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Information
Taxation
Income Tax
20 November 2008
Article by Lucy S. Lee and Paula Charpentier
The United States generally imposes an income tax filing requirement on all
U.S. persons and certain foreign persons, including certain foreign trusts
with U.S. owners or other U.S. nexus. For purposes of U.S. federal income
tax and reporting, section 7701(a)(30) of the Internal Revenue Code (the
"Code")1 defines the term a "U.S. person" to mean a citizen or resident of
the U.S., a domestic partnership, a domestic corporation, any estate other
than a foreign estate and certain trusts. Section 7701(a)(31) defines the
term a "foreign trust" broadly to mean any trust other than a trust treated
as a U.S. person.
Section 6012 contains the requirements for when an individual or entity is
required to file a U.S. federal income tax return. U.S. persons are
generally required to file annually a Form 1040 to report their worldwide
income, while foreign persons are generally required to file annually a Form
1040NR to report their fixed determinable and periodic ("FDAP") income from
sources within the U.S. and income that is effectively connected with a U.S.
trade or business for the year ("effectively connected income" or "ECI").2
Section 6012 also contains the exceptions for when an individual is not
required to file a Form 1040.3
For purposes of U.S. federal income tax reporting, a foreign nongrantor
trust is treated as a foreign individual and, thus, must file annually a
Form 1040NR to report its U.S.-source FDAP income and effectively connected
income. In addition, the Code imposes certain information reporting
requirements on foreign grantor trusts with certain U.S. nexus and on any
U.S. persons who maintain certain connections with foreign trusts during the
year, including (1) ownership of a foreign grantor trust, (2) transfer of
property to a foreign trust (i.e., the U.S. transferor must notify the IRS
of the transfer and provide the IRS with the identify of the trustees and
beneficiaries),4 and (3) receipt of property from a foreign trust. Reporting
is also required for any testamentary transfer of property, as well as the
death of a U.S. citizen or resident who was considered to own any portion of
a foreign trust or in whose estate are included a foreign trust's assets.5
In the case of testamentary transfers and the death of a U.S. owner of a
foreign trust, notice must be furnished by the decedent's executor.6
Since U.S. federal income tax reporting requirements vary depending on the
residence and classification of trusts, the return preparer must determine
both the residence and classification of the trust. The following discussion
in Section II is provided to serve as a general guideline of factors to be
considered in making these determinations. However, since the determination
of a trust's residence and classification often entail intricate analyses of
trust terms and agreements, practitioners should consult appropriate advice
before determining the residence and classification of trusts for purposes
of U.S. federal income tax and reporting.
Determining the Residence and Classification of a Trust
A. Determination of an Entity as a "Trust"
Before considering the residence and classification of a trust, the entity
in question must be a "trust" from the U.S. perspective. For purposes of
U.S. federal income tax, a "trust" is defined to mean an arrangement by
which title to property is held by a person or persons, with a fiduciary
responsibility to conserve or protect the property for the benefit of
another person or persons.7 Thus, a trust is an arrangement by which
trustees take title to property for the purpose of protecting or conserving
the property for the beneficiaries.8
Depending on the terms and conditions of a trust, a trust can be treated as
a grantor trust, a simple trust or a complex trust for purposes of U.S.
federal income tax. However, certain arrangements are not treated as trusts
because they behave more as business entities by actively engaging in the
operation of a business, rather than merely holding and conserving the
assets for the beneficiaries. These trusts are referred to as "business
trusts" and are classified as corporations or partnerships for U.S. federal
tax purposes.9 In addition, certain investment trusts are not classified as
trusts.10