Double Taxation on Trust Distributions
Published on November 06, 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 US citizens may experience double taxation on trust distributions in Australia.
US expats in Australia who are involved in trust structures may face significant challenges with double taxation.
Anyone who tells you that double taxation doesn’t exist between Australia and the US because of the “tax treaty”, run away. Fast.
When a US citizen is a beneficiary or involved in an Australian trust, especially a discretionary trust, both Australian and US tax laws come into play, often leading to double taxation without prior planning.
How does double taxation happen with trust distributions?
Double taxation happens when income from a trust is taxed in both Australia and the US if there is no ability to claim foreign tax credits.
In Australia, discretionary trust earnings are generally taxed to the beneficiaries when distributed, often at lower rates if the beneficiaries have little or no other income. However, the US Internal Revenue Service (IRS) treats these trusts differently, often classifying them as “grantor trusts.”
This means the person who created or controls the discretionary trust must pay US tax on all earnings, even if the earnings are distributed to someone else.
What is the strategy to handle double taxation?
One way to manage double taxation is for the US expats to pay themselves the distribution. This way, they pay tax in Australia and can use that Australian tax as a foreign tax credit on their US return. While this may make the trust less tax-efficient in Australia, it helps reduce the risk of being taxed twice.
Another approach is to keep the income within the trust and have it taxed by the trustee in Australia. If the trustee is the US taxpayer, they may be able to use the tax paid in Australia as a foreign tax credit.
However, this approach can be complicated if the trust’s earnings are not distributed as expected.
I want to know more about US taxes abroad
Why is double taxation a problem for US expats?
In Australia, a common strategy for discretionary trusts is to distribute income to beneficiaries with lower incomes to reduce taxes. However, the IRS disregards these distributions and expects the grantor to pay US tax on all earnings within the trust.
For example, if a trust distributes AU$30,000 earned within the trust to an adult child in university, the child may pay little or no tax in Australia. However, the IRS still considers the grantor responsible for US taxes on that distribution.
Since the tax was paid by the child, not the grantor, the grantor cannot claim it as a foreign tax credit, leading to double taxation.
How can expats reduce double taxation on trust distributions?
To reduce double taxation, the grantor can take the distribution themselves, pay the Australian tax, and then use that tax as a foreign tax credit in the US. This helps reduce the risk of being taxed twice.
Another strategy is to avoid distributing income to beneficiaries who cannot use Australian tax payments to offset US taxes. Keeping income within the trust and having it taxed by the trustee may make it easier for the grantor to claim a foreign tax credit in the US.
Can trusts still be useful for US expats despite double taxation?
Trusts can still be useful for asset protection and estate planning, but they are generally not tax-efficient for US expats due to double taxation risks.
Compliance requirements and penalties for incorrect reporting also make discretionary trusts less appealing compared to other wealth management options.
For example, setting up a trust involves ongoing costs, such as trustee fees and compliance costs. If there is no tax benefit because the US expat must pay US taxes on all trust income anyway, the additional costs may outweigh the benefits of having the trust.
Asset protection and control of assets for vulnerable individuals are also valid reasons to have discretionary trusts while still being subject to the US Foreign Grantor Trust rules.
What happens if the trust owes money to a US beneficiary?
An unpaid present entitlement (UPE) can occur when a trust distributes income on paper but doesn’t actually pay it out. For example, if a trust declares a distribution to a US beneficiary but keeps the money within the trust, the IRS may treat the beneficiary as owning a share of the trust’s assets.
This could make the US beneficiary a grantor of the trust, leading to complex reporting requirements and higher US taxes.
How do unpaid present entitlements affect US tax obligations?
If a US beneficiary is entitled to income from a trust but hasn’t received it, they are generally considered a part owner of the assets within the trust from a US perspective due to being owed money from the trust as this is recorded as a liability on the trust balance sheet.
The trust is then considered a foreign grantor trust to that US beneficiary, requiring them to report trust details like balance sheets and earnings.
What should US expats do if they are considering using a trust?
US expats considering a trust should consult a tax professional experienced in both US and Australian tax laws. A tax advisor can help determine whether a trust is suitable and suggest strategies to minimize tax obligations.
US expats must understand the risks of double taxation and the need for proper reporting to avoid penalties. Expert advice can help meet tax obligations and minimize unnecessary burdens.
