Foreign Trusts, Tax and Information Reporting – It’s Complicated!

With regard to foreign (i.e., non-US) trusts, there are many potential US tax filing and reporting requirements which, if missed, can result in imposition of shocking penalties.  The filing requirements are applicable in different circumstances.  This series of blog posts provides an overview of foreign trusts, and discusses some relevant US tax filings imposed on the US creator (or grantor), the trustee and US beneficiaries of foreign trusts.

Due to the complexity of the material, I have divided this blog topic into four separate posts, including this introductory post, Part I. The following weeks will present three posts covering US tax filings required by, respectively (i) Part II, US grantor of (or, US transferor to) a foreign trust (ii) Part III, fiduciary/trustee of a foreign trust and (iii) Part IV, US beneficiaries of a foreign trust.

Are You Dealing With a “Trust?”

Generally speaking, an arrangement will be treated as a “trust” (as opposed to some other type of entity) under the Internal Revenue Code (IRC), if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility.  If this is the purpose, then the parties are not associates in a joint enterprise for the conduct of business for profit, which might be taxable as a partnership, or corporation, for example. An entity created to “operate a business” rather than to “protect or conserve assets” is not recognized as a trust for US tax purposes. Instead, entities conducting business activities are more properly classified as business entities.

The question may sound simple, but in cross-border situations, the answer is not always easily reached.  Once it is determined that the entity is properly classified as a “trust”, the next task is to determine if it is a US (domestic) trust or a “foreign” trust.  Whether a trust qualifies as “foreign” is, in itself, a complicated topic and is not examined in this post.

Assuming you have a foreign trust, the next step is to determine if it is a foreign “grantor” trust (FGT) which is disregarded as an entity for US tax purposes, or, a foreign non-grantor trust, which is treated as a separate taxable entity. The type of trust is important in determining the taxability of the trust, those who funded it, distributions from the trust, as well as related reporting obligations.

Take for example, the Hindu Undivided Family (HUF) arrangement which is funded with assets owned by the extended family and managed by a Karta, often a senior family member, for the benefit of the family. Under India’s tax rules, the HUF is a separate taxable entity, eligible for separate exemptions and deductions. However, how is the HUF to be treated for US tax purposes? Is it to be treated as a “trust”, with the Karta as the trustee?  If so, if those funding the HUF are US persons (e.g., green card holders or US residents), the HUF could be treated as a FGT, with tax impact on the grantors of the HUF.

More on these issues, later.

Proliferation of IRS Materials Regarding Foreign Trusts

The US Internal Revenue Service (IRS) has recently provided an excellent site map on the topic of foreign trusts, including links to its International Practice Units (IPU) covering foreign trusts. I’ve provided the IPU trust links below.

IPUs are a fairly new educational material prepared by the IRS. They are designed to help IRS agents understand the complex rules involved in international tax topics. The fact that the IRS continues to issue IPUs in the foreign area and has set up “campaigns” in its new audit strategy, indicates to me that there is an increase in IRS focus and activity in these areas. The foreign trust area is one in which penalty amounts can be very steep.  Foreign trusts or other foreign entities can bring in the money when US tax and information filings are not done properly.

IRS International Practice Units

Defining the Entity – Foreign Trusts

Foreign Grantor Trust Determinations – Part I – Section 679

Foreign Grantor Trust Determination – Part II – Sections 671-678

Failure to File the Form 3520/3520-A – Penalties

Complex US Tax and Information Filings

Foreign trusts have been used by some US taxpayers to hide assets and income.  In an attempt to stem such abuse, Congress has imposed special reporting obligations for those US taxpayers holding interests in foreign trusts or receiving distributions from foreign trusts.

“Grantor” Trust?

Whether a trust qualifies as a FGT is another very complicated topic. Whether a foreign trust is a “grantor” trust is determined specifically under provisions of the IRC (Sections 671-679). Any trust determined not to be a grantor trust will be treated as a non-grantor trust.

Putting the complexities aside, here are some general rules: A FGT can be created when a US person funds (or transfers assets to) the foreign trust and there is potential for the trust to have a US beneficiary. In this case, the US person is treated as the tax owner of the foreign trust under the so-called “grantor trust” rule of IRC § 679.

When a beneficiary receives something from the FGT, he is not taxed on it (but he will have reporting duties). The reason the beneficiary is not taxed is because for US tax purposes, the US person-grantor is treated as the tax owner and he must report all items of income, deduction, credits and loss on his personal income tax return (Form 1040).

A foreign trust can also qualify as a FGT when it is created or funded by a nonresident alien individual (NRA), provided that certain exacting requirements are met. See IRC Section 672(f).  Typically a foreign trust created by a NRA that is fully revocable by him will meet the FGT requirements and the NRA will be treated as the tax owner of the trust. When a beneficiary receives something from this trust, it will be treated as a nontaxable “gift”, but the beneficiary will still have very critical US tax reporting duties

The US grantor (or transferor), US beneficiary and even the non-US fiduciary of a FGT will each have his, her or its own various tax and information filing duties.  When a trust is a “grantor” trust, this means that the trust as an entity is ignored for US tax purposes. Instead, the grantor or creator of the trust (generally, the individual who funded the trust) will be treated as the tax owner of the trust and its income.  When the US beneficiary receives something from the FGT, he is not taxed since the amount received is not treated as a taxable trust “distribution” to him, but rather is treated as a “gift” from the grantor.  Gifts are not items of taxable income.

Details on the filing rules required of US grantors, will follow in a separate post coming soon.

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