In the new millennium, we often see family members living in different foreign countries, and more frequently than ever, fiduciaries are faced with estate and trust administrative responsibilities involving distributions to foreign beneficiaries. Throw in economic factors, international tax issues, foreign currency exchange rates, and planning needed to maximize beneficiary distribution amounts, and simple trusts become complex.
New tax laws, especially the Foreign Account Tax Compliance Act (FATCA) enacted in 2010, and effective in 2013, as well as corresponding Treasury regulations and rulings, affect the correct reporting by fiduciaries of domestic trust and estate distributions to foreign beneficiaries. Sales of U.S. real property by trusts or estates can create undue tax burdens for foreign beneficiaries. What may seem rather straightforward fiduciary administrative and reporting procedures can involve numerous complexities, sometimes with unexpected consequences! Daszkal Bolton recommends early coordination with fiduciaries to carefully plan the distribution and accounting procedures before embarking on reporting the results for tax return purposes.
Careful planning and prudent administration should consider a number of factors, including:
Each beneficiary’s income tax filing status, both in the United States and in the country of residence;
The potential relevance of tax treaty provisions advantageous to the beneficiaries applicable to each foreign jurisdiction;
The practical aspects of trust/estate administration, focusing on “flexible” aspects, if possible;
Being informed on applicable law changes, including the standards for making distributions and reporting them in the beneficiary’s foreign jurisdiction to ensure the proper reporting; and
Proper allocation of receipts and disbursements between income and principal under local law and the governing instruments
Key Point: Nonresident beneficiaries may be faced with more challenging technical issues before enjoying their net distribution benefits from a U.S. trust, compared to their fellow U.S. beneficiaries.
To comply with U.S. withholding and reporting rules, before making distributions to foreign beneficiaries, fiduciaries and practitioners must determine the beneficiaries’ tax status and whether the income distributed is subject to withholding. U.S. persons for U.S. tax purposes include U.S. citizens, resident aliens (green card holders), and U.S. residents who meet the “substantial presence” test , generally those present in the United States for more than 183 days over a three-year period), or make a first-year election. (There are certain exceptions of course) An individual who fails the substantial presence test may avoid being classified as a U.S. resident if he or she can establish a closer connection to a foreign country which is determined based on facts and circumstances, including the location of family, personal belongings, and business connections; where the individual holds a driver’s license; and where he or she votes. Form 8840, must be filed to claim the closer connection exception. A nonresident alien is any individual who is neither a U.S. citizen nor a resident alien. After determining the beneficiary’s tax status, the fiduciary should obtain the nonresident’s identifying tax number and tax withholding certificate to withhold the tax required to be withheld on certain items of income distributed to nonresident alien trust or estate beneficiaries.
Requirements for Withholding Tax for Foreign Beneficiary Distributions of Income
Fiduciaries may be required to withhold tax on distributable net income that is distributed by estates and complex trusts or required to be distributed by simple or complex trusts to a foreign beneficiary (foreign beneficiaries can include foreign trusts). Taxes are withheld when the distributions consist of amounts subject to withholding. The withholding requirements apply to foreign persons, but not resident aliens. A grantor trust is subject to tax withholding when a foreign person is treated as its owner and the trust has income subject to withholding.
Whoever can disburse or make payments is responsible for withholding the tax before the “net distribution” is paid. There are rules for when an exemption or a reduced rate of withholding should apply. The gross amount of income subject to withholding tax may not be reduced by any deductions, except to the extent that a nonresident alien is allowed a personal exemption for remuneration for personal services rendered in the United States.
A fiduciary is not required to withhold tax if a foreign person assumes responsibility for withholding as a qualified intermediary or an authorized foreign agent like a foreign financial institution.The fiduciary remains fully liable for the acts of its agent.
In addition to withholding, the tax must be paid in coordination with filing Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, with the IRS for the applicable calendar tax year.
There are certain presumptions about a payee who is a foreign beneficiary that the fiduciary must be aware of during a grace period to establish foreign tax status. The fiduciary may rely on the information and certifications stated on the Form W-8BEN which now requires filers to provide a foreign tax identification number. This requirement is an attempt under FATCA procedures to collect non-U.S. taxpayer information that could be transmitted under recently announced intergovernmental agreements between the U.S. and treaty countries.
Tax must be withheld on payments of interest, dividends, and other fixed or determinable annual or periodic U.S.-source income paid to foreign persons. The beneficiary may be eligible for a reduced withholding rate or an exemption from withholding, if he or she is entitled to benefits under provisions in a U.S. income tax treaty.
Separate Forms 1042-S Foreign Person’s U.S. Source Income Subject to Withholding must be filed to report each type of income for each beneficiary. For example, a trust that distributed distributable net income consisting of dividends and rental income to two foreign beneficiaries is required to file four Forms 1042-S. Such reporting is required even if withholding was not made because of a treaty provision or an exception in the Code.
Payment of the withholding taxes to the IRS is reported on Form 1042. The fiduciary is indemnified against the claims and demands of any person for the amount of any tax it deducts and withholds, however, this indemnity does not relieve the fiduciary from tax liability and the fiduciary can be personally liable, even if the payer reasonably believed that correct action was taken.
If distributions are made to a foreign beneficiary, tax withholding is required on amounts from U.S. sources, and those amounts are reported on Form 1042-S, including:
FDAP income (fixed or determinable annual or periodic income (e.g., rents and royalties).
Certain gains from the disposal of timber, coal, or domestic iron ore with a retained economic interest.
Gains related to contingent payments received from the sale or exchange of patents, copyrights, and similar intangible property.
Distributions of effectively connected income from a publicly traded partnership.
Capital gains, other than those listed above and gains on the sale of U.S. real estate or real property interest or gains from effectively connected income property are notsubject to withholding tax on distributions to foreign beneficiaries. 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. Certainly, allocating capital gains to income would be favorable (depending on the type) and reduce U.S. tax liability. Such income distribution would be tax-exempt to the nonresident alien beneficiary for U.S. tax purposes.
Income that might be included in the distributable net income of a U.S. trust or estate, subject to Form 1042-S reporting, includes, but is not limited to, the following U.S.-source amounts:
Rents and royalties;
Pension and other deferred income, including IRAs;
Most gambling winnings;
Cancellation of debt income;
Effectively connected income, including bank deposit interest that is effectively connected income;
Original issue discount (OID) from the redemption of an OID obligation; and
Amounts, whether or not subject to withholding, paid to a foreign payee and have been withheld on, by another withholding agent under the “presumption rules”
The following income items are exempt from tax withholding but should be reported by category:
Interest on bank deposits, provided that the income is not effectively connected, including bank deposit interest from foreign branches of U.S. banks or savings and loans. The exemption also applies to interest paid to Canadian residents who are not U.S. citizens, but only if less than $10 per calendar year.
Interest and OID from short-term obligations (i.e., those payable 183 days or less from the date of original issue).
Accrued interest and OID.
When the normal conduit rules of trust and estate taxation apply, the interest income is ultimately received by the nonresident alien beneficiary. Otherwise, the bank interest income would be taxable to the U.S. trust or estate. As the interest income is not taxable to the nonresident, the fiduciary should not have to withhold tax on that income item.
In 2012, the Treasury issued final regulations that require U.S. financial institutions to annually report bank deposit interest income of all nonresident individuals to the IRS, effective for payments made on or after January 1, 2013. These new rules only affect reporting requirements and do not affect the taxation of the interest income.
The distributable net income of the estate or trust is typically determined for each beneficiary’s Schedule K-1 in a three-step process:
1. gross income by type
2. allowable deductions allocated to each gross income item
3. distributable net income as calculated in steps 1 and 2 is then compared to the distributions to each of the entity’s beneficiaries
The method of allocating amounts found in Step 2 among trust beneficiaries depends on whether the trust is a simple or a complex trust. For the purposes of satisfying the Form 1042-S reporting and withholding requirements, the foreign beneficiary faces a higher effective tax rate than the U.S. beneficiary of the same trust or estate on some income items. However, by filing a Form 1040NR for the tax year, the foreign beneficiary may be able to file for a refund on a portion of the tax withheld on his or her Forms 1042-S.
Tax Treaty Benefits
Most types of U.S. source income received by a foreign person are subject to U.S. tax of 30%. To prevent double taxation in an international context, the U.S. tax treaty system with many foreign countries protects foreign persons from U.S. tax in certain cases. When a foreign beneficiary has an income type subject to a reduced withholding rate based on a foreign country’s tax treaty provision, a separate Form 1042-S must be prepared to report that rate. Exceptions for U.S. bank debt or “portfolio interest” are common income items. The tax benefits incorporated in a U.S. tax treaty are generally available only to persons who are residents of one or both of the contracting states, and is liable for tax under that state’s laws by reason of his or her domicile, residence, or citizenship. The withholding agent will be required to analyze the facts and circumstances in each foreign beneficiary’s case to determine if he or she is entitled to income tax treaty benefits in his or her resident foreign country. The United States and the other signatory country usually agree that any item of income that is not covered such as Business Profits, Dividends, Interest, Royalties, etc. is taxable onlyin the jurisdiction of the recipient’s residence. Recipient must prove they are not merely a resident, but a “qualified resident” of the contracting state.
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.
Special rules apply for expatriates. Whether a non-grantor trust makes a direct or indirect distribution to a covered expatriate, the trustee may be required to withhold 30% of the “taxable portion” of the distribution.
Some income in respect of a decedent (IRD) items are favorable to nonresident alien beneficiaries. Examples include accrued interest income and capital gains included in installment sale payments.
Foreign beneficiaries can face severe tax consequences in terms of withholding for their allocation of Schedule K-1 trust or estate income from a pass-through 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 pass-through entity did not transfer cash at least equal to the K-1 income distribution amount to the trust or estate.
Most foreign beneficiaries would desire a cash distribution be paid in their currency. To do so requires that the fiduciary be knowledgeable of the applicable federal tax reporting issues, as well as future foreign currency conversion amounts, to maximize potential gains and minimize potential losses before making such distribution conversions. If the amount subject to withholding tax is paid in a currency other than U.S. dollars, the amount of withholding is determined by applying the applicable rate of withholding to the foreign currency amount and converting the amount withheld into U.S. dollars on the date of payment at the spot rate in effect on that date. The fiduciary could elect to calculate the withholding tax and withhold the tax before making the currency conversion for the distribution payment to the foreign beneficiary. However, in that case, if the currency conversion transaction results in a gain to the beneficiary, additional withholding tax may be due.
Recent Income Tax Law Changes
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. 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 exceeds the dollar amount at which the highest tax bracket begins in the tax year. 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. The new tax does not apply to a nonresident alien. Also, in most cases the investment income tax does not apply to simple trusts or grantor trusts. The fiduciary must consider not only the tax impact of certain investment income but 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.
Contact Us: Best practices and sound strategies are needed for U.S. estate and trust administration in order to maximize net distributions to foreign beneficiaries. Let Mark Chaves, CPA, Partner in Charge of International Tax, assist with the myriad forms to be filed and documentation necessary to verify residence and to compute the correct withholding tax annually. Mark can analyze U.S. tax treaty provisions to determine correct withholding rates, and mitigate risks involved with currency conversions. Complex Trusts are even more complex for non-resident alien beneficiaries and certain income items create tax burdens for foreign beneficiaries. Contact Mark at 561-367-1040 or [email protected]