U.S. Tax Implications of Foreign Grantor Trusts under Section 679
Foreign trusts, as distinct from other trusts, are subject to different federal income tax rules in the U.S. In contrast to the majority of trusts that are recognized as separate entities, foreign trusts are classified as grantor trusts, with the grantor (or the deemed owner) responsible for reporting the trust's tax items, such as income, deductions, and credits. A trust becomes a grantor trust if it meets one or more requirements outlined in the grantor-trust rules, which span from Sections 671 to 679.
Under Section 679 of the U.S. tax code, many foreign trusts are specifically targeted for this tax treatment if they have a U.S. transferor and U.S. beneficiaries. In these instances, the U.S. transferor is considered the grantor of the trust and is required to report the trust's income and other taxable items on their tax return and corresponding international information returns, such as IRS Form 3520-A. Due to the nuances of Section 679, it can often catch taxpayers and tax professionals off guard.
To better comprehend the term "foreign trust," it's crucial to understand that the Internal Revenue Service (IRS) defines a trust as "an arrangement in which a trustee takes title to property for the purpose of protecting or conserving it for the benefit of third-party beneficiaries." To classify a foreign entity as a trust, rather than a different legal arrangement like a foreign corporation, taxpayers must analyze the context of both applicable foreign law and U.S. tax principles. A trust is considered foreign if a U.S. court lacks the authority to exercise primary supervision over the trust or a U.S. person lacks control over the trust's decisions.
Section 679 applies when a U.S. person transfers property or cash to a foreign trust and the foreign trust has a U.S. beneficiary. In order for a foreign trust to have a U.S. beneficiary under Section 679, that beneficiary must possess rights to trust income or corpus. This means a foreign trust has a U.S. beneficiary under Section 679 if any part of the trust's income or corpus may be paid or accumulated during the tax year to or for the benefit of a U.S. person, or if the trust is terminated in the tax year, any part of the trust's income or corpus could be paid to or for the benefit of a U.S. person.
In some situations, foreign persons may create a foreign trust and later become U.S. residents. In these cases, the foreign trust becomes subject to Section 679's grantor-trust rules if a nonresident alien individual transfers property or cash to the trust and becomes a U.S. resident within five years of the transfer date. The residency starting date is determined by specific U.S. tax laws.
Section 679 also provides a special rule for domestic trusts that are later treated as foreign trusts. In these cases, the individual who transferred property to the domestic trust will be deemed to have made a transfer of property to the foreign trust at the moment it becomes foreign.
Section 679(d) contains a provision that presumes that a foreign trust has U.S. beneficiaries. Consequently, if a U.S. person transfers property or cash to a foreign trust, the IRS may treat the trust as having U.S. beneficiaries unless the person submits the requested information to the IRS and demonstrates that the trust does not have U.S. beneficiaries.
Foreign trusts, which may hold investments and other income-producing assets, are often not subject to U.S. income tax. However, they become subject to taxes when Section 679 applies, with the U.S. transferor responsible for reporting the trust's income under the grantor-trust rules and often preparing and filing substitute IRS Forms 3520-A to report the trust's activities to the IRS. Ignorance of the broad scope of Section 679 can result in adverse U.S. tax consequences, such as the need to pay prior year income taxes, interest, and significant penalties.
The U.S. transferor of a foreign trust, under Section 679 of the U.S. tax code, is responsible for reporting the trust's income and other taxable items on their tax return and corresponding international information returns, such as IRS Form 3520 and IRS Form 3520-A. To avoid potential tax liabilities and penalties, it's crucial for taxpayers to understand the requirements and implications of Section 679, especially when dealing with foreign trusts that hold investments and other income-producing assets.
