By Anthony Diosdi
This article provides an overview of the U.S. federal tax rules governing U.S. beneficiaries of foreign trusts. The term “U.S. person means:
1. A citizen or resident of the United States;
2. A domestic partnership;
3. A domestic corporation;
4. Any estate other than a foreign estate;
5. A domestic U.S. trust.
The first step is to determine whether the entity at issue is a trust. A trust is a fiduciary relationship in which a trustee gives another party, known as the trustee, the right to hold title to property or assets for the benefit of a third party. Thus, in order to have a trust, there must be an arrangement, written or oral, in which a trustee takes title to property, which is protected or conserved for beneficiaries of the trust.
Once a determination is made that an entity can be classified as a “trust,” the next step is to determine if the trust can be classified as a “foreign” trust. Under U.S. law, a foreign trust is an entity which does not meet both the “Court Test” and “Control Test” described below.
Court Trust
The Court Test is satisfied if 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 four so-called “bright-line rules” for meeting the U.S. court test.
1. A trust will automatically meet the court test if the trust is registered with a U.S. court.
2. In the case of a testamentary trust created pursuant to a will probated within the U.S. (other than ancillary probate), the trust will meet the court test if all fiduciaries of the trust have been qualified as trustees of the trust by a court within the U.S.
3. If the fiduciaries and/or beneficiaries take steps with a court within the U.S. that causes the administration of the trust to be subject to the primary supervision of such U.S. court, the trust will meet the court test.
4. If the trust specifies that a court within the U.S. has the authority to exercise primary supervision over enforcing the governing law of the trust, the court test will be met. Please note that if a trust document specifies that a foreign country’s law will govern the trust, this does not necessarily mean that the trust will fail the court test.
The income tax regulations also provide that a trust where there is a provision in the trust stating that a U.S. court’s attempt to assert jurisdiction over an “automatic migration” clause to a foreign country.
Control Test
The Control Test is satisfied if 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. Substantial decisions mean all decisions other than ministerial decisions, that any person is authorized to make under the terms of the trust instrument or applicable law, including but not limited to:
1. Whether and when to distribute income or corpus;
2. The amount of any distributions;
3. The selection of a beneficiary;
4. Whether to allocate receipts to income or principal;
5. Whether to terminate the trust;
6. Whether to compromise, arbitrate or abandon claims of the trust;
7. Whether to sue on behalf of the trust or to defend suits against the trust;
8. Whether to remove, add or replace a trustee; and
9. Investment decisions.
It should be noted that it is possible to establish a trust which is managed in the United States, but fails the control test because the trust has a foreign protector. This type of planning could be beneficial if there is a need to “domesticate” a foreign trust because the trust has or will acquire U.S. beneficiaries.
Types of Foreign Trusts
The U.S. income taxation of a foreign trust depends on whether the trust is a grantor or nongrantor trust. A grantor is a type of trust in which the grantor retains ownership of the Trust’s assets for income tax purposes. A “grantor” for purposes of Internal Revenue Code Section 679 is defined in Prop Regs. Section 1.671-2(e) to include any person to the extent such person either creates the trust or acquires an interest in a trust in a non-gratuitous transfer from a person who is a grantor of the trust. A grantor trust can also be created if one person establishes a trust for another person. In such a situation, the other person may potentially be treated as a grantor of the foreign trust. At one time, a U.S. person could transfer cash or assets to a foreign trust for the benefit of his or her family members. With the enactment of the Section 679 grantor trust rules, all foreign trusts established by U.S. persons for U.S. beneficiaries are taxable for U.S. income tax purposes. This means, all transfers to foreign trusts by U.S. persons, are taxed at fair market value. U.S. grantors and beneficiaries of foreign trusts must annually file a Form 3520 and Form 3520-A with the Internal Revenue Service or (“IRS”).
In order to make sure there are no abuses associated with the U.S. of foreign trusts, the U.S. owner of a foreign trust must appoint a U.S. person to act as the trust’s U.S. agent. If a U.S. agent is not appointed, the IRS may determine the trust owner’s tax obligations.
With a grantor trust, the U.S. grantor of a foreign trust is subject to all the tax on the trust income. This means distributions from a foreign grantor trust made to U.S. beneficiaries can potentially be made without the U.S. beneficiary being subject to U.S. income tax consequences. Sometimes a grantor trust can be established with a non-U.S. grantor. A foreign grantor trust will be recognized under U.S. tax law if a foreign person is regarded as the owner of a foreign trust property. A foreign person is considered the owner of a foreign trust if either the foreign trust is revocable solely by the grantor without the approval or consent of any person other than a related or subordinate party who is subservient to the grantor, or where, during the lifetime of the grantor, the amounts distributable (whether income or corpus) from the foreign trust are distributable only to the grantor or the grantor’s spouse. A grantor trust with a non-U.S. grantor can be a highly effective tax planning structure since distributions can potentially be made to U.S. beneficiaries free from U.S. tax.
Distributions from a foreign nongrantor trust are subject to a complex set of rules. This type of trust affords no control or power to the grantor. This means that the grantor is unable to revoke or change the terms of the trust or make changes to the trust beneficiaries. A nongrantor trust is generally taxed in the same manner as individuals, with certain modifications. Thus, like a U.S. citizen or resident, a domestic trust will pay U.S. tax on its worldwide income and capital gains. Items of ordinary income are taxed at graduated rates after the allowance of certain deductions and credits. Gains from the sale of capital assets are taxed at capital gains rates. Similar to a nonresident alien, a foreign trust will pay U.S. income tax only on its income and certain gains from U.S. sources and on income or gain that is “effectively connected” to a U.S. trade or business.
In calculating its taxable income, a trust will receive a deduction for distributions to its beneficiaries to the extent that these distributions carry out the trust’s “distributable net income” or “DNI” for the taxable year. Generally, the DNI of a domestic nongrantor trust for a particular year is equal to its taxable income for that year adjusted 1) by adding to taxable income the amount deducted as a personal exemption, the amount of its tax exempt income, and the amount of the trust’s deduction for distributions to beneficiaries and 2) by subtracting from taxable income the trust’s capital gains except to the extent such capital gains are “paid, credited or required to be distributed to any beneficiary during the taxable year.” See IRC Section 643(a)(3). Any DNI so distributed will retain its character in the hands of the recipient beneficiaries and will be taxed to them.
Capital gains of a domestic nongrantor trust generally do not enter into the DNI calculation and are usually taxed to the trust. Any distributions by the trust to U.S. beneficiaries in excess of DNI will be a non-taxable distribution of capital. The DNI of a foreign nongrantor trust includes its capital gains. In addition, a foreign nongrantor trust’s DNI includes the amount of its income from non-U.S. sources subject to certain reductions. Distributions to beneficiaries are considered first to carry out the DNI of the current year (pro rata as to each item of income or gain) and will be taxed to the recipient beneficiaries. If a foreign trust does not distribute all of its DNI in the current year, the after tax portion of the undistributed DNI will become “undistributed net income” or “UNI.”
Distributions of the UNI of a foreign nongrantor trust received by a U.S. beneficiary are taxed under the “throwback rule,” which generally seeks to treat a beneficiary as having received the income in the year in which it was earned by the trust. A foreign nongrantor to UNI for for any particular year is equal to the amount by which its DNI for such year exceeds the sum of:
1. The amount of trust accounting required to be distributed in such year;
2. The amount of any other amount properly paid or credited or required to be distributed for such year; and
3. The amount of any taxes imposed on the trust that are attributable to its DNI for the year. See IRC Section 665(a).
The throwback rule 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.
If a beneficiary has received an accumulation distribution from a foreign nongrantor trust, the “throwback tax” on the distribution will be calculated by the following nine steps discussed below.
Step 1: An allocation needs to be made for the accumulated income for the prior years. 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 2007, $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 to the amount deemed, under Step 1, to have been distributed on the last day of a preceding year the taxes that were imposed on such amounts in such a year. 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 identify the beneficiary’s computation years. The computation years are those three of the beneficiary’s five immediately preceding taxable years left after eliminating the year in which his or her income was the highest and the year in which his or her income was the lowest.
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. Tom’s three computation years are now 2020, 2022, and 2023.
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.
In Illustration 2, the amount deemed distributed was $112,000 and the number of preceding years in which the distribution is deemed to have been made was three. 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.
Calculation of the Interest Charge
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.
Conclusion
The foregoing discussion is intended to provide the reader with a basic understanding of the basic U.S. tax considerations in connection with foreign trusts. It should be evident from this article that this is a complex subject. It is important to understand that this area is constantly subject to new development and change. As a result, it is crucial that any U.S. beneficiary of a foreign trust consult with an international tax attorney to determine the U.S. tax consequences associated with a foreign trust and if there are any tax planning opportunities available.
Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony 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.