It is not uncommon anymore that a US Citizen has parents and elders living in foreign countries who may have set up trusts in those countries under (obviously) its laws. There are also US Citizens who have expatriated to/ now live in foreign countries and set up trusts for their children there.
Today’s post was prompted by questions from several clients about an urban legend that seems to be perpetuating itself out there: “You do not have any US tax reporting requirements if you are a US citizen/ permanent resident and your foreign assets and/ investments are in a foreign trust.”
If you have believed this to be true and set up a trust in a foreign country or are thinking of taking this step or are just plain curious about foreign trusts, then you need to read this blog post. U.S.owners and beneficiaries of foreign trusts have complex U.S. reporting requirements, which are different from the reporting requirements imposed on U.S. domestic trusts.
Please Note: All references to “U.S. owners” and “U.S. beneficiaries” refer to persons who are considered U.S. residents for income tax purposes; i.e., either a U.S. citizen, a green card holder, or someone who meets the “substantial presence test” in any tax year.
The U.S. taxation of the income and distributions from a foreign trust depends on the type of foreign trust and the status of the trust’s beneficiaries at the time of distribution.
How is the Tax Residence of the trust determined?
If your trust fails the “Court Test” and the “Control Test”, then it is considered a foreign trust as per § 301.7701-7 (a) (2).
For purposes of brevity for this post:
• A “Court Test” is fulfilled when “any federal, state, or local court within the United States is able to exercise primary authority over substantially all of the administration of the trust (the authority under local law to render orders or judgments)”. There are also bright-lines rules and safe harbor rules for fulfilling the “Court Test”.
• A “Control Test” is fulfilled when “one or more U.S. persons have the authority, by vote or otherwise, to make all “substantial decisions” of the trust with no other person having veto power (except for the grantor or beneficiary acting in a fiduciary capacity)”.
• The trust will automatically fail these two tests if the trust instrument provides words to the effect that will cause it fail the 2 tests.
There are TWO types of foreign trusts, Foreign Grantor Trust and Foreign Nongrantor Trust:
The “grantor” is the person who creates the trust, and the beneficiaries are the persons identified in the trust to receive the assets. The “trustee” is a person who manages the trust for the benefit of someone else, namely, a “beneficiary”.
The US income taxation of a foreign trust depends on whether the trust is a grantor or nongrantor trust. Income from a foreign grantor trust is generally taxed to the trust’s grantor, rather than to the trust itself or to the trust’s beneficiaries.
On the contrary, income from a foreign nongrantor trust is generally taxed when distributed to US beneficiaries, except to the extent US source or effectively connected income is earned and retained by the trust, in which case the nongrantor trust would pay US income tax for the year such income is earned.
The following flow charts explain the tax compliance obligations of the trustees & US beneficiaries of the foreign grantor & nongrantor trusts. They only provide a broad overview of the obligations of the trustees, US owners and beneficiaries.
Flow Chart for Foreign Grantor Trust Tax Compliance Obligations:
Flow Chart for Foreign Nongrantor Trust Tax Compliance Obligations:
There will also be reporting & tax obligations if a beneficiary uses property owned by a foreign trust, since the use itself is considered a “distribution”.
The disclosure requirements under § 6038D also apply to foreign trusts and so also the requirements to file the FinCEN Form 114.
The Internal Revenue Service states that, “Citizens and residents of the United States are taxed on their worldwide income. To help prevent the use of foreign trusts and other offshore entities for tax avoidance or deferral, Congress has enacted several specific provisions in the Internal Revenue Code. Some provisions trigger recognition of gains that would otherwise be deferred. Others deny deferral of tax on income moved offshore.”
So going back to the urban legend we started with, please consult an Enrolled Agent, CPA or Tax Attorney well-versed in foreign trusts if you are a beneficiary/ trustee of a foreign trust or are thinking of setting up a trust in a foreign country.
Bibliography: www.irs.gov; §301.7701-7; Form 3520; Form 3520-A; § 6308D; Abusive Offshore Tax Avoidance Schemes from the IRS.
Original Post By: Manasa Nadig