What Are the Foreign Grantor Trust Rules?

A foreign grantor trust is a trust established outside the United States where the creator, or grantor, is treated as the owner for U.S. tax purposes. A trust is a legal arrangement where a grantor gives control over property to a trustee for a beneficiary’s benefit. A trust is considered “foreign” if it is formed under another country’s laws or supervised by a foreign court.

The grantor trust designation means the IRS attributes the trust’s income, deductions, and credits directly to the grantor. This structure prevents shifting income to beneficiaries in lower tax brackets. The grantor is taxed on the trust’s income regardless of where the trust, its assets, or its beneficiaries are located.

Grantor Trust Classification for Foreign Trusts

A foreign trust’s classification as a grantor trust is based on rules in the Internal Revenue Code (IRC). Under IRC sections 671 through 678, a trust is considered a grantor trust if the grantor retains certain powers or interests, such as the power to revoke the trust or the right to receive its income. These rules identify situations where the grantor has not fully relinquished control over the assets, making it appropriate to tax them as the owner.

A primary scenario involves a foreign trust established by a U.S. person. IRC Section 679 provides a rule that automatically treats a foreign trust as a grantor trust if it was created by a U.S. person and has at least one U.S. beneficiary. This rule applies even if the grantor does not retain any of the traditional powers. The definition of a “U.S. beneficiary” is broad, including situations where assets could potentially be directed to a U.S. person in the future.

A foreign trust can also be classified as a grantor trust if established by a foreign person, though this occurs under a more limited set of circumstances. For instance, if the foreign grantor is the sole beneficiary during their lifetime, or if they and their spouse are the only permissible recipients of distributions, the trust is treated as a grantor trust. Another trigger is if the foreign grantor retains the power to revoke the trust and reclaim its assets.

When a trust is established by a foreign person, that person is considered the owner for U.S. tax purposes. While the trust is foreign, its income may be subject to U.S. taxation if it comes from U.S. sources. These classification rules ensure the correct person is held responsible for tax obligations, preventing the use of foreign trusts to improperly avoid U.S. tax.

Tax Treatment of U.S. Owners and Beneficiaries

When a foreign trust is classified as a grantor trust with a U.S. owner, that individual must report all of the trust’s income, deductions, and credits on their personal U.S. income tax return. For tax purposes, the trust is effectively disregarded, and its financial activities flow through directly to the owner’s return.

This tax liability exists regardless of whether the income was actually distributed from the trust to the owner. The U.S. owner is taxed on the trust’s worldwide income as it is earned by the trust. This principle ensures a U.S. person cannot defer U.S. tax on income earned by a foreign trust over which they are considered to have control.

For a U.S. beneficiary who receives a distribution from a foreign grantor trust, the tax treatment is favorable. Because the U.S. owner has already been taxed on all the trust’s income, any subsequent distribution of that income to a U.S. beneficiary is received tax-free, treated as a gift from the trust’s owner.

To ensure this tax-free treatment, proper reporting is necessary. The beneficiary must be able to demonstrate that the distribution came from a properly classified and reported foreign grantor trust. Without adequate records, the IRS could recharacterize the distribution, potentially leading to it being taxed as an accumulation distribution with less favorable consequences.

Information and Forms for U.S. Reporting

Compliance requires the U.S. owner to collect comprehensive financial records from the trust. This information includes:

• A complete accounting of its income and expenses
• A record of all distributions made during the year
• The full name and address of the foreign trustee
• A balance sheet detailing the trust’s assets and liabilities at the end of the year

A primary reporting requirement is Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner. While the foreign trustee is technically responsible for filing this form, the U.S. owner is penalized if it is not filed, so the owner or their advisor often prepares it. The U.S. owner must ensure they receive a copy of the Foreign Grantor Trust Owner Statement from it, which details the income they must report.

The U.S. owner personally files Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. On this form, the owner reports their status as the grantor of the foreign trust and confirms that the trust is a grantor trust. They must also attach the Foreign Grantor Trust Owner Statement received from the Form 3520-A to their Form 3520.

The U.S. owner will use the financial statements and trustee information they gathered to fill out the income statement, balance sheet, and beneficiary distribution sections on the forms. Failure to provide complete and accurate information can lead to significant penalties and unwanted scrutiny from the IRS.

Filing Requirements and Deadlines

The completed Form 3520-A and Form 3520 are not filed with the owner’s personal income tax return but must be mailed to the IRS service center detailed in the form instructions. The due dates for these forms are different. Form 3520-A is due by the 15th day of the third month after the end of the trust’s tax year, which is March 15 for a calendar-year trust. An extension for filing Form 3520-A can be obtained by filing Form 7004.

The deadline for the U.S. owner to file Form 3520 is the same as their individual income tax return, April 15. This deadline is automatically extended if the U.S. owner files for an extension for their personal Form 1040. An extension for the owner’s income tax return also extends the time to file Form 3520, but not Form 3520-A.

Penalties for failing to comply with these filing requirements are steep. For a late or incomplete Form 3520-A, the U.S. owner faces a penalty of $10,000 or 5% of the gross value of the trust’s assets owned by the U.S. person, whichever is greater. For failure to file a timely Form 3520, the penalty is $10,000 or 35% of the gross value of the property transferred or received, whichever is greater.