Grantor trusts are treated differently from other trusts for federal income tax purposes. Whereas many trusts are respected as separate entities, grantor trusts are disregarded with the grantor (or deemed owner) of the trust required to report the trust’s tax items (e.g., income, deductions, credits, etc.). Generally, a trust is characterized as a grantor trust if the trust meets one or more of the requirements set forth in the grantor-trust rules (i.e., sections 671 through 679).
Foreign trusts often qualify as grantor trusts under the grantor-trust rules. Indeed, section 679 of the Code specifically targets foreign trusts for this tax treatment if the trust has a U.S. transferor and U.S. beneficiaries. Where section 679 applies, the U.S. transferor is treated as the grantor of the trust, requiring the transferor to report the trust’s income and other items on a tax return and corresponding international information returns such as IRS Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner. Because many tax professionals and taxpayers are unaware of the nuances of section 679, the provision often acts as a trap for the unwary.
What Is A Foreign Trust?
Prior to discussing section 679, it is important to understand the term “foreign trust” as section 679 only applies to these types of trusts. Under federal tax law, a trust means an arrangement in which a trustee takes title to property for the purpose of protecting or conserving it for the benefit of third-party beneficiaries. To determine whether a foreign entity is a trust or another type of legal arrangement (e.g., a foreign corporation), taxpayers must analyze applicable foreign law against the backdrop of U.S. tax principles.
If the arrangement constitutes a trust for U.S. tax purposes, the next inquiry is whether the trust is foreign. Generally, a trust is foreign if a U.S. court lacks the authority to exercise primary supervision over the trust or a U.S. person lacks the authority to control the decisions of the trust. All other trusts are considered domestic trusts and not subject to section 679.
The Nuts And Bolts of Section 679.
Section 679 applies if a U.S. person transfers property or cash to a foreign trust and the foreign trust has a U.S. beneficiary. For these purposes, U.S. persons and beneficiaries include U.S. citizens and residents.
To qualify as a U.S. beneficiary of a foreign trust under section 679, the U.S. beneficiary must have rights to trust income or corpus. Therefore, a foreign trust has a U.S. beneficiary under section 679 if: (i) any part of the trust’s income or corpus may be paid or accumulated during the tax year to or for the benefit of a U.S. person, or (ii) if the trust was terminated in the tax year, any part of the trust’s income or corpus could be paid to or for the benefit of a U.S. person. Trust income and corpus is deemed accumulated even if the U.S. person’s interest in the trust is contingent on future events.
Generally, the trust’s governing documents and applicable foreign law determine whether a U.S. beneficiary has rights in the income or corpus of a trust. However, section 679 recognizes that U.S. persons may enter into oral understandings concerning the trust’s administration—accordingly, section 679(c)(5) provides that the IRS may look beyond the trust’s written documents to determine whether there is a U.S. beneficiary.
Foreign Persons Who Become U.S. Persons.
In some instances, foreign persons may establish a foreign trust and relocate to the U.S. Under section 679(a)(4), a foreign trust becomes subject to the section 679 grantor-trust rules if a nonresident alien individual transfers property or cash to a foreign trust and becomes a U.S. resident within five years of the transfer date (assuming the foreign trust also has a U.S. beneficiary).
A nonresident alien individual’s starting date for these purposes is governed under section 7701(b)(2)(A). For example, an individual who becomes a lawful permanent resident (e.g., a green-card holder) and who does not meet the substantial presence test in that tax year has a starting residency date based on that person’s first day present as a lawful permanent resident. If the individual satisfies the substantial presence test, the starting residency date is the first day in which the individual was physically present in the U.S.
Outbound Trust Migrations.
Section 679 also provides a special rule for domestic trusts that are later treated as foreign trusts. Under this rule, section 679 applies if a U.S. citizen or resident transfers property to a domestic trust and the trust becomes a foreign trust during that person’s lifetime. Where this rule applies, the U.S. person is deemed to make a transfer of property to the foreign trust as of the date the trust becomes foreign.
Presumption That Section 679 Applies.
Notably, section 679(d) contains a provision that presumes that a foreign trust has U.S. beneficiaries (i.e., that it falls within the scope of section 679). Therefore, if a U.S. person transfers property or cash to a foreign trust, the IRS may treat the trust as having U.S. beneficiaries unless the person: (i) submits any requested information to the IRS, and (ii) demonstrates to the satisfaction of the IRS that the trust does not have U.S. beneficiaries.
Conclusion.
Foreign trusts often hold investments and other income-producing properties. Although foreign trusts are often not subject to U.S. income tax, they become subject to such taxes when section 679 applies. In these instances, the U.S. transferor must report the foreign trust’s income under the grantor-trust rules. In addition, the U.S. transferor must often prepare and file substitute IRS Forms 3520-A on behalf of the trust to report the trust’s activities to the IRS. The failure to understand the broad scope of section 679 can result in adverse U.S. tax consequences, including required payment of prior year income taxes, interest, and significant penalties.
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