Part II: US Recipients of Gifts from Foreign Trusts – Tension Headache Turning Migraine

Part I of this blog post detailed the rules for reporting gifts and bequests from foreign donors and foreign estates.  Readers were warned they might experience a tension headache. This blog post covers a more complicated issue – what happens when a US person receives a gift from a foreign (non-US) trust. It will also examine the nuts and bolts of filing the required tax Form 3520.

What if I Get a Gift from a Foreign Trust?

In this case, you absolutely must reach for the Imigran.  Gifts received from foreign trusts are treated quite differently from gifts received from an individual or an estate.  Very generally, gifts from foreign trusts are viewed as trust distributions and must be reported on Part III of Form 3520

Trust distributions are generally taxable income to the beneficiary who receives them. When distributions are received from a foreign trust, the rules become very intricate and detailed.  The complexity is a result of US Congress’ attempt to deter some of the serious tax abuses that were perceived to exist through the use of foreign trusts.  Broadly speaking, if adequate records are not provided to determine the tax treatment of a distribution from a foreign trust such distribution may be treated as a so-called “accumulation distribution”.

An accumulation distribution is taxed very harshly to the US beneficiary under a certain draconian rule called the “Throwback Rule”.  The goal of the Throwback Rule is to prevent a US trust beneficiary from being able to enjoy the deferral of tax on income that was earned by the trust, and remained untaxed while it was accumulating in the trust, many years before.  It seeks to destroy any tax deferral benefit.  Since the foreign trust was not paying US income tax while it accumulated the income, then the US beneficiary must pay the Taxman when he receives a distribution from the trust that carries such accumulated income. With the Throwback Rule in place, any earlier tax deferral is destroyed.  

The “Throwback Rule,” generally treats a beneficiary of a foreign trust as having received the trust distribution in the year in which the income was actually earned by the foreign trust. The rule effectively results in tax being assessed at the US beneficiary’s highest marginal income tax rate for the year in which the income or gain was earned by the trust. This year can be many, many years before the actual distribution is made to the beneficiary. In addition, capital gains accumulated by a foreign trust for distribution in a later taxable year will lose their character as “capital” and will be treated as ordinary income, thus eliminating any beneficial tax rate for long-term capital gains. Finally, to add insult to injury, the Throwback Rule adds a compounded interest charge to the taxes relating to the throwback distribution in order to offset all possible benefits of tax deferral. Surely, Imigran is in order.

When to File

Form 3520 is filed separately from your income tax return. The due date for filing Form 3520 is the same as the due date for filing your annual income tax return, including extensions. Remember, Form 3520 is an annual return.  You must examine all foreign gifts and bequests you receive during each taxable year to determine if the Form is required to be filed for that particular year.

Where to File

Mail Form 3520 to the following address:

Internal Revenue Service Center P.O. Box 409101 Ogden, Utah 84409

Part III of this blog post will examine the rules when gifts or bequests are received from former US citizens or former US long term residents (green card holders).  It will examine the very recently issued IRS  Proposed Treasury Regulations regarding the imposition of tax on US recipients of certain gifts and bequests from so-called “covered expatriates.” Have your Imigran ready.


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