It's essential that practitioners know not only the fundamentals of U.S. federal income taxation of foreign non-grantor trusts and their beneficiaries, but also the ways to plan around the “throwback tax” that's imposed on distributions of accumulated income to the U.S. beneficiaries of these trusts. Of course, if you can't avoid the throwback tax, you're going to have to know how to calculate it. And advisors must be aware of the U.S. tax reporting requirements related to foreign non-grantor trusts.

The Rules

If a trust is classified as a non-grantor trust, it's a separate taxpayer that falls under the taxation regime of Subchapter J of the Internal Revenue Code. (These rules contrast to those applicable to a “grantor trust,” which is essentially ignored for income-tax purposes, because its income is taxed to the trust's grantor as the income is realized each year. See “Grantor vs. Non-Grantor Trust,” p. 54.)

In general, a non-grantor trust is taxed on its taxable income (TI), and the beneficiaries are taxed on their share of the trust's distributable net income (DNI) that is distributed to them. A non-grantor trust's DNI is generally the trust's TI for the year, taking into account statutory adjustments set forth in IRC Section 643.

With a foreign non-grantor trust, any DNI that is not distributed in the year in which it's realized will carry forward as undistributed net income (UNI) into the next year.

In a year when the trustee of a non-grantor trust makes distributions to the trust's beneficiaries, the trust is allowed a deduction against its current year's net income for such distributions, to the extent of the current year's DNI.1 The beneficiaries, in turn, must include in their income for the year that portion of the distributed amount that is DNI.2 If the distribution exceeds the trust's DNI for the year, the excess will first be considered a distribution of UNI from previous years, and if the trust has no UNI, then the excess is considered a distribution of trust principal. Distributions of trust principal are not included as income to the beneficiary.

If the non-grantor trust is foreign, a distribution of UNI to U.S. beneficiaries also is subject to the throwback tax, imposed on the recipient beneficiaries.

Allowing a deduction to the trust for distributions and requiring income inclusion for the beneficiaries is based on the concept that a non-grantor trust should be taxed on income that it receives and retains in a taxable year, but distributions of income to a beneficiary should carry that income out of the trust, to be taxed in the hands of the beneficiary.

In the context of U.S. trusts, the income tax rates for individuals historically were higher than those rates applicable to trusts. Thus, there was an incentive for high-income earners to transfer income-producing assets to a trust, and for the trust to accumulate the income and pay tax at its lower rates.

In the context of foreign non-grantor trusts, an even more attractive incentive existed for accumulating income within the trust: Foreign non-grantor trusts are generally not taxable in the United States (that is, they are taxed only on U.S. source income.) This provided an opportunity for deferral of U.S. tax until a distribution was made to the trust's U.S. beneficiaries.

To preclude the reduction of tax (in the case of a U.S. trust) or the deferral of tax (in the case of a foreign trust), the throwback rules were added to the IRC. These rules were designed to capture the incremental amount of tax that would have been paid if income had been distributed (and taxed) to the beneficiary in the years in which it was originally earned. To accomplish this goal, the throwback rules impose an interest charge upon the regular income tax that the beneficiary pays on the distribution. This interest charge is compounded over the length of time that the income accumulated in the trust. As an additional punitive measure, the throwback rules strip capital gains of their favorable tax character if they are accumulated and then distributed as UNI.

Clearly, this throwback regime made it less attractive to retain income within a trust for long periods of time.

Over the years, the tax rates applicable to U.S. trusts have increased so that trusts currently are taxed at higher rates than individuals. This now creates an incentive to distribute income to the beneficiaries each year rather than retain it in the trust, or to deliberately structure trusts as grantor trusts so that the income is taxed each year to the trust's grantor at his lower individual rates. Because there is no longer an incentive to accumulate income in domestic trusts, the throwback tax has been repealed for nearly all domestic non-grantor trusts.

But with foreign non-grantor trusts, there remains a key tax-deferral incentive for the trust to retain income rather than distribute it to its U.S. beneficiaries: These trusts are outside the U.S. tax system. Thus, the throwback tax continues to apply to distributions of UNI from foreign non-grantor trusts to U.S. beneficiaries.

Once a foreign non-grantor trust has UNI, the UNI remains in the trust until it's distributed. If the UNI is distributed to U.S. beneficiaries, it's subject to throwback tax in the hands of those U.S. beneficiaries.3 Furthermore, because the throwback tax consists of an interest charge that is compounded over the length of time that the UNI accumulated in the trust, the longer the distribution of UNI is deferred, the larger the total tax becomes.

In addition to the fact that UNI cannot be eliminated from a trust other than by a distribution, a distribution in excess of the trust's current-year DNI (referred to as an “accumulation distribution”) is subject to a “tiering” rule, which “forces” UNI out of the trust. The tiering rule dictates that, after all of the current year's DNI is distributed, the accumulation distribution will be deemed to consist first of UNI. Thereafter, to the extent that the distribution exceeds UNI, it's considered a distribution of trust principal.4

Avoiding UNI

Clearly, the trustee of a foreign non-grantor trust that has U.S. beneficiaries wants to minimize the accumulation of UNI within the trust. There are three primary ways to meet this goal:

  1. Invest trust assets in tax-exempt bonds

    Because DNI is a subset of taxable income, tax-exempt income will not generate DNI, and therefore it will not accumulate as UNI. However, tax-exempt bonds don't usually provide a satisfactory investment return, and this return may not outstrip inflation.

  2. Adopt a buy-and-hold investment strategy

    Capital gains are included in a foreign trust's DNI only when they are realized; therefore, simply holding appreciating assets will not generate DNI. However, it's important to mention that the throwback rules will strip realized capital gains of their favorable lower tax rate if the gains are not distributed in the year of realization. Like tax-exempt bonds, a buy-and-hold strategy may not provide satisfactory investment returns or keep up with inflation.

  3. Invest trust assets in private placement life insurance

    Life insurance is a superior DNI/UNI blocker because the following items are not considered taxable income (and hence, are not DNI): (a) income and investment returns within the policy; (b) death benefit proceeds; (c) withdrawals of premium up to basis (if the policy is structured as a non-modified endowment contract (non-MEC)); and (d) policy loans (if structured as a non-MEC.) Because income and investment returns within the policy are not taxable, the policy assets can be invested more aggressively than a tax-exempt or buy-and-hold portfolio. The result should be superior returns. Add to the attraction the fact that no taxes are deducted from the policy's investments, creating minimal drag on the investments.

Delaying UNI Distributions

Because of the interest charge imposed as part of the throwback tax, which compounds with each year that passes, it could be argued that it's better to distribute any UNI as soon as possible so as to reduce the overall U.S. tax. Nonetheless, there are ways to delay the distribution of UNI if the trustee so desires. To effectuate this goal, the trustee could:

  • invest the trust assets in a life insurance policy that is structured as a non-MEC, take loans from the non-MEC policy, and re-lend the proceeds to the beneficiaries under promissory notes that meet the U.S. qualified obligation rules;

  • invest the trust assets in a life insurance policy that is structured as a modified endowment contract (a MEC), which will allow the trustee to generate DNI (through withdrawals from the MEC) when needed to make distributions to the U.S. beneficiaries; or

  • structure the trust's distribution scheme so that certain distributions fall within explicit exceptions under the IRC to the basic trust-deduction/beneficiary-inclusion rules.

Let's examine these options:

  • Option 1: Non-MEC loans to beneficiaries

    A loan from a life insurance policy will not generate any income to the trust because it's an obligation that the trust must pay back to the policy. Because a policy loan does not generate DNI, a distribution of the loan proceeds to the U.S. beneficiaries will carry out UNI to those beneficiaries under the tiering rule if the distribution exceeds the trust's DNI. If, instead, the trust were to lend (rather than distribute) the funds to the U.S. beneficiaries, no distribution of UNI would occur. To prevent the loan from being treated as a distribution to the beneficiary, the promissory note that the U.S. beneficiary gives to the trust in exchange for the cash received must be structured as a “qualified obligation.”

    A promissory note will be treated as a qualified obligation only if it meets six requirements:

    1. The obligation is reduced to writing by an express written agreement.
    2. The term of the obligation does not exceed five years and is actually repaid within the five-year term.
    3. All payments on the obligation are denominated in U.S. dollars.
    4. The yield to maturity is not less than 100 percent of the applicable federal rate (AFR) and not more than 130 percent of the AFR in effect on the day that the obligation is issued.
    5. The U.S. taxpayer (here, the U.S. beneficiary) extends the period for assessment of any income or transfer tax attributable to the transfer and any consequential income tax changes for each year that the obligation is outstanding to a date not earlier than three years after the maturity date of the obligation.
    6. The U.S. taxpayer (the U.S. beneficiary) reports the status of the obligation, including principal and interest payments, on Form 3520 for every year that the loan is outstanding.5

    Two benefits of this option are: the policy loans will not generate DNI within the trust, and will therefore not increase the trust's already existing UNI; and the currently low AFRs will provide an opportunity for the beneficiaries to achieve a greater return on the cash proceeds of the loan than the interest rate that they'd have to pay to the trust.

    A downside is that the cash proceeds of the loan will be available to the beneficiary for only a short term (five years).

  • Option 2: MEC withdrawals to generate DNI for distributions

    If a trust purchases a life insurance policy structured as a MEC, withdrawals from the MEC policy will be considered ordinary income (that is to say, DNI) in the year of withdrawal.6 Accordingly, if the trust makes a distribution to the U.S. beneficiaries equal to the amount of a MEC withdrawal, the distribution will not be considered an accumulation distribution because it would not exceed that year's DNI. (See “MEC Withdrawals,” p. 56.)7

  • Option 3: Distributions that do not carry out DNI or UNI

    A final option to avoid the current distribution of UNI could be to structure the trust's distribution scheme so that certain types of distributions will not carry out UNI to the U.S. beneficiaries, even if they exceed DNI. In this regard, the IRC and Treasury regulations set forth two types of distributions that are explicit exceptions to the definition of “accumulation distributions”: specific gifts and mandatory income distributions.8

A specific gift is a gift or bequest of a specific sum of money or specific property that is paid all at once, or in no more than three installments. Specific gifts do not carry out income, whether DNI or UNI, to the beneficiary. The amount of money or the identity of the specific property must be ascertainable under the terms of the trust as of the date of the trust's inception. Specific gifts do not include:

  1. amounts that can be paid or credited only from income (whether current or accumulated);
  2. an annuity, or periodic gifts of specific property in lieu of, or having the effect of, an annuity; or
  3. trust principal.9

Although specific gifts are not subject to income tax in the hands of the beneficiary, the amount of the DNI and the UNI in the trust will remain constant and will not be reduced by the distributed amount. In other words, the trust is not allowed an income deduction for distributions of specific gifts and the beneficiary is not required to include specific gifts in income. Therefore, the distribution of a specific gift will defer only the recognition of the tax — it will not reduce either DNI or UNI at the trust level.10 In fact, the trust's UNI would actually be increased if the trust generated DNI in the year of the specific gift and the DNI is not distributed on top of the specific gift.

This method of avoiding the distribution of UNI is not an option for existing trusts because it requires the specific gifts to be identified at the trust's inception. It's also unlikely that this exception could be used in successor trusts to the original trust, because the IRS would likely regard the date of the initial trust as the date when the specific gifts must have been identified.

Like specific gifts, mandatory income distributions will not carry out UNI to the beneficiaries, even if they exceed DNI.11 To understand how this works, it's important to know that a trust's income can exceed its DNI. This is because “income” for trust-accounting purposes may include items of income that are not included in DNI for federal tax purposes. Also, some expenses may be deducted against DNI for federal tax purposes but are allocable to principal for trust-accounting purposes (therefore reducing DNI but not trust-accounting income.)

Under basic trust and beneficiary taxation rules, the trust is allowed a deduction (limited by the amount of DNI) for mandatory income distributions, and the beneficiary is required to include that amount of DNI in his or her income. But to the extent that the mandatory income distribution exceeds DNI, there is no deduction at the trust level and no inclusion at the beneficiary's level for the excess amounts distributed, and the trust's UNI will remain at its present amount.)12 (See “Look Under the Hood,” p. 58)

Although these options are ways to provide distributions to the beneficiaries without carrying out UNI from the trust, it's important to remember that the already existing UNI will remain constant in the trust until it's distributed. In short, these options only delay the distribution of UNI, and as each year passes with UNI sitting in the trust, the interest charge imposed as part of the throwback tax will get larger and larger.13 Therefore, in making a decision about whether, and to what extent, any of the options should be used, the trustee may want to quantify and compare the tax costs of cleaning out the trust's UNI through accumulation distributions versus further delaying the distribution of UNI.14

Tax Reporting

To avoid penalties, it's critical that both the U.S. beneficiaries and the foreign trustee of a foreign non-grantor trust comply with U.S. reporting requirements:

  • Beneficiary: Form 3520

    A U.S. beneficiary of a foreign trust must file Form 3520 (“Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts”) to provide information to the Internal Revenue Service regarding any distributions received from the foreign trust during the tax year. Failure to provide adequate information to the IRS regarding any distributions received may result in unfavorable tax treatment of the distribution. The beneficiary can avoid unfavorable treatment by obtaining a “Foreign Non-Grantor Trust Beneficiary Statement” from the trustee and attaching it to the Form 3520. Form 3520 is due on the date that the beneficiary's income tax return is due, and that date is extended automatically when the beneficiary's return is extended.

    The penalty for failure to file Form 3520 is equal to 35 percent of the amount of the distribution. Also, if the beneficiary receives a failure-to-file notice from the IRS and does not file the form within 90 days of such notice, an additional penalty of $10,000 will be imposed for each 30-day period thereafter that the beneficiary fails to file the form.15

  • Beneficiary: Form 4970

    A U.S. beneficiary of a foreign non-grantor trust who receives a distribution that consists of UNI must calculate the throwback tax on Form 4970 (“Tax on Accumulation Distribution of Trusts”) and attach it to his Form 3520.

  • Trustee: “Foreign Non-Grantor Trust Beneficiary Statement.”

    The trustee of a foreign non-grantor trust should, but is not required to, provide a “Foreign Non-Grantor Trust Beneficiary Statement” to any U.S. beneficiary who received a distribution from the trust during the year so that the beneficiary may attach the statement to his Form 3520. The information to be included in a Foreign Non-Grantor Trust Beneficiary Statement is set forth in the instructions to Form 3520 and includes (in general terms):

    1. Basic identifying information about the trust, such as the trust's name, address, and taxpayer identification number.
    2. The first and last day of the trust's tax year to which the statement applies.
    3. A description of the property (including cash) and the fair market value of any non-cash property distributed to the beneficiary.
    4. An explanation of the appropriate U.S. tax treatment of any distributions.
    5. A statement identifying whether any grantor of the trust is a partnership or corporation.
    6. A statement that the trustee will permit either the IRS or the U.S. beneficiary to inspect and copy the trust's books, records, and any other documents that are necessary to establish the appropriate treatment of any distribution for U.S. tax purposes (however, if the trustee has appointed a U.S. tax agent, then this statement is not necessary.)
    7. A statement as to whether the trustee has appointed a U.S. agent, and the name, address, and taxpayer identification number of such agent.
  • Trustee: Appointment of U.S. Agent

    If the trustee of a foreign non-grantor trust wishes to issue a Foreign Non-Grantor Trust Beneficiary Statement to a U.S. beneficiary who receives a distribution, the trustee may want to authorize a U.S. person to act as the trust's agent for the limited purposes of applying Code Sections 7602, 7603, and 7604 (relating to the examination of records and the service and enforcement of a summons for the examination of such records.) This will avoid the sixth requirement above that the trustee allow the IRS or the U.S. beneficiary to inspect the trust's records for U.S. tax purposes. If the trustee wishes to appoint a U.S. tax agent, the agent must be appointed under an agreement substantially in the form of the sample agency agreement set forth in the instructions to Form 3520-A (“Annual Information Return of Foreign Trust With a U.S. Owner”). In addition, the name, address, and tax ID number of the U.S. agent must be set forth on the Foreign Non-Grantor Trust Beneficiary Statement.

  • Trustee: Form 2848

    Occasionally, a foreign trustee will want to authorize a U.S. attorney or certified public accountant to communicate directly with the IRS on the trustee's behalf. If so, the foreign trustee will file a Form 2848 (“Power of Attorney and Declaration of Representative”) with the Philadelphia Accounts Management Center authorizing the attorney or certified public accountant to represent the trustee for the specific tax matters set forth in the form.

  • Trustee: Form 1040NR

    The trustee of a foreign non-grantor trust that has U.S. source income must file a Form 1040NR (“U.S. Nonresident Alien Income Tax Return”) if the U.S. tax attributable to such income was not withheld by the payor. Because Form 1040NR is designed to report income attributable to nonresident individuals, as opposed to nonresident trusts, the trustee must make appropriate adjustments on the form.16 Form 1040NR generally must be filed by June 15 each year (or by April 15, if the trust has a U.S. office.) The penalty for failure to file the Form 1040NR is generally imposed as 5 percent of the amount of tax required to be shown on the return for each month or partial month during which such failure continues (usually up to a maximum penalty of 25 percent of the tax due.)17

Calculating the Throwback Tax

If UNI can't be avoided, practitioners should understand how the throwback tax is calculated on distributions to U.S. beneficiaries. To do this, it's important to begin with the basic rule that trust beneficiaries are taxed on trust distributions only to the extent of their share of the trust's DNI (or UNI). The DNI of all non-grantor trusts (whether foreign or domestic) is equal to the trust's taxable income, with the following adjustments:

  1. no deduction is taken for the personal exemption18 or for distributions to beneficiaries;19 and
  2. the trust's tax-exempt income (which was excluded from the trust's gross income) is included in DNI.20

Also, unlike a U.S. non-grantor trust, a foreign non-grantor trust's DNI includes:

  1. realized capital gains;21
  2. income from non-U.S. sources reduced by certain deductions allocable to tax-exempt income;22 and
  3. certain amounts that were excluded from the trust's gross income by treaty.23

The close connection between a trust's DNI and the beneficiary's tax liability on distributions is evident in the tax rules that set forth the trust beneficiary's gross income inclusions. With certain exceptions, a U.S. beneficiary of a foreign non-grantor trust must include these amounts in his gross income for any particular year:

  1. the amount of trust income required to be distributed (whether or not actually distributed) from a simple trust,24 to the extent of the beneficiary's share of DNI;25
  2. the amount of trust income required to be distributed (whether or not actually distributed) from a complex trust,26 to the extent of the beneficiary's share of DNI;27 and
  3. any other amounts actually paid, credited, or required to be distributed from a complex trust, to the extent of the beneficiary's share of DNI.28

Note that the beneficiary must include in his gross income only the amounts that are either “required to be distributed” or “actually distributed” to him. Therefore, the beneficiary of a purely discretionary trust will include none of the trust's income in his gross income — unless the trustee actually makes a distribution.29 These actual distributions may be subject to the throwback tax if they consist of UNI.

A distribution that exceeds DNI from a trust with UNI is referred to as an “accumulation distribution.”30 When an accumulation distribution consisting of UNI is made, the distribution is allocated to the trust's prior years (beginning with the earliest year) in which UNI existed in the trust,31 which is simply the DNI for such year that was not actually distributed.32 The UNI is then taxed to the beneficiary under a rather complicated calculation to arrive at the beneficiary's throwback tax. The very general steps for this calculation are:

  • Step 1 — Determine the accumulation distribution. An accumulation distribution occurs when the amount distributed exceeds the trust's DNI for that year. Under the tiering rule, the amount of the distribution that exceeds the trust's DNI is deemed to consist first of UNI until all of the UNI is distributed.33

  • Step 2 — Allocate the accumulation distribution. The accumulation distribution determined under Step 1 must be allocated (or thrown back) to the preceding years of the trust in which there is any UNI (starting with the earliest year.) If the amount of the accumulation distribution exceeds the UNI for the earliest year, the excess is allocated to the next year for which there is UNI. This process is repeated until all of the current year's accumulation distribution has been allocated to a preceding year.34

  • Step 3 — Add taxes paid. Add to the amount determined under Step 2 for each preceding year the taxes that were paid by the trust in that year.35 These taxes include U.S. income taxes as well as foreign income, war profits, and excess profits taxes.36

  • Step 4 — Determine the number of years of deemed distributions. Next, determine the number of preceding taxable years in which a distribution is deemed to have been made under Step 2.37 If any one year's UNI that was deemed to be distributed under Step 2 is less than 25 percent of the total amount of the accumulation distribution (Step 1) divided by the number of preceding taxable years to which the accumulation distribution is allocated (Step 2), that year will not be included.38

  • Step 5 — Identify the computation years. The beneficiary's “computation years” are those three of the beneficiary's five immediately preceding taxable years remaining after eliminating the years in which his income was the highest and the lowest.39

  • Step 6 — Determine the average annual distribution amount. To do so, divide the amount deemed distributed (Steps 2 and 3) by the number of preceding years in which the distribution is deemed to have been made (under Step 4.)40

  • Step 7 — Determine the tax increase in the computation years. Determine the amount by which the beneficiary's income tax would have increased in each of the three computation years (identified under Step 5) if the average annual distribution amount (Step 6) had been added to his taxable income in each of those years.41 If any foreign income, war profits, or excess profits taxes were added (in Step 3) to the amount deemed to have been distributed, the amount of these taxes may be allowed as a credit against the increase in tax calculated in this step.42

  • In determining the beneficiary's tax increase under this step, you must treat all amounts deemed distributed (other than tax-exempt income) as ordinary income.43 This is contrary to the general rule that trust income distributed to a beneficiary retains its character in the hands of the beneficiary.44 The result is that the beneficiary will not receive the benefit of lower rates applicable to certain types of income, such as capital gains.

  • Step 8 — Determine the average tax increase. Determine the average tax increase by dividing the sum of the three increases (determined under Step 7) by three.45

  • Step 9 — Multiply the average tax increase by the number of deemed distribution years. Multiply the average tax increase (Step 8) by the number of preceding taxable years in which the distribution is deemed to have been made (Step 4).46

  • Step 10 — Determine the throwback tax. Subtract any U.S. income taxes that were added in Step 3 from the product obtained in Step 9. The result is the amount of the beneficiary's throwback tax.47

  • Step 11 — Calculate interest. Finally, the beneficiary must pay interest on the throwback tax. The interest rate charged will be the floating rates applied to underpayments of tax. This underpayment rate is equal to the federal short-term rate (determined quarterly) plus 3.48 Interest is compounded daily and is calculated over a specially calculated, “dollar-weighted” number of years. The effect of determining the interest over a dollar-weighted number of years is to treat an accumulation distribution as having come proportionately from each year (rather than from the earliest years) in which there was UNI. The dollar-weighted number of years is calculated as follows:49

    • Step 11 A — Multiply the UNI for each year by the number of years between that year and the year of the distribution (counting that year, but not the distribution year.)
    • Step 11 B — Add all products calculated in Step 11 A.
    • Step 11 C — The sum of products calculated in Step 11 B must be divided by the aggregate amount of the trust's UNI. Round this quotient to the nearest half-year. This is the number of years over which the beneficiary will calculate his interest on the throwback tax.

The interest charge will be calculated over the dollar-weighted number of years ending on the “applicable date,” and using the underpayment rate in effect from time to time over that period. The applicable date is either June 30 of the year in which the accumulation distribution was made, or if the beneficiary received only one accumulation distribution in a year, he may use the date of the distribution.50

Being faced with a foreign non-grantor trust can be rather daunting to most trusts-and-estates professionals due to the complexity of the throwback rules and the U.S. tax reporting for such trusts. However, the number of foreign non-grantor trusts with U.S. beneficiaries is increasing in recent years as the grantors of older foreign trusts are beginning to pass away. Therefore, it is important for U.S. advisors to become familiar with the taxation and tax reporting for these trusts, and with the unique planning opportunities they present.

Endnotes

  1. Internal Revenue Code Section 661(a).
  2. IRC Section 662(a).
  3. If, however, the trust properly distributes all of its undistributed net income (UNI) to beneficiaries who are non-U.S. taxpayers, then the trust could be cleansed of UNI without the UNI ever being subject to the throwback tax. This fact might lead to the conclusion that the non-U.S. beneficiaries could receive a distribution of UNI and then hand it over to the U.S. beneficiaries as a “gift.” However, this loophole has been tightly closed. See IRC Section 643(h).
  4. Treasury Regulations Section 1.665(a)-0A(2).
  5. See the instructions to Form 3520.
  6. IRC Sections 72(e)(10) and 72(e)(2)(B).
  7. Treas. Regs. Section 1.665(b)-1A(d), Examples 1-3.
  8. Treas. Regs. Section 1.665(b)-1A(c).
  9. Treas. Regs. Section 1.663(a)-1(b).
  10. Treas. Regs. Section 1.665(a)-1A(c).
  11. Treas. Regs. Section 1.665(b)-1A(c)(3).
  12. This also applies in the case of distributions of income that are excluded from the trust's federal gross income (such as a life insurance death benefit.) Because such income is excluded from federal gross income, the trust may not take a deduction for that portion of the distribution, and the beneficiary will likewise exclude it from his gross income. IRC Section 661(c).
  13. If the interest calculation period includes any years before 1996, the interest rate applicable to that period will be 6 percent (simple, not compounded), and for 1996 and after, interest will be compounded daily using the federal underpayment rate in effect from time to time over the applicable period. IRC Section 668(a)(6).
  14. Assumptions would need to be made regarding the performance of the trust's investments over time, as well as the future interest charge that will eventually be payable as part of the throwback tax. Additionally, the drawdown of cash value by making withdrawals from a modified endowment contract (MEC) and the imposition of the 10 percent early-withdrawal penalty on beneficiaries under age 59 1/2 would have to be taken into account when quantifying whether the performance (and future value) of the trust's investments will exceed the throwback tax interest charge.
  15. The penalties for failure to file may not exceed the gross amount of distributions received from the trust. IRC Section 6677.
  16. See the instructions to Form 1040NR. Several years ago, the Internal Revenue Service was reportedly developing a new form (Form 1041NR) to be used by foreign trusts for tax reporting purposes; however, the IRS is no longer considering developing such a form.
  17. IRC Section 6651(a)(1).
  18. IRC Sections 643(a)(2) and 642(b).
  19. IRC Sections 643(a)(1), 651 and 661.
  20. IRC Sections 643(a)(5) and 103.
  21. IRC Section 643(a)(6)(C).
  22. IRC Sections 643(a)(6)(A) and 265(a)(1).
  23. IRC Sections 643(a)(6)(B) and Section 894.
  24. A simple trust is a non-grantor trust that: (i) has a mandatory distribution requirement; (ii) is not permitted to make payments to charity; and (iii) makes no principal distributions in the applicable year.
  25. IRC Section 652.
  26. A complex trust is a non-grantor trust that is not characterized as a simple trust.
  27. IRC Section 662(a)(1).
  28. IRC Section 662(a)(2).
  29. If, however, the trust owns stock in a controlled foreign corporation (CFC), a foreign personal holding company (FPHC) or a passive foreign investment company (PFIC), the beneficiary may be required to recognize income currently, whether or not he actually receives a distribution. See Elyse G. Kirschner, “When Foreign Trusts Own Foreign Companies,” Trusts & Estates, April 2008, at p. 44.
  30. IRC Section 665(b); see Step 1. An accumulation distribution generally does not include amounts accumulated before the beneficiary's birth or before the beneficiary reaches the age of 21, but this exception does not apply to foreign trusts. IRC Section 665(b).
  31. IRC Section 666(a); see Step 2. If the trust's records are not sufficient to establish which years have UNI, the accumulation distribution will be allocated to the earliest year in which the trust was in existence. IRC Section 666(d).
  32. UNI is not reduced for taxes paid by the trust on the UNI — in other words, the gross amount is treated as a distribution. IRC Section 666(b) and (c); see Step 3.
  33. Treas. Regs. Section 1.665(a)-0A(2).
  34. Each portion of the accumulation distribution allocated to a preceding year is deemed to have been distributed on the last day of that year. IRC Section 666(a).
  35. IRC Section 666(b) and (c).
  36. IRC Section 665(d). Special rules apply if the beneficiary has received distributions from more than two trusts that are deemed to have been distributed on the last day of the same preceding taxable year. IRC Section 667(c).
  37. IRC Section 667(b)(1)(A).
  38. IRC Section 667(b)(3).
  39. IRC Section 667(b)(1)(B).
  40. IRC Section 667(b)(1)(C).
  41. Ibid. For purposes of adding the accumulated income to a beneficiary's computation years, the beneficiary's income cannot be less than zero. Therefore, if the beneficiary sustained a loss in any of those years, then his taxable income to which the amount in Step 6 is added will be deemed to be zero. IRC Section 667(b)(2).
  42. IRC Section 667(d).
  43. IRC Section 667(a); Committee Report on Public Law 94-455 (Tax Reform Act of 1976).
  44. IRC Section 662(b).
  45. IRC Section 667(b)(1)(D).
  46. IRC Section 667(b).
  47. Ibid.
  48. The underpayment rate for the first quarter of 2008, for instance, is 7 percent. Revenue Ruling 2007-68, Internal Revenue Bulletin 2007-52, Dec. 26, 2007.
  49. See the instructions to Internal Revenue Form 3520 (2006).
  50. If the beneficiary uses June 30 as the applicable date, he may use a chart provided in the instructions to Form 3520 to calculate the interest charge. If the beneficiary uses the date of distribution, then he must calculate the interest charge using the underpayment rates in effect from time to time over the dollar-weighted period of years. The beneficiary should calculate the interest charge using both methods to determine which method is desirable. The tax and interest is calculated on Internal Revenue Form 4970 and attached to Form 3520.

Amy P. Jetel is an associate in the Austin, Texas, law firm of Giordani Schurig Beckett Tackett LLP

Grantor vs. Non-Grantor Trust

How a trust is classified as one or the other under U.S. tax rules

It matters greatly for tax purposes whether a trust is considered a grantor or non-grantor trust.

To determine which a trust is, the Internal Revenue Code and the Treasury regulations use some terminology and concepts that can seem confusing. The essential terms to understand are a trust's “grantor” and a trust's “owner.” A trust's grantor is the person who transferred (or who is deemed to have transferred) assets to a trust, and a trust's “owner” is the person (if any) who is treated as “owning” the trust's assets for income-tax purposes.

Under the IRC and Treasury regs, a trust's grantor will not always be treated as its owner, and vice versa. Nonetheless, if a trust is treated as having an owner (whether it's the grantor or someone else), then it's called a “grantor trust,” and if a trust does not have an owner, it's called a “non-grantor trust.”

The key tax consequence of grantor trust status is that the owner must include the trust's income on his income tax return and pay tax on that income as it's realized each year — regardless of whether such income is distributed. Because the income realized within a grantor trust is taxed currently to the owner, the beneficiaries of a grantor trust are not taxed on trust distributions.

In contrast, a non-grantor trust has no owner and is thus treated as a separate taxpayer. To the extent that the trustee does not currently distribute income realized within the trust, the trust itself reports and pays tax on that income. And to the extent that the trustee of a non-grantor trust does make distributions to the trust's beneficiaries, each beneficiary must report, and pay tax on, his pro rata share of income received (or carried out) from the trust.

GRANTOR TRUST

To determine whether a trust will be classified as a grantor trust, it is necessary to first place the trust into one of the following four categories:

  1. a domestic trust created by a U.S. grantor;
  2. a foreign trust created by a U.S. grantor that does not have (and can never have) U.S. beneficiaries;
  3. a foreign trust created by a U.S. grantor that has (or could ever have) U.S. beneficiaries; or
  4. a foreign or domestic trust created by a non-U.S. grantor.

Each of these categories gives rise to a separate classification analysis under the grantor-trust rules.

For a trust in category (1) or category (2) to be treated as a grantor trust, the U.S. grantor must retain certain controls over, or rights in, the trust assets (for example, the right to revoke the trust or the power to control beneficial enjoyment of the trust property.)1

As for trusts in category (3), the U.S. grantor will always be treated as the trust's owner, regardless of whether he retains any controls over, or rights in, the trust.2

Finally, the non-U.S. grantor of a trust in category (4) will be treated as the trust's owner only if: (a) the grantor retains the right to re-vest trust assets in himself, or (b) the only amounts distributable from the trust are distributable to the grantor or his spouse.3

In addition, there are two ways in which someone other than the grantor will be treated as a trust's “owner” under the grantor trust rules:

  • The power of the other person to vest the trust assets in himself.4 The first way that a person other than the grantor can be treated as a trust's owner applies only if the trust's grantor is not already treated as the trust's owner. If this is the case and a person who is not the grantor holds the unrestrained power to vest the trust property in himself (whether he exercises that power or not), then that other person will be treated as the trust's owner. This rule can cause the “other person” to be treated as the trust's owner only if he is a U.S. person because a foreign person cannot be treated as a trust's owner unless he retains, as “grantor,” specific powers (that is to say, the power to re-vest trust assets, or a sole beneficial interest in the trust.)5

  • The exercise of a general power of appointment in favor of a grantor trust.6 The second way that a person other than the original grantor can be treated as a trust's owner is if that other person holds a general power of appointment over the trust property (that is to say, the power to vest trust assets in anyone, including himself, his estate, his creditors, or the creditors of his estate) and then exercises that power in favor of another trust. In this case, the “other person” will be treated as the new grantor of the second trust (regardless of whether the original grantor is still treated as the owner of the first trust.) Then, the other person, as the grantor of the new trust, also can be treated as the owner of that trust if the second trust meets the grantor-trust requirements with respect to that other person — for example, if the second trust is a category (1) trust and the new grantor has the right to revoke the trust. Under these rules, a foreign person can be considered the owner of the second trust if it meets the requirements of a category (4) trust.

NON-GRANTOR TRUST

In general, a trust that does not meet any of the grantor trust requirements (or one that ceases to do so) will be considered a non-grantor trust. In particular, it's important to note that a grantor trust will become a non-grantor trust upon the death of the trust's owner, unless one of the rules applies that causes “someone other than the grantor” to be the new owner of the trust.

Endnotes

  1. Internal Revenue Code Sections 671-678.
  2. IRC Section 679.
  3. IRC Section 672(f).
  4. IRC Section 678.
  5. IRC Section 672(f).
  6. Treasury Regulations Section 1.671-2(e)(5).
    — Amy P. Jetel

MEC Withdrawals

How to generate DNI

If the trust makes a distribution to the U.S. beneficiaries equal to the amount of a withdrawal from a modified endowment contract (MEC), the distribution won't be considered an “accumulation distribution,” because it wouldn't exceed that year's distributable net income (DNI).

TOTAL DISTRIBUTION* $100
LESS INCOME REQUIRED TO BE DISTRIBUTED (SECTION 661(A)(1)) $0
OTHER AMOUNTS DISTRIBUTED (SECTION 661(A)(2)) $100
DNI (ORDINARY INCOME FROM MEC) $100
LESS INCOME REQUIRED TO BE DISTRIBUTED (SECTION 661(A)(1)) $0
BALANCE OF DNI $100
OTHER AMOUNTS DISTRIBUTED (SECTION 661(A)(2)) $100
LESS BALANCE OF DNI $100
ACCUMULATION DISTRIBUTION $0
* Note: This example applies the methodology set forth in the Treasury regulations.
— Amy P. Jetel

Look Under the Hood

Here's how mandatory income distributions work

NO ACCUMULATION DISTRIBUTION

If a trust has $100 of “income” for trust-accounting purposes but no distributable net income (DNI) for federal-tax purposes, and the trust has a mandatory income distribution standard, then the calculation of accumulation distributions is:

TOTAL DISTRIBUTION* $100
LESS INCOME REQUIRED TO BE DISTRIBUTED (IRC SECTION 661(A)(1)) $100
OTHER AMOUNTS DISTRIBUTED (SECTION 661(A)(2)) $0
DNI $0
LESS INCOME REQUIRED TO BE DISTRIBUTED (SECTION 661(A)(1)) $100
BALANCE OF DNI $0
OTHER AMOUNTS DISTRIBUTED (SECTION 661(A)(2)) $0
LESS BALANCE OF DNI $0
ACCUMULATION DISTRIBUTION $0

ACCUMULATION DISTRIBUTION

If a trust has no trust-accounting income and no DNI, and/or if the trust has a purely discretionary distribution standard, then the calculation of accumulation distributions is:

TOTAL DISTRIBUTION $100
LESS INCOME REQUIRED TO BE DISTRIBUTED (SECTION 661(A)(1)) $0
OTHER AMOUNTS DISTRIBUTED (SECTION 661(A)(2)) $100
DNI $0
LESS INCOME REQUIRED TO BE DISTRIBUTED (SECTION 661(A)(1)) $0
BALANCE OF DNI $0
OTHER AMOUNTS DISTRIBUTED (SECTION 661(A)(2)) $100
LESS BALANCE OF DNI $0
ACCUMULATION DISTRIBUTION $100
Note: These examples apply the methodology set forth in the Treasury Regulations Section 1.665(b)-1A(d), Examples 1-3.
— Amy P. Jetel