Foreign trusts are an area of US tax law where small mistakes can lead to unexpected taxes, penalties, and compliance problems. Many of these issues arise not from deliberate non-compliance, but from misunderstandings about how foreign trusts are classified, taxed, and reported.
This guide highlights common mistakes US taxpayers make when dealing with foreign trusts and explains how they can be avoided.
Mistake 1: Assuming a Trust Is Domestic Because It “Looks” US-Based
A frequent mistake is assuming a trust is domestic simply because it is managed in the US or has US trustees.
For US tax purposes, a trust must meet both the Court Test and the Control Test to be considered domestic. A trust can become foreign if:
- A foreign person has veto power over trust decisions
- A protector or trustee is not a US person
- The trust instrument includes an automatic migration clause
How to avoid it:
Confirm that the trust meets both tests. Even one foreign control element can make a trust foreign for US tax purposes.
Mistake 2: Misunderstanding Grantor vs Non-Grantor Trust Status
Another common error is assuming that the person who funded the trust is always taxed on its income.
- Some foreign trusts are grantor trusts, where income is taxed to the grantor.
- Others are non-grantor trusts, where income is taxed to the trust or beneficiaries.
Incorrect classification can result in income being reported by the wrong taxpayer or not reported at all.
How to avoid it:
Review whether the grantor retained powers over income or distributions and whether the trust can benefit US persons.
Mistake 3: Ignoring Accumulation and Throwback Tax Exposure
US beneficiaries often underestimate the tax consequences of receiving distributions from foreign non-grantor trusts.
If a trust accumulates income instead of distributing it, later distributions may be treated as accumulation distributions and subject to the throwback tax, including interest charges.
How to avoid it:
Understand whether distributions come from current-year income or from accumulated prior-year income before accepting them.
Mistake 4: Treating Non-Cash Benefits as Non-Taxable
Many US beneficiaries believe tax only applies when they receive cash.
Under US rules:
- Use of trust property is treated as a distribution based on fair rental value.
- Loans are generally treated as outright distributions unless strict conditions are met.
How to avoid it:
Recognise that economic benefits, not just cash, can trigger taxable distributions.
Mistake 5: Failing to File Required IRS Forms
One of the most costly mistakes is failing to meet foreign trust reporting obligations.
Common filing errors include:
- Not filing Form 3520 for distributions or benefits
- Trustees failing to file Form 3520-A
- Missing or incomplete trust statements
Penalties can apply even when no US tax is due.
How to avoid it:
Ensure all required forms and trust statements are filed on time and accurately.
Mistake 6: Assuming Income Can Be Shifted Through Intermediaries
Some taxpayers believe distributions can avoid US tax by routing them through non-US beneficiaries.
US rules generally prevent this where one purpose of the transaction is tax avoidance. Transfers between related parties within a 24-month period are presumed to be for avoidance unless proven otherwise.
How to avoid it:
Do not rely on indirect payment structures to change tax outcomes.
Mistake 7: Overlooking Foreign Investments Held by Trusts
Foreign trusts may hold interests in foreign corporations such as:
- Controlled foreign corporations (CFCs)
- Passive foreign investment companies (PFICs)
These interests may be attributed to US beneficiaries or grantors, triggering tax and reporting obligations even without distributions.
How to avoid it:
Review the trust’s underlying investments and understand how ownership may be attributed to US persons.
Mistake 8: Missing Gain Recognition When Funding or Changing Trust Status
Certain transfers involving foreign trusts can trigger immediate US tax on unrealized gains, including:
- Funding a foreign non-grantor trust with appreciated assets
- A US trust becoming foreign
- A grantor changing residency status
- Death of a grantor causing the trust to become non-grantor
Losses are generally not deductible in these situations.
How to avoid it:
Identify when transfers or status changes may trigger gain recognition.
Key Takeaways
- Foreign trust classification errors are common and costly.
- Grantor vs non-grantor status determines who is taxed.
- Accumulation distributions can trigger the throwback tax.
- Non-cash benefits may still be taxable.
- Reporting failures can result in penalties even without tax due.
Final Thoughts
Foreign trusts require careful attention to classification, distributions, and reporting. Avoiding these common mistakes can significantly reduce compliance risks and unexpected tax exposure for US taxpayers.
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.
