Tips To Avoid U.S. Tax Surprises From Foreign Trusts
Foreigners relocating to the U.S. should understand the complex U.S. tax reporting requirements and potential penalties associated with foreign trusts.
Wealthy foreigners continue to move to the U.S. — 10,000 millionaires migrated during 2018 alone. Many of them have created or are beneficiaries of foreign trusts, often used to protect their worldwide assets.
The laws for reporting and paying taxes on foreign trusts are more complicated than those for domestic trusts, and the Internal Revenue Service imposes hefty penalties for noncompliance when foreign trusts are not reported correctly. With tax laws having changed so recently, it is more important than ever for attorneys, certified public accountants and financial advisers to work together when planning for distributions from or dealing with foreign trusts.
Asking Questions and Establishing a Team
No matter the reason for their move, clients do not always discuss the details of their family’s financial situation with attorneys they may have engaged. Anytime you are talking with a client who is thinking about moving to the U.S., consider asking certain questions early in the process.
One of those questions should be how many days they’ve spent in the U.S. during the last three years — or, better yet, ask for a copy of their passport. This will help you identify their likely tax residency status. It is also important to ask for a list of a client’s worldwide assets, including whether they own or are beneficiaries of foreign trusts.
You might also want to ask these same financial and residency-related questions about any immediate family members who may be owners or beneficiaries of foreign trusts.
Finally, it’s also a good idea to bring a CPA with international tax expertise onto your team, as well as a financial adviser, if it makes sense for your client. Together, you and your team will ascertain the tax status of both the individual and any trusts, and can plan for timely filings, extensions and tax payments. The right CPA will make it easier to keep up with changes in tax laws and the large volume of information required to help clients avoid unpleasant tax surprises.
Identifying Tax Residence Status
U.S. persons are taxed on their worldwide income and must report their worldwide financial interests, including certain interests in foreign trusts.
It is not just U.S. citizens and green card holders who are considered U.S. persons and subject to U.S. income taxes. Nonresidents may be subject to U.S. income taxes if they meet the substantial presence test in any given year, meaning they spent at least 31 days in the U.S. during the tax year, as well as a total of 183 days taking into consideration the following:
- All days present in the U.S. during the tax year;
- One-third of the days in the U.S. during the year before the tax year; and
- One-sixth of the days in the U.S. during the year that falls two years before the tax year.
For example, if an individual does not spend more than 120 days in the U.S. during each of the three years, then that person would not be considered a resident under the substantial presence test.
There are several types of presence that don’t count toward this test, such as spending a few hours in the U.S. in transit between two other countries, being stuck in the U.S. due to a medical condition that developed while in the U.S. and commuting to work from Canada or Mexico. Time in the U.S. under some visas, such as foreign government-related individuals, teachers or trainees, temporary student visas, and professional athletes, also does not count toward the presence test. However, time in the U.S. under an investor visa generally does count in the presence test.
There are other circumstances under which an individual who has spent a total of 183 days in the U.S. under the presence formula is still not a U.S. taxpayer. A foreigner may establish a closer connection to a country where they have a tax home, even after spending significant time in the U.S. to establish a new business, for example. Or a person may be able to take a treaty-based return position — available for those whose tax home is in a country that has a tax treaty with the U.S. This may allow them to reduce the U.S. income taxes due.
Visa-based exempt days, closer-connection positions, and treaty-based positions each have their own set of requirements, including IRS filings.
Determining the Type of Trust
Once you and your team of advisers have decided on a client’s residency status and have established if the client is a settlor/grantor or the beneficiary of a trust, you should ascertain whether the trust is domestic or foreign.
Just because a trust was created in the U.S. does not mean it is a domestic trust for U.S. tax purposes. To be considered domestic, it must satisfy both the court test and the control test.
To meet the court test, a U.S. court must be able to exercise jurisdiction over the administration of the trust. To meet the control test, one or more U.S. persons must have authority over all substantial decisions of that trust, such as control of income, amount of distributions, selection of beneficiaries, termination of the trust and investment decisions.
If either the court test or the control test is not met, the trust is considered a foreign trust for U.S. tax purposes.
You will also want to be clear on whether the foreign trust is a grantor or a nongrantor trust, as this also affects the taxing of income. A foreign trust is considered a grantor trust for income tax purposes when:
- The trust is revocable, meaning the grantor or grantor spouse retains a certain degree of dominion or control over the assets of the trust, or
- During their lifetime, the grantor and the grantor’s spouse are the only beneficiaries of the trust.
Special rules apply under Internal Revenue Code Section 679 when a nonresident alien individual transfers property, directly or indirectly, to a foreign trust and then becomes a U.S. person within five years after the transfer. In this situation, U.S. tax laws treat the individual as making a transfer to a foreign trust on the individual’s U.S. residency start date. Accordingly, if the trust has U.S. beneficiaries, the laws treat this person as a grantor with respect to the portion of the trust that was transferred.
The income, deductions and credits of a foreign grantor trust are usually attributed and flow through to the grantor (if a U.S. tax person) and not to the trust itself. Any distributions from the foreign grantor trust to its U.S. beneficiaries during the grantor’s lifetime will be treated as gifts to the beneficiaries and not as income.
Foreign trusts that are not grantor trusts are considered nongrantor trusts. As with domestic trusts, a foreign nongrantor trust can be either a simple trust or a complex trust.
Income from a foreign nongrantor trust is taxed the year it is earned, either by the beneficiaries when it is distributed (distributed net income) or by the trust if it is retained.
A distribution in excess of the trust’s distributed net income is treated either as a nontaxable distribution of the corpus or as a distribution of income accumulated from prior years, which is taxable under the so-called throwback rule.
This rule prevents U.S. persons from using these types of foreign trusts to accumulate income without having to pay current tax. The computations under the throwback rule are onerous and the income is taxed at the highest applicable ordinary rates (37% in 2019), plus a nondeductible interest charge that in some cases can be very substantial for the U.S. beneficiaries.
Digging Deeper to Understand Underlying Assets and Their Reporting Requirements
Once you have established a client’s taxpayer status and the structure of any trusts, you should set up a schedule for the various filings and payments that may be required. Believe it or not, some of the most common mistakes that we see involve missing these deadlines.
Two forms must be filled out for the trustee and the beneficiaries of a foreign grantor trust: “Form 3520A, Annual Information Return of Foreign Trusts with a U.S. Owner,” and “Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts” — on which the U.S. beneficiaries will report the distributions.
Not all foreign nongrantor trusts are subject to U.S. tax filing. However, the trustee of these types of trusts should furnish to the U.S. beneficiary a foreign nongrantor trust beneficiary statement reporting the distributions for the year, and the beneficiary should report these distributions on Form 3520.
If the foreign nongrantor trust produces effectively connected income, then it must file Form 1040NR, U.S. Nonresident Alien Income Tax Return, to report all income from sources within the U.S. connected with the conduct of trade or business. One example is rental income from real estate.
Depending on the structure of the trust, other filing requirements for the underlying assets may include informational returns such as Foreign Bank Account Reporting, FinCEN Form 114 and Statement of Specified Foreign Financial Asset, Form 8938. Each of them carries its own set of penalties for failure to file in a timely fashion.
Common oversights include missing the timely filing of an extension or payment, and not filing for an employer identification number for a foreign trust. While it may be acceptable to file an extension without an EIN, this isn’t always the case. It’s often preferable to obtain an EIN for the trust, rather than file required forms using an individual’s taxpayer identification number.
Finally, working internationally necessitates careful logistical planning. Some forms (such as forms 3520A and 3520) require original signatures and must be filed on paper. It can take weeks to months to track down the right signers and get the forms to them. And, if you’re working at the last minute, don’t forget to account for the fact that, in many parts of the world, overnight mail often takes several days.
Avoiding Costly Penalties Through Timely Communication and Planning
The penalties for failure to file a required tax form, or to report and pay taxes to the IRS, can be significant.
For instance, failure to file Form 3520A in a timely manner, not furnishing all the required information or including incorrect information may trigger an initial penalty of the greater of $10,000 or 5% of the gross value of the portion of the trust’s assets owned by the U.S. person at the close of that tax year.
In other circumstances, the penalty for Form 3520 can be as high as 35% of the gross value of any property transferred or distributions received. Penalties may continue to increase, for example, if the noncompliance continues for more than 90 days.
To avoid these penalties, planning and communication are key. Clarify for your client why you need to be kept abreast of related developments, and keep any CPAs and financial advisers you are working with informed of changes as they happen, even if you’re not certain whether those changes have tax implications.
Also, it is imperative to communicate and plan with any foreign trustees, if possible. They often don’t understand the U.S. tax system’s many requirements, and you may need quite a bit of information from them in a timely manner.
The Right Team Can Help Your Clients Succeed
Trusts have many valuable uses, but properly classifying them for U.S. tax purposes, reporting them and paying taxes related to them requires a team of professionals who understand international taxation. Members of that team must communicate with one another, be are aware of U.S. tax and other reporting deadlines and understand the underlying assets of the trust. Working together, they can help the taxpayer avoid stiff penalties for noncompliance. After all, the U.S. is likely to continue to see a millionaire migration for years to come.
Maria Toledo, CPA, MST, is a International Tax Principal at Kaufman Rossin, one of the Top 100 CPA and advisory firms in the U.S.