The perfect storm of more and more families emigrating and the historic love of South Africans to house their assets in trusts (local and foreign), has caused headaches for many unsuspecting trust beneficiaries in their new country of residence.
A particularly problematic country to emigrate to if you are the beneficiary of a trust (where the trust was not formed by you), is the US, which has very punitive tax rules for foreign (i.e. non-US) trusts.
A common situation that arises (and that will be the topic of this article) is that one of the family members who relocates to the US is a beneficiary of a discretionary trust that was formed by the family member’s parent or grandparent, many years ago. The person who formed the trust was not (and is not) a US taxpayer and the assets are not located in the US.
The starting point is to determine the tax liability for the US beneficiary is to establish whether the trust will be regarded as a Grantor or Non-grantor trust.
Foreign trusts are almost always Non-grantor trusts, unless the grantor is a US taxpayer or the beneficiary made a settlement to the foreign trust within five years of becoming a US taxpayer.
The US tax treatment of the distribution received by the family member in the US will vary greatly depending on the nature of the distribution received and whether it consists of trust capital, distributable (current) net income (“DNI”) or accumulated income earned in prior years (“UNI”).
Distributions of trust capital are free from tax in the US.
Where the distribution is equal to or less than the trust’s current net income/DNI, the income will retain its nature in the hands of the beneficiary and will be taxed accordingly. For example, if the distribution includes realized long-term capital gains, the distribution will be taxed at the lower long-term capital gains rate applicable in the US.
However, where the trust has accumulated income earned in prior years/UNI and the distribution to the beneficiary exceeds the current net income of the trust, the portion of the distribution that exceeds the current net income of the trust will be treated as an accumulation distribution that will be subject to very punitive “throwback tax” and interest charges.
In this case, the beneficiary will be taxed as though he received the accumulation distribution over the period that the income of the trust was accumulated. The US tax on the accumulation distribution will be at the highest marginal tax rate prevailing for each year that the excess built up. In addition, the beneficiary will be subject to penalty interest for each year that the accumulation distribution was built up. The longer the period that the income was accumulated over, the more punitive the effect of the throwback tax and interest will be, to the extent that the tax and interest liability can erode the entire distribution.
Where a trust has US beneficiaries, the trustees also need to be aware of their reporting obligations to the US beneficiaries. The trustees should provide the beneficiary with a Foreign Non-grantor Trust Beneficiary Statement, which records the amount of the distribution, as well as the composition of the distribution and whether it contains UNI (and the nature of such income, for example: dividends, interest etc.), DNI or capital. This statement must be submitted by the beneficiary to the IRS, failing which, the beneficiary will be required to calculate their US tax liability on the distribution by using a default method, which may result in more tax being payable than if the beneficiary statement had been obtained from the trustees.
The calculations required when a distribution of accumulated income is made by a Foreign Non-grantor trust to a US beneficiary are complex and the trustees often do not have the information available that is required for these calculations.
Trustees of Foreign Non-grantor trusts are therefore cautioned to obtain tax advice from a US tax advisor before making any distributions to a US beneficiary.