U.S. Beneficiaries of Foreign Trusts May Be In for an Unpleasant Surprise This Year by Arthur Dichter, JD
Posted on February 14, 2019
The Tax Cuts and Jobs Act (TCJA) has had broad-reaching impact on all taxpayers for 2018 and going forward. This includes U.S. persons who are beneficiaries of foreign non-grantor trusts.
As a result of the TCJA suspending the deduction for miscellaneous itemized deductions, which includes the deduction for investment management fees, trust distributable net income (DNI) is likely to be higher in 2018 than it was in prior years. Therefore, to avoid accumulation of income and later imposition of the onerous “throwback” tax rules, foreign trusts will likely have to make larger distributions (before March 6, 2019) to their U.S. beneficiaries to clear out all 2018 DNI. This will result in more taxable income and higher tax liabilities for the U.S. beneficiaries on their personal income tax returns. Finally, if a trust has insufficient cash available to pay those larger distributions (since it used the cash to pay those non-deductible investment management fees), it may have to sell assets to generate cash, which could result in an unexpected increase in DNI for 2019. This cycle could continue until 2026, when miscellaneous itemized deductions may be reinstated or indefinitely if the miscellaneous itemized deductions are not reinstated.
Let’s take a step back and review how we got here.
Every trust is presumed to be a foreign trust unless it meets both the court test and the control test. A trust meets the first test if a court within the U.S. is able to exercise primary supervision over the administration of the trust. A trust meets the control test if one or more U.S. persons have the authority to control all substantial decisions of the trust with no other person having the power to veto any of the substantial decisions. In other words, if one foreign person has authority to make one substantial decision, the control test is not met, and the trust is a foreign trust.
A foreign trust will be considered a grantor trust if either (i) the trust is revocable and, upon revocation, the assets re-vest in the settlor, or (ii) during the lifetime of the settlor and the settlor’s spouse, the only beneficiaries of the trust are the settlor and/or the settlor’s spouse.
A grantor trust is essentially disregarded for income tax purposes. The grantor or owner of the trust, usually the Settlor or other person making contributions to the trust, will be considered the owner of the trust and that person will continue to be subject to U.S. income tax on the income derived by the trust. A non-grantor trust is a separate taxpayer.
U.S. Income Taxation during a Settlor’s Life
Distributions made from a foreign grantor trust to a U.S. beneficiary during the lifetime of the settlor are typically considered gifts to the beneficiary from the settlor. The U.S. beneficiary has an obligation to file IRS Form 3520 to report receipt of any and all distributions from a foreign trust, even if the amount is just $1. Should the trust make a distribution to the settlor, who then makes a gift to a U.S. beneficiary, the beneficiary must file IRS Form 3520 only when the aggregate value of all such gifts exceeded $100,000 during the year.
While both of these circumstances subject U.S. beneficiaries to reporting obligations, they do not expose beneficiaries to U.S. income tax on the gifts/distributions they receive. On the other hand, when a corporation or partnership owned by a foreign grantor trust or its settlor makes a “gift” to U.S. beneficiaries, the IRS may recharacterize the transfer as a taxable dividend to the U.S. recipient. Furthermore, when gifts came from a foreign corporation or partnership owned by the trust or the settlor in 2018, the reporting threshold for Form 3520 is only $16,076. For this reason, direct transfers from a foreign corporation or partnership to a U.S. beneficiary should be avoided.
U.S. Income Taxation after a Settlor’s Death
A trust that was a grantor trust during the settlor’s life will be considered a foreign non-grantor trust for U.S. income tax purposes upon the settlor’s death. In additional to being reportable on Form 3520, any distributions to a U.S. beneficiary after that point are subject to U.S. income tax to the extent that the foreign non-grantor trust has current or accumulated income.
Distribution of a non-grantor trust’s current DNI to a U.S. beneficiary is taxable to the beneficiary and the character of that income generally flows through from the trust. Therefore, distributions attributable to the trust’s qualified dividend income or long-term capital gain entitles the beneficiaries to a reduced U.S. tax rate of 20 percent plus the 3.6 percent net investment income tax (NIIT). On the other hand, distributable net income that is not distributed in the same year becomes accumulated (undistributed) net income (UNI). Distributions of UNI are subject to a complicated set of “throwback tax” rules which allocate the UNI over the amount of time the trust has been in existence and imposes income tax, plus an interest charge, as if the income had been distributed pro rata over the accumulation period. The tax rate may be as high as 39.6%, plus NIIT and the interest charge may be substantial depending on the length of time that the trust has been in existence.
The trustee of the foreign trust typically provides an annual Foreign Non-Grantor Trust Beneficiary Statement to help beneficiaries understand and apply the appropriate U.S. tax treatment to the distributions they receive from foreign non-grantor trusts.
Impact of TCJA
Trusts are generally treated like individuals for tax purposes. For example, under the TCJA, a foreign trust that files a U.S. income tax return because it has income from a U.S. business, will face a top tax rate of 37 percent, reduced from 39.6 percent, on taxable income in excess of $12,500. At the same time, the TCJA reduces or eliminates many of the deductions to which trusts were previously entitled, including a new $10,000 limit on the deduction for state and local income taxes.
More importantly, the new tax law’s suspension of miscellaneous itemized deductions is likely to have a dramatic impact on the U.S. tax liability of U.S. beneficiaries of foreign trusts. These items, including tax-preparation fees, investment-management fees and unreimbursed business expenses, are no longer deductible for purposes of computing a trust’s DNI for 2018. The good news, however, is that expenses paid in the administration of an estate or a trust and that would not have been incurred if the property were not held in such estate or trust and that were not subject to the 2 percent adjusted gross income (AGI) limitation under prior law and are still fully deductible to the trust. This includes trustee fees and accounting, legal, and tax-return preparation fees to the extent such fees would not have otherwise been incurred by an individual.
In order to avoid the accumulation of income and the application of the throwback tax in future years, many foreign trusts will distribute all their DNI on an annual basis. Since it is difficult to compute a trust’s income for the year prior to the last day of the year, Section 663(b) of the tax code allows a trustee of a foreign trust to annually elect to treat a distribution in one year as though it was made on the last day of the prior year, as long as the distribution is made within the first 65 days of that next year. Thus, a calendar-year trust can make a distribution on or before March 6, 2019, to clear out all of its DNI from 2018 as long as it files its election with the IRS on or before June 15, 2019.
In order to make the 663(b) distribution on or before that 65th day, the trustee may find that they do not have sufficient cash on hand because they used the cash to pay those investment management fees. In that case, they may decide to sell assets which would potentially create additional gain that would be included in DNI for that year and the cycle starts all over again.
If you are a trustee of a foreign trust, you might consider starting the DNI computation process a little earlier this year to make sure that there is sufficient time to generate the cash needed to make the 663(b) distribution. If you are the beneficiary of a foreign trust, you might want to communicate with the trustee to make sure they are aware of these new rules.
The advisors and accountants with Berkowitz Pollack Brant work with settlors, trustees and beneficiaries of foreign trusts to help them understand and comply with U.S. tax and reporting obligations and to compute DNI and UNI.
About the Author: Arthur Dichter, JD, is a director of International Tax Services with Berkowitz Pollack Brant, where he works with multi-national businesses and high-net worth foreign individuals to structure their assets and build wealth in compliance with U.S. and foreign income, estate and gift tax laws. He can be reached at the CPA firm’s Miami office at (305) 379-7000 or via email at firstname.lastname@example.org.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.