October 30, 2013 - Phil Hodgen

Chapter 8 – Taxation of Nongrantor Trust Interests

Covered Expatriates who are beneficiaries of nongrantor trusts face another tax problem.  Beneficial interests in nongrantor trusts are subjected to the exit tax.  Generally, you face 30% withholding as distributions are made, but you can elect to be taxed in a lump sum.

Section 1.  Nongrantor Trust Interests

The mark-to-market rules do not apply to an interest in a nongrantor trust. A Covered Expatriate who is a beneficiary of such a trust will be subjected to taxation under special rules.

Nongrantor Trust

A nongrantor trust is any trust where the Covered Expatriate is not the owner under the normal grantor trust rules. If your parents created a trust for your benefit, the beneficial interest in that trust will be subjected to the special exit tax rules.

Who is a Beneficiary?

In order for these tax rules to apply, the Covered Expatriate must be a beneficiary of the nongrantor trust on the day before the expatriation date. This means one of three things:

  • The trust document or local law says that the Covered Expatriate can get a distribution of principal or income;
  • The Covered Expatriate has the power to distribute trust assets to himself or herself; or
  • The trust could distribute principal or income to the Covered Expatriate if it terminated.

Section 2.  Taxation

Look at a nongrantor trust when it makes distributions to the Covered Expatriate. Calculate the taxable portion of that distribution. What is principal? How much is income?

Tax at 30%

The trustee must withhold 30% of the taxable portion of the trust distribution as it is made. This continues even after the Covered Expatriate is long gone from the United States.

The principal in the trust is not taxed if and when it is distributed to a Covered Expatriate who is a beneficiary of the trust.

Choose Lump Sum Tax

Alternately, the Covered Expatriate can elect to swallow the medicine immediately at expatriation. This requires applying for a Private Letter Ruling.

Thereafter, however, the 30% tax rules do not apply, and if there are income tax treaty provisions that apply to the distributions, the Covered Expatriate can use them.