What US beneficiaries of trusts need to know about tax

If you're a US citizen, resident or and Green Card Holder (AKA a US person) and are the settlor or a beneficiary of a non-US trust, there are US tax and compliance issues that you need to be aware of. Our latest Stepping Stone focuses on the tax issues that US beneficiaries face.

The popularity of trusts with families has expanded globally over the years as a tool for asset protection and wealth preservation. However, with millions of people migrating into and out of the US, there are many situations where there are non-US (foreign) trusts with US beneficiaries, as well as US trusts with foreign beneficiaries.

There are also examples of US domestic trusts that have been exported out of the US due to the trustees moving outside of the US. These could be considered as foreign trusts with US beneficiaries.

It is important for beneficiaries to understand the tax implications of a US trust, as there are some adverse rules that can result in high or unexpected taxation.

Case study

Anita is a Hong Kong citizen who lives in Hong Kong with her parents and three siblings. Anita was born in the US, when her parents were living there temporarily in the early 1990s, during her father’s five-year work assignment in New York. Neither her parents nor her siblings were born in the US and they do not live there or have permanent resident (‘Green Card’) status.

Anita and her three siblings are the beneficiaries of a trust established in Hong Kong by her grandfather, who passed away in 2019. Her grandfather was not a US citizen, resident or Green Card Holder and during his lifetime, he was the sole beneficiary of the trust. Only since his death have Anita and her siblings become entitled to the trust funds. Anita has no other sources of income.

There are substantial funds within the trust consisting mainly of cash, a Hong Kong rental property and a portfolio of non-US financial assets, in the form of stocks and bonds. The trust is about to start making distributions to Anita and her three siblings.

Anita’s US tax status

Anita is a US citizen because she was born in the US when her parents were living there. Neither her parents nor her siblings are US citizens, residents or Green Card holders, but Anita is a citizen just because she was born in the US. This is the case, even though she has not lived there since the family left the US after her father’s assignment ended, and even though she has no assets or sources of income in the US. As a US citizen, when her income exceeds the filing threshold, Anita has a requirement to report her worldwide income and gains to the IRS, regardless of where she is resident at the time and regardless of where her assets are located.

The status of the trust

Before the death of Anita’s grandfather, who was the settlor or ‘Grantor’ of the trust, it was a Foreign Grantor Trust for US tax purposes but with no US beneficiaries. Consequently, there were no US filing requirements for the trust or its beneficiaries and none of the income arising to it was subject to US tax. However, on the death of the Grantor, the trust became a Foreign Non-Grantor Trust with a US beneficiary, Anita.

US beneficiary filing requirements

US citizens are taxable in the US on their worldwide income, regardless of where they live. If their income is over the filing threshold applicable to them, they are required to file tax returns and may owe US tax on their income. They may also have other ‘information’ filing requirements in respect of non-US financial accounts or other assets that they own outside the US.

Until her grandfather died, making her a beneficiary of his trust, Anita did not have a US filing requirement and did not owe any US tax because she did not have any income or own any assets. However, since her grandfather’s death in 2019 she now has to consider a possible exposure to US tax and the associated filing requirements.

Starting from calendar year 2019, Anita must file a tax return (Form 1040) annually if she receives taxable distributions from the trust, which is her only source of income. These returns are normally due on 15 June following the relevant calendar year, but because she lives outside the US she has an automatic extension from 15 April to 15 June. However, for 2019, due to concessions from the IRS in response to the COVID-19 pandemic, the filing deadline for that year is extended to 15 July. Anita must also file, by the same deadline, a separate form to report her trust distributions (Form 3520).

'Throwback' tax rules

As the trust was considered a Foreign Non-Grantor Trust, Anita needs to consider the ‘throwback’ tax rules, which can apply to distributions of accumulated income/gains within a Foreign Non-Grantor Trust with US beneficiaries. If income and gains accumulate without being distributed within the tax year in which they arise, then punitive tax rates and an interest charge will apply.

However, this can be avoided with some careful and timely planning. If distributions of income are made within 65 days of the end of the tax year in which that income arises, then they are treated as having been made within the year and therefore these punitive rules do not apply. Therefore, the trustees are advised to calculate annual Distributable Net Income (DNI) and make sure it is distributed within the 65-day period.

In some cases, it is possible to direct income to be distributed to beneficiaries who are non-US persons in order to reduce or in some cases remove altogether, the exposure to tax, while distributions of non-taxable ‘Corpus’ are made to US persons. However, in this case it was not possible to do this, so the tax liability and filing requirements for Anita could not be removed.

Working to such a short deadline can be a real challenge, so you will need to act swiftly once you are aware that these rules may apply to you. Fortunately, in this case, Buzzacott were engaged soon after the grandfather’s death, so we were able to advise the trustees in good time. We carried out the necessary calculations and informed the trust of what needed to be distributed to Anita and her siblings within the required time frame in order to keep Anita’s tax exposure to a minimum.

What should you do?

If you are a beneficiary of a trust and are considering a move to the US you should seek pre-immigration advice to ensure you avoid unnecessary reporting requirements, and a potentially higher tax bill. If you are a US person (US citizen, Green Card Holder or resident) and you are the trustee or the beneficiary of a non-US trust, you should ensure that you know what responsibilities you have from a US tax perspective.