US Taxation and information reporting for New Zealand family trusts and their US owners and US beneficiaries
U.S. owners and beneficiaries of foreign trusts (i.e., non-U.S. trusts) face complex taxation and reporting obligations that differ significantly from those associated with domestic trusts. The U.S. taxation of income and distributions from a foreign trust depends on the type of trust and the beneficiary's status at the time of distribution. This guide provides an overview of the essential questions that foreign trustees, U.S. owners, and U.S. beneficiaries of foreign trusts must address under current U.S. law.
Key Definitions
U.S. Owners: Individuals who are considered U.S. residents for income tax purposes. This includes U.S. citizens, green card holders, or individuals who meet the "substantial presence test" within a tax year.
U.S. Beneficiaries: Similar to U.S. owners, these are persons deemed U.S. residents for income tax purposes, which encompasses U.S. citizens, green card holders, or those meeting the substantial presence test.
What is a Trust?
A trust is a legal arrangement in which one party, known as the trustee, holds and manages assets on behalf of another party, known as the beneficiary. Trusts are established by a settlor or grantor, who transfers assets to the trust. Trusts can be used for various purposes, including estate planning, asset protection, and charitable giving.
What is a Foreign Trust for U.S. Tax Purposes?
For U.S. tax purposes, a foreign trust is any trust that does not meet the criteria of a domestic trust. A domestic trust is one where a U.S. court has primary supervision over its administration, and one or more U.S. persons have control over all substantial decisions. Foreign trusts are subject to specific reporting requirements and tax regulations, which U.S. persons must adhere to when they have interests in such trusts.
What are the different types of foreign trusts for U.S. tax purposes?
The US income taxation of a foreign trust depends on whether the trust is a grantor or non-grantor trust.
What is a Grantor Trust?
A trust is considered a grantor trust when the grantor retains significant control over the trust's assets. For U.S. federal income tax purposes, the grantor is treated as the owner of the trust.
A foreign trust is also regarded as a grantor trust for U.S. income tax purposes when a U.S. grantor makes a gratuitous transfer to the trust, and there are U.S. beneficiaries or potential U.S. beneficiaries for any part of the trust. Most foreign trusts established by U.S. grantors typically have at least one current or future U.S. beneficiary.
It's crucial to note that when a foreign trust is funded by a U.S. person, it is usually treated as a grantor trust under U.S. tax laws. This designation has significant implications for tax reporting and compliance.
What is a Non-Grantor Trust?
All trusts that are not grantor trusts are considered non-grantor trusts for US purposes.
U.S. Income Taxation of Foreign Grantor Trusts with U.S. grantors (U.S. citizens or residents)
U.S. persons who are treated as owners of a New Zealand family trust under the grantor trust rules of Internal Revenue Code (IRC) sections 671-679 may have U.S. income tax consequences. This includes reporting income, gains, and losses of the trust on their U.S. tax returns.
The U.S. income taxation of a foreign trust hinges on whether the trust is classified as a grantor trust or a non-grantor trust. For foreign grantor trusts, the income is typically taxed to the trust's grantor, instead of being taxed to the trust itself or to its beneficiaries.
Obligations of the Trustee:
The trustee of a foreign grantor trust with a U.S. owner must file Form 3520-A annually with the IRS.
Form 3520-A is due on March 15th, with a possible six-month extension. Trustees should also send relevant statements to U.S. owners and beneficiaries. If the trustee fails to file, penalties are imposed on the U.S. grantor.
Obligations of U.S. Owners:
U.S. owners are taxed on their share of the trust's income annually. During his or her lifetime, the US grantor
must report all items of trust income and
gain on his or her Form 1040, US Individual
Income Tax Return, for the year earned. The
trust itself will not be subject to US income
tax.
Form 3520 titled "Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts," must be filed to report any transfers to or distributions from a foreign trust. Additionally, U.S. owners must file Form 3520 annually to report ownership of the foreign trust, even if no transfers or distributions are made in that year. The form is due by the due date (including extensions) of the individual's Form 1040. The U.S. owner must attach the "Foreign Grantor Trust Owner Statement" received from the trustee to Form 3520.
U.S. owners must ensure that the trustee files Form 3520-A annually. If the trustee fails to do so, penalties are imposed on the U.S. owner.
Obligations of U.S. Beneficiaries:
A U.S. beneficiary who receives a distribution from a foreign grantor trust (regardless of whether the grantor is a U.S. person or a nonresident alien) must file Form 3520 by the due date (including extensions) of their Form 1040.
If the U.S. beneficiary receives a complete Foreign Grantor Trust Beneficiary Statement for the distribution made during the taxable year, this statement should be attached to Form 3520.
No tax is payable on the distribution if the beneficiary statement is obtained and attached to Form 3520.
If the U.S. beneficiary does not obtain the beneficiary statement, they will be required to pay U.S. income tax on the distribution.
U.S. Income Taxation of Foreign Grantor Trusts with foreign grantors (U.S. non-resident aliens)
Current regulations significantly limit the ability of a NRA to be treated as the grantor of a trust under U.S. grantor trust rules. However, in certain limited circumstances, the grantor trust rules may still apply to an NRA grantor. If a trust is a foreign grantor trust with an NRA owner, the following filing requirements must be met:
Obligations of the Trustee:
The trustee must provide a Foreign Grantor Trust Beneficiary Statement to any U.S. recipient of a distribution.
Unlike a Foreign Grantor Trust with a U.S. owner, where the beneficiary statement is part of Form 3520-A, the beneficiary statement from a foreign grantor trust with an NRA grantor is not filed with the IRS until it is attached to the U.S. beneficiary's Form 3520.
Obligations of the non-U.S. Owner:
The non-U.S. owner is generally not subject to U.S. tax on trust income, unless the income is U.S. source income or effectively connected income with a trade or business in the United States.
If the trust has U.S. source income, the non-U.S. owner must file Form 1040-NR, "Nonresident Alien Income Tax Return," to report and pay any U.S. tax due on such income.
Obligations of U.S. Beneficiaries:
A U.S. beneficiary who receives a distribution from a foreign grantor trust (regardless of whether the grantor is a U.S. person or a nonresident alien) must file Form 3520 by the due date (including extensions) of their Form 1040.
If the U.S. beneficiary receives a complete Foreign Grantor Trust Beneficiary Statement for the distribution made during the taxable year, this statement should be attached to Form 3520.
No tax is payable on the distribution if the beneficiary statement is obtained and attached to Form 3520.
If the U.S. beneficiary does not obtain the beneficiary statement, they will be required to pay U.S. income tax on the distribution.
U.S. Income Taxation of Foreign Non-Grantor Trusts
Income from a foreign non-grantor trust is generally taxed when it is distributed to U.S. beneficiaries. However, if the trust earns and retains U.S. source income or effectively connected income, the non-grantor trust itself must pay U.S. income tax for the year in which that income is earned.
Obligations of the Trustee:
The trustee must provide Foreign Non-grantor Trust Beneficiary Statement to U.S. recipients of any distribution. It details the amount and composition of the distribution, including current year income (and its character), prior year income, or corpus.
Unlike a Foreign Grantor Trust with a U.S. owner, this beneficiary statement is not filed with the IRS.
If the trust earns U.S. source or effectively connected income, the trustee is responsible for filing Form 1040-NR, Nonresident Alien Income Tax Return, to report and pay any U.S. tax due on such income.
Obligations of U.S. Beneficiaries:
U.S. beneficiaries receiving distributions from a foreign non-grantor trust must file Form 3520 by the due date (including extensions) of their Form 1040.
If the U.S. beneficiary receives a Foreign Non-grantor Trust Beneficiary Statement for the distribution made during the taxable year, this statement should be attached to Form 3520.
Without a beneficiary statement, the U.S. beneficiary must compute their U.S. income tax using the "default" method, which may result in higher taxes compared to the "actual" method that can be used when the statement is available.
The U.S. beneficiary must pay U.S. tax on the current year trust income included in the distribution.
Beneficiaries may be subject to an additional "throwback tax" on prior year trust income included in the distribution. An interest charge may also be imposed on the tax associated with the accumulation distribution.
The calculations required for distributions of accumulated income are highly complex. It is strongly advised to consult a qualified U.S. tax advisor whenever a U.S. person receives a distribution from a foreign trust.
Are New Zealand family trusts considered foreign grantor trusts for US tax purposes?
Yes, New Zealand family trusts are generally considered foreign trusts for U.S. tax purposes. Specifically, they are often treated as foreign non-grantor trusts unless a U.S. person is deemed to be the owner (grantor) of the trust.
What is a Family Trust?
A family trust is a type of trust created to manage and protect family assets. It is often used for estate planning to ensure that wealth is preserved and transferred smoothly to future generations. Family trusts can also provide benefits such as asset protection, tax efficiency, and ensuring that beneficiaries are provided for according to the settlor's wishes.
How Does a Family Trust Work?
A family trust works by transferring the legal ownership of assets from the settlor to the trustee while continuing to use and enjoy them as long as the trust deed permits. The trustee, who manages the trust, holds the legal title to the assets, while the beneficiaries hold the beneficial interest. For example, if your family home is in a trust, you no longer personally own the house – but you can still live in it if that’s what the trust deed states, and the trustees agree.
The trust document outlines the terms and conditions under which the trustee must manage and distribute the assets. The trustee is responsible for managing the assets according to the trust's terms and in the best interests of the beneficiaries.
A legal document called a ‘trust deed’ will formally set up the family trust.
It will name the trustees, list the beneficiaries, and state various rules for the administration and management of the trust. The trust deed needs to be very carefully written, preferably by a lawyer.
What are the Benefits of a Family Trust?
Asset Protection: Protects family assets from creditors and legal claims, for example, to protect a family home from the potential failure of a business venture.
Estate Planning: Facilitates the smooth transfer of assets to heirs, reducing potential disputes. Ensure our children, not their partners, keep their inheritances.
Tax Efficiency: Can provide tax advantages by managing how and when income and assets are distributed.
Control and Flexibility: Allows the settlor to specify terms for the use and distribution of assets, ensuring that the assets are used according to their wishes.
Child's Education: Set aside money for special reasons, such as a child or grandchild’s education.
Unwanted Claims: Manage the risk of unwanted claims on your estate when you die – such as from a former partner.
Who is Involved in a Family Trust?
Settlor (Grantor): The person who creates the trust and transfers assets into it.
Trustee: The individual or institution responsible for managing the trust assets and administering the trust according to its terms.
The settlor can also be a trustee. It’s also a good idea to appoint an independent trustee who is not a relative. Professionals like lawyers and accountants (or companies they have set up) often act as independent trustees.
Beneficiaries: The individuals or entities entitled to benefit from the trust assets, for example members of your family.
Often there is more than one trustee. There may also be more than one settlor of a trust.
The trust deed will state who has the power to appoint and remove trustees. The settlor – or anyone else who is named in the trust deed – can have this power. This is an important power that the person can also transfer to someone else in their will or during their lifetime.
Note that a trust doesn’t usually end with the settlor’s death – it can last for a maximum of 80 years from inception but this is likely to be extended in the future.
What are the Costs of Maintaining a Family Trust?
Legal Fees: Costs associated with drafting and establishing the trust.
Administration Fees: Ongoing fees for managing the trust, including trustee fees, accounting, and reporting.
Tax Preparation Fees: Costs for preparing and filing tax returns for the trust.
What are the Risks Involved in a Family Trust?
Mismanagement: If the trustee does not manage the assets effectively, the value of the trust may decline.
Legal Challenges: Beneficiaries or third parties may challenge the terms or administration of the trust.
Costs: The costs of maintaining the trust may outweigh the benefits if not managed properly.
Complexity: Trusts can be complex to establish and administer, requiring professional advice and management.
Conclusion
Family trusts can be quite technical, so we’ll typically need legal, and sometimes accounting, expertise.
Trusts should usually be formed by a lawyer or a professional trustee company.
If using a lawyer, they should be experienced in trust work (lawyers have different specialties and not all of them are experienced with trusts).
Putting property that could qualify as relationship property in a trust? Both partners should get independent legal advice on the implication and effects of that transaction before proceeding.
Good advice on trusts is important. Get professional advice right from the start.
It may seem expensive to get an expert in, but it may cost even more if things are not done well.
Miscellaneous issues
Use of Foreign Trust Property by U.S. Beneficiaries
When a U.S. beneficiary uses property owned by a foreign trust, it is considered a distribution from the trust. The value of this deemed distribution is determined based on the fair rental value of the assets utilized by the beneficiary.
Examples of Trust Assets:
Real Property: Such as a primary residence or vacation home used by the beneficiary.
Artwork or Antique Furniture: Owned by the trust and used in the beneficiary's primary or vacation home.
Taxation and Reporting:
Deemed Distribution: The fair rental value of the used assets is treated as a distribution from the trust.
Income Taxation: Such distributions are subject to U.S. income tax rules and must be reported accordingly.
Information Reporting: These transactions need to be reported, following the same information reporting and taxation rules applicable to other trust distributions.
Penalties for failure to file required foreign trust forms:
The IRS imposes substantial penalties for failure to file information forms relating to foreign trusts (Forms 3520-A and 3520).
Gain Recognition Upon Transfer to a Foreign Non-Grantor Trust
When a U.S. person transfers assets to a foreign non-grantor trust, this transfer may be treated as a sale or exchange of the property, requiring the U.S. transferor to recognize gain and pay U.S. tax on any appreciated assets.
Key Points:
Gain Recognition: The U.S. transferor must recognize gain and pay U.S. tax on the transfer of appreciated assets to a foreign trust.
Exemption for Grantor Trusts: These gain recognition rules do not apply to transfers to trusts where the U.S. transferor is considered the grantor (i.e., a foreign grantor trust with a U.S. owner).
Change in Trust Status: If the trust ceases to be a grantor trust upon the death of the U.S. owner or if the U.S. owner becomes a nonresident alien, the trust may then be treated as a foreign non-grantor trust. In this case, the gain recognition rule applies, and the trust or estate of the settlor is generally responsible for paying U.S. tax on any appreciation in the trust's assets as of the date of the owner's death.
Taxpayer identification number for foreign trusts that file US tax returns:
When a trustee is required to file a U.S. tax return or informational form on behalf of a foreign trust, such as Form 3520-A (Annual Information Return of Foreign Trust With a U.S. Owner) or Form 1040-NR (Nonresident Alien Income Tax Return), it is necessary to obtain a taxpayer identification number (TIN) for the trust.