The U.S. income taxation of a foreign trust depends on whether the trust is a grantor or nongrantor trust:
- In the case of a foreign grantor trust, income is generally taxed to the trust’s grantor. And not to the trust itself or to the trust’s beneficiaries.
- In contrast, income from a foreign nongrantor trust is generally taxed when distributed to U.S. beneficiaries. Well, except to the extent U.S. source or effectively connected income is earned and retained by the trust. In this case, the nongrantor trust would pay U.S. income tax for the year such income is earned.
Let’s define such terms: All trusts have a grantor, i.e. the person who created the trust.
The IRS defines a grantor trust as a trust over which “the grantor or other owner retains the power to control or direct the trust’s income or assets”. Essentially, this is the case when the grantor keeps control over the trust. Control includes the power to revoke the trust (or amend the trust documents). It also includes the ability to direct the income coming from the trust.
For a grantor trust, the grantor is usually also a trustee and beneficiary of the trust’s income and principal. The principal refers to the property funding the trust. Generally, grantor declares items of income and deduction on their income tax return. The trust doesn’t have a tax identification number (TIN) or file its own return.
A person other than the grantor could also fulfill that role, and be designated as “substantial owner” under IRC 678(a)(1). It states that “such person has a power exercisable solely by himself to vest the corpus or the income therefrom in himself”.
Practically speaking, in the case of a foreign trust such as a Canadian RESP, the grantor would file forms 3520 (and substitute form 3520-A). And he/she would report all of the trust income on his tax return. They need to file form 1040, either as interest, dividend, capital gain, as the case may be as if he/she incurred such income himself/herself.
In non-grantor trusts, the grantor has given up all right to the principal. Only the trustee may revoke or terminate the trust. In a non-grantor trust, the grantor cannot be named as a trustee or beneficiary.
The trust would file a tax return itself on form 1041. If the trust doesn’t have any activity in the United States, then, no return would need to be filed.
This would be the case is a foreign person (such as a grandmother, or an unrelated person) created a trust for the benefit of her grandson. The grandson might be a U.S. person. But he wouldn’t have to report anything unless and until the income is distributed to him.
Of course, in the face of such tax deferral, Congress created a specific set of rules in order to tax it at a maximum tax rate and with interest once it is indeed distributed. It is known as the “throwback rule”. It generally seeks to treat a beneficiary as having received the income in the year in which it was earned by the trust. The throwback rule effectively results in tax being levied at the recipient’s highest marginal income tax rate for the year in which the income or gain was earned by the trust. Thus, any capital gains accumulated by a foreign trust for distribution in a later taxable year lose their character and are treated as ordinary income. In addition, the throwback rule adds an interest charge to the taxes on a throwback distribution in order to offset the benefits of tax deferral.
This is very similar to the PFIC Excess Distribution rule. But it could still be a way for assets to remain in the family. In many cases, the grandson would consider renouncing U.S. citizenship in order to avoid the throwback rule.