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Income Taxation of Foreign Trusts and Beneficiaries



The income taxation treatment of foreign trusts and beneficiaries takes into account whether the party or entity has entered United States taxing jurisdiction. It is essential to draw a distinction between a foreign trust and a United States, domestic trust. A foreign trust is defined as one that is not a domestic trust. (1) The term trust itself embraces the notion of an inter vivos declaration in which trustees take title to property for the purpose of protecting or conserving it for beneficiaries in accordance with ordinary rules applicable in chancery or probate courts. (2)

The income taxation of a foreign trust requires there be certain contact factors. The factors to be considered, prior to the 1996 Tax Act, (Small Business Job Protection Act of 1996) in this connection for the purpose of determining whether trust income was foreign trust income, were based upon the following components in a subjective analysis:

1. Jurisdiction where the trust is created;

2. Actual location of trust assets;

3. Situs of Trust Administration;

4. Trustee’s nationality and residence;

5. Settlor’s nationality and residence; and

6. Beneficiaries’ nationality and residence.

The determination of whether a trust is a foreign trust is no longer a subjective test. The determination of whether a trust entity is domestic or foreign is specific. The Code defines a domestic trust as a United States person if a United States court has the ability to exercise primary administration over the supervision of the trust and one or more United States fiduciaries have the authority to control all substantial decisions of the trust. (3)

In the event a trust in any respect fails to satisfy either of those two elements, it is a foreign trust. A foreign trust determined not to be taxable as a domestic trust is taxable analogous in concept to a nonresident alien individual. The taxation of nonresident alien individuals occurs only on certain income from sources within the United States and with respect to income described in Section 864 of the Code. That income is from sources without the United States and determined to be effectively connected to the conduct of a trade or business in the United States. (4)

A foreign trust that is structured to be revocable continues to be subject to grantor trust rules of the income taxation of a foreign trust Settlor. The applied scheme of the taxation is that which is applicable to a nonresident alien individual. The Settlor of a revocable foreign trust is taxed individually as a nonresident alien. This is the application of the same principles in the taxation of a revocable domestic trust. (5)

The Code provides that other than capital gains income, income not connected with a United States trade or business and received from sources within the United States is taxable at a flat rate of thirty percent of the amount to a nonresident alien individual. (6) These United States sources of income are those consisting of interest, dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, or other fixed or determinable annual or periodical gains, profits, and income. (7)

There are certain designated United States sourced incomes that, if not effectively connected with a United States trade or business and are fixed or determinable annual or periodical incomes, are deemed to be exempt from taxation to a nonresident alien. These incomes consist of certain interest on a United States bank deposit, interest from qualifying portfolio indebtedness, and a percentage of any dividend paid by a United States corporation which is in conformity with an eighty percent foreign business requirement test. (8) Additionally, United States sourced, non-real estate capital gains income is not taxable if not effectively connected to a United States trade or business. (9)

United States sourced real estate gain generated as capital gains is deemed to be income effectively connected with a United States trade or business and therefore subject to normal domestic tax rates imposed upon a United States taxpayer. (10) A Settlor of a trust also would be subject to tax rates imposed upon a United States taxpayer with respect to certain foreign sourced income effectively connected to a trade or business when such income is derived by a grantor trust. (11)

On the other hand, an irrevocable foreign trust not determined to be a grantor trust is taxed similarly to a nonresident alien. All such income, gain, or loss from sources determined to be without the United States is not to be treated as effectively connected with the conduct of a trade or business within the United States. (12) A beneficiary of a foreign irrevocable trust determined to be a nonresident alien is not subject to United States income taxation of distributable net income that is foreign source income or exempt income. (13)

Beneficiaries of a foreign trust who have a nonresident alien status are subject to United States income taxation to the extent that the distribution of distributable net income is attributable to a United States trade or business and income determined to be fixed and determinable annual or periodical income. Additionally, a distribution to a nonresident alien beneficiary of foreign trust distributable net income consisting of fixed or determinable annual periodic income retains its income characterization to the recipient beneficiary. (14)

A nonresident alien beneficiary of a foreign trust who sells a trust interest and such trust owns United States real property will be subject to income taxation as though the income is effectively connected with the conduct of a United States trade or business and subject to United States taxation. (15) To the extent that a nonresident alien beneficiary of a foreign trust receives United States sourced taxable distributions of distributable net income, the beneficiary is required to file a United States individual income tax return. (16) The exempt income provisions accorded a foreign trust by virtue of a nonresident alien status also exempts income from a foreign trust beneficiary receiving distributable net income consisting of such exempt categories. (17)

In accordance with Circular 230 Disclosure

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Footnotes
1. IRC Section 7701 (a) (31) (B) (1986).
2. There are various characteristics which if present can cause an entity to be viewed as other than a trust. See Rev. Ruling 78-371, 1978-2 C.B. 344. Also see Bank of America National Trust and Savings Association v. U. S. 77-1 USTC Par. 9400 (9th Cir. 1977); Oak Commercial Corp. 9 T. C. 947 (1947), aff’d sub. Nom., Aramo-Stiftng v. Comm., 49-1 USTC Par. 9205 (2nd Cir. 1949); Estate of Oei Tjong Swan, 24 T. C. 829 (1955), rev’d on other grounds, 57-2 USTC Par 11,714 (2nd Cir. 1957).
3. IRC Section 7701 (a) (30) (E) (i) (ii) (1986).
4. Treas. Reg. Section 1.871 – 1 (a) of the IRC of 1986 and as thereafter amended.
5. Id. at note 4.
6. Treas. Reg. Section 1.864-4 (a) of the IRC of 1986 and as thereafter amended.
7. Id. at note 6.
8. IRC Section 871 (i) (1986).
9. IRC Section 871 (a) (1) (1986).
10. IRC Section 897 (a) (1) (A) (1986).
11. IRC Section 871 (b) (1986).
12. IRC Section 864 (c) (4) (1986). Also see IRC Section 871 (b) (2) (1986). A trustee must avoid being found present in the United States for a period of 182 days (that which distinguishes resident alien and non-resident alien) in a taxable year for which the income is determined to be reportable income. See Treas. Reg. Section 1.871-2 (a) and (b) of the IRC of 1986 and as thereafter amended.
13. IRC Section 864 (c) (4) (A) (1986).
14. IRC Section 652 (b) (1986).
15 IRC Section 897 (g) (1986).
16. IRC Section 6012 (1986).
17. IRC Sections 662 (b) and 871 (a) (1) and (i) (2) (A) (1986).

William Richards is a Sole Practitioner in Orlando, Florida, USA 32626. Attorney at Law, Legal Advisor. 1978 – Present

PUBLICATIONS: International Financial Centers, Adell Financial Series, AD Adell Publishing, Copyright 2012, 378 pages. The Handbook of Offshore Financial Centers, Adell Financial Series, AD Adell Publishing, Copyright 2004, 266 pages; Offshore Financial Centers and Tax Havens, Archives of Tulane Law Library, Tulane Law School, Tulane University, New Orleans, Louisiana, Copyright, 1996, 512 Pages.

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