Tax Services • Published 5/17/2022 U.S. Taxation of Foreign Trusts and Related Transactions
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Did you know that creating or having a transaction with a foreign trust may result in U.S. income tax consequences and/or information reporting requirements? A U.S. person's failure to observe these rules can lead to significant penalties and an extended time for the IRS to assess any tax imposed for a relevant period.

The tax consequences can apply to U.S. persons treated as owners of a foreign trust and U.S. persons treated as beneficiaries of a foreign trust and to the foreign trust itself. So, it is essential to understand your relationship to any trust you believe is a foreign trust.

Who is considered a U.S. person?

The IRS defines U.S. person to include the following:

  • A U.S. citizen,
  • Domestic partnership,
  • Domestic corporation,
  • Any domestic estate, and
  • Any trust if a U.S. person exercises primary supervision over the administration of the trust, or if one or more U.S. persons have the authority to control all substantial decisions of the trust.

What is a trust?

Do you have a trust? Clients often have complex legal agreements where the creation of a trust is evident. In other situations, the existence of a trust may not be that clear. A taxpayer may have a trust when the following four factors have been satisfied:

  1. A written or oral arrangement exists,
  2. The arrangement was created via a will or inter-vivos declaration,
  3. The arrangement provides Trustees with the rights to take title to property to maintain and preserve said property for beneficiaries, and
  4. The beneficiaries do not possess the powers of a trustee.

What is a foreign trust?

Once you have determined that you have a trust, the question becomes whether the trust is domestic or foreign. A trust will be considered foreign when it does not meet both the "control test" and "court test." A trust that meets just one of the tests will be viewed as a domestic trust and taxed appropriately under the U.S. income tax laws.

The control test seeks to determine if any U.S. persons can control the material decisions of the trust. Specifically, the control test will be satisfied if a U.S. person(s) has the authority to control all substantial decisions of the trust without any other entity having the power to veto said decisions. A substantial decision is any decision that a person is required/authorized to make under the trust arrangement.

If your trust does not meet the control test, you can proceed to analyze whether it fails or satisfies the court test. The court test may be satisfied when a U.S. court has jurisdiction over a trust to resolve all issues regarding the administration duties (whether prescribed by law or the trust documents).

U.S. Treasury regulations attempt to provide further guidance by stating that the court test will be satisfied under any of the following circumstances:

  • The trust is registered with a U.S. court,
  • The fiduciaries of a testamentary trust have been qualified as trustees by a U.S. court,
  • The fiduciaries or beneficiaries of an inter-vivos trust take actions with a U.S. court that cause the trust to be under the primary supervision of the court, or
  • A U.S. court and a foreign court may both exercise primary supervision of the trust administration.

Failure to understand these regulations can create situations where a trust meant to be foreign is classified as a domestic trust. To prevent the misclassification of a trust, the regulations provide for an "automatic migration clause" and a "safe harbor rule" so taxpayers can have clarity in planning.

The automatic migration clause clarifies that the court test will not be satisfied when the trust instrument states that any attempt by a U.S. court to assert jurisdiction would cause the trust to migrate from the U.S.

Under the safe harbor rule, a trust without an automatic migration clause will satisfy the court test if the administration of the trust is exclusively in the U.S. and there is no provision in the trust's instrument allowing for its administration elsewhere. Careful planning and execution are required if a U.S. person aims to establish a foreign trust.

Is the foreign trust a grantor trust?

The next question in determining the U.S. tax impacts is whether the foreign trust is considered a grantor trust for U.S. tax purposes.

When the grantor (person funding the trust) is a U.S. person, a grantor trust may exist where the grantor retains powers over the distribution of income:

  • To the grantor or the grantor's spouse,
  • Held or accumulated for future distribution, or
  • Applied to the payment of premiums on life insurance policies on the grantor's life or the spouse's life.

The possibility of applying income in satisfaction of the grantor's obligation of support of a beneficiary other than the spouse isn't enough to create a grantor trust. Only income applied to or distributed in the discharge of the grantor's legal obligation of support will make the trust a grantor trust.

When the grantor is a foreign person, a grantor trust may exist where:

  • The grantor has the power to revoke the trust, exercisable solely by the grantor without the approval or consent of any other person (or with the consent of a related party who is subordinate to the grantor), or
  • The only amounts distributable from the trust during the grantor's lifetime are distributed to the grantor or the grantor's spouse.

What are the tax impacts of having a foreign grantor trust with a foreign grantor?

For U.S. income tax purposes, a foreign grantor owns all income generated by the foreign grantor trust. However, only the income generated from U.S. sources may be taxed by the U.S. government. Any income earned from sources outside of the U.S. may escape U.S. taxation. This fact creates a great U.S. tax planning opportunity.

The idea is that a foreign grantor can establish a foreign grantor trust for U.S. beneficiaries and may be able to accumulate earnings free from U.S. taxation by investing the corpus outside the U.S. The earnings may then be distributed tax-free to U.S. beneficiaries.

What are the tax impacts of having a foreign grantor trust with a U.S. grantor?

The U.S. grantor of a foreign grantor trust may be taxed on all the trust income earned worldwide. The distributions from the trust may be made tax-free to any U.S. beneficiaries. Special rules prevent a U.S. grantor from establishing a foreign non-grantor trust to shield income from U.S. income taxation. The potential foreign non-grantor trust will automatically become a foreign grantor trust if it could distribute any of the income or corpus to U.S. persons in the future. In addition, if the trust acquires a U.S. beneficiary within five years of creation, the U.S. grantor could be taxed immediately on all undistributed income from the prior tax years. Thus, establishing foreign trusts requires careful planning where the goal is to benefit non-U.S. beneficiaries.

Foreign non-grantor trust

A foreign non-grantor trust may only be subject to U.S. taxation on income derived from U.S. sources. The income is not taxed on the U.S. returns of any foreign or U.S. grantor. The U.S. beneficiaries may be taxed on distributions received from foreign non-grantor trusts.

A complex set of rules governs this taxation, including the following stipulations:

  • A U.S. beneficiary will be taxed on distributions to the extent of the person's share of the trust's current year distributable net income (DNI).
  • If a trust does not distribute all DNI in a year, the DNI will become classified as undistributed net income (UNI) in the next tax year.
  • Should a U.S. beneficiary receive a distribution more than DNI, the person would be taxed to the extent of the person's share of UNI.
  • Interest may be charged on the UNI tax if the IRS determines it should have been taxed in previous years.
  • The IRS will only consider distributions that are more than UNI and DNI to come from the trust's capital.

Information reporting requirements

In addition to filing U.S. income tax returns, U.S. beneficiaries, U.S. grantors, and trustees may be required to file the following informational returns:

  • Form 3520 – Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts
  • Form 3520-A – Annual Information Return of Foreign Trust with a U.S. Owner
  • Form 114 – Report of Foreign Bank and Financial Accounts
  • Form 8938 – Statement of Specified Foreign Financial Assets

Keep the above information and reporting requirements in mind when conducting transactions with a foreign trust. Contact your P&N tax advisor to learn more about strategies to minimize your U.S. income tax obligations.

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