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How foreign trusts transform gold into lead
Phil Hodgen
Attorney, Principal
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Hi from Phil Hodgen.This is the Friday Edition, a biweekly international tax update. You signed up, but if you want to stop receiving it, just click the Unsubscribe link at the bottom. On the other hand, if you want more of the emails we send out, go take a look at hodgen.com/lists.
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I want to give you a quick example of how foreign trusts can create appalling tax results for U.S. beneficiaries. My example shows you how we can convert nontaxable cash gifts into taxable income by using a trust.Warning: this is for tax nerds only.Facts
Nonresident Dad puts $100,000 into a foreign nongrantor trust on December 30, 2014. The only beneficiary is his U.S. citizen daughter.There are two distributions made by the trustee:- $10,000 is distributed to the daughter on December 31, 2014; and
- $10,000 is distributed to the daughter on January 2, 2015.
How U.S. beneficiaries are taxed
A U.S. beneficiary of a foreign trust is taxed in one of two ways:- Diligent Trustee. If the trustee prepares and delivers the right kind of paperwork to the U.S. beneficiary, then income is taxed in the way specified in that paperwork. Capital gains are treated as capital gains, interest as interest, etc. etc. This paperwork is called a Foreign Nongrantor Trust Beneficiary Statement. See Notice 97-34 to get the full details on what this statement contains.
- Slack Trustee. If the trustee does not deliver the Foreign Nongrantor Trust Beneficiary Statement to the beneficiary, then the beneficary calculates the tax on the distribution received according to a formula. Let's call this the "default method".
Common sense
Common sense tells us that the $10,000 distributed to the daughter on January 2, 2015 -- three days after the trust was established -- should be treated as a nontaxable distribution of capital. The trust did not have time to earn any income.Common sense fails when it meets the default method.The default method
The reason the default method applies is because IRC § 6048(c)(2) says that all distributions from foreign nongrantor trusts to U.S. beneficiaries will be taxed as accumulation distributions unless the IRS specifies otherwise.The IRS specified otherwise in Notice 97-34, Section 5.B, which gives a short-cut method:- Look at the distributions in the three prior years.
- Do a bit of simple math. You end up with a number.
- Anything above that number is taxed as an accumulation distribution and anything below that number is taxed as ordinary income.
If a U.S. beneficiary cannot obtain such a beneficiary statement from the trust, it is expected that Form 3520 will allow the U.S. beneficiary to avoid treating the entire amount as an accumulation distribution if the U.S. beneficiary can provide certain information regarding actual distributions from the trust for the prior three years. Under this “default treatment,” the U.S. beneficiary will be allowed to treat a portion of the distribution as a distribution of current income based on the average of distributions from the prior three years, with only the excess amount of the distribution treated as an accumulation distribution (and therefore subject to the interest charge of section 668). Form 3520 will describe this default treatment option in greater detail.For the nitty-gritty of how it works, we have to go line-by-line through Form 3520. It won't take long, and what you will see is that the $10,000 of non-taxable capital distributed to the U.S. citizen daughter will turn into $10,000 of taxable income to her.
Form 3520, Part III, Schedule A
Here is what it looks like. Remember:- December 30, 2014: Dad created the trust;
- December 31, 2014: The trustee distributed $10,000 to the U.S. citizen daughter; and
- January 2, 2015: The trustee distributed $10,000 to the U.S. citizen daughter.
Line by line
- Line 31. This is where we report the $10,000 distribution received on January 2, 2015.
- Line 32. This is where we tell the IRS how many years the trust has been a foreign trust. The instructions to Form 3520 tell us that one day = one year, so the trust has been a foreign trust for two years: 2014 and 2015.
- Line 33. This is the beginning of the simple math. It is an averaging calculation looking back at distributions received in prior years. You go back three years, unless there are fewer than three years of history of the trust. In our case (preparing the 2015 tax return) there is only one year of history for the trust, so we write down the amount of the distribution received in 2014, which is the $10,000 distribution received by the daughter on December 31, 2014.
- Line 34. Multiply by 1.25. Easy. $12,500.
- Line 35. Divide Line 34 by 3, or a smaller number if the trust has been in existence for fewer than three years. In our case, the divisor is 1. The result we get is $12,500.
- Line 36. The amount treated as ordinary income is anything received in 2015 under $12,500. Since the daughter received only $10,000 in 2015, we put $10,000 here.
- Line 37. Simple subtraction to see if more than $12,500 was distributed to the daughter in 2015. The answer is "No," so we put zero here.
- Line 38. This is unimportant for our purposes here.