Overview of Tax Implications for US Persons with Non-US Trusts (Foreign Trusts)

You are a US tax resident, and you are connected to a trust. There may be various reasons for your connection to the trust – for example, maybe you transferred certain assets to a trust to avoid probate exposure, or you may have transferred certain assets to a trust to preserve them for a minor. Or maybe you were lucky enough to be named as a beneficiary of a trust, and you started receiving distributions. All these valid reasons for using a trust come with their benefits, but it’s also important to understand one of the key downsides, which is increased complexity on your US tax return, especially if the trust is a non-US trust (foreign trust).

US Trust vs. Foreign Trust

The US tax code generally defines a US trust to be a trust where (i) a US court is able to exercise primary supervision over the administration of the trust, and (ii) one or more US persons have the authority to control all substantial decisions of the trust. A foreign trust is defined as any other trust that is not a US trust.

 A foreign trust is usually required to file its own US trust income tax return only if it has an effectively-connected US trade or business, or it has US source fixed, determinable, annual, or periodical (FDAP) income on which insufficient tax was withheld.

Otherwise, the foreign trust has no US tax filing obligations, but the US grantor or beneficiary may be required to file additional informational returns with respect to their ownership / beneficial interest in the trust.

Grantor Trust vs. Non-Grantor Trust

 A trust could be further categorized for US tax purposes as either a grantor trust or a non-grantor trust for US income tax purposes, and each of them comes with completely different income tax consequences. In general, a grantor trust refers to a trust that either the grantor retains certain control over or where the grantor has enjoyment of assets / income of the trust. You might also often hear the terms “revocable trust” and “irrevocable trust” in the trust context. A revocable trust is more likely a grantor trust while an irrevocable trust is often a non-grantor trust, but the definitions are not the same and there could be exceptions, so an analysis of the trust agreement is usually needed to determine the US tax classification of the trust.

Foreign Grantor Trusts

For US income tax purposes, the income of a grantor trust is deemed to be earned by the grantor directly. For example, a grantor trust earning $100 of interest income would be attributed to the grantor as if the grantor earned the $100 interest directly. The grantor will report the income from the trust on their own income tax return. Since the income earned with the trust is already taxed to the grantor, it will not be taxable again upon a distribution.

If you are a US grantor of a foreign grantor trust, you are required to file Form 3520 (Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts) and Form 3520-A (Annual Information Return of Foreign Trust with a U.S. Owner) to report certain general and financial information relating to the foreign grantor trust, such as a balance sheet, income statement and the distribution details, as well as computing the US taxable income attributed from the trust to the grantor on a Foreign Grantor Trust Owner Statement attached to the Form 3520-A. You will then report the taxable income calculated on the Owner Statement on your Form 1040.

If the grantor trust made a distribution to a beneficiary, regardless of whether the beneficiary is yourself or another person, you will also need to prepare a Foreign Grantor Trust Beneficiary Statement with your Form 3520-A to disclose the beneficiary and distribution information. The Beneficiary Statement needs to be provided to the beneficiary, so that they know the trust is a grantor trust and that the distribution is not taxable to them. Note that the distribution from a grantor trust could lead to gift tax consequences if the initial contribution of assets to the trust was not considered a taxable gift.

The grantor may also have to file the FBAR (FinCEN 114) to report any foreign bank accounts of the trust, and to file Form 8938 to report their financial interest over the trust. An exception applies to Form 8938 if you have already filed Form 3520 / Form 3520-A with respect to your interest in the trust.

As the US beneficiary of a foreign grantor trust who has received an actual or deemed distribution from the trust, if the grantor is a US person, you will receive the Foreign Grantor Trust Beneficiary Statement. In this case, the distribution is non taxable to you, but you will have to file Form 3520 to report the receipt of distributions from the foreign grantor trust and attach the Beneficiary Statement. If the grantor is not a US person and you believe the trust is a grantor trust, you will have to request the trustee to produce and provide you with a Foreign Grantor Trust Beneficiary Statement. You may also have to file Form 8938 to report your beneficial interest in the trust, but an exception applies to Form 8938 filing if you have already filed Form 3520 with respect to your interest in the trust.

Note that there are substantial penalties for failure to file Form 3520 and Form 3520-A as either a grantor or a beneficiary of the trust, as well as for failure to file the FBAR and Form 8938.

Foreign Non-Grantor Trusts

If you are the settlor of a foreign non-grantor trust, meaning you contributed your assets to the trust, you generally have to file a US gift tax return for the transfer of assets. Any subsequent activities of the trust would not be attributed to the settlor so there would not be any subsequent implications in general.

If you are a US beneficiary of a foreign non-grantor trust and you receive an actual or deemed distribution from the trust, you are required to file Form 3520 to report your receipt of the distribution. The income tax consequences also become much more complicated because only the distribution of income from the trust will be taxable, but the distribution of trust corpus / principal is non-taxable. You may also be required to file Form 8938 to report your beneficial interest in the foreign trust, but an exception applies if you have already filed Form 3520.

The trustee has no legal obligation to produce and provide you with a Foreign Non-Grantor Trust Beneficiary Statement, but it would be more beneficial to your tax exposure if you nonetheless request the trustee to provide you with one. Normally, they would be willing to hire US tax accountants to prepare a Beneficiary Statement for you. If you are unable to obtain a Beneficiary Statement, you will need to compute your taxable income on Form 3520 under the “default calculation of trust distributions” where the part of distributions received in the current year that is more than 125% of the average distributions received in the previous three years would be treated as an “accumulation distribution.” The accumulation distribution will be subject to the “throwback rules” as if the income was earned and taxed in the previous years and an interest charge is imposed on the deferred payment of tax, similar to the “excess distribution” rules under the PFIC regime.

If you can obtain the Beneficiary Statement, it will indicate the portion of the distribution that is attributed to the trust’s “Distributable Net Income (DNI)”, “Undistributed Net Income (UNI)”, and corpus. In general, DNI usually means the current year taxable income of the trust calculated under the US tax rules as if the trust was a US trust, subject to certain modifications to the rules. UNI refers to the previous years’ DNI that has not been distributed. The distribution allocated to DNI will be taxed to you according to the nature of the income. For example, any distribution of qualified dividends allocated to DNI will be taxed as qualified dividends to you on your tax return. For the distribution allocated to UNI, it will be subject to the “throwback rules” as explained above. The distribution allocated to corpus is non-taxable.

It is generally more beneficial to obtain the Beneficiary Statement for a few reasons. A distribution from corpus can be tax-free only if a Beneficiary Statement is available, otherwise the entire distribution is assumed to be taxable. The default calculation in the absence of the Beneficiary Statement would also likely assume a certain portion of the distribution to be an accumulation distribution, which comes with punitive tax consequences under the throwback rules, where the distribution might not really be attributed to UNI.

As a side note, it might also be beneficial for the foreign non-grantor trust to appoint a US agent by signing and executing an Authorization of Agent. With a US agent, the US beneficiary can avoid submitting certain documents to the IRS as required by Form 3520, such as the trust documents, instruments and agreements, financial statements, etc. The beneficiary themself can be the agent of the trust.

As the US tax rules around foreign trusts are highly complicated and the penalties for failure to file certain forms related to foreign trusts can be substantial, you should always consult a trusted cross-border tax advisor to ensure you are in compliance with the tax rules.