Many foreign grantors establish foreign trusts to benefit themselves and their foreign beneficiaries. It is not uncommon, however, for a foreign beneficiary to relocate to the United States. This article addresses the U.S. tax consequences to a foreign trust and a beneficiary of a foreign trust who is or becomes a U.S. citizen or resident alien. It is assumed that the grantor is and always will be a foreign person. Recent tax law changes have made planning more difficult in these situations.

For U.S. tax purposes, a foreign trust can be only one of two types – either a "foreign grantor trust" or a "foreign nongrantor trust."

U.S. TAXATION OF FOREIGN TRUSTS

Foreign Grantor Trust

A trust will be characterized as a foreign grantor trust ("F.G.T.") only under two conditions: either, the grantor reserves the right to revoke the trust solely or with the consent of a related or subordinate party (and revest the title assets to himself), or the amounts distributable during the life of the grantor are distributable only to the grantor and/or the spouse of the grantor. Under these circumstances, the income of the trust is taxed to the grantor (i.e., the person who made a gratuitous transfer of assets to the trust). U.S. tax is limited generally to U.S. sourced investment income and income effectively connected with a U.S. trade or business will be subject to U.S. income or withholding tax. A foreign grantor trust will generally become a foreign nongrantor trust upon the death of the grantor. However, U.S. situs assets (which would include U.S. real and tangible property, and stocks and securities of U.S. issuers, other than debt instruments that qualify as "portfolio interest" indebtedness) held by the F.G.T. upon the death of the grantor would be subject to U.S. estate tax.

Foreign Nongrantor Trust

Any trust that does not meet the definition of a foreign grantor trust is a foreign nongrantor trust ("F.N.G.T."), taxed as if it were a nonresident, noncitizen individual who is not present in the U.S. at any time. U.S. tax is generally limited to U.S. sourced investment income and income effectively connected with a U.S. trade or business.

TAXATION OF DISTRIBUTIONS TO U.S. BENEFICIARIES

Foreign Grantor Trust

Distributions to a U.S. beneficiary by an F.G.T. will generally be treated as non-taxable gifts but may be subject to U.S. tax reporting requirements.

Foreign Nongrantor Trust

A U.S. beneficiary will be subject to tax on distributions to the beneficiary of "distributable net income" ("D.N.I.") from the F.N.G.T. The character of such D.N.I. distributions will reflect the character of the income as received by the F.N.G.T. If a F.N.G.T. accumulates its income and distributes the accumulation in later years in excess of D.N.I., the U.S. beneficiary will be subject to the "throwback rules," which generally seek to treat a beneficiary as having received the income in the year in which it was earned by the trust, using a relatively complex formula. The beneficiary may be required to pay a "throwback tax" (a "catch up" tax) and an interest charge on the deferral. Furthermore, such throwback distributions will be taxed at ordinary income tax rates. The throwback rules will not apply to amounts accumulated when the trust was an F.G.T.

REPORTING OBLIGATIONS

Reporting obligations will arise when a foreign trust makes a distribution to a U.S. beneficiary. A U.S. person who receives a distribution from a foreign trust must include Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts) with his or her tax return. Generally, the Trustee should furnish to the U.S. beneficiary a "Foreign Non-grantor Trust Beneficiary Statement," which will be attached to the Form 3520. (While there is a "Foreign Grantor Trust Beneficiary Statement," that Beneficiary Statement contemplates a U.S. grantor, who will report the Trust's income on his or her U.S. income tax return, and therefore may not suitable for an F.G.T. with a foreign grantor.) For a F.N.G.T., the Beneficiary Statement includes the distributable net income for the year, the years to which an accumulation distribution is attributed, and the amounts allocable to each year. Steep penalties may apply for failing to report fully all required information and for failing to report on a timely basis.

OTHER TAX CONSEQUENCES

Special Taxing Regimes

If the foreign trust has investments in foreign corporations, the presence of a U.S. beneficiary may have the unfortunate effect of subjecting the U.S. beneficiary to two special U.S. taxing regimes: those applicable to "controlled foreign corporations" ("C.F.C.'s") and those applicable to "passive foreign investment companies" ("P.F.I.C.'s"). The C.F.C. rules (which generally preempt the P.F.I.C. rules) subject certain types of income allocable to a "U.S. Shareholder" (as specially defined) to immediate U.S. taxation, whether or not distributed, and characterize certain gains upon disposition of the stock as ordinary income. Unless certain exceptions apply, the P.F.I.C. rules are designed to penalize U.S. taxpayers on "excess distributions" from a P.F.I.C. or upon a disposition of P.F.I.C. stock, imposing the highest ordinary income rates and an interest charge.

Tax law changes in late 2017 made significant – and unfortunate – changes to planning for investments in foreign corporations. It is not uncommon for an F.G.T. to own U.S. stocks and securities through a foreign corporate "blocker" corporation, usually in a low or no-tax jurisdiction, to avoid the imposition of U.S. estate tax upon the death of the foreign grantor. If the foreign corporation became a C.F.C. upon the death of the grantor, because of the presence of sufficient U.S. beneficiaries, it was often possible to make a check the box election (effective immediately after death) to treat the C.F.C. as a disregarded entity. The election would be treated as a taxable liquidation of the C.F.C. for U.S. tax purposes, resulting in "foreign personal holding company income" that could be subject to an income tax inclusion by a U.S. beneficiary as a form of so-called "Subpart F income." However, under prior law, no such inclusion was required unless the corporation was a C.F.C. for 30 days or more.

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