U.S. Tax Implications of Foreign Grantor Trusts Under Section 679
Foreign Trusts Under U.S. Tax Law: A Close Look at Section 679
Under the U.S. tax system, foreign trusts can be discriminately treated as grantor trusts for federal income tax purposes, resulting in the grantor, or deemed owner, reporting the trust's income, deductions, and credits. This distinction is drawn from provisions laid out in the grantor-trust rules, specifically sections 671 through 679, and may particularly apply to foreign trusts when Section 679 is invoked.
To qualify as a grantor trust under this section, a foreign trust must have a U.S. transferor and U.S. beneficiaries. This means a U.S. citizen or resident who transfers property or cash to a foreign trust is considered the grantor, and the trust's income and other tax items must be reported on their annual tax return along with corresponding international information returns, such as IRS Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner.
It is essential first to understand the terminology "foreign trust." According to federal tax law, a trust is defined as an agreement in which a trustee takes possession of property to safeguard and preserve it for the benefit of a third-party beneficiary. To distinguish a foreign trust from other legal arrangements, such as a foreign corporation, taxpayers must evaluate applicable foreign law and interpret its principles according to U.S. tax standards. If the arrangement qualifies as a trust for U.S. tax purposes, the next step is determining whether it is foreign or domestic. A foreign trust is characterized as one over which a U.S. court lacks primary supervision or where a U.S. person lacks control over the trust's decisions. Any other trusts are deemed domestic trusts and not subject to Section 679.
When a U.S. person transfers property to a foreign trust and the trust has a U.S. beneficiary, the latter must possess rights to trust income or corpus, among other criteria. As a result, a foreign trust is considered to have a U.S. beneficiary if part of its income or corpus may be paid or accumulated to or for the benefit of a U.S. person during the tax year, or if the trust was terminated during the tax year, and any part of its income or corpus could be paid to or for the benefit of a U.S. person. The governing documents and applicable foreign law typically determine whether a U.S. beneficiary has rights in the income or corpus of the trust. However, the IRS will consider oral understandings concerning trust administration under Section 679(c)(5) if necessary.
In instances where a foreign person establishes a foreign trust and decides to relocate to the U.S., Section 679(a)(4) applies when the foreign trust has a U.S. beneficiary, and the nonresident alien individual transfers property to the foreign trust within five years of becoming a U.S. resident. Similarly, Section 679 also has a special rule for domestic trusts that later become foreign trusts. In this case, the U.S. citizen or resident who transferred property to the domestic trust becomes responsible for the trust's assets and income when it transforms into a foreign trust during their lifetime.
In contrast to other foreign trusts, Section 679(d) contains a provision that presumes the foreign trust has U.S. beneficiaries. As a result, if a U.S. person transfers property or cash to a foreign trust, the IRS will consider the trust to have U.S. beneficiaries unless the person provides the necessary information and demonstrates to the IRS's satisfaction that the trust does not have U.S. beneficiaries.
Foreign trusts often hold investments and other income-producing properties. Although they are typically exempt from U.S. income tax, they become subject to such taxes under Section 679, especially when the U.S. transferor must report the foreign trust's income under the grantor-trust rules. Moreover, the U.S. transferor may be required to prepare and file substitute IRS Forms 3520-A on behalf of the trust to report the trust's activities to the IRS. Without a thorough understanding of Section 679 and its ramifications, U.S. taxpayers may face unforeseen consequences, including payment of prior-year income taxes, interest, and substantial penalties.
In the context of U.S. tax law, a foreign trust may be classified as a grantor trust for federal income tax purposes, especially when Section 679 is applied. This classification is significant because the grantor or deemed owner must report the trust's income and other tax items on their annual tax return, which includes International Information Returns such as IRS Form 3520 and Form 3520-A. Consequently, businesses dealing with foreign trusts need to be familiar with Section 679 and its implications to avoid potential financial complications.
