How Do Discretionary Trusts Work for US Expats in Australia
Published on October 29, 2024
by Nick Wee
Nick Wee, an IRS Enrolled Agent with 17 years of expat tax experience, specializes in US tax preparation, tax planning, and tax advice for US citizens and Green Card holders living and working in Australia.
Table of Contents
Why Australian discretionary trusts don’t work for US citizens, dual nationals, and Green Card holders. holders.
Yes, discretionary trusts, often called family trusts in Australia, can be useful for US citizenship holders in Australia; but the tax advantages are slim and often non-existent because of how the IRS views distributions to the beneficiaries of the trust.
Even if you’re also an Australian citizen, it doesn’t help here.
Australian family trusts are particularly complicated due to US tax laws and they apply to all those with US citizenship and Green Cards.
What is an Australian discretionary trust?
A discretionary trust is a type of trust where the trustee has the power to decide how the income or capital of the trust is distributed among the beneficiaries.
In Australia, families use these trusts to manage wealth and reduce taxes. Typically, the person creating the trust transfers assets like cash or shares into the trust, and the trustee decides how to distribute earnings from those assets.
Why do people set up discretionary trusts in Australia?
People set up discretionary trusts in Australia to manage assets and reduce their overall tax burden. The trust itself isn’t taxed directly.
Instead, earnings from the trust—such as income from investments—are distributed to beneficiaries, who are taxed individually. By distributing income to family members with little or no other income, the overall tax paid can be significantly reduced.
For example, if a family member, like an adult child in university, has little or no other income, distributing trust earnings to them means those earnings are taxed at a lower rate, potentially using tax-free thresholds.
This is more tax-efficient than keeping the income under the original taxpayer’s name, which might be taxed at the highest rate of 47% in Australia.
I want to know more about US taxes abroad
What happens when US expats use discretionary trusts?
Things get more complicated for US expats using discretionary trusts because of US tax laws. The US Internal Revenue Service (IRS) treats discretionary trusts as “grantor trusts.”
Why does the IRS consider discretionary trusts grantor trusts?
A grantor trust is one where the person who created it (the grantor) is still considered the owner of the assets. This means that the IRS expects the grantor to pay tax on all income generated by the trust, even if the income is distributed to someone else.
The IRS views discretionary trusts as a way for the original owner to retain control while avoiding US taxes.
For example, if a US expat in Australia transfers assets into a discretionary trust and the trustee distributes income to a low-income family member, the IRS still expects the grantor to pay tax on those earnings.
The IRS sees this as an attempt to shift taxable income to someone else, so they tax the grantor as if they still own the assets.
Can beneficiaries in Australia pay lower taxes while the grantor pays US taxes?
Yes, and this is where the main problem lies for US expats using discretionary trusts. If income from the trust is distributed to a family member in Australia, that family member may pay little or no tax due to their low income.
However, the grantor (the US expat) is still liable for US taxes on the trust’s earnings.
For instance, if a trust distributes AU$30,000 to an adult child in university, the child may pay a minimal amount of tax in Australia. However, the IRS considers the original grantor responsible for paying tax on the full amount at US rates.
Plus, the grantor cannot use the tax paid by the child in Australia to claim a foreign tax credit in the US, since it wasn’t the grantor who paid those taxes.
Why do US expats face double taxation issues with discretionary trusts?
The Australian tax system allows income from a discretionary trust to be taxed to the beneficiary. However, the IRS disregards this and expects the US grantor to pay taxes on the trust’s earnings as if they still control them.
Since the US grantor cannot use the taxes paid by Australian beneficiaries as a foreign tax credit, they end up being taxed twice on the same income—once in Australia and again in the US.
What are the penalties for incorrect reporting of a discretionary trust?
Failing to correctly report a discretionary trust to the IRS can result in substantial penalties. If a US expat fails to report the trust as a grantor trust using Form 3520 or Form 3520-A, the penalties can be as high as US$10,000 per missed form.
In addition, there can be penalties of up to 5% of the value of the trust for each month of non-compliance. These penalties can quickly add up, making it extremely important for US expats to understand and properly report their trusts.
How does the IRS treat trust earnings in Australia?
The IRS considers all earnings generated by a discretionary trust to be taxable to the US grantor, even if those earnings are distributed to someone else in Australia.
Whether the income comes from dividends, bonds, or other investments, the grantor must report it on their US tax return. This often leads to a higher tax burden for the US grantor compared to the tax treatment in Australia.
Can US expats use discretionary trusts without running into tax problems?
The only way to safely use a discretionary trust as a US expat is with the help of a knowledgeable tax advisor who understands both US and Australian tax systems.
Proper planning can help, but for many expats, the complexities and risk of double taxation make discretionary trusts impractical. Some may use other methods to manage their wealth that don’t trigger the grantor trust rules.
Should US expats avoid discretionary trusts?
Whether US expats should avoid discretionary trusts depends on their situation.
While these trusts can help manage wealth and reduce taxes in Australia, US tax implications can negate those benefits and lead to a lot of headaches.
For many US expats, it may be more practical to explore alternative structures or consult with a tax professional who can help navigate the specific rules surrounding trusts.