Distributions from foreign trusts can have very different US tax consequences depending on the type of trust and the nature of the distribution. For US beneficiaries, understanding how income, accumulated amounts, and trust benefits are treated is essential to avoid unexpected tax charges and penalties.

This guide explains how distributions from foreign trusts are taxed under US rules, with a particular focus on the throwback tax.

Why Distributions From Foreign Trusts Are Special

Unlike distributions from US trusts, distributions from foreign trusts are subject to a layered tax system designed to prevent income from being deferred indefinitely outside the United States. The rules are especially complex for foreign non-grantor trusts, while foreign grantor trusts follow a simpler approach.

Foreign Grantor Trust Distributions

In a foreign grantor trust, the trust’s income is treated as belonging to the grantor for US tax purposes.

Key Points for US Beneficiaries

• The grantor is taxed on all trust income, whether or not it is distributed.
• Because the income has already been taxed to the grantor, distributions to US beneficiaries are generally not taxed again, provided reporting requirements are met.
• Proper filing of required information returns is critical to avoid unintended taxation and penalties.

As a result, foreign grantor trusts generally do not trigger throwback tax issues for US beneficiaries.

Foreign Non-Grantor Trust Distributions

Distributions from foreign non-grantor trusts are treated very differently and are subject to detailed ordering rules.

Step 1: Distributable Net Income (DNI)

When a US beneficiary receives a distribution, it is first treated as coming from the trust’s current-year distributable net income (DNI).

• The beneficiary is taxed on their share of DNI at the same rates that would apply if the trust did not exist.
• If the trust distributes all of its DNI during the year (or within 65 days after year-end if a special election is made), no accumulation arises.

Step 2: Undistributed Net Income (UNI)

If the trust does not distribute all of its income in the year it is earned, the undistributed portion becomes undistributed net income (UNI).

• When a distribution exceeds the beneficiary’s share of DNI, the excess is treated as an accumulation distribution.
• Accumulation distributions are subject to the throwback tax, which may include an interest charge designed to reflect the deferral of US tax.

Step 3: Trust Capital

Only after all DNI and UNI have been fully distributed can a US beneficiary receive distributions treated as trust capital.

The Throwback Tax Explained

The throwback tax applies when a US beneficiary receives an accumulation distribution from a foreign non-grantor trust.

• It is intended to eliminate the tax benefit of accumulating income offshore.
• The tax calculation looks back to the years in which the income was earned but not distributed.
• An interest charge may be imposed on the tax due, increasing the overall cost to the beneficiary.

Because of this, accumulation distributions can result in higher effective tax rates than regular income distributions.

Non-Cash Benefits Treated as Distributions

US tax rules also treat certain benefits as distributions, even if no cash is received.

Use of Trust Property

• When a US beneficiary uses trust property, the fair rental value of that use is treated as a distribution from the trust.

Loans From the Trust

• Loans are generally treated as outright cash distributions, unless they qualify as restricted “qualified obligations” under narrowly defined terms.

These rules ensure that US beneficiaries are taxed on economic benefits received from foreign trusts, not just cash payments.

Indirect Distributions and Anti-Avoidance Rules

Distributions cannot usually be avoided by routing payments through non-US persons.

• If a foreign trust distributes to a non-US beneficiary who then transfers funds to a US beneficiary, the IRS may treat the US beneficiary as having received a trust distribution.
• There is a rebuttable presumption of tax avoidance if related-party transfers occur within a 24-month period.

Key Takeaways

• Foreign grantor trust distributions are generally not taxed again to US beneficiaries because income is taxed to the grantor.
• Foreign non-grantor trust distributions follow a strict order: DNI first, then UNI, then capital.
• Accumulation distributions can trigger the throwback tax and interest charges.
• Use of trust property and most loans are treated as taxable distributions.
• Indirect distributions may still be taxed if avoidance is suspected.

Final Thoughts

Understanding these rules is critical for US beneficiaries receiving distributions from foreign trusts, as the tax consequences and penatlies for incorrect or noncompliance can vary significantly depending on timing, trust classification, and proper reporting.

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.