Deep Insights of Throwback Rules & Its Role in the Foreign Trusts by Matthew Ledvina

March 14 02:12 2019

As discussed with Matthew Ledvina, he mentioned that before the introduction of the Throwback rules in 1954, offshore trusts were a crucial part of the tax planning and the management of assets. At that time, it was pretty easy for trusts to accumulate income and convert it to the principal for the US beneficiaries. The accumulated income was distributed to a US beneficiary without any penalty.

Introduction of the Throwback Rules

In 1954, new rules were implemented to restrict the tax loophole followed by the trusts and took on the name of the “Throwback Tax”. In the initial years, the rules tracked the income collected within the previous 5 years. However, over time, a lot of alternations were made to the rules that made them stricter, especially for the non-grantor trusts that have US beneficiaries. Following are some of the key highlights of Throwback Tax that are prevailing currently:

  • The rules mainly focus on two types of incomes namely the Distributable Net Income (DNI) and the Undistributed Net Income (UNI).

  • Distributable net income is effectively the current year’s ‘profit of trust.  For a foreign trust, profit is interest income, dividend income, and realized capital gains. The DNI is offset against trustee fees, administrative fees, and until 2018 could include investment and custody fees.

  • If the trustee would not distribute out the current profit (ie the DNI) to a beneficiary, then the current profit would become accumulated profit (ie, undistributed net income, or UNI)

  • The trustee has a bit of time to pay out the DNI to ensure it does not become UNI.  The IRS is gracious and gives 65 days after the end of the year for a trustee to either pay the DNI out, or at least credit the DNI to a particular beneficiary.  This allows time for the trustee to calculate the DNI.

  • If the trust has UNI, then any payments to a US beneficiary will consist firstly of DNI (ie normal US tax), and then UNI (ie the Throwback Tax), and then capital (ie tax-free money).  The problem is that if the trustee is holding a large amount of UNI it is not possible to access the tax-free capital.

  • The Throwback Tax is an onerous tax, which includes an interest charge that is added to the tax due. In the worst case, the total taxes can go as large as the total amount of the accumulated distribution amount.  So, a trustee makes a distribution of 100 of UNI to a US beneficiary and the US beneficiary will potentially pay a Throwback Tax of 100—a tax of 100%.


A Few Ways to Handle UNI

The accumulation of undistributed net income (UNI) in the foreign trust will make the capital inaccessible.  However, there are a few ways that allow trustees to manage this UNI risk. The easiest way to keep the trust clear of any UNI is to ensure any DNI is paid out to either a beneficiary or another trust.  This way the trust only has DNI and capital. However, one should remember that if the transfer of UNI income is not done with proper planning then it might trigger the Throwback Tax.

If there is already a significant accumulation of UNI, the trustee could consider paying the UNI to a new-sub-trust where US beneficiaries will not receive any benefit.  By moving the UNI to a sub-trust, a US beneficiary can then benefit from the primary trust and only pay tax on the receipt of DNI.

Another, but more radical, solution is to pay all the UNI into an insurance policy which will in the future payout to the trustee a large payout. It will not eliminate the UNI per se, but it will at least stop the problem from growing, and allow, in most cases, the US beneficiary to receive a large tax-free payment which will pay-off the past UNI problem and leave a significant amount to the US beneficiary.  This insurance strategy can lower an effective 100% tax rate to a 20% tax rate (or possibly lower).

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