I have written a series of blog posts about foreign (i.e., non-US) trusts and the US tax issues associated with them including the US tax filing and reporting requirements for each of the different players in the foreign trust scenario (creator or “grantor”/”settlor” of the trust), the trustee; and today, the US beneficiary.
One of my earlier blog posts set out the tax problems that arise generally when one has created a “foreign” trust with US beneficiaries. A follow up post examined the factors that determine whether a trust is a US trust or a “foreign” trust.
My blog post here covered the US tax filing and reporting requirements for US grantors to foreign trusts, and this post provided a summary of relevant US tax filings imposed on the foreign trust’s fiduciary or trustee.
Today’s post covers the relevant forms for US beneficiaries of foreign trusts.
The US beneficiary of a foreign trust should provide the following forms:
1. IRS Form 1040: Schedule B, Part III
A beneficiary must report all of its beneficial interest in a foreign trust in this Schedule of their individual tax returns.
2. IRS Form 1040 (Other Portions)
Beneficiaries are supposed to report any income they receive from foreign trusts in other portions of their individual tax returns, to the extent it is not reported by the transferors to the trust under the grantor trust rules.
3. Form 114: Report of Foreign Bank and Financial Accounts (“FBAR”)
A US beneficiary of a foreign trust who has a beneficial interest in more than 50% of the assets or income of a trust that owns foreign financial accounts must file an annual FBAR. Filing is required only if the aggregate value of the foreign accounts exceeds $10,000. For this purpose a financial account includes any bank, securities, derivatives, or other financial instruments account. You can learn more about FBAR, Form 114 here and here .
4. IRS Form 3520: U.S. Informational Return – Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts
An overview of the Form 3520 was provided in my earlier post under the heading “Filings by Grantor of Foreign Trust”.
US beneficiaries who have received distributions from a foreign trust during the year are required to report information on Form 3520. Included are items such as the name of the foreign trust, the aggregate amount of the distribution, and other information.
In general, the US beneficiary of a foreign trust will report his/her share of foreign trust income to the extent it is not reported by the grantor or transferors to the trust under the grantor trust rules. The US beneficiary should receive a certain statement from the foreign trust which will enable the beneficiary to determine if he is taxable on what was received from the trust and the trust income to be reported (more detail below).
Filing of the Form 3520 by a beneficiary who receives something from the trust is still required even if the foreign trust is considered to be a “foreign grantor trust”, FGT. Under the FGT rules, the trust is ignored as an entity. The grantor is treated as the tax owner and is the person who is taxed on the trust income, rather than the beneficiary who received the distribution. Instead the beneficiary is treated as having received a non-taxable amount, but this does not relieve the beneficiary of the duty to file Form 3520.
Remember, the US beneficiary will have an obligation to file Form 3520 to report receipt of any and all distributions from a foreign trust, even if the amount is just $1! On the other hand, if the FGT were to make a distribution first to the trust creator or settlor, who in turn then makes a gift to the US beneficiary, the beneficiary need not file Form 3520 until the aggregate value of all foreign gifts exceeded $100,000 during the year.
What happens if the beneficiary fails to file the Form 3520, when it was otherwise required? Answer, he will be taxed under draconian provisions, as set out below.
Accumulation Distribution from Foreign Trust
Under certain tax rules (IRC Section 6048), any distribution of income or principal from a foreign trust to a US beneficiary will be treated as a so-called “accumulation distribution” includible in the gross income of the beneficiary unless adequate records are provided to the IRS to determine the proper treatment of the distribution. These accumulation distributions carry very negative US income tax consequences under the Throwback Tax regime (contained in IRC Sections 665-668). Therefore, without the proper submissions from a beneficiary (for example, showing that the trust is a FGT whose income should be taxable to the grantor of the trust), a distribution from a foreign trust will be taxable to the beneficiary as an “accumulation distribution” with severe consequences under the Throwback rules together with an onerous compounded interest charge.
A US beneficiary can avoid accumulation distribution treatment by obtaining proper documentation from the foreign trust. The beneficiary can obtain from the foreign trust a “Foreign Grantor Trust Beneficiary Statement” (Form 3520-A, page 4), showing that the trust is taxable as a grantor trust owned by another person. If the US beneficiary receives a completed “Foreign Grantor Trust Beneficiary Statement” with respect to a distribution, such beneficiary should treat the distribution as a nontaxable gift from the owner of the trust, completing Form 3520 as required. Please note that a beneficiary who received an amount from a foreign trust that would require a report under both Parts III and IV (gifts or bequests) of Form 3520, should report the amount only in Part III.
Alternatively, the trust should provide the beneficiary with a statement showing the proper income tax consequences of the distribution made to him. This statement must provide adequate information to determine the US tax consequences of the distribution from the foreign trust. See Instructions to Form 3520 Part III Schedule B, Actual Calculation of Trust Distributions.
A US beneficiary who cannot obtain such a statement from the trust can possibly avoid accumulation distribution treatment by providing certain information regarding actual distributions from the trust for the prior three years under a special “default rule”. See Instructions to Form 3520 Part III Schedule A, Default Calculation of Trust Distributions. (Under this rule, generally, a US beneficiary can treat 125% of the average of the trust distributions received in the prior three years as a distribution of current income, with only the excess amount treated as an accumulation distribution.)
5. Form 8938: A US person holding an interest in a so-called “specified foreign financial asset” (SFFA) must disclose the interest on Form 8938 if the aggregate value of all SFFAs exceeds certain threshold amounts. The thresholds vary depending on the taxpayer’s filing status and whether he is living in the US or abroad in accordance with specific rules. A SFFA includes an interest in a foreign trust. Determining the value of the beneficiary’s interest in the trust may require use of special valuation rules.
The instructions to Form 8938 provide the following guidance on valuation of an interest in a foreign trust:
“Valuing interests in foreign trusts. If you are a beneficiary of a foreign trust, the maximum value of your interest in the trust is the sum of the following amounts.
The value of all of the cash or other property distributed during the tax year from the trust to you as a beneficiary, and
The value using the valuation tables under section 7520 of your right as a beneficiary to receive mandatory distributions as of the last day of the tax year.”
This disclosure on Form 8938 is in addition to the FBAR requirement described above in number 3. Items reported on Form 3520, described above at 4, do not have to be reported on Form 8938, but Part IV of Form 8938 must be completed to indicate the Form 3520 filing. You can learn more about Form 8938 and SFFAs at my US tax primer here.
Posted November 14, 2019
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