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 may not work for US citizens, dual nationals, and Green Card holders.
Discretionary trusts, often called family trusts in Australia, can be useful for Australians, but for US citizens or US tax residents, the tax advantages are slim and often non-existent because of how the IRS views who the tax owner is of the trust assets and the distributions to the beneficiaries of the trust.
Australian family trusts are particularly complicated due to US tax laws, and they apply to all those with US citizenship, Green Cards, or visa holders in the US.
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 manage taxes on income earned by the trust. 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. Note in some cases, the taxes on the income may be paid by the trustee.
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 in Australia, or potentially no tax if total income is below the tax-free threshold.
This is more tax-efficient than keeping the assets that earn income under the original taxpayer’s name, which might be taxed at the highest rate of 47% in Australia.
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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) typically treats Australian discretionary trusts as “foreign grantor trusts.”
Why does the IRS consider discretionary trusts grantor trusts?
A grantor trust is generally where the person who created or contributed assets to the trust is still considered the owner of the assets, known as ‘the grantor.’ 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, as they are considered the beneficial owner of the trust assets.
For example, if a US tax resident in Australia transfers assets into a discretionary trust and the trustee distributes income earned from the assets to a low-income family member, the IRS still expects the US taxpayer as the grantor to pay tax on those earnings within the trust irrespective of who pays tax the under the Australian tax rules which would be the recipient of the distribution in this example.
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, to expand further on the above example, 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. However, 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 resulting in a double tax scenario.
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.
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. There are alternative uses for trusts such as asset protection and control of assets to protect vulnerable individuals so discretionary trusts cannot be written off in its entirety.
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.
