United States: How To Manage Foreign Trusts With U.S. Beneficiaries

Last Updated: November 23 2017
Article by Rahul P. Ranadive

Do you or did you have a wealthy relative from a different country? Did that relative make you a beneficiary of a non-U.S. trust? Lucky you. But beware that free wealth.

If you get cash or other benefits from a foreign trust, you should be aware of the special tax rules which apply to the non-U.S. trust and your beneficial interest in it. Non-U.S. trusts with U.S. beneficiaries are subject to an extra layer of special rules and complexities which you will need to manage with your tax professional to ensure you avoid the potentially punitive tax rules. It is important to remember these rules apply whether you are a beneficiary of a fixed income trust (meaning the beneficiaries must get a certain fixed amount per year), or a discretionary trust (meaning the trustees have the absolute discretion to distribute some income, all income, or no income at all). Generally, if a non-U.S. trust does not distribute all of its net income and accumulates some or all net income over the years, care must be taken in applying the accumulation distribution rules and navigating the interest surcharge, which can be very punitive.

Congress made a policy decision to make it much less advantageous for a U.S. person to be a beneficiary of a non-U.S. trust rather than a U.S. trust. Primarily, the accumulation distributions and interest surcharge, if not managed properly, can result in tax and interest of up to 100 percent of an ill-timed and ill-planned accumulation distribution, sometimes from a transaction which the trustee and the U.S. beneficiary may not have realized is treated as a distribution for U.S. tax purposes. Further, the penalties for not complying with the special information reporting rules applicable to non-U.S. trusts and their U.S. beneficiaries are very steep, in the range of 25 to 35 percent. Beneficiaries of U.S. trusts do not face the punitive tax consequences of the accumulation distribution rules and interest surcharge, and are not required to file the extra information reporting forms required of non-U.S. trust. Accordingly, many practitioners advise domestication or decanting of a non-U.S. trust into a U.S. trust to avoid the special rules.

If the non-U.S. non-grantor trust of which you are a U.S. beneficiary cannot be domesticated or decanted into a U.S. trust, you will need to know the following to determine your tax and information reporting obligations:

  1. Did the trust distribute anything to me? Picture me making "air-quotes" as I say distribute. Why am I air-quoting the word distribute? Because the IRS thinks a lot more things are treated as distributions than you might think. See below for the full description. Generally, you will have tax and information reporting obligations only if you receive something from the trust. If you don't receive anything from the trust (at least anything the IRS calls a distribution), then you don't have any tax or information reporting obligations, nor any penalties for non-compliance with such obligations.
  1. If you did receive a distribution from the trust, you (or your friendly, neighborhood Spiderman, er, accountant) must determine what type of income it is and how it gets reported on your tax return and separate information returns. Depending on how well the trustee has managed the trust's annual net income in the past, you could have tax-free income, or income subject to the special accumulation distributions and interest surcharge rules which can result in very harsh tax consequences.

What does the IRS call a distribution? A lot more than you would think. Besides receiving cash or property from the trust, the IRS says you received a distribution from a non-U.S. trust if either of the following happen:

  1. The trust makes a loan to you, or someone related to you, which is not a qualified obligation; or,
  2. The trust lets you, or someone related to you, use property owned by the trust at no charge or for less than fair market value.

There's a lot of loaded language in there before you get to an actual tax. What's the definition of a loan? Who is related to you?

You would think a loan can't be a distribution because the beneficiary has to pay the trust back, right? Or does s/he? If the beneficiary really has to pay the money back to the trust within a certain amount of time at a reasonable interest rate, that's probably a qualified obligation. If under market interest is charged, or no actual regular payments are made during the life of the loan, or if the beneficiary has a "wink-wink" from the trustee that the loan might be forgiven in the future, that might be a distribution upon receipt.

To satisfy the IRS that the foreign trust's loan to the U.S. beneficiary is a qualified obligation, the following requirements must be satisfied:

  • The parties enter into a written agreement documenting the loan and its terms;
  • No more than five years for the term of the loan;
  • The loan is expressed in U.S. dollars;
  • The stated interest rate is within an acceptable percentage range of the applicable AFR in effect for the month in which the loan begins;
  • The U.S. beneficiary allows the IRS to audit and assess tax for three years after the loan's maturity date; and
  • The U.S. beneficiary files Form 3520 for every year any portion of the loan is outstanding.

An unexpected way a U.S. beneficiary recognizes income is by indirectly or directly using the foreign trust's property without paying adequate rent, or letting a U.S. person related to such U.S. beneficiary use such property for less than adequate rent. What's adequate rent? Generally, the fair market rental value of the property if it were rented on the open market. Anything less than that could be treated as a distribution to the U.S. beneficiary of the foreign trust.

Who's a related party? To keep things simple, think your spouse, any of your closest relatives (brothers/sisters, parents/grandparents, kids/grandkids), and any of their spouses.

So, what's the solution if you are a U.S. beneficiary or a foreign trust to reduce the chances of being subject to the harsh accumulation distribution and interest surcharge rules? The trustee should be vigilant to review the character and source of income generated by the foreign trust and how such income is being managed on a year-to-year basis. Generally, the trustee should, and the U.S. beneficiaries will prefer to, see what's called DNI (distributable net income) being distributed out to the U.S. beneficiaries during each year so the foreign trust does not have large accumulations piling up over the years. But obviously, each trust and each family has different circumstances and sometimes you may not be able to do that. In which case, the trustee should engage in some long-range forecasting to figure out the optimal amounts and timings of distributions and accumulations per year to minimize the negative consequences of the accumulation distribution tax and the interest surcharge.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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