the 15th day of the 3rd month after the end of the trust’s tax year. However, if you are filing a substitute Form 3520-A with your Form 3520, then your substitute Form 3520-A is due by the due date of Form 3520.
There are other forms required to be filed as well, including a Foreign Grantor Trust Owner Statement to each U.S. owner and a Foreign Grantor Trust Beneficiary Statement” to each U.S. beneficiary who received a distribution (in the current tax year).
The failure to file the form may result in significant fines and penalties.
*The rules for Non-Resident Aliens who own Foreign Grantor Trusts is complex and beyond the scope of this article.
Foreign Non-Grantor Trust
Unlike a Foreign Grantor Trust, a Foreign Non-Grantor Trust is not subject to tax on U.S. income unless there is associated income in the U.S. which is effectively connected to the Trust or (aka ECI).
The Trustee is generally responsible for filing a Form 1040-NR to report any U.S. income.
It possible, the Trustee should provide the U.S. person beneficiary with a statement detailing any distributions, income, deductions etc, that is attributed to the U.S. person.
U.S. Beneficiary of a Foreign Non-Grantor Trust
Even though the trust is a non-grantor trust, the reporting for the U.S. beneficiary is essentially the same – Form 3520.
The Form 3520 is used to disclose the total distributions the U.S. person beneficiary received in the year.
The U.S. Person beneficiary is required to pay tax on the earnings they received from the Foreign Non-Grantor Trust.
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