What is a foreign grantor trust (“FGT”). A FGT is typically used when a non-U.S.…
Beware of U.S. tax consequences to a foreign trust with a U.S. beneficiary
There are many U.S. tax consequences to a foreign trust and a beneficiary of a foreign trust who is or becomes a U.S. citizen or resident alien.
In this article it is assumed that the grantor is and always will be a foreign person. For U.S. tax purposes, a foreign trust can be only one of two types – either a “foreign grantor trust” or a “foreign nongrantor trust”:
U.S. Taxation of Foreign Trusts
Foreign Grantor Trust: A trust will be characterized as a foreign grantor trust (“FGT”) only under two conditions: either, the grantor reserves the right to revoke the trust solely or with the consent of a related or subordinate party (and revest the title assets to himself), or the amounts distributable during the life of the grantor are distributable only to the grantor and/or the spouse of the grantor. Under these circumstances, the income of the trust is taxed to the grantor (i.e., the person who made a gratuitous transfer of assets to the trust). U.S. tax is limited generally to U.S. sourced investment income and income effectively connected with a U.S. trade or business will be subject to U.S. income or withholding tax.
If a U.S. grantor establishes a foreign trust for the benefit of U.S. beneficiaries, it is treated as a grantor trust. I.R.C. §679. Upon termination of grantor trust status (i.e., at the death of the grantor or if there are no longer any U.S. beneficiaries), Section 684 imposes a tax on the unrealized appreciation. However, if that occurs because of the death of the grantor, the stepup in basis under Section 1014 should avoid having any gain to which Section 684 would apply. A foreign grantor trust will generally become a foreign nongrantor trust upon the death of the grantor.
Foreign Non Grantor Trust: Any trust that does not meet the definition of a foreign grantor trust is a foreign nongrantor trust (“FNGT”), taxed as if it were a nonresident, noncitizen individual who is not present in the U.S. at any time. U.S. tax is generally limited to U.S. sourced investment income and income effectively connected with a U.S. trade or business.
Foreign Grantor Trust: Distributions to a U.S. beneficiary by an FGT will generally be treated as non-taxable gifts, but may be subject to U.S. tax reporting requirements.
Converting Non-Grantor Trust to Grantor Trust: There are a few possible ways of converting a non-grantor trust to a grantor trust include the following:
- If the trust allows distributions without an ascertainable standard, change trustees so that more than half of the trustees are related or subordinate parties (§674(c)). (This strategy can also be used to toggle between grantor trust and non-grantor trust status.)
- Turn the trust into a foreign trust (§679) [but many other complexities arise with being a foreign trust].
- Actual borrowing of assets from the trust by the grantor without giving adequate security (§675(3)).
Foreign Nongrantor Trust: A U.S. beneficiary will be subject to tax on distributions to the beneficiary of “distributable net income” (“DNI”) from the FNGT. The character of such DNI distributions will reflect the character of the income as received by the FNGT. If a FNGT accumulates its income and distributes the accumulation in later years in excess of DNI, the U.S. beneficiary will be subject to the “throwback rules”, which generally seek to treat a beneficiary as having received the income in the year in which it was earned by the trust, using a relatively complex formula. The beneficiary may be required to pay a “throwback tax” (a “catch up” tax) and an interest charge on the deferral. Furthermore, such throwback distributions will be taxed at ordinary income tax rates. The throwback rules will not apply to amounts accumulated when the trust was an FGT.
Reporting obligations will arise when a foreign trust makes a distribution to a U.S. beneficiary. A U.S. person who receives a distribution from a foreign trust must include Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts) with his or her tax return. Generally, the Trustee should furnish to the U.S. beneficiary a “Foreign Nongrantor Trust Beneficiary Statement”, which will be attached to the Form 3520. (While there is a “Foreign Grantor Trust Beneficiary Statement”, that Beneficiary Statement contemplates a U.S. grantor, who will report the Trust’s income on his or her U.S. income tax return, and therefore may not suitable for an FGT with a foreign grantor.) For a FNGT, the Beneficiary Statement includes the distributable net income for the year, the years to which an accumulation distribution is attributed, and the amounts allocable to each year.
Extremely high penalties may apply for failing to report fully all required information and for failing to report on a timely basis:
(i) If a U.S. transferor of property to a foreign trust, or a U.S. recipient of a distribution from such a trust, fails timely file a Form 3520 to report these transactions, the IRS may impose a penalty equal to 35% of the gross value of the property transferred to or received from the trust.
(ii) If a U.S. donee fails to timely file a Form 3520 to report the receipt of a large foreign gifts, or files the form incorrectly or incompletely, such donee may be subject to a penalty equal to 5%, not to exceed 25%, of the value of the gift or bequest received in the relevant year.
(iii) If a foreign grantor trust fails to timely file a Form 3520-A, or fails to furnish all of the required information, the U.S. owner may be subject to a penalty equal to 5% of the gross value of the portion of the trust’s assets treated as owned by the U.S. person at the close of the taxable year.
(iv) The failure to timely file a complete and correct Form 3520 or Form 3520-A may result in an additional penalty of $10,000 per 30-day period for failing to comply within 90 days of notification by the IRS that the information return has not been filed. The total penalty for failure to report a trust transfer, however, cannot exceed the amount of the property transferred.
Contrary to foreign grantor trusts, foreign nongrantor trusts generally do not have an information reporting requirement. However, U.S. persons who maintain or engage in certain transactions with foreign grantor or nongrantor trusts during the year are generally required report such transactions to the IRS on a Form 3520. Such reportable transactions include: (1) ownership of a foreign grantor trust; (2) transfer of property to a foreign trust (i.e., the U.S. transferor must notify the IRS of the transfer and provide the IRS with the identity of the trustees and beneficiaries); and, (3) receipt of property or distribution from a foreign trust.
Other Tax Consequences:
Special Taxing Regimes: If the foreign trust has investments in foreign corporations, the presence of a U.S. beneficiary may have the unfortunate effect of subjecting the U.S. beneficiary to two special U.S. taxing regimes: those applicable to “controlled foreign corporations” (“CFCs”) and those applicable to “passive foreign investment companies” (“PFICs”). The CFC rules (which generally preempt the PFIC rules) subject certain types of income allocable to a “U.S. Shareholder” (as specially defined) to immediate U.S. taxation, whether or not distributed, and characterize certain gains upon disposition of the stock as ordinary income. Unless certain exceptions apply, the PFIC rules are designed to penalize U.S. taxpayers on “excess distributions” from a PFIC or upon a disposition of PFIC stock, imposing the highest ordinary income rates and an interest charge.
Report of Foreign Bank and Financial Accounts (“FBAR”) Filings: FBAR filings on Form TD-F 90-22.1 are generally required to be made by U.S. persons who have reportable financial interests in or signature authority over a foreign financial account (“FFA”). A U.S. person who has more than a 50% present beneficial interest in a trust’s income or assets may be deemed to have an FFA interest and may be required to make an FBAR filing. A trust beneficiary of a foreign nongrantor trust may receive an exemption from FBAR reporting if a trustee who is a U.S. person makes an FBAR filing disclosing the trust’s FFAs and provides information as required.
FATCA Entity Reporting: FATCA imposes a 30% withholding tax on payments to “foreign financial institutions” (“FFIs”) that do not comply with certain disclosure requirements about their U.S. account holders. A foreign trust that invests (directly or indirectly) in securities and other financial interests may, under certain circumstances, be treated as an FFI if the trustee is a trust company or if an entity, such as a bank or other financial institution, is acting as the investment advisor. In that case, the trust may have to register with the I.R.S. and receive a global intermediary identification number.
FATCA Individual Reporting: A U.S. person who holds an interest in a specified foreign financial asset must disclose such interest on Form 8938 if the aggregate value of all such assets exceeds certain threshold amounts (e.g., in the case of an unmarried individual, $50,000 on the last day of the tax year, or $75,000 at any time during the year). A foreign financial asset includes an interest in a foreign trust, although special valuation rules may apply. Typically, assets are reported only when and as a trust makes a distribution to a U.S. beneficiary, the amount of the distribution being the reportable asset. This disclosure requirement is in addition to the FBAR requirement described above. Items reported on Form 3520, described above, do not have to be reported on Form 8938, but Part IV of Form 8938 must be completed to indicate the Form 3520 filing.
The presence of a U.S. beneficiary in what had been a purely foreign trust presents tax challenges. In addition to the imposition of additional U.S. taxes and enhanced reporting requirements, the presence of a U.S .beneficiary may have unexpected tax consequences depending on the nature of the assets held by the foreign trust. It is important to preventatively identify these issues early in the process, as it may be easier to address and resolve some of these issues before the beneficiary becomes a U.S. taxpayer.