Who controls the foreign trust?

If you’ve established that the legal arrangement is a foreign trust for U.S. tax purposes, you should also evaluate the extent to which a U.S. person retains decision-making authority over the foreign trust. A U.S. person’s authority over a foreign trust can significantly alter how the trust should be treated. For example, the level of decision-making authority a U.S. person has over the trust will factor into whether the income of the trust should be taxed currently to U.S. beneficiaries or when distributed to the U.S. beneficiaries. If you’re working with a U.S. tax advisor, they may want to discuss the trust’s administration with the trustee to evaluate the level of decision-making authority U.S. persons retain over the trust’s administration.

What assets does the foreign trust own?

U.S. income tax and reporting requirements for foreign trusts and their U.S. beneficiaries can vary depending on the types of assets that are owned by the foreign trust. Most foreign trusts with U.S. beneficiaries should expect that the U.S. beneficiary or the foreign trust will be required to file Form 3520 and Form 3520-A. The specific reporting requirements will vary depending on the specifics of the foreign trust and whether the foreign trust is controlled by U.S. persons. In addition to Forms 3520 and 3520-A, U.S. beneficiaries may be required to report the assets held within the foreign trust in the following international information returns. Reporting additional international information Foreign financial asset reporting U.S. beneficiaries may be required to include the assets of the foreign trust in their U.S. FBAR (FinCEN Form 114) or Form 8938 – Statement of Specified Foreign Financial Assets. Passive foreign investment companies U.S. beneficiaries often find that investments of the foreign trust, especially mutual fund investments, are subject to the Passive Foreign Investment Company (PFIC) regime. The U.S. beneficiary may be required to file Form 8621 – Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund with their income tax return and additional income taxation rules may apply. Foreign partnerships If the foreign trust has invested in a foreign partnership, the U.S. beneficiary may be required to file Form 8865 – Return of U.S. Persons with Respect to Certain Foreign Partnerships. Foreign corporations If the foreign trust has invested in a foreign corporation, they may also be required to file Form 5471 – Information Return of U.S. Persons with Respect to Certain Foreign Corporations or Form 926 – Return by a U.S. Transferor of Property to a Foreign Corporation. Importance of tax analysis Understanding how a type of entity is classified under U.S. tax principles — such as, a foreign corporation or foreign partnership — is important. Similar to above where a legal arrangement is found to be either a U.S. trust or a foreign trust, the type of entity must be determined under U.S. tax law Any local country tax characterization will usually be irrelevant to making this determination. Completing the required U.S. tax analysis of the trust and its investments can be time consuming and the consequence of errors could be high. Many of the informational forms noted above have $10,000 plus per year penalties for a missed or improper filing. The filings may be required for a U.S. beneficiary who has never received a distribution from the foreign trust.

What can you do to simplify and identify opportunities for tax planning?

The options available to you to modify the U.S. tax implications to U.S. beneficiaries depend on the extent to which you can make changes to the administration or legal status of the trust. If you don’t have decision-making authority over the trust, you may still be able to influence the trustee to make changes for the benefit of U.S. beneficiaries. Note the following things that you can do to streamline complexities for U.S. beneficiaries. Modify the types and timing of distributions from the foreign trust. Consider the tax implications of distribution of trust corpus versus distribution of trust income. Modify the types of assets held by the trust. Considerations could include trading growth stocks versus dividend paying stocks, directly holding shares of individual stocks versus shares of foreign mutual funds or shares of U.S. mutual funds versus foreign mutual funds. Split the assets of the trust. Divide the trust’s assets between those held for U.S. beneficiaries and those held for foreign ones. Convert the U.S. beneficiary’s portion of the trust to a U.S. trust. This can be done to the extent allowable under the terms of the legal document that established the trust.

Article

Tax planning FAQs for U.S. beneficiaries of foreign trusts

July 25, 2022 · Authored by Brittain Cunningham, Stuart Myhill

U.S. citizens or residents who are beneficiaries of foreign trusts must follow complex tax reporting requirements. Below are answers to frequently asked questions on the topic of U.S. taxation of foreign trusts.

What information will your tax advisor need?

You should seek the assistance of a qualified U.S. tax advisor who has experience advising U.S. beneficiaries of foreign trusts. Before meeting with your advisor, you should collect some key information that will help your advisor evaluate your unique facts as noted below.

Checklist of some key information you should gather before meeting with your tax advisor

Can this legal arrangement be considered a foreign trust for U.S. tax purposes?

Your advisor can help you determine if the legal arrangement in question should be treated as a trust for U.S. tax purposes, which isn’t always straightforward considering how different countries may interpret the definition of a trust. These foreign legal arrangements must be evaluated under the parameters of the U.S. definition of a trust. Classifying the trust as either a U.S. or foreign trust is essential for determining the proper reporting required.

Once you’ve determined that the legal arrangement is a trust for U.S. tax purposes, the next step is to consider whether the trust should be considered a domestic or foreign trust.

If a trust fails one of two tests — the court test and the control test — it’s considered a foreign trust. These tests are solely a construction of U.S. law and are independent of any foreign classification of a trust.

Court test

The court test looks to whether the trust is legally established or registered in the United States.

Control test

The control test looks to the residency of the individuals who control the trust.

Brittain Cunningham

Director

Stuart Myhill

Principal

Related sections

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

Tax planning FAQs for U.S. beneficiaries of foreign trusts

What information will your tax advisor need?

Can this legal arrangement be considered a foreign trust for U.S. tax purposes?

Court test

Control test

Brittain Cunningham

Stuart Myhill

Related sections

Who controls the foreign trust?

What assets does the foreign trust own?

Reporting additional international information

Foreign financial asset reporting

Passive foreign investment companies

Foreign partnerships

Foreign corporations

Importance of tax analysis

What can you do to simplify and identify opportunities for tax planning?

Tax planning implications

Have questions? Baker Tilly can help.