The throwback rule is intended to prevent a foreign trust from accumulating income, thereby delaying the reporting of that income by U.S. beneficiaries until the time when the income is eventually distributed. The throwback rules defeat this income tax deferral by imposing tax not only on the deferred income, but also by imposing an interest penalty. The interest penalty is premised upon the theory that since the beneficiary has enjoyed the use of the money — which would otherwise have been used to pay tax on the income had it not been accumulated — it is appropriate to impose interest for the period during which the accumulation occurred.
In addition to the income being “thrown back” to the earlier year, and interest being computed on the delay in distributing the income, another negative incident to accumulation also arises: IRC §662(b) provides in general for “conduit” treatment of amounts distributed to a trust beneficiary. However, IRC §667(a) provides (by negative implication) that capital gains are stripped of their favorable tax treatment when income is thrown back to a previous year. Thus, capital gains not distributed currently will lose their favorable tax treatment. Throwback occurs where a trust makes an accumulation distribution of undistributed net income (UNI) from earlier years. Since both elements are required to trigger throwback, by definition throwback cannot occur in any tax year in which (i) no UNI from previous tax years exists or (ii) no accumulation distribution is made. UNI may arise in unexpected circumstances. Distributable Net Income (DNI) of a foreign trust includes capital gains. In contrast, DNI of a domestic trust does not include capital gains. DNI of a foreign trust is thus increased by capital gains arising in a taxable year. If not distributed, this will result in undistributed net income (UNI) which could result in throwback if a “accumulation distribution” is later made.
II. Undistributed Net Income
A trust will have UNI in a preceding taxable year to the extent, if any, that its distributable net income (DNI) exceeds the sum of (i) IRC §661(a) distributions (income required to be distributed currently or “tier one” distributions); (ii) distributions other than tier one distributions that are properly paid, credited or required to be distributed (“tier two” distributions); and (iii) the taxes “properly allocable” to the undistributed portion of DNI (the “excess”). In general, a complex trust taxed under IRC §§661 and 662 which does not distribute all of its DNI in a taxable year will have UNI under IRC §665(a).
III. Tax “Properly Allocable” to Undistributed DNI
The Regulations provide that the amount of taxes deemed distributed and “properly allocable” to undistributed DNI is an amount “that bears the same relationship to the total taxes of the trust for the year . . . as (a) the taxable income of the trust, other than capital gains not included in DNI . . . bears to (b) the total taxable income of the trust for such year. . .”
In a taxable year in which there is both UNI and the presence of an accumulation distribution, after determining throwback tax, the beneficiary must also determine the interest which is imposed on the throwback tax. The beneficiary must report in income for the year in which the accumulation distribution is made the sum of all years’ UNI, and the taxes allocable to the UNI, as if distributed on the last day of the taxable year.
IV. Accumulation Distribution
An accumulation distribution is the excess of (i) the amount of all distributions (except those of accounting income required to be distributed currently) over (ii) the distributable net income (DNI) reduced (but not below zero) by trust accounting income required to be distributed currently. An accumulation distribution will generally occur when required and discretionary distributions in a taxable year exceed DNI for that taxable year.
V. Calculation of Throwback Tax
The “simple” method provided by the Code to calculate throwback tax involves twelve rather complex steps. To summarize those steps, first any accumulation distribution is allocated to previous years’ UNI seriatim, until the entire accumulation distribution has been allocated to previous years. Then, the amounts deemed to have been distributed in an earlier year must be “grossed up” for taxes paid by the trust which are attributable to the undistributed amounts. The next steps involve a series of approximations, the result of which will yield the number of years in which throwback is applied and the increase in tax to the beneficiary for each of the “computation years.” In the final steps, interest on throwback is computed. Interest rates imposed on throwback tax can fairly be said to be confiscatory. For that reason, using the “default” method for calculating throwback may be preferable.
VI. Reporting Trust Distributions
IRC § 6048(a) imposes a duty on the beneficiary to provide written notice of distributions to the Treasury. Notice 97-34 provides that any U.S. person receiving distributions from a foreign trust must report those distributions to the Service on Form 3520 (“Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts”). Form 3520 is due on the date the income tax return of the beneficiary is due. That date is automatically extended when the filing date of the beneficiary is extended.
If the trustee fails to provide “adequate records,” then all trust distributions will be treated as accumulation distributions. The penalty for not reporting a distribution from a foreign trust is 35 percent of the amount distributed. The penalty may be waived for reasonable cause.
VII. Reporting Throwback Tax
A U.S. beneficiary of a foreign nongrantor trust who receives an accumulation distribution consisting of undistributed net income (UNI) calculates throwback tax on Form 4970 (“Tax on Accumulation Distribution of Trusts”) which is attached to Form 3520. The trustee of a foreign nongrantor trust should (but is not required to) provide the beneficiary with a “Foreign Nongrantor Trust Beneficiary Statement.” If filed with Form 3520, the entire trust distribution will not be deemed to constitute an accumulation distribution subject to throwback. If the beneficiary cannot obtain the statement, the entire distribution will be treated as an accumulation distribution subject to throwback, unless the beneficiary can provide information concerning trust distributions for the prior three years, in which case the “default” rule will apply, and only that portion of the distribution in excess of the average of distributions for the previous three years will be treated as an accumulation distribution.
VIII. Impact of Final Regulations Under New IRC §1411
In December, 2013 Treasury issued final regulations concerning the 3.8 percent net investment income tax. The regulations affect individuals, estates, and trusts whose income meet certain income thresholds. The preamble to proposed §1.1411-3(c)(3) requested comments on the application of Section 1411 to net investment income of foreign trusts that is earned or accumulated for the benefit of U.S. beneficiaries, including whether Section 1411 should apply to the foreign trust, or to the U.S. beneficiaries upon an accumulation distribution. Treasury and the IRS agree that Section 1411 should apply to U.S. beneficiaries receiving distributions of accumulated net investment income from a foreign trust rather than to the foreign trust itself. Treasury is continuing to study how Section 1411 should apply to accumulation distributions from foreign trusts to U.S. persons and intends to issue guidance. It appears unlikely that Treasury would impose net investment income tax on UNI alone (i.e., without an accumulation distribution) since that would mark a radical change in the manner in which foreign trusts are now taxed. Aside from imposing higher marginal income tax rates on beneficiaries who receive distributions from foreign trusts, IRC §1411 does not appear to affect rules governing the taxation of foreign nongrantor trusts.
IX. Planning Where UNI Exists
Use of Loan to Avoid Accumulation Distribution
While IRC §643(i) provides that if a non-U.S. settlor creates a nongrantor trust which loans cash or marketable securities to a U.S. beneficiary, the loan will be treated as a distribution, Notice 97-34 provides an exception for a “qualified obligation.” Thus, Loans made on commercially reasonable terms will not generate throwback. However, the loan must be repaid within five years, and may not be extended. Nevertheless, the deferral of tax for five years in a low-interest rate environment may be attractive.
Increase Trust Accounting Income
If the sum of the amounts properly paid, credited, or required to be distributed is less than the accounting income of the trust for the tax year, there can be no accumulation distribution. For example, if the trust makes distributions of $10,000 but has accounting income of $11,000, no accumulation distribution can arise, even if DNI is less than the amount of the distribution. However, this exception applies only if all “amounts properly paid, credited, or required to be distributed” for any taxable year are less than accounting income. If the distribution exceeds accounting income by even $1, then the entire excess of distributions over DNI would constitute an accumulation distribution. IRC §665(b). By adjusting trust investments, it may be possible to increase accounting income in a future taxable year such that the exception applies. If accounting income exceeds the amounts “properly paid, credited, or required to be distributed” in a given taxable year, then there can be no accumulation distribution in that taxable year. Whether this planning technique is possible depends upon the terms of the trust instrument and the nature of trust investments.
This strategy may be useful if the trust has income not includible in DNI. If the trust has accounting (rather than distributable net) income, such accounting income may indeed exceed DNI. This situation may occur, for example, where (i) an allocation of a portion of the proceeds of a sale of unproductive or underproductive assets occurs; or where (ii) distributions are made from a pass-through entity with respect to income earned in a prior year. This exception might be the result of a statutory “glitch” that was never corrected by Congress.
Planning With “Default” Method
If the “default” method is used to calculate accumulation distributions and UNI, and the trustee distributes trust assets over a three-year period, both the amount of the accumulation distribution, and the amount of interest may be reduced substantially.
Increase Capital Gains
Since accumulation distributions apply only to distributions in excess of DNI in the year distributed, investments in capital assets that will yield capital gains will increase DNI in the year of distribution, and a larger distribution to the beneficiary without causing UNI will be possible.
Distributions in Kind
Distributions of appreciated assets in kind for which the trust claims no deduction will defer the realization of capital gain by the beneficiary, and will allow more value to be distributed without exceeding DNI.