Trusts and US tax: The importance of trustee and beneficiary residency

Changing the residency of a trust 

It is possible to change the residency of a trust for US tax purposes. This can be part of a tax-planning strategy, looking to domesticate a foreign trust to improve the US tax-efficiency for US beneficiaries or it can happen unintentionally.  

Most commonly, an unplanned change of residency occurs when a sole trustee of a trust administered under the law of a US state, becomes a US person, making the trust US resident, or ceases to be a US person, making the trust a foreign trust.  

However, care should also be taken when a trust has a protector with the power to overrule trustee decisions. Protectors are often family members or close friends of the settlor and may be unaware that their personal tax residence can impact the residence of the trust. 

US tax filing requirements – for trustees 

Foreign trust 

Trustees of a foreign trust will only have a US tax filing requirement if the trust has US source income that is Effectively Connected Income (ECI) or Fixed, Determinable, Annual, Periodical (FDAP) income. Usually, this would be in rental income from US real estate or US business profits (ECI) or US dividend income (FDAP). 

The trust would then be required to file a Form 1040NR. The filing and payment deadline for this form is 15 April, with the ability to request an extension to 15 October. The extension is for filing purposes only and does not extend the date to pay any tax liability. 

For most trustees, as the trust will not be in receipt of US earned income subject to withholding reported on a Form W-2, they have until 15 June to file Form 1040NR or request a further extension, without facing late filing or payment penalties. 

The trustees will also need to consider any FATCA reporting requirements to ensure that they have the correct rate of withholding applied to their US income.

US trust 

Trustees of a US trust will need to report all the trust income, gains, deductions, and distributions made in the calendar year on a Form 1041. The filing and payment deadline for this Form is 15 April, with the ability to request an extension until 30 September. The extension is for filing purposes only and does not extend the date to pay any tax liability. 

US tax filing requirements – for US beneficiaries 

Foreign trust 

In any year that the US beneficiary receives a distribution from a foreign trust, they will be required to file a Form 3520 – Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts. The deadline for submission of this follows their individual US Federal tax return, including any applicable extensions up to 15 October. This is an information-only reporting form. It provides basic information to the IRS about the foreign trust as well as detailing the US tax treatment of the distributions received by the beneficiary for the year. 

For the beneficiary to report the distribution correctly, they will either need to receive a Foreign Grantor Trust Beneficiary Statement or a Foreign Non-Grantor Trust Beneficiary statement from the trustees, otherwise there can be punitive tax issues for them.  

US trust 

In any year that there has been a distribution, the trustees must ensure that they provide the beneficiaries with the relevant Form K-1 for them to complete their personal US tax filings.

Case study – Foreign trust accidentally becoming a US trust

Imagine the situation where a close family friend was acting as a sole trustee of a US resident trust. They decide to expatriate from the US, having failed to consider the impact this would have on the trust. 

Once the trustee ceased to be a US person, the trust would fail to meet the Control test, therefore becoming a foreign trust from this point onwards for US tax purposes. This would have a huge impact on the US taxation of the distributions to US beneficiaries going forward, opening the trust up to the punitive Undistributed Net Income (UNI) and Throwback Tax rules. 

Fortunately, IRS regulations provide a 12-month grace period from the date the trust ceases to be a US trust to make the necessary changes to give control back to US persons when the change occurred unintentionally. 

This would provide sufficient time to appoint two new trustees, who were US citizens.

Combined with an amendment to the deed to allow decisions to be made based upon a majority vote, this would be sufficient to restore the US residency of the trust, whilst still allowing the existing trustee to maintain their role within the trust, even though they were no longer a US person. 

In a situation where a trustee plans to moves elsewhere or a successor trustee is appointed who is tax resident outside of the US, then it would be necessary to review the trust residence rules in the other jurisdiction to understand how this could impact the residency of the trust. This review should be undertaken prior to their move or appointment to ensure that any necessary planning can be implemented by the trust. 

Establishing the residence of a trust for US tax purposes can be a complicated matter.  

For professional advice tailored to your unique circumstances, please fill out the form below and one of our experts will be in touch to discuss your requirements and how we can help. Please note that our advisory services are charged at our hourly rates and a formal engagement will need to be in place before any advice is provided.