Foreign Trusts with US Beneficiaries or Settlors

An American who opens a Foreign Trust is usually taxed on the income on an annually arising basis, even if he or she is not entitled to receive any income from the trust. This is because it is usually deemed a grantor trust for US tax purposes.

For Foreign Grantor Trusts, Form 3520-A must be filed annually by the trust and Form 3520 may also be required to be filed by the grantor and/or the beneficiaries.

An American beneficiary who receives income from a Foreign Trust which was not set up by an American is by default deemed to be a nongrantor trust. The beneficiary is taxed as income is distributed. There are punitive interest rates for distribution of accumulated income in later years. If the trust pays out the annual income, this does not solve the problem as under US tax law capital gains accumulated in the trust are included as income for income tax purposes. Thus, the longer the trust is held, the more accumulated income grows in the trust.

For Foreign Nongrantor Trusts, Form 3520 must be filed annually by the beneficiaries if they received any distributions during the calendar year. It is recommended that even if there are no distributions, a reconciliation computation to convert financial statements to US methods be prepared.

Forms 3520 and 3520-A convert financials statements from foreign currency and fiscal year to US dollar and calendar year, using US GAAP and IRS rules for allowable deductions. This This means that the bottom line on the trust can be very different for US tax purposes, particularly as capital gains are included in Net Distributable Income.

Penalties for failure to file these forms are

  • 35% of the gross value of any property transferred to a foreign trust,
  • 35% of the gross value of the distributions received from a foreign trust,
  • 5% of the amount of foreign gifts for each month the failure to report continues up to 25%), and
  • 5% of the gross value of the portion of the trust which has a US owner if the trust fails to file the annual return.

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