Calculate tax on distributions from foreign trusts using the default methodDecember 21, 2011 - Phil HodgenTax and Trusts
[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.