Taken from article originally published 14 February 2024

As is often publicized, New Zealand has one of the highest rates of trust ownership in the world. Although declining in popularity over recent years, we do frequently encounter many trust related issues for our US person clients.

In this instance, we’re looking at two opposing systems and trends. With New Zealand having one of the highest rates of trust ownership, and then the US having some of the most punitive tax systems related to foreign trusts.

So, we’ll look today at the “throwback tax”, and its implications for US person beneficiaries of New Zealand trusts.

IRS Intentions

As we know, a trust can be used to hold assets and generate income, in the form of a separate financial entity from its owner. Of course, even determining who “owns” a trust can be complex in itself, in certain cases.

In the instance of a foreign trust (ie an NZ trust), which has no US tax filing obligation (ie no US beneficiaries or grantors), its assets and income are in essence kept out and shielded from US taxation. But, when a US person becomes involved with a foreign trust, the US tax implications can be complex and costly.

The IRS’ aim with regards to foreign trusts, is to prevent the accumulation of untaxed wealth.

Section 679 of the US tax code determines when a US person is deemed to be an owner (grantor) of a foreign trust, and at which point a foreign trust is treated as fiscally transparent for US tax purposes.

This is a very complex and detailed section of the tax code, and professional advice should be sought to determine when a US person has met grantor/owner status.

As could be expected, once a foreign trust has a US grantor it begins to be treated as transparent (disregarded/look through), with income generated by the trust taxed as if it had been earned in the hands of the US owner.

Of course, this system prevents tax free accumulation of wealth, through the transparent treatment by the IRS.

This is not necessarily onerous from a tax liability perspective.

But, what about trusts which do not have a US owner (therefore not transparent), but do have US beneficiaries?

Foreign Non-Grantor Trust

Generally speaking, a trust which does not have a US grantor, is treated as a Foreign Non-Grantor Trust.

Whilst being a US person beneficiary of a foreign non-grantor trust has no implication alone, a US person receiving distributions may indeed incur a US tax liability.

The Throwback Tax

In order to ensure that a foreign non-grantor trust cannot efficiently be used to accumulate wealth tax free, for the eventual benefit of a US citizen, the IRS introduced the “throwback tax”.

When a US citizen receives a distribution from a foreign trust, how this distribution is taxed depends on the DNI of the trust.

The IRS expects that current year income of the trust will be distributed in the current year (to prevent untaxed accumulation).

DNI – Distributable Net Income

Speaking broadly, DNI consists of income beyond expenses generated by the trust in the current tax year.

UNI – Undistributed Net Income

UNI consists of DNI generated in the current year, but not distributed in the year it was earned.

You might already begin to see where I’m about to go with this.

When the trust income generated in the current year is not distributed, it becomes UNI, undistributed net income.

This is where having UNI in a foreign trust can become very costly from a US tax perspective.

When a US citizen receives a distribution from a foreign trust, we must determine how much DNI was generated in prior years, but not actually paid out to beneficiaries (the UNI).

The current year distribution which is attributable to UNI then has interest applied as a penalty, with the distribution treated as if the beneficiary had received the payment in the year the trust actually earned the income, which could be a number of years ago.

This interest is in addition to the actual tax liability on the distribution.

This interest can be high, and can, when combined with the tax liability on the distribution, swallow up the entire amount to taxation.

In addition, where a trust generates capital gains (which are taxed at a lower rate in the USA), the beneficial treatment by the IRS is lost when DNI is not distributed, and it becomes DNI.

Ordinarily, a trust distribution of current year DNI has the character of income retained. For example, if a trust made income from capital gains, then the US person has a distribution of capital gains (taxed at lower rates than ordinary income).

When income sits in a trust for a number of years and becomes UNI, the character of income is lost, and therefore all of a distribution may be taxed as ordinary income.

Scratching your head? Understandable, this is a little messy. We’ll give here an example of this situation:

Foreign Trust A – A foreign non-grantor trust, with no US owner, but US beneficiaries

Year 1 – Trust Corpus $10,000 – Generates $1000 in income – Therefore $1000 in DNI

No distribution is made – UNI stands at $1000

Year 2 – Generates $2000 in income – Therefore $2000 DNI

No distribution is made – Therefore UNI stands at $3000

Year 3 – No trust income

Distribution of $3000 is made to US person.

Interest applies on the $3000 distribution as if it had been paid out in year 1 and year 2, but that the tax liability was not timely paid.

The US person will need to report the entire $3000 distribution as being made from UNI, whereby interest is calculated on top of the tax liability. Interest will be calculated as if the payments of DNI had been made in Year 1 and Year 2, resulting in years worth of interest on the undistributed DNI earned in the trust.

Summary

When operating a New Zealand or Australian trust, which have the potential to benefit US citizens, the tax implications can be severe.

We all too often see trusts set up with good intentions to support a US person later in life, only for the distributions to be lost to taxation, through the throwback tax.

When a US person becomes involved with a New Zealand trust in any way, through being a trustee, beneficiary, or directly or indirectly contributing to a trust, it is imperative to obtain quality US tax advice as early as possible.

At the US Tax Team, we assist a large number of New Zealand based US citizens with tax advice for a range of different scenarios.

To book a consulting session, reach out to us on info@usatax.nz