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Foreign Trust Distributions and Implications for U.S. Beneficiaries (And Don't Forget About the 65 Day Election)

Paul J. D'Alessandro, Jr.

Tax & Wealth Services Report Blog ImageIn my previous post, I discussed some of the relevant U.S. federal tax implications to consider when a foreign individual makes a gift of cash to a U.S. person. That discussion assumed that the gift was coming directly from the foreign individual (i.e., from a financial account directly owned by the foreign individual). What happens when instead of receiving a gift directly from a foreign individual, a U.S. beneficiary receives a distribution from a foreign trust created by a foreign individual?

The starting point is to determine whether the foreign trust is classified as a grantor trust or a nongrantor trust for U.S. federal income tax purposes. Generally speaking, a trust will be considered a grantor trust as to a foreign individual (i.e., the foreign "grantor"[1]) in limited circumstances, namely:

  1. the foreign grantor has the ability to revoke the trust or otherwise has the power to revest title to the trust assets absolutely in himself or herself (i.e., the grantor has the right and ability to get the trust assets back); or

  2. the only distributions that can be made from the trust during the foreign grantor's lifetime are distributions to the foreign grantor or the foreign grantor's spouse (with limited exceptions).

A trust meeting either of these two tests will qualify as a grantor trust as to the foreign grantor, and the foreign grantor will be viewed as the owner of the trust's assets for U.S. federal income tax purposes.[2]  This means that the trust itself is not a taxpayer, but rather, the foreign grantor is treated as directly earning the income earned by the trust. A trust that does not partially or completely qualify as a grantor trust under the foregoing tests is a nongrantor trust as to the foreign individual, and the trust itself is considered the taxpayer for U.S. federal income tax purposes.

The grantor versus nongrantor trust distinction has significant implications for U.S. beneficiaries receiving distributions from a foreign trust. Note that this discussion assumes that the trust is a "foreign" trust for U.S. federal tax purposes.[3]  In the case of a distribution from a grantor trust, the distribution is generally viewed as a gift from the foreign grantor that would not be subject to U.S. federal income tax in the hands of the beneficiary.  The purported gift rules would still apply, however, if the distribution was made from a bank account of a foreign company owned by the foreign trust, rather than from a financial account directly owned by the trust.[4] In addition, in the case of a revocable trust, it is possible for the foreign grantor to be subject to U.S. federal gift tax on the distribution depending on the assets being distributed.[5] 

The rules in the case of a foreign nongrantor trust are more complex. As a general matter, if a U.S. beneficiary receives a distribution from a foreign nongrantor trust, a set of ordering rules applies to determine what is included in the U.S. beneficiary's gross income. First, a distribution includes amounts that were earned in the current year (commonly referred to as distributable net income, or "DNI"). The amount of tax imposed on current year DNI is determined based on the underlying character of the income (i.e., ordinary income, capital gain, or tax-exempt). If, however, a foreign trust makes a distribution to a U.S. beneficiary in excess of DNI in any year, then what is considered to be distributed next out of the trust are the amounts that were accumulated from previous years (commonly referred to as undistributed net income, or "UNI"). In that situation, the distribution could be subject to a complex set of rules known as the "throwback tax" or "accumulation distribution" rules.

In short, these rules result in ordinary income tax treatment for the U.S. beneficiary accompanied by an interest charge to account for the previous deferral that was received due to the foreign trust's accumulation of the income. Based on the amount of UNI present in a trust and the accompanying interest charges that could be imposed, application of the throwback tax rules can result in tax and interest charges equal to the entire amount of the distribution. As a result of the foregoing rules, it is generally not possible for a U.S. beneficiary to receive a tax-free distribution of capital from the trust until all of the UNI in the trust has been distributed.

The throwback tax rules can sometimes be minimized by making what is known as a "65 day election." By making this election, distributions that are made within the first 65 days of a calendar year are treated as though they were made on the last day of the previous year. In the foreign nongrantor trust setting, utilizing the 65 day election can have the practical effect of eliminating UNI that would have otherwise accrued as a result of the trust not distributing all of its DNI from the previous year. As we enter 2021, practitioners should therefore be cognizant of the impending deadline for making distributions within the first 65 days of this year.

Regardless of whether the U.S. beneficiary receives a nontaxable distribution from a foreign grantor trust or a taxable distribution from a foreign nongrantor trust, such distribution must be reported to the IRS on a timely filed Form 3520. Unlike gifts received directly from a foreign individual that are reportable on Form 3520, the reporting of foreign trust distributions is generally more involved and requires a beneficiary statement to accompany the Form 3520. Failure to include all of the appropriate information on the beneficiary statement can result in taxation under the throwback tax rules in certain cases. Accordingly, compliance in this area is of the utmost importance in order to minimize penalties.

The treatment of foreign trust distributions received by U.S. beneficiaries is a complex area of U.S. tax law. Even simple compliance or administration errors can lead to undesirable tax outcomes. Accordingly, care should be exercised and advice from qualified U.S. tax counsel should be sought out prior to making any distributions.

[1] It is important to note that under the applicable definition contained in the U.S. Treasury Regulations, the term "grantor" includes any person who created a trust, or any person who made a gratuitous transfer of property to a trust. In order to be treated as an "owner" of the assets of the trust, however, a person must have gratuitously transferred property to the trust (i.e., the person must have made a gift to the trust). Accordingly, when used in this post, the term "grantor" refers to the person who not only created the trust, but also funded it.
[2] In the case of a U.S. grantor, the grantor trust rules are much broader, resulting in many more ways in which a trust could be classified as a grantor trust as to the U.S. grantor.
[3] A full discussion of what makes a trust a "foreign" trust and related planning considerations will be the subject of a future post.
[4] It is not uncommon in these types of structures for the foreign trust not to have a separate bank account. Accordingly, practitioners should proceed with caution, and the source of funds should be confirmed before making the distribution. Making sure there is an up-to-date organizational chart is also advisable.
[5] For a discussion of relevant U.S. federal gift tax implications, see my previous post.

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