Distributions from foreign grantor trusts and U.S. paperworkNovember 8, 2013 - Phil HodgenTax and Trusts
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. ((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.))
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. ((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.))
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. ((Section 6048(d)(1).))
“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. ((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.)) 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. ((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.))
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. ((Section 6677(a)(2).)) 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). ((Section 6048(c)(2)(A).))
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. ((See, 2012 Instructions for Form 3520, page 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. ((The recipient reports this gift–if it is more than $100,000 in a single year–on Form 3520 in Part IV.))
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.