How the Throwback Tax is Calculated on a Foreign Trust Distribution on the Form 3520

U.S. beneficiaries of non-grantor foreign trusts are subject to a special tax regime known as the “throwback tax.” Not only is the throwback tax incredibly punitive, computing the throwback tax is extremely complicated. The throwback tax is the difference between distributable net income and undistributed net income of a foreign nongrantor trust to a U.S. beneficiary.  This article discusses how the throwback tax is computed. 

Throwback Tax Rules In General

In order to understand how the throwback tax rules operate, it is necessary to review the income tax rules that govern complex trusts. A complex trust is a separate taxable entity, and is taxed on its gross income, less deductions. One of these deductions which is unique to trusts is the deduction for distributions of distributable net income or (“DNI”). DNI is taxable income of the trust, with the following modifications:

1. No distribution deduction is taken;
2. No personal exemption is taken;
3. Capital gains are ordinarily excluded;
4. Capital losses are not taken, except to the extent of capital gains which are included in DNI;
5. Tax-exempt interest is included, less certain expenses.

In general, distributions that carry out DNI are deducted by the trust and taxed to the beneficiary. Moreover, if the trust has DNI, trust distributions will ordinarily “carry out” DNI whether they are in fact made from DNI or not. Generally speaking, distributed income takes the same character in the beneficiary’s hands as it had in the trust. And, unless the terms of the governing instrument specifically allocate different classes of income to different beneficiaries, a trust distribution carrying out DNI is deemed to consist of the same proportion of each class of income included in DNI as the total of each class bears to total DNI. However, in order for an allocation mandated by a trust instrument to be respected by the Internal Revenue Service (“IRS”), it must have economic effect independent of the income tax consequences.

The items of deduction entering into the computation of DNI are generally allocated in proportion to the trust’s and beneficiary’s shares of income, with certain exceptions. In certain circumstances, a trustee may not be able to determine the DNI of a nongrantor trust. In these cases, under the so-called “65-day rule,” the trustee can elect to treat all distributions made within the first 65 days of the taxable year as made within the previous year.

To the extent that DNI is not distributed, it is taxed to the trust. The after-tax amount is accumulated, and constitutes UNI or (“undistributed net income”). When the UNI is ultimately distributed, it is an “accumulations distribution,” and is subject to a “throwback tax.” If a foreign nongrantor trust makes a distribution in excess of its DNI, the U.S. beneficiary who receives the distribution will be subject to the throwback tax. The throwback tax effectively results in federal tax being levied at the recipient’s highest marginal income tax rate for the year in which the income tax rate for the year in which the income or gain was earned by the trust. This means any capital gains accumulated by a foreign trust for distribution in a later taxable year will lose its favorable rate and instead be taxed at ordinary income rates. In addition, the throwback rule adds an interest charge to the taxes on a throwback distribution in order to offset the benefits of tax deferral. The interest charge accrues for the period beginning with the year in which the income or gain is recognized and ending with the year that the UNI amount is distributed, and is assessed at the rate applicable to underpayments of tax, as adjusted compounded daily.

Step 1: An allocation needs to be made for the accumulated income for the prior years.   The accumulation distribution is deemed made from each year’s UNI beginning with the earliest year. Determining the number of years and the amounts in each year, using the UNI in an earlier year before proceeding to the later year. If the amount of accumulated income exceeds the UNI for the earliest year of the trust, the excess income is allocated to the next year for which there is any remaining UNI. This process continues from year to year until all of the accumulation distribution has been properly allocated. Each allocation of accumulated income is distributed on the last day of the year for trust accounting purposes.

Below, please see Illustration 1. which demonstrates Step 1 to calculating the throwback tax.

Illustration 1.

Tom is a beneficiary of F, a foreign nongrantor trust. F was established in 2017 by Tom’s mother who is not a citizen or resident of the United States. F distributed $100,000 to Tom in 2024, a year in which F’s DNI and trust distributed income was $20,000. Consequently, $80,000 of the distribution is treated as an accumulation distribution. F’s DNI, none of which was distributed, in each of its preceding years was as follows:

2017- $4,000

2018- $20,000

2019- $30,000

2020 – $40,000

Tom’s $80,000 accumulation distribution is deemed to have been made $4,000 on the last day of 2017, $20,000 on the last day of 2018, $30,000 on the last day of 2019, and $40,000 on the last day of 2020.

Step 2: Next, add the income taxes paid by the trust attribution to the accumulation distribution. The sum is the deemed distribution. Such taxes include U.S. and foreign income taxes.

Below, please see Illustration 2. which demonstrates Step 2 in calculating the throwback tax.

Illustration 2.

Assume that F, the trust discussed in Illustration 1, paid taxes in each of its preceding taxable years equal to 40 percent of its DNI. The total amount deemed to have been distributed to Tom on the last day of 2017, 2018, 2019, and 2020 will be $5,600, $28,000, $42,000, and $36,400 for each year respectively. Based on this example, the entire amount deemed to be “Throwback Tax” is $112,000. See Example in “The Throwback Tax, by Ellen K. Harrison, Carlyn S. McCaffrey, Amy E. Heller, and Elyse G. Kirshner, February 2015.

Step 3: Next, determine the number of preceding taxable years in which the distribution is deemed to have been made to the beneficiaries of the trust. For purposes of this calculation, if any year’s deemed distribution is less than 25 percent of the total amount of the accumulation distribution divided by the number of preceding taxable years to which the accumulation distribution is allocated, that year will not be included for purposes of calculating the throwback tax.

Below, please see Illustration 3. which demonstrates Step 3 in calculating the throwback tax.

Illustration 3.

In Illustration 1. and Illustration 2. the number of preceding taxable years in which a distribution is deemed to have been is three. The year 2017 is disregarded because the amount of the accumulation distribution allocated to that year ($4,000) is less than 25 percent of the total accumulation distribution ($80,000) divided by the number of years to which the distribution is deemed allocated is four. 

Step 4: Next, it will be necessary to ascertain the beneficiary’s taxable income for the beneficiary’s five taxable years preceding the distribution. This means, it is necessary to disregard the two years with the highest and lowest taxable income.

Below, please see Illustration 4. which demonstrates Step 4 in calculating the throwback tax.

Illustration 4.

Assume that Tom’s taxable income for the 2019, 2020, 2021, 2022, and 2023 tax years was $50,000, $100,000, $200,000, $150,000, and $175,000 respectively. The year of the highest taxable income was in 2021, and the year of the lowest taxable income received in 2019 are both eliminated for purposes of this calculation. We’ll call the remaining three years the “Base Years.”  Tom’s three computation years or Base Years are 2010, 2012, and 2013.

Step 5: Next, it will be necessary to determine the average annual distribution amount. This is done by dividing the amount of deemed distribution by the number of preceding years in which the distribution is deemed to have been made to the beneficiaries.

Below, please see Illustration 5. which demonstrates Step 5 in the calculation of the throwback tax.

Illustration 5.

Here, in Illustration 2, the $112,000 deemed distribution was three. Under our facts, the average annual distribution amount is $37,333 ($112,000/3 = $37,333).

Step 6: Next, it will be necessary to determine the amount by which the beneficiary’s income tax would have increased in each of the three computation years if the annual distribution amount had been added to his or her taxable income for these years. To make this calculation, no differentiation is made among the various types of income that were included in the foreign nongrantor’s trust’s UNI (other than tax-exempt income). Consequently, if a portion of the trust’s UNI was long term capital gain, the beneficiary will not receive the advantage of the lower rate that generally applies to such grants. If any foreign income were added in Step 2 to the amount deemed to have been distributed, the amount of such taxes may be allowed as a credit against the increase in tax calculation in this step.

Step 7: It will next be necessary to determine the average tax increase by dividing the sum of the three increases by three.

Step 8: Next, it will be necessary to multiply the average tax increase by the number of preceding taxable years in which the distribution is deemed to have been made as determined under Step 3.

Step 9: Finally, it will be necessary to subtract from the product obtained in Step 8 by the amount of any U.S. income taxes that were added into the calculation in Step 2. The final result is the amount of the beneficiary’s throwback tax.

Reporting UNI on the Form 3520

If a foreign nongrantor trust makes a distribution of UNI to a U.S. beneficiary, the distribution will not only be subject to the throwback tax, the distribution will also be subject to an interest charge as per Internal Revenue Code Section 668. As per the Internal Revenue Code, the interest rate charged on the throwback tax is the rate applied under Internal Revenue Code Section 6621 to underpayments of federal income tax. This interest is also compounded daily. The number of years over which interest is calculated is determined by a process which is said to produce a “dollar-weighted” number of years.

The interest charge is calculated utilizing a three step formula. This formula is set forth in Schedule C “Calculation of Interest Charge” on Form 3520. First, the UNI for each year must be multiplied by the number of years between such a year and the year of the distribution. Second, all products calculated in the first step must be added together. Finally, the sum of such products calculated in the second step must be divided by the aggregate amount of the nongrantor foreign trust’s undistributed income. The quotient is to be rounded to the nearest half-year. For purposes of this calculation, an accumulation is treated as having come proportionately from each year with respect to which there is UNI.

In order to avoid the harsh throwback rules, the Department of Treasury and the IRS allows U.S. trust beneficiaries of a foreign trust to utilize the so-called “default method.” The “default” method of calculating distributions from a foreign nongrantor trust may, under certain circumstances, enable distributions of UNI to be made to U.S. beneficiaries without triggering a throwback tax. Part III, Schedule A of Form 3520 discusses three steps to determine if accumulated earning distributions can avoid the throwback tax under the default method:

First, the U.S. beneficiary enters the total distributions he or she received from the foreign trust in the three preceding years (or the number of years that the trust has been a foreign trust, if fewer than three). Second, the U.S. beneficiary of the foreign nongrantor trust multiplies that total by 1.25. Finally, the U.S. beneficiary of the nongrantor foreign trust divides the total stated in the last step by three or by the number of years that the trust has been a foreign nongrantor trust if it was in existence less than three years. If the amount of the actual distribution from the foreign trust does not exceed the product of the final calculation, the distribution will not be subject to the throwback tax. We go through the relevant sections of the Form 3520 to determine the default method for interest charge.

First, a U.S. beneficiary of a foreign nongrantor trust must disclose on Schedule B of Form 3520, Lines 39 through 44, the type of distributions he or she received from the trust (i.e., ordinary income, qualified dividends, capital gains, and unrecaptured Section 1250 gain).

On Line 45 of Schedule B of Form 3520, the foreign trust beneficiary must disclose the aggregate UNI. For example, assume that a nongrantor foreign trust was created in 2013 and has made no distributions prior to 2019. Assume the trust’s ordinary income was $0 in 2018, $60 in 2017, $124 in 2016, $87 in 2015, $54 in 2014, and $25 in 2013. Thus, for 2019, the trust’s UNI would be $350. If the trust earned $100 and distributed $200 during 2019 (so that $100 was distributed from accumulated earnings), the trust’s 2020 aggregate UNI would be $250 ($350 + $100 – $200).

Line 45 and 46 of Schedule B of Form 3520, the foreign trust beneficiary must disclose the trust’s aggregate and weighted undistributed net income.

The foreign trust’s weighted UNI is its accumulated income that has not been distributed, weighted by the years that it has accumulated income. To calculate weighted UNI, multiply the undistributed income from each of the trust’s years by the number of years since that year, and then add each year’s results. The instructions promulgated for Form 3520 provide guidance how to calculate weighted UNI as follows:

Year No. of years UNI from Weighted UNI
Since that year each year

2018 1 $0 $0

2017 2 60 120

2016 3 124 372

2015 4 87 348

2014 5 54 270

2013 6 25 150

To calculate a foreign trust’s UNI discussed on the example provided for Line 45 of the Form 3520:

1. Begin with 2019 weighted UNI.
2. Add UNI at the beginning of 2019.
3. Add trust earnings in 2019.
4. Subtract trust distributions in 2019.
5. Subtract weighted trust accumulation distributions in 2019 (Weighted trust accumulation distributions are the trust accumulation distributions in 2019 multiplied by the applicable number of years from 2019).
   

Using the example above, the foreign trust’s 2020 weighted UNI would be $1,150, calculated as follows:

2019 weighted UNI $1,2

UNI at beginning of 2019 + 3

Trust earnings in 2019 +1

Trust distributions in 2019 – 2

Weighted trust distributions in 2019
($100 x 3.6) -3

2020 weighted UNI $1,1

Next, on Line 47 of Schedule B of the Form 3520, the foreign trust beneficiary must calculate the trust’s number of years by dividing line 46 by line 45.

According to the instructions for Form 3520, Line 47 is determined by calculating the trust’s applicable number of years by dividing line 46 by line 45. This would be the weighted UNI divided by the annual UNI. Using the examples in the instructions for Lines 45 and 46, the foreign trust’s applicable number of years would be 3.6 in 2019 (1,260/350) and 4.6 in 2020 (1,150/250).

Calculating the Interest Charge on the Form 3520

A beneficiary of a foreign trust calculates the interest charge on Schedule C of the Form 3520. A beneficiary of a foreign trust must complete Schedule C of the Form 3520 if there was an amount entered on Line 37 or Line 41a of the Form 3520.

If there were amounts entered on Line 37 or Line 41a of Form 3520, these amounts must be entered on Schedule C, Line 48 and Line 49 of the Form 3520.

According to the instructions for the Form 3520, the U.S. beneficiary of a foreign trust must include the amount from Line 48 of the Form 3520 on Line 1 of Form 4970, Tax on Accumulation Distribution of Trusts. Then the U.S. beneficiary must compute the tax on the total accumulation distribution using Lines 1 through 28 on Form 4970. The beneficiary of the foreign trust must enter Line 49 the tax from Line 28 on Form 4970.

The beneficiary of the foreign trust must then enter the applicable number of years of the foreign trust. For Line 51 of Schedule C of the Form 3520, the beneficiary of the foreign trust must combine the interest rate on the total accumulation distribution.

According to the instructions for Form 3520, interest accumulates on the tax from Line 49 for the date beginning on the date that is the applicable number of years prior to the applicable date and ending on the applicable date. For the purposes of making this interest calculation, the applicable date is the date that is mid-year through the tax year for which reporting is made. For portions of the interest accumulation period that are prior to 1996 (and after 1976), interest accumulates at a simple rate of 6 percent annually, without compounding. For portions of the interest accumulation period that are after 1995, interest is compounded daily at the rate imposed on underpayments of tax under Internal Revenue Code Section 6621(a)(2).

The beneficiary of the foreign trust must then disclose the interest charge by multiplying the amount on line 49 by the combined interest rate on line 52 of Schedule C of the Form 3520.

Finally, on Line 53 of Schedule C of Form 3520, the beneficiary of the foreign trust must disclose the tax attributes to accumulation distributions.

Conclusion

The rules pertaining to preparing IRS Form 3520 and taxation of foreign trust are complex. Despite detailed instructions provided by the IRS to prepare Form 3520, there are many issues not specifically addressed by the instructions. We prepare Form 3520 and advise clients regarding the rules pertaining to the taxation of foreign trusts. We also assist other tax professionals with the preparation Form 3520 and provide guidance regarding the taxation of foreign trusts to other tax professionals.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.