In general, the tax rules involving trusts are very complicated. That is because there are many different types of trusts — and depending on the specific type of trust, there may be complex tax rules at play. For example, when dealing with foreign trusts, there is an initial concern about the tax implications in the country where the trust was formed and/or where it is legally obligated to report. Then, taxpayers next have to determine if a US person is considered an owner, trustee, or beneficiary of the foreign trust. If so, the next issue is to evaluate whether or not the foreign trust is a grantor trust or non-grantor trust — and if any income is associated with the trust that could become subject to US tax. Let’s focus for the moment on a US beneficiary of a foreign non-grantor trust.
A US person is originally from a foreign country in which one of their wealthy relatives created a foreign non-grantor trust to protect their foreign assets. The US person is named as one of the beneficiaries of the foreign trust and receives distributions from the trust. The question for US tax purposes is whether or not the beneficiary of the trust has to pay tax on the income distributions he received from the foreign non-grantor trust.
With a grantor trust, the grantor is still considered the owner of the trust for tax purposes — and any income of the trust is attributed to the grantor. Conversely, with a non-grantor trust, the initial settlor is no longer the owner of the trust, and therefore it is the trust/beneficiaries who receive the distributions that are required to pay tax on the income. This can come as a shock to many US beneficiaries of a foreign trust, because when they were residing overseas, they may have not been taxed at all on the income — since different countries operate differently when it comes to trust income and many countries have their own set of exceptions, exclusions, and limitations for taxing beneficiaries under a particular trust scheme.
When a US beneficiary receives a distribution from a foreign trust, it is reported on the individual’s own personal Form 1040 tax return. In a perfect world, the foreign trust will provide the US beneficiary with a K-1 or equivalent so that the taxpayer can report the income properly (and avoid various penalty situations in which the lack of a Foreign Non-Grantor Trust Beneficiary Statement can impact how the income is treated for US tax purposes). The US beneficiary of a foreign non-grantor trust will also have to contend with the throwback rule and difference between DNI and UNI in their US tax return.
In addition to the tax implications of being a beneficiary of a foreign trust, the beneficiary must also file a Form 3520 in any year they receive a trust distribution. If they are considered an owner of the trust, more detailed Form 3520 and 3520-A requirements may be necessary.
Once a taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist that specializes exclusively in these types of offshore disclosure matters.
In recent years, the IRS has increased the level of scrutiny for certain Streamlined Procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead of the Streamlined Procedures. But, if a willful taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties.
