Example of a Throwback Tax Calculation for Foreign Trust Distributions

Example of a Throwback Tax Calculation for Foreign Trust Distributions

Example of a Throwback Tax Calculation for Foreign Trust Distributions

In recent years, the Internal Revenue Service has significantly increased enforcement of matters involving foreign trust reporting and compliance. While the reporting of the foreign trusts on Form 3520/3520-A can be very complicated, equally challenging is calculating the income and taxes associated with the foreign trusts — especially when that income is not only current year distributions and includes undistributed income from prior years (aka accumulated distributions). Let’s walk through the basics of calculating the throwback tax on foreign trust distributions when involving non-grantor trusts — this rule refers primarily to non-grantor trusts because grantor trusts with a U.S. grantor are taxed each year whether or not the income is distributed.

This is for illustrative purposes only and not legal advice. You should speak with a Tax Attorney if you have questions about your own Throwback Tax calculation.

What is UNI (Undistributed Net Income)?

The Throwback Tax Rule comes into effect for foreign trusts when a foreign trust distributes income that was generated (in whole or part) in a prior year — so that the income is not DNI. The UNI income is income that has accumulated in the foreign trust, so what may have been deemed DNI in the year the income was generated is now categorized as UNI — and triggers the throwback tax rule.

Section 26 U.S.C. 665

• • • (a) Undistributed net income

      • For purposes of this subpart, the term “undistributed net income” for any taxable year means the amount by which distributable net income of the trust for such taxable year exceeds the sum of—

        • (1) the amounts for such taxable year specified in paragraphs (1) and (2) of section 661(a), and

        • (2) the amount of taxes imposed on the trust attributable to such distributable net income.

        •  

Example of UNI and the Throwback Tax Rule

Let’s take a very basic scenario to illustrate how to calculate the tax.

• • • Michelle is a Lawful Permanent Pesident and the discretionary beneficiary of a foreign non grantor trust.

    • In 2024, Michelle received a $60,000 distribution from the foreign non-grantor trust – even though in the current year of 2024 the DNI was only $20,000.

    • Therefore, the additional $40,000 that Michelle received was income that was generated from the trust in prior years and therefore the $40,000 that is not considered DNI, is actually considered UNI and is a accumulation distribution. 

Next, Did the Trust Pay Any Taxes?

It is important to note that in this example the foreign non-grantor trust is legitimate in the country where it was created and the trust pays annual taxes of around 20% (mostly foreign taxes but some U.S. tax as well). As a result, the amount of tax that was paid is also deemed a distribution so that when determining the amount of the distribution it would not be $40,000, but rather $48,000 which includes the $40,000 portion of the UNI and 20% of tax paid by the trust on the income.

25% ‘Disregard’ Rule under 26 U.S.C. 667

• • • “(3) Certain preceding taxable years not taken into account For purposes of paragraph (1), if the amount of the undistributed net income deemed distributed in any preceding taxable year of the trust is less than 25 percent of the amount of the accumulation distribution divided by the number of preceding taxable years to which the accumulation distribution is allocated under section 666(a), the number of preceding taxable years of the trust with respect to which an amount is deemed distributed to a beneficiary under section 666(a) shall be determined without regard to such year.”

Here’s where it can begin to get more complicated — especially in years in which there was an accumulation distribution comprising several prior years of distributed income. When determining the number of years in which a distribution was made the taxpayer has to include all years but disregard the years in which the accumulative distribution associated with that year is less than 25% of the total UNI.

Here is how the UNI breaks down based on the trust earnings:

• • • 2011:$1,000

    • 2012: $1,000

    • 2013: $1,000

    • 2014:$11,000

    • 2015: $14,000

    • 2016: $12,000

Thus in 2011 – 2013, the $1000 is less than 25% in value of the UNI ($40,000) so these would be disregarded.

3/5 Year Rule Calculation

Next, the beneficiary determines the computation years. To do so, the beneficiary selects three of the past five years by eliminating the highest year and eliminating the lowest year within the 5 year compliance period.

The beneficiary’s earnings were

• • • 2019:$300,000

    • 2020: $800,000

    • 2021: $550,000

    • 2022: $650,000

    • 2023: $700,00

Tax years 2019 and 2020 would be eliminated So that the computation here is going to include 2021, 2022, and 2023.

Next, Divide and Conquer

Section 26. U.S.C. 667

• • • “(C) by adding to the beneficiary’s taxable income for each of the 3 taxable years remaining after the application of subparagraph (B) an amount determined by dividing the amount deemed distributed under section 666 and required to be included in income under subsection (a) by the number of preceding taxable years determined under subparagraph (A), and (D)by determining the average increase in tax for the 3 taxable years referred to in subparagraph (C) resulting from the application of such subparagraph. The partial tax imposed by subsection (a)(2) shall be the excess (if any) of the average increase in tax determined under subparagraph (D), multiplied by the number of preceding taxable years determined under subparagraph (A), over the amount of taxes (other than the amount of taxes described in section 665(d)(2)) deemed distributed to the beneficiary under sections 666(b) and (c).”

The Taxpayer divides the amount of the accumulation distribution along with the taxes paid, $48,000 by three, which is $16,000 (average annual distribution amount). Then, the average annual distribution amount of $16,000 is aggregated to the income in each of the three years being used for the computation to determine what the additional income tax would have been in those years had the average annual distribution amount been distributed.

*Note: Taxpayer does not receive income benefits if portions of the income may have qualified for Long Term Capital Gain or Qualified Dividends. Let’s estimate the additional tax for those years would have been for 2021, 2021, and 2023.

• • • $5,000

    • $5,500

    • $6,000

Determining the Throwback Tax Amount

The annual taxes (we used estimated) are then averaged. We kept it simple for calculation purposes so that the average tax would have been $5,500 per year.  The average increase in tax of $5,500 is then multiplied by three which represents the taxable years in which the distributions were made, which equals $16,500. Then, the Taxpayer refers back to the earlier calculation to determine what portion of the taxes paid by the foreign trust were used to pay U.S. taxes, and that amount is deducted from the $16,500 – which results in the Throwback Tax. For example, if $3,000 of the $8,000 taxes paid were for U.S. Taxes, the $3,000 is subtracted from the $16,500, which results in $13,500 of throwback tax.

*Interest must also be calculated separately.

Late Filing Penalties May Be Reduced or Avoided

For Taxpayers who did not timely file their FBAR and other international information-related reporting forms, the IRS has developed many different offshore amnesty programs to assist Taxpayers with safely getting into compliance. These programs may reduce or even eliminate international reporting penalties.

Current Year vs. Prior Year Non-Compliance

Once a Taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, Taxpayers should consider speaking with a Board-Certified Tax Law Specialist who specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties. 

Need Help Finding an Experienced Offshore Tax Attorney?

When it comes to hiring an experienced international tax attorney to represent you for unreported foreign and offshore account reporting, it can become overwhelming for Taxpayers trying to trek through all the false information and nonsense they will find in their online research. There are only a handful of attorneys worldwide who are Board-Certified Tax Specialists and who specialize exclusively in offshore disclosure and international tax amnesty reporting. 

*This resource may help Taxpayers seeking to hire offshore tax counsel: How to Hire an Offshore Disclosure Lawyer.

Golding & Golding: About Our International Tax Law Firm

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