The Pre-Immigration Foreign Trust (5-Year Tax Rule)

Pre-Immigration Foreign Trust: Are You a US Person?

Pre-Immigration Foreign Trust

One of the most complicated aspect of international tax law is when it comes to foreign trust tax and reporting. Internal Revenue Code section 671 through 679 identify the tax rules involving US and foreign trusts. There are additional code section such as Internal Revenue Code Section 6048 and Section 6038 which involve certain reporting requirements a foreign trust as well. One very common scenario the taxpayers have to be aware of is what happens if a non-resident alien owned a trust while they were a foreign person and then became a US person. What are the tax and reporting requirements?

26 U.S.C. 679

(4) Special rules applicable to foreign grantor who later becomes a United States Person

• • • (A) In general

      • • If a nonresident alien individual has a residency starting date within 5 years after directly or indirectly transferring property to a foreign trust, this section and section 6048 shall be applied as if such individual transferred to such trust on the residency starting date an amount equal to the portion of such trust attributable to the property transferred by such individual to such trust in such transfer.

    • (B) Treatment of undistributed income

      • • For purposes of this section, undistributed net income for periods before such individual’s residency starting date shall be taken into account in determining the portion of the trust which is attributable to property transferred by such individual to such trust but shall not otherwise be taken into account.

    • (C) Residency starting date

      • • For purposes of this paragraph, an individual’s residency starting date is the residency starting date determined under section 7701(b)(2)(A).

26 USC 7701(b)(2)(A) – Resident Definition

• • (b) Definition of resident alien and nonresident alien

    • (2) Special rules for first and last year of residency

      • (A) First year of residency

        • (i) In general

          • If an alien individual is a resident of the United States under paragraph (1)(A) with respect to any calendar year, but was not a resident of the United States at any time during the preceding calendar year, such alien individual shall be treated as a resident of the United States only for the portion of such calendar year which begins on the residency starting date.

        • (ii) Residency starting date for individuals lawfully admitted for permanent residence

          • In the case of an individual who is a lawfully permanent resident of the United States at any time during the calendar year, but does not meet the substantial presence test of paragraph (3), the residency starting date shall be the first day in such calendar year on which he was present in the United States while a lawful permanent resident of the United States.

        • (iii) Residency starting date for individuals meeting substantial presence test

          • In the case of an individual who meets the substantial presence test of paragraph (3) with respect to any calendar year, the residency starting date shall be the first day during such calendar year on which the individual is present in the United States.

        • (iv) Residency starting date for individuals making first year election

          • In the case of an individual who makes the election provided by paragraph (4) with respect to any calendar year, the residency starting date shall be the 1st day during such calendar year on which the individual is treated as a resident of the United States under that paragraph.

26 CFR 679-5 Pre Immigration Trusts (Regulation)

• • • (a) In general.

      • If a nonresident alien individual becomes a U.S. person and the individual has a residency starting date (as determined under section 7701(b)(2)(A)) within 5 years after directly or indirectly transferring property to a foreign trust (the original transfer), the individual is treated as having transferred to the trust on the residency starting date an amount equal to the portion of the trust attributable to the property transferred by the individual in the original transfer.

What does this Mean?

It means that in general, if someone is a non-resident alien and resides overseas and then becomes a US person within five years after transferring property to a foreign trust, then under the us tax law, the individual is treated as the owner of the percentage portion of the trust attributed to his share — starting on the residency date. For example if a non-resident alien formed a foreign trust in 2020 and then relocated to the united states in 2023, then the portion contributed will go towards determining what their total ownership of the foreign trust is relative to the total value of the trust.

• • (b) Special rules –

    • (1) Change in grantor trust status

      • • For purposes of paragraph (a) of this section, if a nonresident alien individual who is treated as owning any portion of a trust under the provisions of subpart E of part I of subchapter J, chapter 1 of the Internal Revenue Code, subsequently ceases to be so treated, the individual is treated as having made the original transfer to the foreign trust immediately before the trust ceases to be treated as owned by the individual.

    • (2) Treatment of undistributed income

      • • For purposes of paragraph (a) of this section, the property deemed transferred to the foreign trust on the residency starting date includes undistributed net income, as defined in section 665(a), attributable to the property deemed transferred. Undistributed net income for periods before the individual’s residency starting date is taken into account only for purposes of determining the amount of the property deemed transferred.

What does this Mean?

Of the two subparts listed under (b) special rules, number 2 of the special rules is very important — because it is relatively common. In this type of situation, in trying to determine what portion of the foreign trust is owned by the new US person, the total value of contributions made to the foreign trust includes undistributed net income due to the now US person. Noting, that while it will be taken into consideration to determine the value and ownership percentage of the trust, that is the only purpose of utilizing the undistributed income that was earned before the person was a US person.

• • • (c) Examples.

      • The rules of this section are illustrated by the following examples:

        • Example 1. Nonresident alien becomes resident alien. On January 1, 2002, A, a nonresident alien individual, transfers property to a foreign trust, FT. On January 1, 2006, A becomes a resident of the United States within the meaning of section 7701(b)(1)(A) and has a residency starting date of January 1, 2006, within the meaning of section 7701(b)(2)(A). Under paragraph (a) of this section, A is treated as a U.S. transferor and is deemed to transfer the property to FT on January 1, 2006. Under paragraph (b)(2) of this section, the property deemed transferred to FT on January 1, 2006, includes the undistributed net income of the trust, as defined in section 665(a), attributable to the property originally transferred.

        • Example 2. Nonresident alien loses power to revest property. On January 1, 2002, A, a nonresident alien individual, transfers property to a foreign trust, FT. A has the power to revest absolutely in himself the title to such property transferred and is treated as the owner of the trust pursuant to sections 676 and 672(f). On January 1, 2008, the terms of FT are amended to remove A’s power to revest in himself title to the property transferred, and A ceases to be treated as the owner of FT. On January 1, 2010, A becomes a resident of the United States. Under paragraph (b)(1) of this section, for purposes of paragraph (a) of this section A is treated as having originally transferred the property to FT on January 1, 2008. Because this date is within five years of A’s residency starting date, A is deemed to have made a transfer to the foreign trust on January 1, 2010, his residency starting date. Under paragraph (b)(2) of this section, the property deemed transferred to the foreign trust on January 1, 2010, includes the undistributed net income of the trust, as defined in section 665(a), attributable to the property deemed transferred.

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 that 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 of the Streamlined Procedures. 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. 

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure. 

Contact our firm today for assistance.