US Tax Compliance for Foreign Trusts: A Primer

Tax | Ladidas Lumpkins | Apr 18, 2019

A threshold question in determining how a trust will be taxed in the US is whether the trust is foreign or domestic. The default rule is that a trust is foreign, unless the trust fails both the “Court Test” and the “Control Test.” The Court Test is met if a US court is able to exercise primary supervision over the administration of the trust. The “Control Test” is satisfied if one or more US persons have the authority to control all substantial decisions of the trust.

Once established that a trust is a foreign trust, the US taxation of the foreign trust depends on whether the trust is a grantor trust or a non-grantor trust. If the foreign trust is a grantor trust, then the settlor is treated as the owner, and she must report her portion of the income on her US income tax return. The trustee of a foreign grantor trust must file Form 3520- A, Annual Information Return of Foreign Trust with a US Owner.

If the trust is a not a grantor trust, then it pays tax only on certain US-sourced income.

If a distribution is made to a US beneficiary from a foreign non-grantor trust, the trustee must provide the beneficiary with a statement that enables her to determine the appropriate US tax treatment of the distribution. If the trustee fails to provide this statement, the beneficiary may inadvertently elect the default tax treatment whereby the harsh “throwback rules” would apply. These rules impose higher tax rates and penalties on certain distributions from foreign trusts.

The US beneficiary of a foreign trust must report distributions from a foreign non-grantor trust on Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts. Furthermore, if the trust is a “Specified Foreign Financial Asset”, the US beneficiary may also be required to file Form 8938, Statement of Specified Foreign Financial Assets.

The US tax and reporting rules are complex, and non-compliance can result in severe penalties.

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