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.
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:
The trustee does not give the daughter a Foreign Nongrantor Trust Beneficiary Statement. (Important assumption! In fact this is the normal state of affairs for foreign trusts — paperwork is sorely lacking.)
We are going to prepare her 2015 U.S. income tax return.
A U.S. beneficiary of a foreign trust is taxed in one of two ways:
You are stuck with the default method if the Trustee does not give you the Foreign Nongrantor Trust Beneficiary Statement on time, or if — in any previous year — you used the default method.
I will now explore how the $10,000 distribution received on January 2, 2015 by the daughter will be taxed.
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 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:
For your reading pleasure, Notice 97-34, Section 5.B says:
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.
Here is what it looks like. Remember:
We are preparing the daughter’s 2015 income tax return.
Here is what Form 3520 looks like, filled in.
Look at that. Line 36, through the application of mechanical rules written on a piece of paper, tells us that $10,000 received from trust capital on January 2, 2015 will be treated as $10,000 of taxable income.
You will take this amount and transfer it to Schedule E. From Schedule E it will flow onto the 2015 Form 1040 at Line 17 to be added to income.
The moral of this story is that foreign trusts can be dangerous anti-alchemy devices when U.S. beneficiaries are involved. Gold is transformed into lead.
Insert it here. Not advice. Don’t rely on it. Seek competent professional advice.
See you in a couple of weeks.