Reporting trust and estate distributions to foreign beneficiaries.

• Author: McNamara, Lawrence H., Jr.
• Position: Part 2

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 (p. 800), 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 2008 (1) targets "covered expatriates," certain designated former U.S. persons who leave the United States on or after June 18, 2008. The HIRE Act (2) 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. 6.52(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...