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As most are aware, the IRS has undertaken an initiative to identify unreported foreign income of U.S. taxpayers. While most of the attention has been focused on U.S. expatriate citizens who are behind in their U.S. tax filing obligations, little attention has been paid to U.S. citizen and resident tax obligations with respect to Canadian family trust structures. The IRS’s unprecedented access to Canadian banking and brokerage accounts of U.S. persons could put settlors and/or U.S. beneficiaries at risk for significant noncompliance penalties.
The Canadian Family Trust Structure
Under a classic Canadian family trust structure, parents may choose to “freeze” their interest in assets such as investment real estate held by a corporation from death taxes by holding a non-appreciating class of shares and issuing “growth shares” to a family trust which names their children as beneficiaries.
Parents or Grantor are U.S. Citizens or Residents
Under a classic family trust structure, a third party settlor makes a nominal contribution to the trust to provide the initial funding and the parents contribute the growth shares of the corporation.
If either the settlor or contributing parent(s) are U.S. citizens or residents or become a U.S. citizen or resident within five years of the contribution, the Canadian family trust may be treated as a “grantor trust” under U.S. tax rules. The potential U.S. tax exposures for a grantor trust include:
- The requirement for the U.S. grantor to report all of the trust income for U.S. purposes regardless of the fact the income is taxed to the beneficiaries for Canadian tax purposes.
- A 50% penalty for the maximum balance in all unreported foreign bank and brokerage accounts held by the trust.
- Significant potential penalties for failures to include Form 8938 ($10,000 per year), Form 3520 (5% of the gross value of the trust per year), Form 3520-A (an additional 5% penalty of the gross value of the trust), Form 5471 ($10,000 per corporation per year owned by the trust) and civil penalties for failure to file gift tax returns.
Beneficiaries who are U.S. Citizens and Residents
When a child who is a beneficiary of the trust either moves to the U.S., whether for family or work purposes, or becomes a U.S. citizen, trust distributions to said child can be problematic for U.S. purposes. The U.S. tax exposure includes the following:
- The failure to complete a timely Form 3520 for the years of a distribution can trigger a penalty of the greater of 35% of the distribution or $10,000.
- The distribution can be subject to a punitive “throwback tax” to the extent the distribution exceeds the beneficiary’s share of the current income of the trust.
- The distribution can be subject to the 39.6% U.S. federal tax rate, regardless of the beneficiary’s U.S. tax bracket, plus a deferred interest charge if it is determined that the underlying corporation is a passive foreign investment company (“PFIC”) for U.S. purposes.
- An annual $10,000 penalty for omitting Form 5471 reporting underlying foreign corporation ownership.
Fixing the Problem
We are in the process of assisting a number of clients who have family trusts where family members have moved to the U.S. Approaching the IRS through one of their voluntary disclosure programs can assist in mitigating or eliminating the existing exposures. As well, we can assist with structuring the prospective actions of the family trust to mitigate the U.S. tax costs and exposures.
If the IRS identifies the noncompliance prior to a taxpayer’s voluntary disclosure, it will show little mercy in assessing penalties. In a recent, widely reported case, a U.S. expatriate resident in B.C. was assessed a US $862,000 penalty for failure to provide foreign bank account information on a timely basis.
Years ago, the penalty for failure to disclose foreign bank account information was unimaginable to U.S. citizens living in Canada. With the IRS’s unprecedented access to Canadian banking and brokerage information, no prospective enforcement by the IRS can be considered unimaginable any more.
For more information, contact your Zeifmans advisor or Stanley Abraham at sa@zeifmans.ca or 647.256.7551.
