For US taxpayers, foreign trusts can be complex, and foreign non-grantor trusts have their own special rules. Understanding how they are taxed and reported is essential if you are a US beneficiary or otherwise involved with one.

What Is a Foreign Non-Grantor Trust?

A foreign non-grantor trust is a trust which meets neither the court test or the control test for US tax purposes, and is not taxed as a grantor trust. This means that the trust itself, rather than the grantor, is generally considered responsible for any income it earns. Both US and non-US grantors can create foreign non-grantor trusts, but the rules for taxation and distributions focus on the trust’s income and its beneficiaries.

US Tax Treatment

A foreign non-grantor trust is generally taxed like a non-US individual:

• The trust is subject to US tax only on US-source income, unless that income is distributed to a US beneficiary in the same year it arises.
• Income retained by the trust is not immediately taxed to US beneficiaries, but distributions carry special rules.

Distributions to US Beneficiaries

When a US beneficiary receives a distribution from a foreign non-grantor trust, tax treatment depends on the type of income distributed:

1. Distributable Net Income (DNI) – The beneficiary is taxed on their share of current-year trust income. That income keeps its original character (e.g., interest, dividends, capital gains) and is taxed to the beneficiary at the applicable US tax rates for that type of income.
2. Undistributed Net Income (UNI) – If the distribution exceeds the DNI for the year, the excess is treated as accumulation distribution. This can result in additional tax and an interest charge, often called the “throwback tax.”
3. Return of Trust Corpus – If a trust distribution exceeds both DNI and accumulated UNI, the excess is generally treated as a return of trust corpus (principal). Such distributions should not be taxable to the beneficiary, as they represent a return of capital rather than income.

Other points to note:

• Use of trust property by a US beneficiary is treated as a distribution, based on its fair rental value.
• Loans from the trust are generally treated as taxable distributions unless they meet strict exceptions.
• If the trust owns interests in foreign corporations, such as controlled foreign corporations (CFCs) or passive foreign investment companies (PFICs), US beneficiaries may be taxed on the income attributable to these corporations even if no cash is distributed.

Reporting Requirements

US beneficiaries of foreign non-grantor trusts must comply with several reporting obligations to avoid penalties:

• Form 3520 – Beneficiaries report distributions or other benefits from the trust.
• Foreign Non-Grantor Trust Beneficiary Statement – Trustees provide this statement to help beneficiaries complete their filings.
• Failing to file correctly can result in higher taxes or penalties.

Additionally, US grantors and beneficiaries may need to file:

• FinCEN Form 114 (FBAR) – Reporting foreign financial accounts.
• Form 8938 – Reporting specified foreign financial assets.

Even if these forms overlap in information, filing one does not eliminate the requirement to file the other. Appointing a US agent for the trust can help ensure accurate reporting and reduce the risk of the IRS imposing taxes or penalties.

Key Takeaways

• A foreign non-grantor trust is taxed on US-source income and distributes income to US beneficiaries with special rules.
• Distributions are taxed based on DNI, with excess amounts treated as accumulation distributions and subject punative tax rates and throwback interest charges.
• Use of trust property and certain loans can trigger taxable distributions.
• Reporting with Form 3520, beneficiary statements, and other forms like FBAR or 8938 is essential.

Final Thoughts

Understanding these rules helps US beneficiaries comply with tax law and plan for distributions from foreign non-grantor trusts without unexpected penalties.

The information in this blog post is for general informational purposes only and does not constitute professional tax advice. We strongly recommend consulting a qualified tax professional before making any decisions. US Expat Tax Advisor is not liable for any actions taken based on this content.