Taxation of Foreign Trust Distributions (And Why Congress Hates Them)

Congress Hates Foreign Trusts

Congress hates foreign trusts.¹ We know this because:

• Distributions to U.S. beneficiaries from some foreign trusts (foreign nongrantor trusts, to be precise) can face a tax rate of up to 100%. You receive $100 and must pay $100 in tax? Yes.
• Penalties are staggering if you don't file the right paperwork² on time: 35% of contributions and 35% of distributions not reported.

I like to convert foreign trusts to domestic trusts in order to eliminate these problems. Whenever there are foreign trust distributions, there is paperwork. Beneficiaries of domestic trusts do not have to file the offending forms (eliminating the penalty risk), and do not face the horrific tax cost imposed on distributions.³ In their typical understated way, the IRS calls this "significant penalties."

What Beneficiaries Need to Know

Let's talk mostly about foreign nongrantor trusts. If you are stuck with being a beneficiary of a foreign nongrantor trust, you need to know the answers to two questions:

1. Did I receive a distribution? As a general principle, U.S. beneficiaries of foreign trusts only have a tax paperwork requirement when they receive distributions. No distributions, no paperwork required. No paperwork required, no penalty risk for screwing up paperwork requirements.
2. If I received a distribution, what type of income is it? The answer can range from "not income at all, therefore not taxable" to the previously-mentioned "massively painful" type of income.

Did I Receive a Foreign Trust Distribution?

There are three ways that a beneficiary can receive a distribution from a foreign trust:

• Loans. The trust can make a loan to the beneficiary (or to a person related to the beneficiary).
• Use of Assets. The trust can let the beneficiary use the trust-owned property for free.
• Cash/Property. The trust can distribute cash or assets to the beneficiary.

That last one is stunningly obvious, so let's ignore it. Instead, let's look at the subtle ones.

Loans Are Distributions (Or Not)

On the surface, a loan should not be a distribution. A trust loans money to a beneficiary, and the beneficiary has a legally binding obligation to repay the loan. A distribution is a one-way transfer of money: from a trust to a beneficiary, and the money does not go back into the trust. A loan is a two-way event: money goes out of the trust and back into a trust. So it can't possibly be a distribution, right?

That's not how it works for foreign trusts.

Loans are Distributions

When a foreign trust makes a loan to a U.S. beneficiary, the beneficiary is treated as having received a distribution from the trust. And--almost always--receiving a distribution from a trust means that the recipient has taxable income of some kind.

Except as provided in regulations, if a foreign trust makes a loan of cash or marketable securities . . . directly or indirectly to . . . [a] beneficiary of such trust who is a United States person, or . . . any United States person . . . who is related to such . . . beneficiary, the amount of such loan . . . shall be treated as a distribution by such trust to such . . . beneficiary. . . .⁴

Note the important wiggly bit that can create a problem: you're a beneficiary and the trust loans money to someone related to you? You, not your relative, will have a trust distribution to report and (almost always) an income tax bill to pay because of it.

A person is related to another person if the relationship between such persons would result in a disallowance of losses under section 267 or 707(b). In applying section 267 for purposes of the preceding sentence, section 267(c)(4) shall be applied as if the family of an individual includes the spouses of the members of the family.⁵

The related party rules are always a pleasure⁶ and I will leave this exercise to you. However, related humans are:

• siblings (whether by the whole or half-blood),
• spouses,
• spouses of siblings,
• ancestors,
• spouses of ancestors,
• lineal descendants, or
• spouses of lineal descendants.

There is more to this problem. Check the definition of "beneficiary". It is not as limited as you think it is:

A “beneficiary” includes any person that could possibly benefit (directly or indirectly) from the trust at any time (including any person who could benefit if the trust were amended), whether or not the person is named in the trust instrument as a beneficiary and whether or not the person can receive a distribution from the trust in the current year.⁷

Your foreign trust probably has a clause that allows the trustee (and the protector, if there is one) to add beneficiaries at will. Fair warning.

There are two morals to this story.

Moral the First. Be exceedingly careful whenever a foreign trust makes a loan.

Moral the Second. If you find yourself patting yourself heartily on the back for being clever, you are probably making a grievous error.

When Loans Are Not Distributions

The Lord giveth, the Lord taketh away. Sometimes a loan is treated as a loan.

A loan from a foreign trust that is a "qualified obligation" is treated as a loan and not a distribution from a foreign trust.⁸

A qualified obligation is a loan that satisfies all of the following requirements:⁹

• It is a written agreement;
• The term does not exceed five years;
• The loan is denominated in U.S. dollars;
• The yield to maturity is 100% - 130% of AFR;
• The borrower extends the time for the IRS to audit and assess additional tax until three years after the maturity date; and
• The borrower reports the qualified obligation on Form 3520 every year until paid in full.

Use of Trust-Owned Property

Consider a trust that owns a condominium in Vail, available for use by the beneficiaries.

If the trust is a domestic trust, a U.S. beneficiary can use the property rent-free without tax consequences.

However, if the trust is a foreign trust, a U.S. beneficiary who uses the property rent-free (or pays less than fair market value rent) will be treated as receiving a distribution from the trust. And remember, if you have a distribution from a foreign trust, you probably have taxable income.

Except as provided in regulations, if a foreign trust . . . permits the use of . . . trust property directly or indirectly . . by . . . any . . . beneficiary of such trust who is a United States person, or . . . any United States person . . . who is related to such . . . beneficiary, the . . . fair market value of the use of such property[] shall be treated as a distribution by such trust to such . . . beneficiary.¹⁰

Again, remember the morals drawn from the previous story. A person related to the beneficiary uses the property rent-free? That is a distribution to the beneficiary.

If You Have a Distribution

If a beneficiary of a foreign nongrantor trust receives a distribution, our next job is to decide how the Internal Revenue Code treats that distribution.

Distributions from foreign nongrantor trusts to U.S. beneficiaries are taxed in one of three ways. The key to understanding how this works is to look at the quality of the data available to the IRS.

1. Excellent Data. If the IRS can get actual accounting data from the trust--good enough to calculate the tax attributes of the distribution--then you use the actual calculation method.¹¹ Income keeps its character as capital gain, qualified dividends, etc. Corpus distributions are treated as corpus distributions.
2. Minimal Data. If the IRS gets rough-and-ready data (simply the distribution amounts for the three previous years), you use the default method.¹² The entire distribution is allocated to accumulation distribution, ordinary income, or a combination of the two. This is a rough-and-ready result.
3. No Data. If the IRS gets no data at all, then the worst possible result occurs: it's all accumulated income.¹³

Tax Calculation

This is long enough already. Next time I will talk about how trust distributions are taxed. To get that, subscribe to our newsletter.

What does this mean in dollars? Which method results in the worst tax result? (Hint: I organized them from least bad to worst).

And we'll talk about the why. (Hint: economic incentives at work. Incentives to provide data, incentives to avoid tax deferral strategies).