- IRD income or deductions of a trust or estate can be either tax-favorable or unfavorable to foreign beneficiaries, depending on the type of income or expense involved.
- Simple trusts become complex when they have foreign beneficiaries.
- Sales of U.S. real property by trusts or estates can create undue tax burdens for foreign beneficiaries.
- A comprehensive example shows how many types of income and expenses are treated for an estate with three beneficiaries, two of whom are foreign.
This two-part article explains the computations, payment, and reporting requirements for U.S. trust and estate distributions to foreign beneficiaries. Part I, in the December issue, explained how to verify the tax status of foreign beneficiaries for U.S. tax purposes, calculate the “net distribution” amount after properly withholding tax payments, and comply with the reporting requirements. Part II contains a comprehensive example that illustrates various aspects of fiduciary accounting and how the corresponding distributable net income (DNI) allocations affect the net distribution amounts to the foreign beneficiaries.
It is recommended that readers be familiar with Part I of this article to fully understand the analysis and discussion in Part II. Estate and trust administration can be challenging for fiduciaries, even if all the beneficiaries are U.S. persons. Having one or more foreign beneficiaries can significantly complicate the administrative procedures and responsibilities for fiduciaries.
Focus on the Current Global Environment
In today’s global society, it is not unusual to see family members living in different foreign countries. As such, with more frequency, fiduciaries are faced with estate and trust administrative responsibilities involving distributions to foreign beneficiaries. These circumstances are complicated by economic factors, including international tax issues, foreign currency exchange rates, and the necessity to plan prudently to maximize beneficiary distribution amounts.
Impact of Recent Income Tax Law Changes
From a tax perspective, recent federal tax law changes increasingly raise international tax issues. For example, the HEART Act of 20081 targets “covered expatriates,” certain designated former U.S. persons who leave the United States on or after June 18, 2008. The HIRE Act2 in 2010 created laws that require determining whether U.S. persons are beneficiaries for international tax reporting purposes. In a corollary responsibility, U.S. fiduciaries must verify the residency and citizenship of foreign beneficiaries for administrative and tax reporting purposes.
Beginning in 2013, U.S. fiduciaries face the new 3.8% Medicare tax on net investment income exceeding the threshold amount for the trust or estate.3 Because the net investment income tax applies only to the undistributed net investment income of the estate or trust, a fiduciary for a discretionary trust should consider making distributions to the beneficiaries to reduce the trust’s undistributed net investment income. The net investment income tax is imposed on the lesser of the undistributed net investment income or the amount by which the estate or trust’s adjusted gross income (as defined in Sec. 67(e)) exceeds the dollar amount at which the highest tax bracket begins in the tax year.4 In 2012, the highest tax bracket for estates and trusts was 35%, which kicks in for income in excess of $11,650, so the net investment income tax is a concern. However, the nonresident beneficiary’s net investment income (in his or her share of distributable net income) will not subject him or her to the tax. Fellow U.S. beneficiaries could be subject to the tax after 2012, based upon their share of distributable net income and whether their other income is high enough.
The new tax does not apply to a nonresident alien.5 Also, in most cases the investment income tax does not apply to simple trusts or grantor trusts. Simple trusts require that all income be distributed currently (so there is no undistributed net investment income subject to the tax at the entity level). Grantor trust income is taxed directly to the owner.
Impact of the Estate Plan on Foreign Beneficiaries
The U.S. fiduciary’s administration is affected by the estate plan (i.e., trust instrument and will provisions, as well as the local law Uniform Principal and Income Act (or equivalent) provisions). Accordingly, the prudent fiduciary will consider not only the tax impact of certain investment income but also the intent of the grantor and/or decedent, as expressed in the documents. Further, he or she will consider the particular circumstances of each beneficiary, the advisability and timing of making distributions, and the feasibility of allocating some or all capital gains to income. Such allocation could minimize the entity’s tax and maximize benefits to foreign beneficiaries (as such income could be tax-exempt in the case of nonresident aliens, as discussed in Part I).
Analysis of Certain Fiduciary Accounting Issues Affecting Foreign Beneficiaries
The allocation of the distributable net income can have unique nuances from the foreign beneficiary’s tax perspective. For example, certain income items included in the foreign beneficiary’s pro rata share of distributable net income are nontaxable, as explained in Part I, in contrast to the tax consequences of the same items for the U.S. beneficiary. Fiduciaries should seek knowledgeable professionals to assist them in planning beneficiary distributions early in the entity’s administration.
Analysis of Specific Income Items
In general, all amounts a domestic trust distributes to a beneficiary, whether those amounts represent income or principal for fiduciary accounting purposes, are treated as income to the beneficiary for federal income tax purposes to the extent that the trust has distributable net income for the tax year. However, assume, for example, that the trust has portfolio bank interest income, which is included in its distributable net income for the tax year. The fiduciary paid distributions during the tax year evenly between A, a U.S. beneficiary, and B, a citizen and resident of Australia.
Such interest income is excluded from fixed or determinable annual or periodic income under Sec. 871(h) for the nonresident alien beneficiary’s allocated share, which the U.S. tax treaty with Australia respects by treating the interest income as “tax-exempt” for Australian tax purposes, too. However, the trust is eligible for an income distribution deduction under Sec. 661 for the pro rata distributions to A and B. Accordingly, under Sec. 662, the allocated income portion is includible in the taxable income of both beneficiaries. However, because B is a nonresident alien and the interest income is not U.S.-source income (i.e., effectively connected income (ECI)), B is not subject to Sec. 1441 withholding tax on that portion of the distribution.6 See further analysis on this issue in Part I. Case law and IRS rulings support the position that the income distribution deduction is not limited to distributions made to U.S. citizens or residents.7
Capital Gains Tax Treatment and Reporting for Foreign Beneficiaries
Under Sec. 643(a), distributable net income encompasses the trust’s taxable income, computed with certain modifications, the most notable of which is the subtraction, in most cases, of the trust’s capital gains. However, the definition of income under Regs. Sec. 1.643(b)-1 reflects changing fiduciary investment practices. IRS guidance was updated because of revisions to state principal and income acts that allow for a more equitable division of the return on trust investments among beneficiaries. Accordingly, the fiduciary is permitted to exercise discretion (if the trust instrument allows such discretion) in allocating realized capital gains to income in a consistent manner. If the fiduciary allocates capital gains to income, those gains will be treated as included in distributable net income for the tax year and thus taxed to the beneficiaries (Regs. Sec. 1.643(a)-3).
However, the nonresident alien beneficiary does not recognize U.S.-source capital gains income unless he is present in the United States for at least 183 days during the tax year.8 Part I further discusses this issue. Under Secs. 652(b) and 662(b), income has the same character in the hands of the beneficiary as it does in the hands of the trustee. Accordingly, whether a particular income item is taxable to a nonresdient alien beneficiary is determined at the trust level.
IRD Planning With Regard to Foreign Beneficiaries
A U.S. estate is treated similarly to a complex trust and is taxed as a separate entity on its undistributed ordinary income and capital gains. Income in respect of a decedent (IRD) consists of those items of income earned by a decedent as of the date of death that are not includible in the decedent’s gross income before his or her death under the decedent’s cash method of accounting. Sec. 691(c) allows the decedent’s estate or successor in interest, whoever collects the IRD items, to deduct from gross income an allocation of estate tax attributable to those items included in the gross estate as a separate deduction on the income tax return.
Sec. 691 also allows estates and certain other persons an income tax deduction for deductions in respect of a decedent. IRD items are generally paid after the decedent’s death, but are owed as of his or her death. Examples include accrued real estate taxes and accrued mortgage interest as of the date of death. These deductions may not be used to reduce Sec. 1441 withholding to the nonresident alien beneficiary’s pro rata portion of the IRD income allocated to distributable net income. Examples of IRD income items subject to Sec. 1441 withholding include retirement income, IRA income, accrued dividend income, and compensation for personal services rendered before death.
Other IRD items are favorable to nonresident alien beneficiaries. Examples include accrued interest income and capital gains (other than Sec. 897 gains) included in installment sale payments. Part I of this article explains the reasons these income items are favorable for nonresident alien beneficiaries. Those IRD income items can enable a fiduciary to execute some tax planning if they are included in “trapping distributions.” A trapping distribution is a distribution from an estate or trust to another “new” trust or trusts that carry out the dstributable net income of the distributing estate or trust. The new trust(s), created in the post-death estate plan, can then distribute some of the distributable net income of the distributing estate or trust to the trust beneficiaries. Trapping distributions thus allow the estate to split or share its income among several taxpayers, which may include nonresident alien beneficiaries.
A trapping distribution will be made to a simple trust only if the distribution is treated as principal for fiduciary accounting purposes. Otherwise, the estate’s distributable net income will pass through the trust and be taxable to the beneficiary to whom the trust income must be distributed. Distributable net income is not carried out to the beneficiaries of a complex trust in the year the trapping distribution is made, except to the extent the trust makes a distribution. In this case, it does not matter whether the trapping distribution is treated as principal or income for fiduciary accounting purposes.
Simple Trusts Are Not Simple When They Have Nonresident Alien Beneficiaries
A simple trust is one whose governing instrument (1) requires that the trust distribute all of its fiduciary accounting income currently and (2) does not provide for certain charitable payments or such amounts set aside for later payment. A trust is not treated as a simple trust during any tax year in which it distributes principal to beneficiaries.9
Further, Sec. 651 provides that a simple trust receives an income distribution deduction for the amount of income that it is required to distribute currently, but only to the extent that the trust has distributable net income. Such treatment applies whether or not the trust actually distributes any income for the tax year. Correspondingly, the income beneficiaries of a simple trust include in their gross incomes an amount equal to the trust’s income distribution deduction, whether or not a distribution was actually made.10 That amount is allocated among the beneficiaries either ratably to the extent that no distribution was made or according to the actual payment amounts received. As such, all income beneficiaries are treated as receiving a proportionate share of each type of income (i.e., dividends, interest, etc.) included in distributable net income.
Caution Needed With Nonresident Alien Beneficiaries
Tax return preparers and fiduciaries should be cautious with foreign beneficiaries. The tax authorities in the foreign country in which the foreign beneficiary is domiciled may take the position that all of the trust’s income, not just the amounts distributed, is taxable to their resident beneficiary taxpayer. Accordingly, practitioners and fiduciaries, as a best practice, should consult with local counsel in that particular foreign jurisdiction, to determine the likelihood of such claims before they occur. Part I of this article analyzes other aspects of simple trusts for foreign beneficiaries.
Complex Trusts Are Even More Complex for Nonresident Alien Beneficiaries
U.S. trusts that are not simple trusts are complex trusts. Fundamentally, such trusts permit the accumulation of trust accounting income, or they distribute principal during the year. It is therefore not unusual to have a trust classified as a simple trust one year and as a complex trust another year and vice versa. The income tax rules that apply to complex trusts also generally apply to estates.
The income distribution deduction for a complex trust is determined for the tax year as follows:
- First, income that the trust under its governing instrument is required to distribute currently is added to all amounts that are properly paid or credited, or required to be distributed, for that year.11 The trustee can elect under Sec. 663(b) to treat an amount properly paid or credited within the first 65 days of a tax year as if it were paid or credited on the last day of the preceding tax year. That election is also available for an estate.
- Next, (a) that sum, reduced by the amount of tax-exempt income that was distributed (or deemed to have been distributed) by the trust, is compared to (b) the trust’s distributable net income, reduced by the amount of tax-exempt interest earned by the trust. The lesser of the two amounts is the trust’s income distribution deduction for the tax year.
The beneficiaries, under Sec. 662(c), are treated as receiving distributable net income distributed by the trust as if it were received on the last day of the trust’s tax year. Thus, each beneficiary must include the taxable portions of distributable net income in his or her gross income for that year. A complex trust with multiple beneficiaries may need to be classified according to a “tier system” or a “separate share treatment,” as determined by the terms of the governing instrument (or local law).
For tax years ending after Dec. 31, 1999, if there exist separate economic interests for a beneficiary or class of beneficiaries, and the interests neither affect nor are affected by interests accruing to another beneficiary, or class of them, then each beneficiary’s or class’s interest must be treated as a “separate share” for the purpose of computing distributable net income (the separate share rule).12 The rule applies to trusts and estates. If a Sec. 645 election has been made by the trustee and/or executor to adopt the estate’s fiscal year, the trust will always be a “separate share” of the estate.13 IRS regulations also indicate that the separate share rule will apply for purposes of allocating income in an estate plan that provides for creation of a marital trust and a credit shelter trust. Under these circumstances, the fiduciary has discretion to use a “reasonable and equitable” method for allocating the income for each separate share.14
The purpose of the tier system is to expose mandatory income beneficiaries to the maximum amount of distributable net income, based upon the income that they receive, with the remaining distributable net income, if any, allocated among beneficiaries receiving other distributions (i.e., tier 2 beneficiaries). Under the tier system, if the amount of income required to be distributed currently is greater than the trust’s distributable net income, the entire distributable net income amount is allocated to the beneficiaries (tier 1 beneficiaries) of the mandatory income distributions, in proportions based upon the amount of income that each beneficiary receives. The tier 2 beneficiaries are taxed only if the distributable net income exceeds the first-tier distributions. If there is more than one tier 2 beneficiary, each is taxed on his or her proportionate share of the excess distributable net income based upon the amount of trust property distributed to each.
Specific Application to Nonresident Alien Beneficiaries
In terms of the best estate plan administered for either a U.S. complex trust or an estate with foreign beneficiaries, there are many issues to analyze. With tax planning objectives in mind (at the least to avoid double taxation and gift tax issues in the beneficiary’s foreign jurisdiction) the tax laws in the beneficiary’s home country should be analyzed as well as the U.S. laws. The premier issue, again, is the type of income and its magnitude in terms of the determination of distributable net income for the U.S. entity.
As discussed previously and in Part I, if the income type is favorable to the nonresident alien beneficiary, designating him or her as a tier 1 beneficiary would have fewer tax consequences to him or her than if the income type is less favorable. Certainly, allocating capital gains to income would be favorable (depending on the type, as discussed in Part I) and reduce the entity’s U.S. tax liability, accordingly. Under these circumstances, the U.S. entity would not owe a “capital gains tax” because of the income distribution deduction attributable to the capital gains allocated to income. Such income distribution would be tax-exempt to the nonresident alien beneficiary for U.S. tax purposes, as previously discussed. The same analysis and conclusions could be drawn from execution of the “separate share rule” in the distributions. These principles should be reviewed with the grantor during the drafting stage (possibly executed by document amendments) of the estate plan and correlated with his or her objectives and intent.
Income Items Creating Tax Burdens for Foreign Beneficiaries
Foreign beneficiaries can face severe tax consequences in terms of Sec. 1445 withholding for their allocation of Schedule K-1 trust or estate income from a passthrough entity (i.e., an estate or trust, a partnership, or an S corporation) that sold a U.S. real property interest at a gain. The consequences can be further compounded if the passthrough entity did not transfer cash at least equal to the K-1 income distribution amount to the trust or estate. Under Sec. 1445(e)(4), the trustee of a domestic trust or the executor of a domestic estate must deduct a tax equal to 10% of the fair market value of the U.S. real property disposition (or 35% of the gain realized, under Sec. 1445(e)(1)—i.e., a Sec. 897(c) transaction) that would constitute a taxable distribution to a foreign person beneficiary (based upon his or her pro rata share of the gain).
In some cases, the fiduciary may not have sufficient cash to withhold and pay the Sec. 1445 withholding tax and may have to liquidate other assets to make the payment. Also discussed in Part I was the allocation of IRD income to foreign beneficiaries who face unfavorable tax consequences because of Sec. 1441 withholding tax and an inability to share deductions as their fellow U.S. beneficiaries do in their distributable net income allocated distributions. Caution should be exercised with these types of transactions.
Putting Trust/Estate Administration in Proper Perspective
A fiduciary who performs estate and trust administration services may be an individual, a trust company, or a family office organization. The settlor’s decision of which fiduciary to designate in the estate planning documents is more critical when the estate will include foreign beneficiaries.
A fiduciary’s performance can be measured by good decisions, meaningful communication, and effective actions. Successful results require immediate access to all relevant information at hand. The greater the size of the trust’s or estate’s assets and number of beneficiaries, the greater the need for effective trust management and administration. Knowledgeable estate planning professionals can assist the grantor to understand what will be required from the fiduciary and to identify the right person or institution to act in that capacity. Alternatively, in a family office setting, the family office executive usually coordinates the advisers, advocates for the needs of family members, and makes sure that the trustee has the information and knowledge to perform his or her duties properly. Such a family model also can, with its management support structure, assist the trustee in his or her strategy and execution of the trust or estate administration.
An educated trustee can better enhance the trustee/beneficiary relationship from both a personal and a legal viewpoint. A sound working relationship is essential with nonresident beneficiaries in various foreign countries. Striving for such objectives will hopefully enable those beneficiaries to understand the necessary reporting requirements under U.S. tax laws.
Practical Example Illustrating Foreign Beneficiary Distributions
The tax nuances in reporting income distributions to foreign beneficiaries, as analyzed and discussed in Parts I and II, can be better understood with comprehensive examples of various income items. The following examples illustrate how estate plan drafting and a prudent fiduciary’s administration can increase opportunities for foreign beneficiaries to overcome some dilemmas from their U.S. tax consequences. Understanding these unique reporting issues will enhance the fiduciary’s success in his or her administration responsibilities.
Domestic estate example: H, a single U.S. citizen residing in Nevada, died on April 30, 2011. H’s estate plan documents provide for the post-death funding of a discretionary trust with income beneficiaries. The decedent created a revocable trust during his lifetime, and his assets were held in the name of the trust. The income beneficiaries of the testamentary trust in the event of H’s death include B, his brother, a U.S. citizen and resident of Nevada; C, his sister, a citizen and resident of Australia; and D, another brother, a citizen and resident of England. The estate plan provides that the three beneficiaries will receive discretionary distributions from the executor and trustee, W, a professional trustee, in equal shares.
W elects under Sec. 645 to treat the revocable trust as part of the estate for federal income tax purposes. As such, during the election period, W will allocate income of the estate in accordance with the “separate share rule” of Sec. 663(c) and allocate the income tax burden between the estate and trust in a reasonable manner. Since the election period will begin at the date of death, there will be no estate for income tax purposes (only a trust) for W to make the income allocations. W elected a fiscal year ending Nov. 30, 2011, for the first tax year. He anticipates that the estate administration, including the filing of Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, will not be completed until 2012. Both beneficiaries C and D have provided W with a signed Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding, for 2011.
Included in the estate of H are the following assets and income: commercial rental properties in Nevada (two shopping centers with multistory office buildings, both with on-site property management personnel); U.S. dividend-paying stocks; money market accounts at U.S. banks; a residence; various personal property; and accrued rents, dividends, and interest income.
The estate’s income, expenses, and distribution payments for the period from May 1, 2011, to Nov. 30, 2011, using the cash receipts and disbursements method, are indicated in Exhibit 1. Other provisions in H’s estate plan documents are included in Exhibit 2. The computation of “Net Rental Income” on Schedule E, Supplemental Income and Loss, for the first tax year is illustrated in Exhibit 3. The allocation of the depreciation deduction between the entity and the beneficiaries is illustrated in Exhibit 4. The calculation of DNI and the income distribution deduction for the tax year is illustrated in Exhibit 5. The tax reporting for the foreign beneficiaries on Forms 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, and their respective net distributions are illustrated for the tax year in Exhibit 6. Exhibit 7 illustrates the Schedule K-1, Beneficiary’s Share of Income, Deductions, Credits, etc., reporting for the first tax year for each beneficiary.
Summary of the Results for the Estate of H for 2011
W, the executor and trustee of the Estate of H, would file the Forms 1042-S as shown in Exhibit 6, four forms for each foreign beneficiary, C and D (for a total of eight for 2011), by March 15, 2012. Copy A of each Form 1042-S (by paper form) would be sent with Form 1042-T, Annual Summary and Transmittal of Forms 1042-S, to the address in the form instructions. A separate Form 1042-T is filed with each type of Form 1042-S (see page 1 of the 2013 Form 1042-S instructions).
W would provide copies B, C, and D of Forms 1042-S to beneficiaries C and D to use to file their respective Forms 1040NR, U.S. Nonresident Alien Income Tax Return, for 2011. Copy E of the Forms 1042-S would be retained for W’s records.
W would make timely payment of the Sec. 1441 withholding tax ($2,100) following the IRS instructions. Current IRS deposit requirements, as described in the Form 1042 instructions, require the withholding agent to use the Electronic Federal Tax Payment System (EFTPS) to deposit the tax withheld and required to be shown on Form 1042. As the undeposited taxes exceed $2,000 for the Estate of H at the end of the quarter-monthly period, W must deposit the $2,100 within three business days after the end of December 2011, if not deposited earlier.
The “net cash distribution” to the foreign beneficiaries would be calculated, as indicated in Exhibit 6, as $69,950 each. The taxable amount of their corresponding distribution, to the extent of each beneficiary’s allocable share of distributable net income, is reported on each beneficiary’s Schedule K-1, as indicated in Exhibit 7. The “gross taxable distribution” for beneficiaries C and D is $71,000 because the federal income tax withholding is a “credit” that is itself a distribution from the entity to each of them. Part I of this article contains an analysis and explanation of the law and IRS guidance on these issues. Because the distributable net income ($176,000) was less than the total distributions paid ($213,000) in the tax year, the full amount of distributable net income in Exhibit 5 is apportioned on the Schedules K-1 on a pro rata basis (using the separate share rule).
Because of his prudent administrative procedures, W would have informed beneficiaries C and D in their initial communications for each to obtain an individual taxpayer identification number (ITIN) by filing Form W-7, Application for IRS Individual Taxpayer Identification Number, with the IRS. It usually takes four to six weeks to obtain the ITIN. The ITIN is required when claiming benefits under a U.S. income tax treaty, which both intend to do. On June 22, 2012, the IRS announced interim changes to its procedures for issuing ITINs.15 The procedures now require applications on Form W-7 to include original documentation (i.e., passports and birth certificates or certified copies of such documents from the issuing agency). Fiduciaries and practitioners should review these new requirements to assist the foreign beneficiaries.
Fiduciaries should seek professional advice and assistance when they administer a U.S. estate or trust with foreign beneficiaries. Knowledgeable practitioners can guide them through some tricky reporting and administrative duties to comply with U.S. laws and IRS regulations, which can change frequently. At the same time, the timing of distributions and any planning beforehand can enhance the foreign beneficiary’s net distribution amounts.
1 The Heroes Earning Assistance and Relief Tax Act, P.L. 110-245; see Part I for further analysis and discussion.
2 The Hiring Incentives to Restore Employment Act of 2010, P.L. 111-147.
3 New Sec. 1411 is effective for tax years beginning after Dec. 31, 2012; net investment income will be subject to a new 3.8% tax; types of income subject to the new tax are defined in the statute.
4 Sec. 1411(a)(2).
5 Sec. 1411(e).
6 See Rev. Rul. 86-76, 1986-1 C.B. 284; see also IRS Letter Ruling 8828034 (7/8/88).
7 Examples of such authority include Estate of Petschek, 81 T.C. 260 (1983), and Regs. Sec. 1.651(a)-1.
8 See Sec. 871(a)(2).
9 Regs. Sec. 1.651(a)-1.
10 Sec. 652(a).
11 Sec. 661(a).
12 See Regs. Sec. 1.663(c)-1.
13 See Regs. Sec. 1.663(c)-4(a).
14 See Regs. Secs. 1.663(c)-2(c) and 1.663(c)-5, Example (3).
Larry McNamara is a sole practitioner in Bend, Ore. He is a member of the AICPA Trust, Estate and Gift Tax Technical Resource Panel, its Foreign Trust Task Force, and its Trust Accounting Income Task Force–Technical Issues Working Group. For more information about this article, contact Mr. McNamara at email@example.com.