QUESTION: In foreign trusts, it is not unusual to give the trustee the authority to capitalize undistributed income (including capital gains). Does that in effect cause the “undistributed income” to become ”trust corpus/principal” and therefore avoid being treated as ”accumulation distribution”—under U.S. regulations ?
REPLY: For trust accounting purposes, it is my understanding that the trustee can convert income into corpus/principal if the trust agreement calls for undistributed income to become part of the trust corpus. This would permit the trustee to make income distributions based on criteria in the trust agreement (such as health, education, standard of living) and to then re-direct part of the income to the remainder beneficiaries if that income is not deemed to be needed by the income beneficiaries.
For U.S. tax purposes, if a trust is a grantor trust, all income of the trust is subject to tax by the trust grantor and therefore is included in principal (aka previously taxed corpus) if not distributed. The same rule would apply to a foreign grantor trust, because the U.S. grantor is subject to tax on the income whether or not distributed.
If a U.S. based (domestic) trust is a non-grantor trust, then any undistributed income would be subject to tax at the compressed tax rates of a domestic trust. Subsequent distributions of that income are generally deductible by the trust and taxable to the beneficiary. Therefore, a non grantor U.S. (domestic) trust would not convert undistributed income into principal/corpus for tax purposes.
However, your question is in response to my comments about non-grantor foreign trusts, which are not subject to U.S. tax on undistributed income. Instead, the distribution of any previously untaxed income of a foreign non-grantor trust to a U.S. beneficiary would be subject to a complicated “throwback tax”, which includes the imposition of compound interest on the amount of tax deferred because of the deferral of income to the beneficiaries.
These comments are an extremely brief and non-technical explanation of some very extensive tax rules and should not be interpreted as a complete explanation of the U.S. tax rules for distributions to trust beneficiaries.
by Vern Jacobs
Join me in New Zealand this coming December and I’ll be available for small group discussions with attendees during the symposium. Early bird discounts of $450 are still available but time is getting short before the discounts are no longer available. Here are some good reasons for visiting New Zealand this winter.
1. Auckland New Zealand Rated 5th Best Urban Center in Which to Live
2. New Zealand Offers Outstanding Real Estate Investment Potential
3. New Zealand is Tax Free for New Residents
4. New Zealand Ranked First in Business in 2006 by World Bank
5. It is Summer in New Zealand When it’s Snowing Up North
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