In my previous post, I discussed some of the relevant U.S. federal tax implications to consider when a foreign individual is giving cash to a U.S. individual. This discussion assumed that the gift came directly from the foreign person (ie from a financial account owned directly by the foreign person). What happens if a U.S. beneficiary receives a distribution from a foreign trust created by a foreign individual instead of a gift directly from a foreign individual?
The starting point is to determine whether the offshore trust is classified as a grantor trust or a nongrantor trust for US federal income tax purposes. Generally, a trust is considered to be a grantor trust for a foreign person (ie the foreign “grantor”).) under certain circumstances, namely:
- The foreign benefactor has the option to revoke the trust or otherwise has the authority to absolutely revoke ownership of the trust assets in himself (i.e. the grantor has the right and the ability to get the trust assets back) . or
- The only distributions that can be made from the trust during the life of the foreign fellow are distributions to the foreign fellow or the spouse of the foreign fellow (with limited exceptions).
An escrow meeting that passes either of these two tests is considered a grantor trust for the foreign grantor, and the foreign grantor is considered to be the owner of the trust’s assets for US federal income tax purposes. This means that the trust is not itself a taxpayer, but rather that the foreign financier is treated as if he were directly earning the income generated by the trust. A trust that does not qualify as a grantor trust in whole or in part by the preceding tests is a nongrantor trust with respect to the alien, and the trust itself is considered a taxpayer for US federal income tax purposes.
The distinction between Grantor and Nongrantor Trust has a significant impact on US beneficiaries who receive distributions from a foreign trust. Note that this discussion assumes that the trust is a “foreign” trust for US federal tax purposes. In the case of a distribution from a grantor trust, the distribution is generally considered to be a gift from the foreign grantor that would not be subject to US federal income tax in the hands of the beneficiary. However, the alleged gift rules would still apply if the distribution was made from a bank account of a foreign company of the foreign trust rather than from a financial account of the trust. Additionally, in the event of a revocable trust, the foreign funder may be subject to US federal tax on the distribution depending on the assets distributed.
The rules for a foreign nongrantor trust are more complex. When a US beneficiary receives a distribution from a non-grantor overseas trust, a number of ordering rules generally apply to determine what is included in the US beneficiary’s gross income. First, a distribution includes amounts earned during the current year (commonly referred to as net distributable income, or “DNI”). The amount of tax imposed on the current year DNI is determined based on the underlying nature of the income (i.e. ordinary income, capital gain or tax exempt). However, if a foreign trust makes a distribution to a U.S. beneficiary in excess of DNI in one year, the amounts accumulated from previous years (commonly referred to as undistributed net) will be distributed next from the trust income or ” UNIVERSITY”). In this situation the distribution could be subject to a complex set of rules known as “fallback tax” or “accumulation distribution” rules.
In short, these rules result in normal income tax treatment for the U.S. beneficiary, accompanied by an interest charge to account for the prior deferral received due to the accumulation of income by the foreign trust. Due to the amount of UNI in a trust and the associated interest expense, the application of the fallback tax rules may result in tax and interest expense equal to the total amount distributed. Because of the foregoing, it is generally not possible for a US beneficiary to receive a tax-free capital distribution from the trust until all UNIs in the trust have been distributed.
The rules for the fallback tax can sometimes be minimized by making what is known as a “65 day election”. With this choice, distributions made within the first 65 days of a calendar year are treated as if they had been made on the last day of the previous year. In setting up the foreign non-grantee trust, using the 65-day option can have the practical effect of eliminating UNI that would otherwise have arisen if the trust had not distributed all of the previous year’s DNI. Therefore, by the beginning of 2021, practitioners should know the upcoming distribution deadline within the first 65 days of that year.
Whether the U.S. beneficiary receives a non-taxable distribution from an overseas grantor trust or a taxable distribution from an overseas nongrantor trust, such distribution must be reported to the IRS on a timely filed Form 3520. In contrast to gifts received directly from a foreign person, reporting distributions from foreign trusts is usually more time-consuming and requires a beneficiary declaration, which is attached to Form 3520. If not all relevant information is included in the beneficiary declaration, this can in certain cases lead to taxation according to the rules for the fallback tax. Accordingly, compliance in this area is of paramount importance to minimize penalties.
The treatment of overseas trust distributions to US beneficiaries is a complex area of US tax law. Even simple compliance or administrative errors can lead to undesirable tax results. Accordingly, caution should be exercised prior to distributions and the advice of a qualified US tax advisor should be sought.
 It is important to note that the term “grantor” as defined in US financial regulations includes anyone who has established a trust or any person who has made a transfer of property to a trust free of charge. However, in order to be treated as the “owner” of the trust’s assets, a person must have transferred ownership of the trust free of charge (that is, the person must have given the trust a gift). Accordingly, the term “grantor” in this post refers to the person who not only created the trust but also financed it.
 In the case of a US grantor, the rules for the grantor trust are much broader, which means that a trust can be classified much more like a grantor trust in relation to the US grantor.
 A full discussion of what makes a trust a “foreign” trust and related planning considerations will be the subject of a future post.
 With such structures, it is not uncommon for the foreign trust not to have a separate bank account. Accordingly, practitioners should proceed with caution and confirm the source of funds prior to distribution. It is also advisable to ensure that you have an up-to-date organizational chart.
 For a discussion of the relevant US federal tax impact on gift taxes, see my previous post.