What Is a Foreign Trust for US Tax Purposes?

When individuals or entities in the United States engage with trusts established outside the country, understanding the specific tax implications becomes important. The Internal Revenue Service (IRS) classifies trusts as either domestic or foreign for tax purposes, a distinction that significantly affects reporting obligations and tax treatment. This article clarifies what constitutes a foreign trust under US tax law, outlines the tax treatment for such trusts and their US beneficiaries, and details the information gathering and reporting requirements US persons must navigate.

Defining a Foreign Trust for US Tax Purposes

For US tax purposes, a trust is considered foreign unless it satisfies both the “court test” and the “control test.” These two criteria, established by the IRS, determine a trust’s residency for tax purposes. If a trust fails either of these tests, it is classified as a foreign trust.

The “court test” requires that a court within the United States must be able to exercise primary supervision over the administration of the trust. Factors indicating a trust meets this test include:
The trust instrument specifying US court jurisdiction.
All fiduciaries being subject to US court orders.
Conversely, if the trust’s administration is primarily overseen by a non-US court, or if the trust instrument contains an “automatic migration” provision (a “flee clause”) that shifts jurisdiction away from a US court upon certain events, it would fail the court test.

The “control test” mandates that one or more US persons must have the authority to control all substantial decisions of the trust. “Substantial decisions” are defined as fiduciary decisions authorized or required by the trust agreement and applicable law. These include:
Decisions concerning distributions.
The selection of beneficiaries.
Investment decisions.
The appointment or removal of trustees.
If a non-US person possesses the power to veto any of these substantial decisions, or if non-US persons collectively hold control over such decisions, the trust would fail the control test and be deemed foreign. For trusts established after August 19, 1996, these two tests serve as the default rules for determining a trust’s foreign or domestic status.

US Tax Treatment of Foreign Trusts and US Beneficiaries

The tax treatment of a foreign trust and its US beneficiaries depends on whether the trust is classified as a “grantor trust” or a “non-grantor trust” for US tax purposes. This distinction dictates who is responsible for paying tax on the trust’s income.

A foreign trust is treated as a “grantor trust” if a US person retains certain powers or interests over the trust assets, such as the ability to revoke the trust or if the trust income can be distributed to the grantor or their spouse. In such cases, the grantor, who is a US person, is considered the owner of the trust for tax purposes and is taxed directly on the trust’s worldwide income, even if they do not receive distributions. The trust’s income, deductions, and credits are reported on the grantor’s personal US tax return.

If a foreign trust is not classified as a grantor trust, it is considered a “non-grantor trust” and is treated as a separate tax entity. Non-grantor foreign trusts are subject to US tax on US-sourced income or income effectively connected with a US trade or business. US beneficiaries of foreign non-grantor trusts are taxed on distributions they receive. Distributions of current income, known as Distributable Net Income (DNI), are taxable to the beneficiary in the year received, retaining their character (e.g., ordinary income, capital gains).

Important for taxing distributions from foreign non-grantor trusts are the “throwback rules” for accumulation distributions. These rules apply when a foreign trust distributes previously accumulated income, referred to as Undistributed Net Income (UNI). The throwback rules prevent tax deferral by taxing these accumulation distributions as if they had been distributed in the year the income was earned by the trust. An interest charge is also added to the tax on UNI distributions to account for the deferral of US tax. Capital gains accumulated by a foreign trust and later distributed as UNI lose their favorable capital gains treatment and are taxed as ordinary income under these rules. Gifts or bequests received by a foreign trust from foreign persons are not subject to US gift or estate tax at the time of transfer, but subsequent income generated by these assets and distributed to US beneficiaries may be taxable.

Information Gathering for Foreign Trust Reporting

US persons with involvement in foreign trusts face significant reporting obligations to the IRS. Fulfilling these requirements begins with meticulous information gathering, including comprehensive data about the trust, its parties, and its financial activities.

Required information includes:
The trust’s full legal name, creation date, and country of establishment.
The trust’s Employer Identification Number (EIN) or foreign equivalent.
Names, addresses, and tax identification numbers (TINs) of all trustees, grantors (settlors), and beneficiaries.
Fair market value of all trust assets.
A breakdown of income by type (e.g., interest, dividends, capital gains).
A record of all expenses incurred by the trust.
Details of any distributions made from the trust, including amounts and recipients.
Details of any property transferred to or from the trust, including dates, value, and description.
Documentation related to who holds control over the substantial decisions of the trust, as defined by the “control test.”
This thorough collection of data prepares US persons for necessary IRS filings, such as Form 3520 and Form 3520-A.

US Tax Reporting Requirements for Foreign Trusts

US persons involved with foreign trusts have specific annual reporting obligations to the IRS, distinct from their income tax returns. These requirements primarily involve Form 3520 and Form 3520-A, along with potential FBAR filings. Compliance is important to avoid significant penalties.

Form 3520

Form 3520, “Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts,” is filed by US persons who engage in specific reportable transactions with foreign trusts. This includes those who create a foreign trust, transfer property to a foreign trust, or receive a distribution from a foreign trust. It is also required if a US person is treated as the owner of any portion of a foreign trust under the grantor trust rules. The filing deadline for Form 3520 aligns with the US person’s income tax return due date, April 15, with an automatic extension to October 15 if an extension for the income tax return is filed.

Form 3520-A

Form 3520-A, “Annual Information Return of Foreign Trust With a US Owner,” is the responsibility of the trustee of a foreign trust that has a US owner. This form provides the IRS with information about the foreign trust, its US owners, and its activities. The filing deadline for Form 3520-A is the 15th day of the third month after the end of the trust’s tax year, March 15 for calendar year trusts. If the foreign trustee fails to file Form 3520-A, the US owner is responsible for ensuring its submission. An extension for Form 3520-A can be requested by filing Form 7004.

FBAR (FinCEN Form 114)

US persons may also need to file an FBAR, or FinCEN Form 114, “Report of Foreign Bank and Financial Accounts.” This form is required if a US person has a financial interest in, or signature authority over, foreign financial accounts (which can include certain foreign trust accounts) with an aggregate value exceeding $10,000 at any time during the calendar year. The FBAR is due by April 15, with an automatic extension to October 15.

Failure to timely and accurately file these required forms can result in significant penalties. Penalties for Form 3520 and 3520-A can be substantial, ranging from $10,000 or a percentage of the value of the property transferred or assets owned. FBAR violations can incur penalties of up to $10,000 for non-willful violations, while willful violations may lead to civil penalties of the greater of $100,000 or 50% of the account’s maximum value, and potentially criminal charges.