Should Trusts file income tax returns to the IRS? in United States

Should Trusts file income tax returns to the IRS?

Trusts must file a Form 1041, U.S. Income Tax Return for Estates and Trusts, for each taxable year where the trust has $600 in income or the trust has a non-resident alien as a beneficiary. However, if the trust is classified as a grantor trust, it is not required to file a Form 1041, provided that the individual grantor reports all items of income and allowable expenses on his own Form 1040, U.S. Individual Income Tax Return. Thus, the grantor/individual would pay the total tax liability upon the filing of his return for that taxable year.

A trust other than a grantor trust is obligated to file a tax return if it has any taxable income, has more than $600 of gross income in a single year, or has a beneficiary who is a nonresident alien (we understand that a US company is a resident alien). Otherwise, no filing requirement exists, even for a trust that is not a grantor trust.

Nonresident alien. A nonresident alien is an individual who is not a U.S. citizen or a resident alien. A resident of a foreign country under the residence article of an income tax treaty is a nonresident alien individual for purposes of withholding.

Resident alien. A resident alien is an individual who is not a citizen or national of the United States and who meets either the green card test or the substantial presence test for the calendar year.

Green card test. An alien is a U.S. resident if the individual was a lawful permanent resident of the United States at any time during the calendar year. This is known as the green card test because these aliens hold immigrant visas (also known as green cards).

Substantial presence test. An alien is considered a U.S. resident if the individual meets the substantial presence test for the calendar year. Under this test, the individual must be physically present in the United States on at least:

-31 days during the current calendar year, and

– 183 days during the current year and the 2 preceding years, counting all the days of physical presence in the current year, but only 1/3 the number of days of presence in the first preceding year, and only 1/6 the number of days in the second preceding year.

In most cases, the days the alien is in the United States as a teacher, student, or trainee on an “F,” “J,” “M,” or “Q” visa are not counted. This exception is for a limited period of time.

All “revocable trusts” are by definition grantor trusts. An “irrevocable trust” can be treated as a grantor trust if any of the grantor trust definitions contained in Internal Code §§ 671, 673, 674, 675, 676, or 677 are met. If a trust is a grantor trust, then the grantor is treated as the owner of the assets, the trust is disregarded as a separate tax entity, and all income is taxed to the grantor.

A ‘grantor trust’ is a trust that is treated, for US federal income tax purposes, as having an owner, typically the trust’s grantor (the person who transferred assets to the trust), under the principles set forth in IRC §§ 671-679.

If a trust is a “grantor trust” under Subchapter J of the Code, the trust is disregarded for income tax purposes and
the grantor is required to include its income, deductions credits and capital gains of the trust in his income.21 This
is so, regardless of whether the income is actually paid to the grantor, accumulated in the trust, or paid to another
beneficiary.

A person is the “grantor” of a trust to the extent that he or she either created the trust or made a
gratuitous transfer to the trust. Thus, the settlor of a trust is a “grantor” of that trust. A foreign
trust settled solely by a nonresident alien (who was the only transferor of property to the trust) is
treated as a grantor trust while and to the extent that either (a) the settlor has the power to revest
title in the assets of the trust in himself without the approval or consent of another person or with
the consent of a related or subordinate party who is subservient to the grantor or (b) distributions
may be made only to the settlor and/or the spouse of the settlor during the lifetime of the settlor.

A person other than the grantor is treated as the owner of any portion of a trust with respect to
which such person has a power exercisable solely by himself to vest the corpus or the income
therefrom in himself. This rule does not apply, however, to (i) a power which has been renounced
or disclaimed within a reasonable time after the holder of the power first became aware of its
existence or (ii) a power that requires the consent of any other person, whether or not adverse to
the power holder.

For some practitioners, there is no need to file IRS Form 1041, U.S. Income Tax Return for Estates and Trusts for the grantor (revocable) living trust as long as you’re alive and well and serving as the sole Trustee or as a Co-Trustee of the trust. This is because under these circumstances the tax ID number that will be used for your revocable living trust will be your very own Social Security Number, and so all interest, dividends and other income earned by the assets held in your trust will be reported to the IRS under your very own Social Security Number. As such, all income earned by your revocable living trust will be reported on your very own Form 1040, not on a separate Form 1041.

There are, however, a few circumstances where a separate Tax ID number (called an “Employer Identification Number,” or “EIN”) may be required for your revocable living trust and Form 1041 will then need to be filed. For example, if you become mentally incapacitated, then your Disability Trustee may need to obtain a separate EIN for your grantor trust. This will generally depend on the exact circumstances of your incapacity and who you’ve named to serve as your Disability Trustee (for example, your spouse vs. someone else). In some cases your Disability Trustee may determine that in order to fulfill his or her fiduciary duties and limit his or her own personal liability for paying your income tax bills, it will be necessary to obtain an EIN for your revocable living trust.

Also, sometimes your estate planning attorney may determine that it will be in your best interest for you to obtain an EIN for your revocable living trust and report all income earned by the trust on Form 1041.

In 2004: One of these disregarded entities is a revocable living trust. If you own property in a revocable living trust, you know that the trust does not file an income tax return. All of the rents, dividends, interest, expenses, etc. arising from assets owned by the living trust are reported in your individual 1040.

Good: Sept 2010: Section 6034(b)(1) provides that every trust that is not a split-interest trust described in section 4947(a)(2) but that is claiming a deduction under section 642(c) for the taxable year shall furnish the information with respect to the taxable year as the Secretary may by forms or regulations prescribe, including:

1. The amount of the deduction taken under section 642(c) within the year;
2. The amount paid out within the year which represents the amount for which deductions under section 642(c) have been taken in prior years;
3. The amount for which the deductions have been taken in prior years but which has not been paid out at the beginning of the year;
4. The amount paid out of principal in the current and prior years for the purposes described in section 642(c);
5. The total income of the trust within the year and the expenses attributable thereto; and
6. A balance sheet showing the assets, liabilities, and net worth of the trust as of the beginning of the year.

Section 6034(b)(2)(A) provides an exception to the reporting requirement of section 6034(b)(1) for a trust for any taxable year if all the income for the year, determined under the applicable principles of the law of trusts, is required to be distributed currently to beneficiaries.

Trusts use Form 1041-A to satisfy their reporting obligation under section 6034(b). According to the instructions, the trustee must file Form 1041-A for a trust that claims a charitable deduction or other deduction under section 642(c) unless an exception applies. The exceptions are for a trust that is required to distribute currently to the beneficiaries all the income for the tax year determined under section 643(b) and the related regulations ; a charitable trust described in section 4947(a)(1) ; and for tax years beginning after 2006, a split-interest trust described in section 4947(a)(2). Section 642(c)(1) provides that a trust is allowed a deduction in computing its taxable income for any amount of the gross income, without limitation, that pursuant to the terms of the governing instrument is, during the taxable year, paid for a purpose specified in section 170(c). For a trust to claim a charitable deduction under section 642(c) for amounts of gross income that it contributes for charitable purposes, generally the governing instrument of the trust must give the trustee the authority to make charitable contributions.

Trusts with foreign owners

Feb 2010: Trusts with foreign owners offer unique tax benefits because they are not liable for US income taxes in many situations. With a foreign owner, the foreign grantor trust is treated for US income tax purposes as an NRA, and the foreign grantor is taxed only on the trust’s US-source income. For this reason, foreign grantor trusts are not favoured under US tax policy, and the US Congress has taken steps to significantly restrict the opportunities for foreign persons to use these types of trusts.1 Thus, unlike US domestic trusts, which are not difficult to qualify as a grantor trust (assuming proper structuring), a foreign trust will only be a grantor trust in very limited circumstances. Specifically, a foreign trust qualifies as a grantor trust if: the trust is revocable, or if distributions from the trust may be made only to the trust’s grantor or the grantor’s spouse, or if the trust is a compensatory trust. (RC § 672(f). In some circumstances, a US beneficiary of a trust could be considered the owner of the trust, which is otherwise owned by a foreign person, if that US beneficiary transfers assets to the foreign person for less than full and adequate consideration. Id. Also, any foreign grantor trust that was in existence prior to 20 September 1995, is ‘grandfathered’ and will continue to be a grantor trust as to any property transferred to it prior to such date, provided that the trust continues to be a grantor trust under the normal grantor trust rules. Separate accounting is required for amounts transferred to the trust after 19 September 1995, together with all income and gains thereof.)

Instead, most foreign trusts are foreign non-grantor trusts with respect to which the foreign person who created the trust is not considered the owner of the trust’s assets for US tax purposes. These FNGTs are subject to draconian tax rules intended to eliminate the ability to defer the payment of income tax by US beneficiaries of the trust. If a FNGT has one or more US beneficiary, all of the worldwide distributable net income (DNI) in the trust should be distributed to the beneficiary or beneficiaries each year. If all of the trust’s DNI is not distributed, it is carried forward as UNI in the trust. UNI, when distributed, is subject to additional interest charges, which have been compounded over the length of time the UNI exists in the trust, on top of the regular tax owed by the trust’s beneficiaries, as well as potential penalties.

State Rules

State income taxes are governed separately from federal income tax. Each state is different, and the state tax obligation is distinct from the federal tax obligation. If you are dealing with an irrevocable trust, understand that the trust is governed by the law of the state where it was set up, even if grantors or beneficiaries live elsewhere.

For example, in Ohio, generally each trust which must file the IRS fiduciary income tax return (IRS form 1041) must also file the Ohio fiduciary income tax return, with the following exemptions:

1. Ohio law expressly exempts from the filing and payment requirement the following types of trusts: grantor trusts, charitable remainder trusts, qualified funeral trusts, endowment and perpetual care trusts, qualified settlement trusts and funds, designated settlement trusts and funds, and retirement trusts.
2.  The trust need not file if the trust meets all the following three requirements:* The trust has no federal taxable income on account of the trust’s having distributed all income and all gain;* The trust is not an electing small business trust (often such trusts will pay federal income tax, but the income attributable to the ESBT’s investment in an S corporation is not shown as federal taxable income on the IRS form 1041); and
3. An inter vivos irrevocable trust does not have to file or pay if (i) for the entire taxable year of the trust the trust has no potential current beneficiaries, as defined in IRC section 1361(e)(2), who are Ohio residents for purposes of Ohio individual income tax law, and (ii) the trust has recognized only modified nonbusiness income.

* There are no adjustments required by ORC section 5747.01(S) which would result in Ohio taxable income (example: the trust has invested in bonds issued by another state, and the trust has not distributed the interest income from such investments. This income would not be part of federal taxable income but would be an ORC section 5747.01(S) adjustment resulting in Ohio taxable income).

Foreign Trusts

Under Internal Revenue Code (IRC) section 7701(a) (31) (B), a foreign trust is any trust that is not a US person. A trust is a US person if it satisfies two requirements:

a court within the United States is able to exercise primary supervision over the administration of the trust, and
one or more United States persons have the authority to control all substantial decisions of the trust (IRC § 7701(a)(30)(E).

(¿Per Internal Revenue Code Section 6048 any trust established in a foreign country or its US beneficiary must file certain forms with the US department of the treasury (Internal Revenue Service) each year..?)

Forms 3520 and 3520A must be filed by anyone who holds an interest in a foreign trust as a beneficiary. (IMPORTANT: 3520-A is an Annual Information Return of Foreign
Trust With a U.S. Owner) These forms are many pages long. The form 3520A is due on March 15th following the end of a calendar year. Form 3520 is due on the extended due date of the taxpayer’s personal tax return. These forms must be filed each year that the foreign trust is in existence. These forms report on the assets, liabilities and income and expenses of the foreign trust.

Congress has repeatedly attempted to discourage the use of foreign trusts by US individuals by passing legislation that has gradually reduced the tax benefits accruing from such trusts. Such legislation has included the following:

· Revenue Act of 1962.[1]

· Tax Reform Act of 1976.[2]

· Revenue Reconciliation Act of 1990.[3]

· The Small Business Job Protection Act of 1996.[4]

· Taxpayer Relief Act of 1997.

Because of the aforementioned legislative changes, the tax and other benefits flowing from foreign trusts to US persons have been greatly eroded. Notwithstanding this, foreign trusts continue to be very useful in certain circumstances.[5]

See more: The U.S. federal reporting requirements, if any, of the trust, the settlor(s) and the beneficiaries of
the trust (i.e., Internal Revenue Service Forms 3520, 3520-A, 8621, 5471, 1040, 1041, and U.S.
Treasury Department Form TD F 90-22.1).

Foreign trusts are subject to annual reporting requirements. The person responsible for the trust must file a Form 3520 and a Form 3520-A. Failure to file the relevant forms results in what the IRS calls “initial” penalties. If the IRS has not received the forms, it will issue a letter, and the party responsible for the trust then has 90 days to file the forms. If the responsible party still does not file the forms, the IRS can assess “additional” penalties. A party can avoid that penalty if it can show “reasonable cause,” which is determined based on the facts and circumstances of each case.

Many foreign trusts contain provisions which provide an individual with various powers over the
trust in the capacity as a protector or otherwise. If, for example, a U.S. person is a beneficiary of a
trust and has the power to remove and replace the trustee of the trust without any restrictions as to
the reason for the removal or as to who can serve as the new or additional trustee, such power
may be treated as a general power of appointment over the assets of the trust with adverse tax
consequences (particularly if the trustee can make discretionary distributions). Any power over a
trust should be carefully considered before the trust instrument is executed in order to determine
whether there would be any U.S. tax consequences in connection with such power if the power
holder is or becomes a U.S. person.

When the trust is considered to be a foreign trust or a domestic trust?

¿A domestic trust is any trust for which both (i) one or more U.S. persons has the power to make
all substantial decisions concerning the trust (i.e. to whom to make distributions, to remove the
trustee, to change the governing law, etc.) and (ii) the jurisdiction for court supervision of the
primary administration of the trust is within the U.S. A foreign trust is any trust which is not a
domestic trust.?

From 1999: The Small Business Job Protection Act (SBJPA) of 1996 redefined foreign and domestic trusts, which now must meet two conditions: (1) a U.S. court can exercise primary supervision over administration of the trust, and (2) only U.S. persons have authority to control substantial trust decisions. This change has important implications for plan sponsors, since under IRS regulations, qualified retirement plans must maintain a domestic trust.

Although IRS regulations spell out the domestic trust requirement, the Internal Revenue Code merely requires that the trust be created and organized in the United States. Under the SBJPA definition of domestic trust, an employee benefit plan trust may satisfy the statutory “created and organized” requirement but fail the regulatory domestic trust requirement. Previous IRS guidance indicates that the statutory standard is effectively identical to the regulatory requirement, but it’s not clear whether the SBJPA’s redefinition of foreign and domestic trusts overrides this previous guidance.

IRS regulations define substantial decisions as including whether and when to:

•
distribute income or principal
•
terminate the trust
•
resolve claims against the trust
•
remove, add or replace a trustee

However, a qualified retirement plan trust will be considered a domestic trust as long as U.S. fiduciaries control all substantial decisions

Tax consequences of foreign non-grantor trust: DNI, UNI and accumulation distributions

When distributions of DNI are made from a FNGT, the beneficiaries of the trust are taxed on their share of the distributions, and the trust receives a deduction from its taxable income to the extent of those distributions. As discussed above, to the extent that DNI is not distributed in a tax year to the trust beneficiaries, it is accumulated in the trust and becomes UNI, carried forward to the next tax year and beyond until it is finally distributed to the trust beneficiaries.3

The accumulation of UNI in the trust is problematic because when UNI is distributed to the beneficiaries, it is classified as an accumulation distribution, subject to the ‘throwback tax.’4 This tax imposes an interest charge on the regular income taxes imposed on the US distributees. The goal of the throwback rules and the interest charge is to simulate, and charge the US beneficiary at, the tax rate that would have been paid if the income had been distributed in the year that the trust originally earned such income and tax was paid at such time.

The problems associated with UNI are further exacerbated by the fact that under the throwback rules the interest charge is compounded over the period during which the trust has UNI, and to the extent that capital gains are accumulated and distributed as UNI, they are stripped of their favourable tax character.5 Thus, the longer UNI remains in the trust, the bigger the problem. And, to the extent that the trust is continuing to earn income, the problem will grow even larger each year that distributions are not sufficient to carry out the entirety of the trust’s DNI.

¿It is not hard to structure a trust so that it will be
classified as foreign under the Treasury Regulations.
All it takes is giving a nonresident a single substantial
decision-making power. For example, a trust is
foreign if it has a non-resident protector who can
replace the trustee. Thus, a trust can have Delaware
law as its proper law and be administered by a
financial institution in Delaware and still be classified
as foreign.?¿“A trust is foreign
if it has a non-resident protector
who can replace the trustee”?.

Domestic trusts are both Treated as US persons, and Are subject to tax on worldwide income, while Foreign trusts are both (1) Treated as nonresident aliens (“NRAs”), and
(2) Are subject to tax only on US source income or income effectively connected with a US trade or business.[7].

General Rule. For tax years beginning after December 31, 1996, a trust is a treated as a U.S. trust if: (i) a court within the United
States is able to exercise primary supervision over the administration of the Trust (the “Court Test”) and (ii) one
or more U.S. persons have authority to control all substantial decisions of the trust (the “Control Test”).14

So, for tax years beginning after December 31, 1996, a trust is a US trust if both:

(i) A court within the US is able to exercise primary supervision over the trust’s administration (“Court Test”); and

(ii) One or more US persons have authority to control all substantial decisions of the trust (“Control Test”).[11]

1. Note 1. A trust that does not satisfy both of these tests will constitute a foreign trust.[12]

2. Note 2. For purposes of the foreign trust definition:

a. A trust is a US person on any day that the trust meets both the court test and the control test.

b. A domestic trust means a trust that constitutes a US person.

c. A foreign trust means any trust other than a domestic trust.[13]

d. Treasury regulations apply the terms of the trust instrument and applicable law to determine whether the court test and the control test are met.[14]

Example 1. Ms. Havisham, a US citizen who resides in Maryland, creates a trust for her children, all of whom are US citizens. She names the Dickens Trust Company, a Delaware corporation, and her brother, Pip, a Bermuda citizen and resident, as co-trustees. The trust instrument (a) gives Pip the right to determine the ages at which each child receives its share of the trust fund, and (b) directs that the trust funds be maintained in the US in the custody of the Dickens Trust Company, and that Maryland law governs the trust’s administration. Here, the trust will be treated as a foreign trust because a foreign person will possess control over a substantial trust decision.

Under Treasury Regulations, “administration” refers to the carrying out of duties imposed by the terms of the trust
instrument and applicable law, including maintaining the books and records of the trust, filing tax returns,
managing and investing the assets, defending the trust from creditor claims and determining the amount or timing
of trust distributions.15 Under a safe-harbor, a trust which does not contain an automatic migration provision (For this purpose, an automatic migration provision is language providing that the trust will migrate from the United
States if a U.S. court attempts to assert jurisdiction or otherwise supervise the administration of the trust, except in case of
foreign invasion or widespread confiscation or nationalization of property in the United States. Treasury Regulation §
301.7701-7(c)(4)(ii).) meets the Court Test so long as the trust instrument does not direct it to be administered outside the United States,
and it is, in fact, administered exclusively in the United States.17 Other bright-line rules also exist for satisfying
the Court Test.18 Despite these rules, which require some action on part of the fiduciary or beneficiaries with a
United States court petitioning it to assume primary supervision of the trust, ambiguity exists with respect to all
other trusts, which do not fall within the safe-harbor and are administered in the U.S. and abroad because of
having both U.S. and non-U.S. connections.
Under Treasury Regulations, the Control Test is met if one or more U.S. persons have power, by vote or
otherwise, to make all substantial decisions of the trust with no other person having authority to veto such
decisions.(For this purpose, all persons who have authority to make such
decisions are considered, whether or not acting in a fiduciary capacity. U.S. persons are not deemed to be in control if the
trust contains an automatic provision which provides that any attempt by a governmental agency or creditor to collect
information from or assert a claim against the trust would cause one or more substantial decision to no longer be controlled
by U.S. persons.) Holding a veto power is not tantamount to control. Substantial decisions are defined as decisions that
a person is authorized or required to make under the trust instrument and applicable law (that are not ministerial),
and the Treasury Regulations provide a non-exclusive list. Importantly, a twelve month grace period exists from
the date of an “inadvertent change” in the status of a person who has the power to make a substantial decision to
make necessary adjustments with respect to the persons who control the substantial decisions, or with respect to
the residence of such persons, in order for a trust to retain its pre-change residency. (An inadvertent change is defined as the death, incapacity, resignation,
change in residency or other change with respect to a person that has a power to make a substantial decision that would cause
a change in the trust’s residency but which was not intended to do so).

Court test.

(a) Generally. The court test is one of the two tests that a trust must satisfy in order to be classified as a domestic trust.

(b) General Rule. To satisfy the court test, a court within the US must be able to exercise primary supervision over the trust’s administration.[17]

(c) Safe Harbor. Under Treasury Regulations, a trust satisfies the court test if:

(i) The trust instrument does not direct that the trust be administered outside of the US;

(ii) The trust in fact is administered exclusively in the US; and

(iii) The trust is not subject to an automatic migration provision described in Treas. Reg. § 301.7701-7(c)(4)(ii).

(d) Example 2.[18] Charles creates a trust for the equal benefit of his two children, Biddy and Pip, called the Dickens Trust. The trust instrument provides that DC, a Virginia corporation, is the trustee of the Dickens Trust. DC administers the trust exclusively in Virginia and the trust instrument is silent as to where the Dickens Trust is to be administered. In addition, the Dickens Trust is not subject to an automatic migration provision. Here, the Dickens Trust satisfies the court test.

(e) Definitions. The following definitions apply for purposes of the court test:

(i) Court.[19] “Court” means any federal, state, or local court.

(ii) The United States.[20] “United States” is used in a geographical sense. Thus, for court test purposes, the United States includes only the States and the District of Columbia.

1. Caution. A court within a territory or possession of the United States (e.g., Puerto Rico) or within a foreign country is not a court within the United States.

(iii) Is able to exercise.[21] “Is able to exercise” means that a court has or would have the authority under applicable law to render orders or judgments resolving issues concerning administration of the trust.

(iv) Primary supervision.[22] “Primary supervision” means that a court has or would have the authority to determine substantially all issues regarding the administration of the entire trust. Note that a court may have primary supervision under this definition notwithstanding the fact that another court has jurisdiction over a trustee, a beneficiary, or trust property.

(v) Administration.[23] “Administration” of the trust means the carrying out of the duties imposed by the terms of the trust instrument and applicable law, including maintaining the books and records of the trust, filing tax returns, managing and investing the assets of the trust, defending the trust from suits by creditors, and determining the amount and timing of distributions.

(f) Bright line rules for satisfying or failing the Court Test. Treasury regulations provide the following bright line rules for determining when a trust will satisfy or fail the court test, which are not intended to be an exclusive list:[24]

(i) Uniform Probate Code.[25] A trust satisfies the court test if an authorized fiduciary registers the trust in a court within the US pursuant to a state statute containing provisions substantially similar to Uniform Probate Code, Article VII, Trust Administration.

(ii) Testamentary trust.[26] A testamentary trust created by a will probated within the US (other than ancillary probate) will satisfy the court test if all fiduciaries of the trust have been qualified as trustees by a court within the US.

(iii) Inter vivos trust.[27] For inter vivos trusts, if the fiduciaries and/or beneficiaries take steps with a court within the US that cause the trust’s administration to be subject to the primary supervision of such court, the trust will satisfy the court test.

(iv) A US court and a foreign court are able to exercise primary supervision over the administration of the trust.[28] If both a US court and a foreign court can exercise primary supervision over the trust’s administration, the trust satisfies the court test.

(g) Automatic migration (i.e., flight) provisions.[29] A court within the US is not considered to have primary supervision over a trust’s administration if the trust instrument provides that a US court’s attempt to assert jurisdiction or otherwise supervise the trust’s administration, directly or indirectly, will cause the trust to migrate from the US. Such provisions are commonly referred to as “flight provisions,” “migration provisions,” and “duress provisions.” This rule will not apply, however, if the trust instrument provides that the trust will migrate from the US only in the case of foreign invasion of the US or widespread confiscation or nationalization of property in the US.

(h) Example 3.[30] Oliver, a US citizen, creates a trust for the equal benefit of his two children, both of whom are US citizens. The trust instrument provides that the Dickens Trust Company, a US corporation will serve as trustee and the trust shall be administered in Bermuda. The Dickens Trust Company maintains a branch office in Bermuda with personnel authorized to act as trustees there. The trust instrument provides that Maryland law governs the trust. Assume that under Bermuda law, a Bermuda court may exercise primary supervision over the trust’s administration. Pursuant to the trust instrument, a Bermuda court applies the Maryland law to the trust. However, under the terms of the trust instrument, the trust is administered in Bermuda, and no court within the US is able to exercise primary supervision over its administration. Here, the trust fails to satisfy the court test. Therefore, it constitutes a foreign trust.

(i) Example 4.[31] Estelle, a US citizen, creates a trust for her own benefit and the benefit of her spouse, Pip, a US citizen. The trust instrument provides that the trust is to be administered in Maryland, by Copperfield Corporation, a Maryland corporation. The trust instrument further provides that if a creditor sues the trustee in a US court, the trust will automatically migrate from Maryland to Gibraltar, a foreign country, so that no US court will have jurisdiction over the trust. Here, a court within the US is unable to exercise primary supervision over the trust’s administration because of the flight provisions. Therefore, the trust fails to satisfy the court test from the time of its creation and constitutes a foreign trust.

(3) Control Test.

(a) Generally. The control test is one of the two tests that a trust must satisfy in order to be classified as a domestic trust.

(b) General Rule. To satisfy the control test:

(i) One or more US persons

(ii) Must have authority to control

(iii) All substantial decisions of the trust.[32]

(c) Definitions.

(i) US person. The term “United States person” means a US person within the meaning of IRC § 7701(a)(30).[33] For example, a domestic corporation is a US person, regardless of whether its shareholders are US persons.[34]

1. Note. The control test, as originally enacted in the Small Business Job Protection Act of 1996, required that one or more “US fiduciaries” have the authority to control all substantial decisions of the trust in order for the trust to be treated as a domestic trust.[35] Treasury regulations use the term “persons” as defined in IRC § 7701(a)(30), which includes US citizens and residents, and domestic corporations and partnerships.[36] As a technical correction to the Small Business Job Protection Act of 1996, the Taxpayer Relief Act of 1997 substituted the term “US persons” for “US fiduciaries.”[37]

(ii) Substantial decisions.

1. Definition under Treasury Regulations. Treasury regulations define “substantial decisions” as non-ministerial decisions that persons are authorized or required to make under the terms of the trust instrument and applicable law.[38]

2. Ministerial decisions. Ministerial decisions, which do not constitute “substantial decisions,” include decisions regarding details such as the bookkeeping, the collection of rents, and the execution of investment decisions.[39]

3. Non-exclusive list of substantial decisions.[40] Treasury regulations provide the following non-exclusive list of substantial decisions:

a. Whether and when to distribute income or corpus;

b. The amount of any distributions;

c. The selection of a beneficiary;

d. Whether a receipt is allocable to income or principal;

e. Whether to terminate the trust;

f. Whether to compromise, arbitrate, or abandon claims of the trust;

g. Whether to sue on behalf of the trust or to defend suits against the trust;

h. Whether to remove, add, or replace a trustee;

i. Whether to appoint a successor trustee to succeed a trustee who has died, resigned, or otherwise ceased to act as a trustee, even if the power to make such a decision is not accompanied by an unrestricted power to remove a trustee, unless the power to make such a decision is limited such that it cannot be exercised in a manner that would change the trust’s residency from foreign to domestic, or vice versa; and

j. Investment decisions

i. Note. With respect to investment decisions, if a US person hires an investment advisor for the trust, investment decisions made by the investment advisor will be considered substantial decisions controlled by the US person if the US person can terminate the investment advisor’s power to make investment decisions at will.

(iii) Control.[41]

1. Treasury regulations define “control” as having the power, by vote or otherwise, to make all of the substantial decisions of the trust, with no other person having the power to veto any substantial decisions.

2. In order to determine if US persons have control, it is necessary to consider ALL persons who have authority to make substantial decisions of the trust, not only the trust fiduciaries.

3. Note. A trust can have a foreign fiduciary and still be a domestic trust, if the foreign fiduciary can be outvoted by domestic fiduciaries. For example, if the trust has one foreign trustee, two domestic trustees, and the trust instrument provides for a majority vote for trustee decisions, the trust satisfies the control test as a domestic trust.[42]

Under current law, effective after August 20, 1996, a trust is not generally treated as a grantor trust with respect to
a non-U.S. person (that is, the general rules of Sections 673-677 do not apply) except (i) if the grantor has power
to revoke the trust and revest its assets in himself either alone or with the consent of a related or subordinate party
subservient to the grantor22 (“Revocable Trust Exception”); or (ii) if the only amounts distributable from the trust (whether income or principal) during the grantor’s lifetime are to the grantor or the grantor’s spouse23 (“Trusts
that Distribute Only to Grantor or Grantor’s Spouse Exception”)(Certain amounts that are distributable to discharge a legal obligation of the grantor or the grantor’s spouse to an
unrelated party (or to a related party but for bona fide and adequate and full consideration or in other limited circumstances)
are treated as if distributed to them.) Some trusts in existence on September 19,
1995 that qualified under prior law as grantor trusts because (i) the grantor or a nonadverse party or both had
power to revoke the trust or revest title to the assets in the grantor (Section 676) or (ii) the income without the
approval or consent of any adverse party, or both, may be distributed or could be accumulated for future
distribution to, the grantor or the grantor’s spouse (Section 677), may continue to so qualify, but only with respect
to transfers made on or before September 19, 1995.25
While there are circumstances in which a person other than the transferor may be treated as an owner for purposes
of the grantor trust rules, in order for a non-U.S. person to be treated as the owner of a trust, he must also be a
grantor.26 A grantor is defined as any person to the extent he (i) creates a trust or (ii) directly or indirectly makes
a gratuitous transfer to the trust. (A gratuitous transfer means a transfer other than for fair market value. A
transfer is for fair market value only to the extent of the value of property received, services rendered or the right to use
property of the transferee. A transfer may be gratuitous even if it is not considered a gift for gift tax purposes and regardless
of whether the transferor recognizes gain on the transfer). A non-U.S. person who creates a trust but who makes no transfers to it (an
“accommodation grantor”) cannot be treated as the owner of the trust under the grantor trust rules. If a trust
makes a transfer to another trust, the grantor of the transferor trust is treated as the grantor of the transferee trust
unless a person with a general power of appointment exercises that power to create another trust. In that case, the
grantor shifts from the original transferor to the power holder who exercises the power to appoint to another trust.

Taxation of Non-U.S. Nongrantor Trusts

A non-U.S. nongrantor trust is taxed as a non-U.S. person (i.e., withholding tax on U.S. source income paid to the
trust or tax on effectively connected income).29 U.S. beneficiaries are subject to income tax when they receive
distributions30 to the extent of their pro-rata share of the non-U.S. nongrantor’s trust’s distributable net income
earned in that year (DNI).31 DNI of a non-U.S. nongrantor trust consists generally of taxable income (including
tax exempt income) before deducting distributions, except with the modifications of Section 643(a)(6), which
include non-U.S. source income and realized capital gains.

Form 8891

When you file a U.S. tax return, the government ordinarily has three years to audit you. After that, the year is closed forever and even if you left something off you cannot be forced to pay the extra tax for the income you failed to report. There are exceptions to this rule for situations like “substantial understatement of income” (you left off at least 25% of your income), civil tax fraud, etc. In those cases the IRS can go back in time at least six years and sometimes longer.

None of the “more than three years” exceptions will likely apply to you. Yes, if you have a massive, massive RRSP it will generate a lot of investment income which is not distributed to you. If you don’t have a lot of reportable income, you could be in the “I left off more than 25% of my income” situation. The RRSP investment income would be treated as taxable income to you in the United States, and compared to your reported taxable income it would be large. Maybe more than 25% of your reported taxable income.

But for most of you, this is not a problem. Your investment earnings inside the RRSP will be small in comparison to your reported taxable income in the United States. Thus, I am going to assume that the three year rule applies to you.

Example

You filed your 2008 Form 1040 on or before April 15, 2009 (the due date). The IRS has until April 15, 2012 to audit your tax return and assess an additional tax liability if they find additional income.

Example

You filed your 2008 Form 1040 on extension, on October 15, 2009. The IRS has until October 15, 2012 to audit your tax return and assess additional tax liability if they find additional income.

This is the default situation, which most people would assume applies to the situation of an RRSP that was not reported correctly for prior years.
Default rule for foreign trusts: 3 years after filing Form 3520

If you have a foreign trust, you are are supposed to file Form 3520. The “three years for the IRS to catch me” clock does not start ticking on until you file Form 3520.

From the Instructions to the 2009 Form 3520:

Note. If a complete Form 3520 is not filed by the due date, including extensions, the time for assessment of any tax imposed with respect to any event or period to which the information required to be reported in Parts I through III of such Form 3520 relates, will not expire before the date that is 3 years after the date on which the required information is reported. See section 6501(c)(8).

Actually, it is worse than that. For any tax returns filed on or after March 18, 2010, the entire income tax return’s statute of limitations is open forever if you fail to file the Form 3520 for your foreign trust.
RRSPs as foreign trusts: the IRS cancelled the reporting requirement

An RRSP is a foreign trust. However, there is no reporting requirement for an RRSP–Form 3520 and Form 3520-A are not required. Since the exception to the general rule (3 years for the IRS to audit you) in Section 6501(c)(8) does not apply, we are back to the normal audit cycle.
Bottom line: three years for RRSPs

If you did not file Form 8891, the IRS can probably only go back three years from the date you filed Form 1040 in order to audit you for unreported income from your RRSP.

Example

You filed your 2007 Form 1040 on April 15, 2008. The IRS has until April 15, 2011 to audit that tax return. If you should have filed Form 8891 and you didn’t, they can catch that error as long as they get to you before April 15, 2011.
Example

You filed your 2006 Form 1040 on April 15, 2007. The IRS had until April 15, 2010 to find you. Clearly, they didn’t find you. For you, 2006 is closed forever. You are safe even if you did not file Form 8891.