The IRS’s Large Business and International Division (LB&I) recently issued a “process unit” that provides guidance on determining the tax on a distribution received by a beneficiary of a foreign nongrantor trust. Process units serve as training materials for IRS staff to enhance their understanding of general tax concepts and specific transaction types. Although process units are not official guidance, they offer insights into the IRS’s likely approach to certain issues.
Taxation of Trust Income
The process unit explains that foreign trust income tax rules combine domestic trust income tax rules and nonresident alien individual income tax rules. These rules generally mirror those for domestic trusts and classify foreign trusts into two types:
Grantor trusts, which are pass-through entities. Grantors report trust income on their tax returns and are responsible for paying related income tax. Usually, distributions from a grantor trust are not taxable to the beneficiary.
Nongrantor trusts, which are taxable entities. These trusts must report income on their own return using Form 1041, “U.S. Income Tax Return for Estates and Trusts,” and their own Tax Identification Number. The trust pays taxes on any income it receives. However, a nongrantor trust may deduct distributions to a beneficiary of distributable net income (DNI). These DNI distributions are reported on the beneficiary’s tax return, and the beneficiary is responsible for any tax due. Consequently, a U.S. beneficiary of a foreign nongrantor trust may be liable for U.S. tax on DNI distributions from the trust.
Examination of Foreign Trusts
When determining the tax on a beneficiary’s receipt of a DNI distribution, an IRS examiner will consider factors such as whether the trust is domestic or foreign, whether it is a simple or complex trust, whether there was a distribution to the beneficiary, and whether the distribution is income or principal, as well as the nature of the distribution (i.e., current income, DNI, accumulated income, or undistributed net income).
The examiner will also assess whether the beneficiary is a U.S. or foreign person and determine if the trust’s income is from a U.S. or foreign source. The process unit outlines how an examiner would make these determinations in specific scenarios involving U.S. and foreign beneficiaries receiving income distributions from foreign nongrantor trusts. It highlights the differences in calculating DNI for foreign trusts and underscores the potential U.S. tax implications for foreign beneficiaries receiving DNI from U.S. sources.
Trusts can be valuable wealth management and estate planning tools, but they also come with their own complexities, particularly in the case of foreign nongrantor trusts. For further information on distributions from foreign trusts that must be reported by beneficiaries or on trusts in general, consult with the international tax team at Sol Schwartz & Associates. Just leave your contact information below and we will get right back to you.