Reporting trust and estate distributions to foreign beneficiaries.

• Author: McNamara, Lawrence H., Jr.
• Position: Part 1

This two-part article explains the procedures and tax compliance issues that fiduciaries face before domestic trust or estate distributions are paid or allocated to foreign beneficiaries. Part I explains how to verify the tax status of foreign beneficiaries for U.S. tax purposes and calculate the net distribution amount after properly withholding tax payments. Part II, in the January issue, will contain a comprehensive example of calculating the net distribution amount and calculating the withholding tax on income items for beneficiaries residing in various foreign countries, as well as the application of certain tax treaty benefits.

[ILLUSTRATION OMITTED]

The increasing interaction of global economic issues and a mobile society make international tax issues more commonplace, even for smaller practitioner firms. New tax laws, especially the Foreign Account Tax Compliance Act (FATCA) provisions enacted in 2010 that will be effective in 2013 (1) and corresponding Treasury regulations and rulings, affect the correct reporting by fiduciaries and practitioners of domestic trust and estate distributions to foreign beneficiaries. What may seem rather straightforward fiduciary administrative and reporting procedures can involve numerous complexities, sometimes with unexpected consequences. The complex rules necessitate early coordination between practitioners and 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. (2)

Determination of Tax Status of the Beneficiary

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 of Sec. 7701( b) (generally those present in the United States for more than 183 days over a three-year period) or make a first-year election. (3) There are certain exceptions for residents of Canada or Mexico who regularly commute to employment in the United States, foreign-government-related individuals, certain teachers and students, and individuals with medical conditions that arose while present in the United States. (4)

An individual who fails the substantial presence test may nevertheless avoid being classified as a U.S. resident if he or she can establish a closer connection to a foreign country. An individual may satisfy the "closer connection test" if the individual can establish that he or she (1) was present in the United States for fewer than 183 days during the current year; (2) maintains a tax home in a foreign country; (3) has a closer connection during the current year to the foreign country where his or her tax home is located than the U.S.; and (4) has not applied or taken affirmative actions to change his or her status to that of a lawful permanent U.S. residents (5) The determination of whether an individual has maintained a closer connection to a foreign country 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. (6) Form 8840, Closer Connection Exception Statement for Aliens, must be filed to claim the closer connection exception to the substantial presence test (attached to a timely filed Form 1040NR, U.S. Nonresident Alien Income Tax Return).

A nonresident alien is any individual who is neither a U.S. citizen nor a resident alien. (7) After determining the beneficiary's tax status, the fiduciary should obtain the nonresident's identifying tax number and tax withholding certificate (as indicated on Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding) to withhold the tax required to be withheld on certain items of income distributed to nonresident alien trust or estate beneficiaries.

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, but that topic is beyond the scope of this article.) Taxes are withheld when the distributions consist of amounts subject to withholding (i.e., the income portion, not corpus). The withholding requirements apply to foreign persons (i.e., nonresident aliens), 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.

The payer (or a person with control, receipt, or custody or who can disburse or make payments) is responsible for withholding the tax before the "net distribution" is paid. The withholding tax rate is ordinarily 30%. The Sec. 1444 regulations provide detailed rules for when a payer is required to withhold tax, the documentation that can be relied on to establish the status of a payee, and whether 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. (8)

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. (9) A "qualified intermediary" is a foreign financial institution or foreign clearing organization that has entered into a qualified intermediary withholding agreement with the IRS, as represented on Form W-8IMY, Certificate of Foreign Intermediary, Foreign Flow-Through Entity, or Certain U.S. Branches for United States Tax Withholding. The fiduciary should request a copy of the form from the intermediary.

If the fiduciary, as the withholding agent, makes a payment to a person that can be treated as an intermediary, the payee is the intermediary to the extent that the intermediary assumes primary withholding responsibility for the payment. (10) In that case, the fiduciary is not required to withhold tax on the payment. For a payment to an authorized foreign agent, that agent can fulfill the withholding obligations of the U.S. fiduciary only if (1) there is a written agreement between the withholding agent fiduciary and the foreign person acting as agent; (2) the fiduciary satisfies certain notification procedures; (3) books, records, and relevant personnel of the foreign agent are available (on a continuous basis, even after the termination of the relationship) for IRS examination to evaluate the fiduciary's withholding and reporting compliance; and (4) the fiduciary remains fully liable for the acts of its agent and does not assert any defenses to avoid any tax liability under the Code. (11)

The fiduciary, by appointing an authorized foreign agent, must file notice of the appointment with the Office of Assistant Commissioner (International) before the first payment for which the authorized agent acts as such and acknowledge the withholding liability as described above in (4). (12) The fiduciary, for example, may be compelled to engage an authorized foreign agent to assist an incapacitated or minor foreign beneficiary in order to maintain security for the ultimate distribution to its beneficial owner.

IRS Guidance for Withholding Requirements for Trusts and Estates

Regs. Sec. 1.1441-5 has specific guidance for tax withholding in the case of U.S. simple trusts, complex trusts, and estates. See Exhibit 1 for a summary of the rules for simple trusts. See Exhibit 2 for a summary of rules for complex trusts and estates. The regulation makes specific reference to the "entity" as having the responsibility for withholding and paying the tax 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. However, for U.S. trusts and estates, the fiduciary has many duties and responsibilities under applicable state laws.

Exhibit 1: Withholding requirements by U.S. simple trusts

1. A U.S. simple trust (i.e., a trust that is required to distribute its income currently, Sec. 651(a)) is required to withhold under Chapter 3 as a withholding agent on the distributable net income includible in the gross income of the foreign beneficiary to the extent that the distributable net income is an amount subject to withholding (Regs. Sec. 7.1447-2(a)).

2. The tax withholding is required when the distribution is made.

3. The fiduciary may make a reasonable estimate of the portion of the distribution that constitutes distributable net income consisting of an amount subject to withholding and apply the appropriate rate of withholding tax to the estimated amount.

4. If the fiduciary determines that tax was underwithheld under Sec. 1441 or 1442, the fiduciary of the trust can be held liable for the underwithheld amount under Sec. 1461.

5. No penalties are imposed for failure to withhold and deposit the tax, if the estimate was reasonable and the trust pays the underwithheld amount for the applicable tax year on or before the Form 1042...