Maximum account value determination for trust beneficiaries for FinCen Form 114
A U.S. beneficiary of a foreign nongrantor trust may be required to report the beneficial interest on the dreaded FBAR form — FinCen Form 114. This blog post is designed to help you figure out the “maximum account value” that you put on Form 114 if you have to file it.
Filing FinCen Form 114
A U.S. person must tell the U.S. government about foreign financial assets on FinCen Form 114. This is the dreaded FBAR and I assume that readers of this blog know about the form. I also assume that readers have an opinion about the form, too.
The legal authority for this is found at 31 U.S.C. Section 5314. The reporting requirement is stated in 31 C.F.R. Section 1010.350(a), which reads (in relevant part) as follows:
Each United States person having a financial interest in, or signature or other authority over, a bank, securities, or other financial account in a foreign country shall report such relationship to the Commissioner of Internal Revenue for each year in which such relationship exists and shall provide such information as shall be specified in a reporting form prescribed under 31 U.S.C. 5314 to be filed by such persons. The form prescribed under section 5314 is the Report of Foreign Bank and Financial Accounts (TD-F 90-22.1), or any successor form.
I will skip over the definition of U.S. person. Let’s assume you have one of these. What is left is a simple if/then statement: “IF you have a financial interest in (a sludgy bureaucratic string of definitions) THEN you have to report whatever the form requires you to report.”
The key understanding here: if you determine that you have a reporting requirement, the question of WHAT you report is entirely up to the Commissioner of Internal Revenue. Translation: bureaucratic whim.
The form we are talking about, of course, is FinCen Form 114.
Nongrantor Trusts and FinCen Form 114
If you are a beneficiary of a nongrantor trust and that trust has a foreign account of some kind, you may have a “financial interest” in a foreign “financial account.” Since everyone having a “financial interest” in a foreign “financial account” must report this relationship on FinCen Form 114, you are going to be adding yet another item to your annual tax reporting paperwork burden.
The Regulations tell us you have a “financial interest” at 31 C.F.R. Section 1010.350(e)(2)(iv), which says:
A United States person has a financial interest in each bank, securities or other financial account in a foreign country for which the owner of record or holder of legal title is . . . . [a] trust in which the United States person either has a present beneficial interest in more than 50 percent of the assets or from which such person receives more than 50 percent of the current income.
Note what this is saying.
First, look at the name of the entity that owns a bank, securities, or other financial account in a foreign country. It’s a trust.
Then look at what the trust owns. If it owns an account of the type that is normally reported on the FBAR form, you are going to have to do some more figuring out of stuff. If the trust owns something that is not reportable on the FBAR form, you don’t worry any further.
Finally, we look at you, the beneficiary. Is your beneficial interest is big enough, you have to report the “financial interest” on your FBAR. If your beneficial interest in the trust is too small, you do not have to report the “financial interest” on your FBAR.
There are two thresholds. If you pass either, you must file the FBAR and report the “financial interest” that you hold indirectly via the trust. These thresholds are similar to the rules for corporations: if you own too much stock (more than 50%) then you trigger financial reporting for the corporation’s foreign bank accounts. There is nothing terribly sinister here.
The first threshold is that you, the beneficiary, have a present beneficial interest in more than 50% of the trust assets.
I leave the very interesting follow-up question to you. What if, as with every foreign nongrantor trust I have ever seen, the trustee has absolute discretion in making distributions among a defined class of beneficiaries?
What’s your “present beneficial interest” in the trust? What if you ask the trustee a series of questions so you can honestly answer the question on Form 114? The trustee might tell you to go stick your nose in a dead bear’s bum, citing privacy and confidentiality and all that fun stuff.
The second threshold is whether you, the beneficiary, receive more than 50% of the current income of the trust.
This, too, gives us a series of brain teasers. Does this mean actual receipt of the current income? Or hard-wired mandatory distribution rules requiring distribution of current income? I assume the Regulations mean both.
If the trust has two beneficiaries with mandatory annual distribution of current income (heh–such a foreign trust is truly the Unicorn of Trusts, found only in examples in the Treasury Regulations), you fail this threshold. You have exactly 50% of the current income.
On the other hand, if you are the only beneficiary of a discretionary trust and you receive occasional distributions from the trustee, probably every year that you receive a distribution you will satisfy this requirement for FBAR purposes. But you don’t know for sure, because you don’t know whether the distribution is current income or not.
And yes, the trustee might tell you enough for you to figure this out. Or the trustee might not, inviting you instead to insert your olfactory apparatus into the aforementioned deceased ursine’s digestive system exhaust portal. It happens.
You pass the threshold
Let’s say that you figure out some way that you pass the thresholds, so you have a “financial interest” in the “financial accounts” owned by the trust.
Or let’s say (as often happens) that you do a quick cost/benefit analysis and assume that the risks favor oversharing of information with the IRS. Better to tell them too much than too little, because the penalties for under-sharing are approximately the same as financial amputation and there are no penalties for over-sharing.
(Did George Washington and Thomas Jefferson anticipate the government we have today, and its imperiously-imposed penalties? But I digress.)
What is reported?
What you are reporting on the Form 114 is not your beneficial interest in the trust. You are reporting the fact that you have a financial interest in a financial account that is owned by the trust.
Going back to 31 C.F.R. Section 101.350(e)(2):
A United States person has a financial interest in each bank, securities or other financial account in a foreign country for which the owner of record or holder of legal title is [a trust in which the person is a beneficiary].
And we know that the general rule is that the thing to be reported is the “financial interest” in the foreign financial account. 31 C.F.R. Section 1010.350(a) says:
Each United States person having a financial interest in, or signature or other authority over, a bank, securities, or other financial account in a foreign country shall report such relationship to the Commissioner of Internal Revenue. . . .
The phrase “such relationship” refers back to having a financial interest in the account.
This means that the only thing the beneficiary reports on Form 114 is the trust-owned financial account.
As an example, let’s say the trust has two assets: an apartment building and a bank account to collect the rent and pay the expenses. The U.S. beneficiary will report a financial interest in the bank account only. The apartment building is not a “financial account” so does not go on FinCen Form 114.
At what value?
Finally (!) we come to the whole point of this blog post. (Inspired by a question from Marina H., by the way.)
The U.S. person is a beneficiary of a trust, and has a large enough beneficial interest to trigger the reporting requirement on FinCen Form 114. The trust has a financial account.
What is the maximum account value that the person lists on FinCen Form 114?
The Regulations do not discuss the question of value. The valuation reporting requirement is one of those things that 31 C.F.R. Section 1010.350(a) left to the tender loving mercies of the Commissioner to determine and specify on the form.
The Instructions for FinCen Form 114 (warning: PDF) are spectacularly unhelpful (see Page 10 of the Instructions):
Step 1. Determine the maximum value of each account (in the currency of that account) during the calendar year being reported. The maximum value of an account is a reasonable approximation of the greatest value of currency or nonmonetary assets in the account during the calendar year. Periodic account statements may be relied on to determine the maximum value of the account, provided that the statements fairly reflect the maximum account value during the calendar year. For Item 15, if the filer had a financial interest in more than one account, each account must be valued separately. For an account denominated in U.S. Dollars, the maximum value of the account is the largest U.S. Dollar value of the account during the report year.
My opinion is that the government is asking about your relationship with an account. They are not asking about how much that account means to your personal wealth. Therefore you must report the maximum value of the account, not the maximum value of your financial interest in the account.
This is just like the reporting requirement where you have signature authority (but not financial interest) in an account. You report the value of the account.
The real problem that humans (taxpayers and those of us–like Marina H.–who try to shield them from GovBot-inflicted damage) face is getting data.
We are back to the trustee cooperation problem. Will the trustee happily reveal the maximum account balance for the year? Or is this a “It doesn’t smell exactly like a rose to me; are you sure, Dear Trustee, that I should be sticking my nose here?” situation again?
If you cannot get any information from the trustee, what are you going to do? I think the only thing you can do is operate from the best information you have available. You may have incomplete information about the trust’s bank account: you received a wire transfer but beyond the information revealed by that transaction you know nothing. You may be completely unaware of any other accounts the trust owns. You received a wire transfer from a bank account but have no idea that the trust has two other accounts.
I sympathize. This is the world I live in every day.
Bonus brain damage
I leave you a little puzzle for self-inflicted tax-law related brain damage in case you like that kind of thing.
Your client is the sole beneficiary of a foreign nongrantor trust. Its sole asset is a BVI corporation. The BVI corporation has a bank account in a foreign country.
Analyze the reporting and income pass-through requirements for FinCen Form 114, Form 8938, Form 3520, (possibly Form 3520-A), and Form 5471. I will give you a head start: Form 8621 does not apply. You get extra credit if you explain why.
Distributions from foreign grantor trusts and U.S. paperwork
This is a Form 3520 “research in a box” blog post for you, BP. Because you asked. And because you subscribed to the Jell-O Shots newsletter mailing list.
- Forms: 3520, 3520-A
- Entity: Foreign Grantor Trust
- Code Sections: 6048, 6677
- Administrivia: Notice 97-34, if you care.
A foreign grantor trust exists, created by a nonresident alien.
The trust makes a distribution of $30,000 to a U.S. person who is not the grantor. We know–because the trustee told us–that $5,000 of this distribution is from current income of the trust, and $25,000 is from capital.
Happily, the trustee has given the U.S. person a piece of paper labelled “Foreign Grantor Trust Beneficiary Statement” which looks suspiciously like Form 3520-A, page 4.
It’s tax season and you’re preparing the U.S. person’s income tax return.
There are two questions embedded in these facts:
- Paperwork. One is a reporting question: what paperwork must the beneficiary file with the IRS in order to avoid getting whomped by Uncle Sam’s Penalty Stick?
- Tax Liability. The other question is whether some or all of the money will be treated as taxable income by the beneficiary.
Internal Revenue Code Section 6048(c)(1) states the general reporting requirement:
If any United States person receives (directly or indirectly) during any taxable year of such person any distribution from a foreign trust, such person shall make a return with respect to such trust for such year which includes–
(A) The name of such trust,
(B) The aggregate amount of the distributions so received from such trust during such taxable year, and
(C) Such other information as the Secretary may prescribe.1
Please note the important feature of this provision: it does not matter whether the U.S. person receiving the money is named as a beneficiary in the Declaration of Trust. All that matters is that the U.S. person received a distribution from the trust.2
Disregard Grantor Trust Status
When you are trying to figure out whether the beneficiary in fact received a distribution from a foreign trust or not, you disregard the grantor trust rules:
For purposes of this section, in determining whether a United States person . . . receives a distribution from a foreign trust, the fact that a portion of such trust is treated as owned by another person under the rules of subpart E of part I of subchapter J of chapter 1 shall be disregarded.3
“Subpart E of part I of subchapter J of chapter 1″ contains Sections 671 through 679 of the Internal Revenue Code. This is where the grantor trust rules live. The fact that this trust was carefully constructed to be a foreign grantor trust under the rules of the Internal Revenue Code? Not relevant.
The simple question then becomes whether the distribution came from the trust or not. Usually this problem pops up because someone in the United States is to receive a gift. Grandmother lives outside the United States and has a foreign grantor trust. She wants to send $30,000 to her granddaughter in the United States.
Grandmother tells the trustee to make it so. The trustee makes it so, and wires money to the granddaughter in the United States.4 The granddaughter is now preparing her U.S. income tax return and wonders what to do about the $30,000 she received from her grandmother in the old country.
We know this is a distribution. Money came from the trust and went to the U.S. beneficiary, to the tune of $30,000.5
Preparing Form 3520, Part III
Form 3520 is the form used to satisfy the reporting requirements of Section 6048. In particular, Part III of Form 3520 is where a U.S. beneficiary of a foreign trust reports receiving distributions.
The distribution is listed on Line 24 of Part III.
I am going to ignore Lines 25 and 26 as being irrelevant to the fact pattern we are looking at.
The total from Line 24 will be repeated on Line 27.
Ignore Line 28, because we don’t have those facts.
This completes the basic reporting requirements. If you fill in all of this information, then the U.S. person who received $30,000 has properly reported the trust distribution. Failing to report a trust distribution carries with it a 35% penalty.6 That means the recipient has dodged a $10,500 bullet.
Income Taxation (Form 3520, Part III, Line 29)
But wait! There’s more!
You have properly reported the receipt of $30,000. But is it taxable? Or does the recipient receive the money tax-free?
The government’s basic position here is “show me stuff or the entire amount is taxable income”:
If adequate records are not provided to the Secretary to determine the proper treatment of any distribution from a foreign trust, such distribution shall be treated as an accumulation distribution includible in the gross income of the distributed under chapter 1. To the extent provided in regulations, the preceding sentence shall not apply if the foreign trust elects to be subject to rules similar to the rules of subsection (b)(2)(B).7
In other words, the entire $30,000 received by the U.S. person will be taxable income unless one of two facts is true:
- “Adequate records” are provided to the Secretary; or
- The foreign trust does what Section 6048(b)(2)(B) tells it to do.
“Adequate records” means that the U.S. person gives the IRS a “Foreign Grantor Trust Beneficiary Statement.” This is normally done using page 4 of Form 3520-A.8 Doing the Section 6048(b)(2)(B) dance means that the foreign trust appoints a U.S. agent.
Since you have a Foreign Grantor Trust Beneficiary Statement in hand, you are golden. Answer Form 3520, Part III, Line 29 by ticking the “Yes” box. Attach it. You are finished with the preparation of Form 3520.
What has happened here?
By giving the IRS the Foreign Grantor Trust Beneficiary Statement, you have provided sufficient information to them to confirm that the money distributed to the U.S. person constitutes the taxable income of someone else–the grantor. Therefore, the IRS knows that the money received by the U.S. person cannot contain taxable income.
Essentially, the Code gives the U.S. person a choice: give the IRS enough information about the trust, or pay income tax on every dollar received.
I set up a lot of foreign grantor trusts. A. Lot. This situation appears to have violated two of of my Golden Rules:
- Never name a U.S. person as a beneficiary of a foreign grantor trust. Such a person has beneficial interests only after the death of the settlor. This way, the trustee will not be tempted to send money to the U.S. person: “I can’t give you money–you’re not a beneficiary!” Use administrative impediments to your advantage, or at least to make people stop and think for a split second.
- When the settlor says “Please send money to my granddaughter on my behalf” never, ever, ever, ever do that from the trust. Instead, move money from the foreign grantor trust to the settlor’s personal bank account. Then have the settlor make the gift from his or her personal bank account.9
If (nonresident) grandmother wants to have a grantor trust and make trust distributions to U.S. resident grandchild, consider the use of a domestic trust that is a grantor trust as to the nonresident grandmother. Then distributions from that trust are reported by the U.S. recipient on Form 3520, Part IV, as a gift–not as a trust distribution.
- The author used the word “such” six times in this brief little Code snippet. Evidently there was a surfeit of suches left near the end of the Federal government’s fiscal year, and the author’s department needed to use them all in order to justify the budget request for the next year’s supply of new, shiny suches. [↩]
- A “distribution” is defined in more detail in the 2012 Instructions for Form 3520, page 2. This largely echoes Notice 97-34, 1997-1 C.B. 422, Section V. [↩]
- Section 6048(d)(1). [↩]
- Let’s ignore, for the moment, the fact that foreign trusts usually do not have bank accounts in the name of the trust. Rather, the general commercial practice for foreign trustees seems to be that a foreign trust will hold all of its assets in a corporation. The corporation has bank accounts, and the money would come to the granddaughter in my example from a corporate bank account rather than a trust bank account. This can create profound problems that are worthy of their own blog post. [↩]
- I am assuming there are no facts that make the $30,000 payment look like a purchase/sale, or a vendor/customer payment, or a loan. [↩]
- Section 6677(a)(2). [↩]
- Section 6048(c)(2)(A). [↩]
- See, 2012 Instructions for Form 3520, page 8. [↩]
- The recipient reports this gift–if it is more than $100,000 in a single year–on Form 3520 in Part IV. [↩]
Is an ISA a foreign trust?
Yesterday and today I have had an interesting email exchange with three tax practitioners about Individual Savings Accounts from the U.K. I will call this type of account an ISA (pronounced “Ice-uh”), because that’s how I say it out loud. I won’t identify them by name unless they want to be identified. (Email me and I’ll give you credit for inspiring this post.)
I stated the title of this blog post as a question, fully cognizant of Betteridge’s Law of Headlines.
The emails flying back and forth told me: (1) my 2011 post on the topic is DFW1; and (2) I should tell the world what I think is the correct answer. So this post is just me looking at the question and coming to a conclusion. The IRS may well come to a contrary conclusion. Them’s the risks. The IRS has opinions, keeps them close to its bureaucratic vest, and chooses to brandish them (or not) at the most inopportune of times.
That’s the disclaimer. Plus the usual disclaimer: don’t rely on anything you read, especially on the internet. Go hire a tax advisor and get advice. Especially don’t rely on me. It’s late afternoon as I’m writing this and I’m hungry.
How an ISA Works in the U.K.
Here’s the TL;DR on how an ISA works in the U.K. (Go to that website. It’s the official HMRC home page for ISAs).
You set one up. There are two different types, and there are limits on how many you can set up every year. You put money in. There are limits on that, too.
An ISA can hold cash. That’s a “cash ISA”. An ISA can hold stocks and shares. That is called a “stocks and shares ISA”. Your ISA can hold life insurance. A convoluted and confusing (to me) set of rules tells you whether your life insurance policy should be held in a “cash ISA” or a “stocks and shares ISA”. I mean really. Why would anyone want to keep things simple and have a “life insurance ISA”?
Interest, dividends, and capital gain are tax-free. (Well, interest on cash in one special type of ISA is subject to a 20% charge. Tax rules always have exceptions, right?)
But that’s the basic idea: save money in the form of cash, stocks and shares, or life insurance, and let it grow tax-free in the U.K.
What Happens When an ISA Touches the United States
Bad things happen when an ISA touches the United States, or more precisely when an individual who owns an ISA touches the United States. This can happen because a U.S. taxpayer (citizen or green card holder) qualifies to open an ISA, and does so. Or perhaps a U.K. citizen or resident moves to the United States to live, and becomes a U.S. taxpayer. In either event, we have problems to solve.
The first problem is the taxation of the ISA’s income. The IRS doesn’t care that the U.K. treats all of the ISA’s income as tax-free. You’ll be taxed on the income in the ISA under Internal Revenue Code rules that I will describe in a while.
The second problem is the scary one. Penalties. The question is simple: “Is an ISA a foreign trust?” If it is, the Internal Revenue Code has a set of paperwork requirements (Form 3520 and Form 3520-A) and some “death penalty for parking violations”-level penalties (Section 6677) if you muff up the paperwork.
Income Taxation of ISA Income in the United States
The income derived on ISA investments is taxable in the United States. This is true whether or not an ISA is considered to be a foreign trust.
If the ISA is not a foreign trust, it is just a regular investment account, owned by you, dear taxpayer. You pay U.S. income tax on all income you received, worldwide, and so if you have an ISA and you are a U.S. taxpayer, you must pay income tax on the ISA income.
If the ISA is a foreign trust, it will be a foreign grantor trust. Either the rules of Internal Revenue Code Section 679 will make it so, or the rules of Internal Revenue Code Section 672(f)(2)(A)(i) will apply. In either event, you, dear taxpayer, will be considered to be the owner of the ISA’s assets for income tax purposes (see Internal Revenue Code Section 671). Therefore you’re the owner of the income derived from them.
Here’s the problem that we see with ISAs again and again. Stocks and shares ISAs specifically. The classic asset held there is a unit trust. Translation: a mutual fund. Since the mutual fund is issued by a U.K. financial institution of one type or another, the mutual fund will be a Passive Foreign Investment Company in the eyes of the IRS. I’ll call this a “PFIC” because that’s what everyone calls it. Pronounce that acronym “PEE-fck”. And yes.
As a result, a U.S. taxpayer who owns a stocks and shares ISA with PFICs inside it will have a PFIC problem. Go look at Form 8621. And as they said in the saloons of the Old West when the outlaws were playing poker, “Read ‘em and weep.” You are going to pay a lot of U.S. income tax (even though everything is tax-free in the U.K.) and your accountant is going to charge you a lot of money to prepare your tax return.
In brief: interest and dividends from your ISAs will go to Schedule B. Capital gain will go to Schedule D. Everything driven by your unit trust shares will go to Form 8621.
An ISA is not a Foreign Trust
Jeez. I should be charging the big bucks for this write-up. I’m weeping when I think of what a saint I am for giving this all away for free. I might even break my arm patting myself on the back.
But I digress.
The income taxation of ISA income is uncontroversial. The bigger issue is whether an ISA is a foreign trust or not. If it is, you, dear taxpayer, have Form 3520 and Form 3520-A to contend with. And massive penalties if you don’t do the paperwork.
I think an ISA is not a foreign trust. One of the correspondents on our four-way email exchange thought that the IRS would disagree with me, if asked. So fair warning to you. Tread lightly, and carry a clove of garlic.
The definition of an “ordinary trust” — for tax purposes, anyway — is in Treasury Regulations Section 301.7701-4(a):
In general, the term “trust” as used in the Internal Revenue Code refers to an arrangement created either by a will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts. Usually the beneficiaries of such a trust do no more than accept the benefits thereof and are not the voluntary planners or creators of the trust arrangement. However, the beneficiaries of such a trust may be the persons who create it and it will be recognized as a trust under the Internal Revenue Code if it was created for the purpose of protecting or conserving the trust property for beneficiaries who stand in the same relation to the trust as they would if the trust had been created by others for them. Generally speaking, an arrangement will be treated as a trust under the Internal Revenue Code if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.2.
There are two other types of trusts defined in the Treasury Regulations. Section 301.7701-4(b) defines “business trusts” and this definition will not apply to an ISA because these are trusts used, well, run an operating business. Hence the name. And Section 301-7701-4(c) defines “investment trusts” which, if you squint at it with the light shining in the right direction, tells you that this is for things like mutual funds. An ISA may contain investments that look like an “investment trust” under this definition, but an ISA itself won’t be one. At least, not on a planet with gravity.
So we are only looking at the definition of an “ordinary trust” in the Treasury Regulations. It has a few key requirements:
- A trustee takes title to property;
- For the purpose of protecting it or conserving it
- For the beneficiaries
- Under the ordinary rules applied in chancery or probate courts.
Here is the money phrase, which was helpfully highlighted above:
Generally speaking, an arrangement will be treated as a trust under the Internal Revenue Code if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.
Our quest is to determine whether–under U.K. law–an ISA manager is charged with the solemn duty to “protect and conserve” property for people “who cannot share in the discharge of this responsibility”. If the ISA manager has this responsibility, then the ISA arrangement is a trust in the eyes of the IRS. If the ISA manager does not have this responsibility, then the ISA is not a
An ISA Manager Is Not Responsible
My opinion is that an ISA manager does not have that responsibility. Even without reading anything (stand by, we will do that), you and I know that all financial institutions worldwide are risk-averse in the extreme and will do anything at all to avoid being at fault. Hence, I would be floored if the U.K. financial institutions that act as ISA managers would ever agree to a level of standard of care that is imposed on trustees. Fiduciary responsibilities are taken really %#$%@#^ seriously in the U.K.
But let’s not make up stuff. Let’s look at what HM Revenue & Customs says (I’m using the American custom of treating an entity as singular, so sorry) about ISA Managers. Helpfully there is a massive PDF titled “ISAs: Guidance Notes for ISA Managers” (warning: massive PDF, so don’t open that link on your mobile phone) that is authored by someone at HM Revenue & Customs, so presumably we can rely on it.
I looked at it and cannot find anything that tells the ISA manager that it will be put in the position of a fiduciary. Maybe you want to look and see what you find.
There are all sorts of other rules for the care and feeding of ISAs. But nothing about the ISA manager’s responsibility to the account holder. I’m not saying that no such rules exist. I’m just saying I see nothing here that would even hint at any role for an ISA manager that is greater than a custodian and possibly investment advisor (“You opened a stocks and shares ISA, so why don’t you buy these shares? The decision is yours, however.”)
The Account Holder Is In Control
The other part of the definition of an ordinary trust is that a trustee is in place to hold and conserve assets for the beneficiaries because they cannot share in the discharge of this responsibility. In other words, the trustee is there because the beneficiaries are not able to do the job themselves for whatever reason.
One thing is abundantly clear with ISAs: the account holder is in full control at all times.
Conclusion: It’s Not a Trust
The ISA is not a trust for two reasons: the ISA manager (the would-be trustee) does not have a fiduciary duty, and the account holder (the would-be beneficiary) has full control over the assets in the ISA.
- Because the ISA manager (who would be the “trustee”) does not have a fiduciary duty, an ISA is not a trust. The normal “I gave my bank some money and they promised not to steal it from me” duty is not sufficient. That’s a custodian’s obligation not to take someone else’s stuff. And if the ISA manager gives investment advice (“Buy stock A, not stock B”), this is nonbonding stuff and the ISA manager does not have the power to force the account holder what to do. So the basic trustee’s administrative power of management is missing.
- The account holder’s ability to designate investments and terminate the ISA at any time defeats the second arm of the IRS’s definition of a trust. Not only does the account holder “share” that responsibility of management, in fact the account holder is the only person who can exercise that management power.
Since I conclude that an ISA cannot be a trust, it follows that an ISA cannot be a foreign trust. If so, then Form 3520 and Form 3520-A are not required for a U.S. taxpayer who owns an ISA.
What Do You Think?
This is just my ranting, of course. The only opinion that matters will belong to someone in the IRS’s Chief Counsel’s office in Washington DC.
So. What does the internet think? Is an ISA a “trust” or not? I am indebted to one of my correspondents today for dredging up the old blog post and pointing out that I was wrong there. Does anyone agree/disgree with this blog post? Comment anonymously if you want.
- There is a swear word in that acronym, and the “W” stands for WRONG [↩]
- Emphasis helpfully added by mygoodself [↩]
- As I was writing that sentence I imagined a very Monty Pythonesque voice shrieking “I am not a witch!” [↩]
Step up in basis for nonresident’s assets in irrevocable trust
What “basis” is
One of the continuing mysteries of life involves the concept of “basis”. Think of basis as your acquisition cost. This is essential in calculating your capital gain tax after selling an asset. Capital gain is the difference between the sale price and your acquisition cost. The higher your basis — or acquisition cost — for an asset, the lower your capital gain (and therefore capital gain tax) will be.
Here is an example:
A person bought a piece of land 20 years ago for $100,000, and now it is worth $1,000,000. If that person sells the real estate today, the capital gain would be $900,000 ($1,000,000 received from sale minus $100,000 acquisition cost). Multiply the $900,000 capital gain by the correct tax rate and you have the tax that must be paid in the year of sale.
Basis when you inherit an asset
It is easy to understand “acquisition cost” when you buy something: how much money did it cost? But what about when you inherit something?
In that case, your acquisition cost (or “basis”) is the fair market value of the asset when the previous owner died. (In some instances you can use the value on the date 6 months after the person died). Think of this as if you “bought” the asset at fair market value on the date of death of the person who left you the inheritance.
Again, an example:
A person bought a piece of land 20 years ago for $100,000, and it is worth $1,000,000 when he dies. The person leaves the land to you in his will. You are treated as if you acquired the land at a cost equal to the value of the land on the day of death.
These basis rules are found in Internal Revenue Code Section 1014.
Step up in basis
Wait. There’s a disconnect: $900,000 of taxable capital gain evaporated. You got a fresh start, so if you sell the land for $1,000,000 you will pay zero capital gains tax — because you have zero capital gain. The land is worth $1,000,000 and your acquisition cost (“basis”) is $1,000,000. Yet, if the person who left you the land had sold it a month before he died, there would have been $900,000 of capital gain, and capital gain tax would be imposed. What happened?
The “what happened” is a concept called “step up”. Simply put, if someone owns an asset when he dies, all of the built-in capital gain is eliminated. The deceased person’s basis (acquisition cost) in the asset adjusted upward to the fair market value when he died. This upward adjustment is called “step up” in tax jargon.
The reverse can happen, of course. The adjustment goes to market value on the date of death. Market value can be lower than acquisition cost. It’s been known to happen once or twice.
Inheriting from a nonresident
The same concepts apply when a U.S. taxpayer inherits an asset from a nonresident.
A resident of Saudi Arabia bought a piece of land in Jeddah 20 years ago for $100,000, and it is worth $1,000,000 when he dies. You inherit the land. You are treated as if you acquired the land at a cost equal to the value of the land on the day of death.
The first time I wrestled with this idea, I was boggled. Here was a tax break (the step up in basis) extended by the U.S. government to an asset outside the United States — an asset that had never been subjected to U.S. estate tax. It made sense, I thought, that the step up in basis idea would apply to an asset that passed through the U.S. estate tax gauntlet. If you inherit something and Uncle Sam had the chance to tax it (by imposing a tax on the estate of the deceased person), fairness says you get the new “acquisition cost” or basis in the asset you inherit.
Yet we have the interesting situation that a piece of land outside the United States is now owned by a U.S. person with an acquisition cost equal to the value of the property on the date of death.
Inheriting through a trust from a nonresident
Now we get to the point of this blog post. For a variety of reasons, people use trusts to hold their assets and pass the assets to their heirs. It’s usually simpler than the local Probate Court proceedings, and it gives far greater privacy. Probate is usually a publicly visible process. Trusts can be opaque to the outside world. Trusts are also a useful tool if you want to have outside managers for your assets.
But assets put into a trust are no longer passed to the heirs at death as an inheritance. The “heirs” are beneficiaries of the trust. What they receive (and when they receive it) is governed by what the trust document says.
This means that you cannot rely on the classic “step up in basis” rules I have described above. If an asset is distributed to a beneficiary from a trust, it will have the same acquisition cost (“basis”) as the trust had in the asset. The tax law jargon for this is “carryover basis”.
But that’s not universally true. It is possible for a nonresident to put assets into a trust (thereby avoiding the local probate procedures) and at the same time get step up in basis for the trust beneficiary (the heir) who receives the assets when the nonresident dies. All of this can happen while there is no U.S. estate tax imposed on the assets.
A resident of Hong Kong creates the right kind of trust (I will describe what “right kind of trust” means in a minute). He bought land in Hong Kong 40 years ago for US$100,000, and now it is worth US$1,000,000. He transfers the land in to the trust. A U.S. individual is the beneficiary of the trust. When the Hong Kong resident dies, the terms of the trust instruct the trustee to distribute the land to the beneficiary.
The beneficiary will receive the land from the trust with a stepped up basis of $1,000,000. If the beneficiary immediately sells the land at its fair market value of $1,000,000, he will have zero capital gain because his acquisition cost (basis) is US$1,000,000 and the money received from the sale is US$1,000,000.
Best of both worlds, etc. There is no U.S. estate tax (and no Hong Kong estate tax, for that matter). And there is no U.S. capital gain tax.
What kind of trust will work? A “grantor” trust
So what kind of trust should a nonresident of the United States establish in order to leave assets to a U.S. person at the time of the nonresident’s death? Simple: a “grantor” trust. This is a trust that — according to U.S. tax law — is treated as if the settlor (the person who contributed the assets to the trust) is the owner of all of the trust assets.
The grantor trust rules are in Internal Revenue Code Sections 671 through 679.
There are two kinds of grantor trusts that will work for nonresidents of the United States:
- Revocable. The idea here is that if the settlor can unilaterally take the assets out of the trust at any time, the situation is functionally identical to direct ownership of the assets by the settlor. The assets remain in the trust solely at the settlor’s whim.
- Irrevocable. With an irrevocable trust, the settlor does not have the unilateral power to extract assets from the trust anytime he wants to. But an irrevocable trust can be a grantor trust if the settlor (or settlor plus spouse) is the sole beneficiary during the lifetime of the settlor (or spouse).
A grantor trust can be a “foreign” grantor trust or a domestic grantor trust. We usually refer to domestic grantor trusts as simply being a grantor trust. A “foreign” trust of any type, whether grantor or nongrantor, is a trust that is either governed by a court outside the United States or is controlled (even just a little bit) by someone who is not a U.S. resident or citizen. I will leave the discussion of whether to make your grantor trust “foreign” or domestic for another blog post.
Private Letter Ruling 201245006 – An Irrevocable Trust is Approved
Don’t take my word for it. Read Private Letter Ruling 201245006. Specifically, look at Issue 1, where the use of an irrevocable trust (properly configured to be a grantor trust) was approved. Private Letter Rulings are only applicable to the taxpayer receiving the ruling, yadda yadda.
Internal Revenue Service
Department of the Treasury
Washington, DC 20224
Release Date: 11/9/2012
Index Number: 671.00-00, 1014.00-00
Person To Contact:
Refer Reply To: CC:PSI:B04 _PLR-105239-12
Date: JULY 19, 2012
Company 1 =
Company 2 =
Dear [redacted data]:
This letter responds to your authorized representative’s letter, dated February 2, 2012, requesting a ruling on the application of § 671 and § 1014 of the Internal Revenue Code.
The facts submitted and representations made are as follows:
Taxpayer, a citizen and resident of Country, proposes to transfer assets to Trust, an irrevocable trust subject to the laws of Country. The assets of Trust include cash and stock in Company 1 and Company 2 that are publicly traded in Country and on the New York Stock Exchange. Taxpayer and X, an unrelated party, are Trustees.
Under the terms of Trust, Trustees are to pay all of the income of Trust to Taxpayer during his lifetime and may, in Trustees’ absolute discretion, pay principal of Trust to Taxpayer. Article IV. Upon the death of Taxpayer, any income of Trust and any corpus remaining in Trust are to be paid or transferred to or in trust for one or more of Taxpayer’s issue in such proportions as Taxpayer may appoint by deed or will. In default of appointment, corpus and accumulated income will be held in further trust for the benefit of Taxpayer’s issue. Article V. Trust further provides that during Taxpayer’s lifetime no adverse party within the meaning of § 672(a) is eligible to serve as Trustee. Article XI.
You have requested the following rulings:
1. Following the death of Taxpayer, the basis of the property held in Trust at Taxpayer’s death will be the fair market value of the property at the date of Taxpayer’s death under § 1014(a).
2. Taxpayer will be treated as the owner of Trust for purposes of § 671, such that the items of income, deductions and credits against tax of Trust will be included in computing Grantor’s taxable income and credits against tax.
Section 1014(a)(1) provides that the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent shall, if not sold, exchanged, or otherwise disposed of before the decedent’s death by such person, be the fair market value of the property at the date of the decedent’s death.
Section 1014(b)(1) provides that property acquired by bequest, devise, or inheritance, or by the decedent’s estate from the decedent shall be considered to have been acquired from or to have passed from the decedent for purposes of § 1014(a).
Section 1014(b)(9) provides that, in the case of a decedent dying after December 31, 1953, property acquired from the decedent by reason of death, form of ownership, or other conditions (including property acquired through the exercise or non-exercise of a power of appointment), if by reason thereof the property is required to be included in determining the value of the decedent’s gross estate, shall be considered to have been acquired from or to have passed from the decedent for purposes of § 1014(a).
Section 1014(b)(9)(C) provides that § 1014(b)(9) shall not apply to property described in any other paragraph of § 1014(b).
Section 1.1014-2(b)(2) of the Income Tax Regulations provides, in part, that § 1014(b)(9) property does not include property that is not includible in the decedent’s gross estate, such as property not situated in the United States acquired from a nonresident who is not a citizen of the United States.
In this case, Taxpayer’s issue will acquire, by bequest, devise, or inheritance, assets from Trust at Taxpayer’s death. The assets acquired from Trust are within the description of property acquired from a decedent under § 1014(b)(1). Therefore, Trust will receive a step-up in basis in Trust assets under § 1014(a) determined by the fair market value of the property on the date of Taxpayer’s death. See Rev. Rul. 84-139, 1984-2 C.B. 168 (holding that foreign real property that is inherited by a U.S. citizen from a nonresident alien will receive a step-up in basis under § 1014(a)(1) and 1014(b)(1)). This rule applies to property located outside the United States, as well as to property located inside the United States.
Accordingly, based solely upon the information submitted and the representations made, we conclude that following the death of Taxpayer, the basis of the property held in Trust will be the fair market value of the property at the date of Taxpayer’s death under § 1014(a).
Section 671 provides, in part, that where it is specified in subpart E of subchapter J that the grantor or another person shall be treated as the owner of any portion of a trust, there shall then be included in computing the taxable income and credits of the grantor or the other person those items of income, deductions, and credits against tax of the trust which are attributable to that portion of the trust to the extent that such items would be taken into account under this chapter in computing taxable income or credits against the tax of an individual.
Section 672(f)(1) and § 1.672(f)-1 provide that, as a general rule, the grantor trust rules (§ § 671 through 679) apply only to the extent such application results in an amount (if any) being taken into account (directly or through one or more entities) in computing the income of a citizen or resident of the United States or a domestic corporation. Section 672(f)(2)(A)(ii) and § 1.672(f)-3(b)(1) provide that the general rule does not apply to any portion of a trust if the only amounts distributable from such portion (whether income or corpus) during the lifetime of the grantor are amounts distributable to the grantor or the spouse of the grantor.
Section 677(a)(1) provides that the grantor shall be treated as the owner of any portion of a trust, whether or not he is treated as such owner under § 674, whose income without the approval or consent of any adverse party is, or in the discretion of the grantor or a nonadverse party, or both, may be distributed to the grantor or the grantor’s spouse.
Under the terms of Trust, the trustees are required to pay all Trust income to Taxpayer during his lifetime and the trustees are authorized to pay, in their absolute discretion, any amounts out of the capital of Trust to Taxpayer. In addition, the only distributions that Trust may make during the Taxpayer’s lifetime are to Taxpayer. Thus, § 672(f) will not prevent Taxpayer from being treated as the owner of Trust. Therefore, Taxpayer will be treated as the owner of Trust under § 677(a).
The rulings contained in this letter are based upon information and representations submitted by the taxpayer and accompanied by a penalty of perjury statement executed by an appropriate party. While this office has not verified any of the material submitted in support of the request for rulings, it is subject to verification on examination.
Except as specifically ruled herein, we express no opinion on the federal tax consequences of the proposed transaction under the cited provisions or under any other provisions of the Code.
This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3) provides that it may not be used or cited as precedent.
Leslie H. Finlow
Senior Technician Reviewer, Branch 4
Office of Associate Chief Counsel
(Passthroughs and Special Industries)
Copy for section 6110 purposes
Calculate tax on distributions from foreign trusts using the default method
[Written on December 20, 2011.]
Warning Shots, Pre-Emptive Strikes, and Other Cautions to Internet Scholars
You’d be a damn fool to rely on this as legal advice. I’ve been wrong many times before, and this might be wrong, too. Go hire some smart tax lawyer or tax accountant to figure out what’s going on with your situation. You might be surprised to find you have a foreign trust when you thought you had a domestic trust. Or indeed, the reverse might be true. This subject is hideously complex and what follows is about as deep as stick figures scrawled in the sand with your finger. KTXHBAI.
Let’s say a foreign trust was established decades years ago. It is an irrevocable trust. It contains the usual provisions found in most foreign trusts. A class of beneficiaries is named, and the trustee has discretion in making distributions to the beneficiaries. The trustee has power to add or remove beneficiaries in its discretion.
You know very little about the trust, and accounting records are not accessible. The trust has about a couple of million dollars in it, and there is a single U.S. beneficiary. The trustee intends to terminate the trust and distribute all of the assets to the beneficiary.
The question is simple: if the trust distributes all of its assets to a U.S. beneficiary now, what will be the income tax cost?
The tax rules that apply
A U.S. beneficiary has no U.S. income tax liability until receiving a distribution from the trust.
There are three categories of distributions:
- Distributions of capital. This is tax-free to the beneficiary.
- Distributions of current income. Income earned in the year in which it is distributed is taxed in the routine method that other income is taxed to the beneficiary. Dividends and interest are taxed at ordinary tax rates, and long term capital gain is taxed at a favorable rate.
- Distributions of accumulated income. Income earned in prior years and distributed in the current year will be taxed at ordinary tax rates, to which is added an interest surcharge.
The key to sanity as a tax return preparer is knowing exactly what you have.
Trust accounting records exist
If good trust accounting records exist, that is the procedure to follow in calculating the beneficiary’s U.S. tax obligations for a trust distribution received. Generally, you can see this procedure at work in Form 3520, Part III, Schedule B.
That’s not what we are going to deal with here. We assume that the trustee either does not have adequate accounting records or the trustee refuses to provide the necessary information.
Trust accounting records are lacking
If the trust accounting records are lacking, the Internal Revenue Code has a default method for taxing trust distributions to a U.S. beneficiary from a foreign trust. And the default presumption is that the entire distribution is from the worst possible category: it is a distribution of accumulated income.
Everything is treated as ordinary income–including long term capital gains that were not distributed in the year recognized. Worse yet, an interest charge is imposed on the calculated income tax on the distribution.
This lesson teaches you how to calculate the accumulation distribution tax (and companion interest charge) when you have no trust accounting records to work with.
Step 1: Calculate the Distribution Amount
The first thing to calculate is the amount of the distribution that the U.S. beneficiary received. This is done in Form 3520, Part III. Lines 24 through 28 walk you through the different types of transactions that are considered distributions from trusts.
- Classic distributions of cash or property are listed at Line 24.
- Loans from trusts are treated as distributions. These can be problematic because the loans need not be to the beneficiary–they can be to related persons and still be considered as distributions to the U.S. beneficiary. See Form 3520, Part III, Line 25.
- Use of trust assets without paying for the use (living rent-free in a trust-owned house, for instance) is treated as a loan, hence is deemed to be a trust distribution. See Form 3520, Part III, Line 25.
- Line 27 is the grand total. This is the total amount of trust distributions received by the beneficiary from the foreign nongrantor trust in the tax year.
Step 2: Committing Yourself to the Default Calculation Method
Now that you know the amount of the trust distribution, it is time to compute the income tax due. Here is where the IRS asks you about the quality of the trust accounting. Form 3520, Part III, Line 30 asks you whether you received a Foreign Nongrantor Beneficiary Statement. Think of this like the free-form equivalent to a Schedule K-1 received from a domestic trust.
By assumption we are dealing with the common situation of “no accounting records at all” so the correct answer here is “No.” This commits you to completing Schedule A (Form 3520, Part III, Lines 31 through 38) to calculate character of the trust distribution received. It will either be a distribution of ordinary income or it will be a distribution of accumulated income.
Step 3: How Much is Ordinary Income and How Much is an Accumulation Distribution?
Lines 31 through 38 will take the total calculated on Line 27 and run it through some simple math to determine whether the trust distribution will be treated as a distribution of ordinary income or as a distribution of accumulated income.
- Line 31 asks you to write in the amount you computed on Line 27.
- Line 32 asks about the trust. How long has it been a foreign trust? This can be a simple or complicated question, depending on your facts. A part-year is treated as a full year. The answer will be an integer. Note that the instructions to Form 3520 ask you to show your work. Explain how you came up with your answer.
- Line 33 asks you to report the total amount of distributions received from the trust in the preceding three years. If you are preparing the 2011 income tax return, you report the total of distributions received in 2008, 2009, and 2010.
- Line 34 is simple multiplication. Multiply Line 33 by 1.25. Why? Because the Code says so.
- Line 35 is simply Line 34 divided by three.
- Line 36 is where you compute the ordinary income amount of this year’s distribution. Ordinary income is the amount up to Line 35. In other words, they’re giving you 125% of the prior three years average trust distribution as ordinary income.
- Line 37 is the excess of the distribution received this year (Line 31) over the 125% of average distributions for the prior three years (Line 35). We have some more work to do before this moves over to Form 1040. Stand by.
- Line 38 is an oddly-positioned question. It only becomes useful elsewhere on the form. Take the number of years that the trust has existed as a foreign trust, and divide by two. Keep the remainder. For instance, if the trust has been a foreign trust for 5 years, the answer on Line 38 is 2.5.
Congratulations. You have now determined how much of the trust distribution is ordinary income, and how much is treated as an accumulation distribution.
Step 4: Take the Ordinary Income to Schedule E
The amount you wrote on Form 3520, Part III, Schedule A, Line 36 goes on Form 1040, Schedule E, Line 33.
Step 5: Calculate the Tax on the Accumulation Distribution
If you have an accumulation distribution–that is, Form 3520, Line 37 has a number in it that is greater than zero–then you have to go to Form 4970 and calculate the income tax on that accumulation distribution.
With that in mind, we now turn to the calculation of tax. The calculation is made on Form 4970. Let’s go through Form 4970, line by line.
- Line 1 is the amount you calculated on Form 3520, Line 37. This is the accumulation distribution.
- Line 2 is something you can ignore. It is an artifact of ancient tax history. When the accumulation distribution rules applied to domestic trusts, the Code gave a bit of a break to accumulations that occurred before the beneficiary reached age 21. That break does not apply to accumulation distributions from foreign trusts, so you can put a zero on Line 2.
- Line 3 is simple subtraction.
- Line 4 has a very simple statement in the Instructions to Form 4970. It tells you to look at Internal Revenue Code Section 665(d)(2). Helpful! What Line 4 asks for is the allocable share of foreign taxes paid on the trust distribution.8 The theory here is that if you received a trust distribution net of foreign income taxes paid, what you should really report on your U.S. income tax return is the gross amount of the income (the distribution received plus the allocable foreign income taxes paid) as your income, then you should take a foreign tax credit for the flow-through of foreign income taxes paid. But we are using the default method of calculating tax, because we have no trust accounting records. We do not know how much money the trust paid in foreign income taxes. So put zero on this line.
- Line 5 is addition. You know what to do.
- Line 6 is another situation where you will write in a zero. If you were fortunate enough to know whether a trust distribution contained tax-exempt interest income, you would be putting a number in here. But you don’t have this information, by assumption. Trust accounting records are lacking.
- Line 7 is subtraction.
- Line 8 asks for the number of years in which the amount is deemed to have been distributed. For a foreign trust, this is the total number of years that the trust has been a foreign trust. It is the same number that you wrote on Form 3520, Line 32.
- Line 9 is a division problem. You are computing the annual accumulation distribution over the life of the foreign trust.
- Line 10 is useless to us. This computation is used in Line 11. But Line 11 does not have any special magic for foreign trusts, so the Line 10 result will mean nothing to you. Write the number in. It will make some Revenue Agent happy to see it.
- Line 11 will be the same number as Line 8. The number of years for which the accumulation distribution rules apply is the number of years that the trust has been a foreign trust.
- Line 12 will be the same amount as Line 9. It would be possible to get a different number if this were a domestic trust, but the rules for foreign trusts are unfortunately quite simple.
- Line 13 requires you to get your hands on the trust beneficiary’s income tax returns for the five years preceding the year for which you are doing all of this work. Write in the taxable income for each year.
- Line 14 asks you to toss out the high and low years from Line 13, and write in the taxable income for each of the remaining years. Don’t forget to write the years at the top of the column for Line 14.
- Line 15 is easy. Take the amount from Line 12 and write it in columns (a), (b), and (c).
- Line 16 is an addition problem. The result is what the trust beneficiary’s taxable income would have been if a trust distribution had been made in that year. The total on Line 16 is the taxable income as originally reported, plus the Line 12 amount which is a “pretend” trust distribution.
- Line 17 requires you to get your hands on the Tax Tables or Tax Rate Schedule for the year in question, and recalculate the new income tax based on the Line 16 recomputed taxable income amount.
- Line 18 is the original income tax liability from the year in question.
- Line 19 is the difference between the income tax liability originally reported and the recomputed income tax liability based on the Line 16 income amount. This shows the income tax effect of adding the Line 12 amount into taxable income in the year in question.
- Line 20 requires you to play around with tax credits. Increasing the taxable income for the year may have an effect on allowable tax credits. Because this lesson is all about trust distributions of accumulated income I will cheerfully punt on this line and assume a zero goes here.
- Line 21 is a subtraction problem. You can do it!
- Line 22 is where you play with the alternative minimum tax consequences of increasing the trust beneficiary’s taxable income. Again, I cheerfully glide past this vexing problem because I am talking about accumulation distributions, not the alternative minimum tax.
- Line 23 is an addition problem.
- Line 24 is the sum of Line 23, columns (a), (b), and (c). This is the total additional tax deemed paid over the three years in question because of the accumulation distribution that was deemed received in those three years.
- Line 25 asks you to divide Line 24 by 3. We arrive at the average additional income tax liability attributable to the accumulation distribution.
- Line 26 is where you finally (!) compute the income tax attributable to the accumulation distribution. Multiply Line 25 by the number of years that the foreign trust has been in existence (Line 11) and you get the income tax.
- Line 27 is where you bring back the foreign income taxes paid–the amount you wrote on Line 4. Since we had no trust accounting records (by assumption), we put zero on Line 4. Put zero on Line 27 as well.
- Line 28 is your ending number. This is the tax on the accumulation distribution.
Step 7: Compute Interest on the Accumulation Distribution Tax
You do not report the accumulation distribution tax on Form 1040, despite what the Instructions to Form 4970 say.
Take your calculated number on Line 28 of Form 4970 and go back to Form 3520. We are now going to complete Form 3520, Part III, Schedule C to compute the interest charge on the accumulation distribution tax.
- Form 3520, Line 49 is where you write in the accumulation distribution tax you computed on Form 4970, Line 28.
- Form 3520, Line 50 is the same as Form 3520, Line 12. This is the “applicable number of years” of the trust.
- Form 3520, Line 51 directs you to the Instructions to Form 3520. There you will find a table with two columns. In the left column, find the number you wrote on Form 3520, Line 50. Then take the corresponding number from the right column of that table and write the number on Form 3520, Line 51.
- Form 3520, Line 52 is a multiplication problem. This is the interest charge on the accumulation distribution. This, my friend, is the amount of money the IRS thinks they need to charge you to equalize present value and future value and take the economic incentive away from a trustee to accumulate income inside a foreign trust.
- Form 3520, Line 53 is the grand finale. Add the computed tax (Form 3520, Line 49) to the interest charge (Form 3520, Line 52).
The Line 53 amount goes to Form 1040, Line 60 (Other Taxes). Write “ADT” on the line.
Step 8: Form 4970 attaches to Form 3520; file everything
File everything with the IRS. Form 4970 attaches as a worksheet to Form 3520 to show your work in computing the tax on the accumulation distribution.