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Financial Accounts & Investing Abroad
As a US citizen, becoming the owner or beneficiary of a foreign trust can complicate your taxes quite a bit. Fortunately, we’re here to help clear things up. In this guide, we’re going to look at everything you need to know about foreign trusts.
A foreign trust is a trust that is established in a foreign country and primarily subject to that country’s laws. In the United States, a foreign trust is generally defined as a trust created by a nonresident alien or foreign corporation or by one of its residents. A US-based trustee is required if the trust contains any US source income and/or assets.
To determine whether a trust is foreign or not, we can ask the following two questions:
If the answer to both questions is no, then that trust will likely be considered a foreign trust.
A trust refers to an arrangement where a grantor gives an asset to a third-party trustee to hold or manage on behalf of one or more beneficiaries. The grantor is the person who creates the trust, while the trustee is responsible for managing and distributing assets to beneficiaries. A trust can be revocable or irrevocable.
A common example of this is a US 401(k) retirement plan. In that case, the grantor is an employer, employee, or both. The grantor(s) deposit money (the asset) into a 401(k) account, which is typically held by a third-party administrator (the trustee). The trustee manages this money on behalf of the employee (the beneficiary) until the employee is eligible to withdraw funds for retirement.
Based on this definition, a retirement plan established and managed outside of the US would qualify as a foreign trust. One example of this would be an Australian superannuation fund.
Yes, any income you receive from a foreign trust will be taxable by the IRS, even though many taxpayers hope that because a foreign trust is not governed by US jurisdiction, it is also exempt from US taxation. Unfortunately, this is not the case. As a US citizen, you will still have to report certain details of any foreign trusts you own or are the beneficiary of.
The rules for how the IRS taxes a foreign trust depend on whether it’s a grantor trust or a non-grantor trust for tax purposes.
In most circumstances, the following rules will determine whether a trust is a grantor or non-grantor trust:
However, when talking about a foreign trust, the rules are a bit more complicated.
A trust that is not treated as a grantor trust under the above rules will be treated as a non-grantor trust for tax purposes. So what does this mean for your taxes?
The IRS taxes foreign trusts differently based on whether they are considered grantor or non-grantor trusts. If the trust is considered a grantor trust, the individual who created it will be taxed on any income or capital gains generated by the property. If it is not considered a grantor trust, then the beneficiaries of the trust are taxed on its earnings instead.
If you are the beneficiary of a foreign trust and have received any distributions from that trust, you will have to report it to the IRS using Form 3520. This applies even if the distribution wouldn’t otherwise qualify as taxable income.
If you are the owner of a foreign trust, you will have to report the income and capital gains of the trust. To do this, you may need to file some or all of the following forms:
Regardless of the details of your tax obligations, failing to file as required could result in severe penalties. The same is true if you make a mistake or withhold information when filing.
Hopefully, this post has helped you understand how foreign trusts are taxed under US law. Contact us, and one of our customer champions will gladly help. If you need very specific advice on your specific tax situation, you can also click below to get a consultation with one of our expat tax experts.