Exploring Foreign Trust DNI, UNI & Throwback Tax Rule 665

Throwback Tax Rule for Foreign Trusts

Throwback Tax Rule for Foreign Trusts: In general, the Internal Revenue Service dislikes Foreign Trusts. That is because many types of offshore or overseas trusts are used for improper tax purposes, such as to artificially reduce the Owner’s tax liability in the United States– and skirt various income taxes that would otherwise be levied against the true owner of the trust. To take some of the allure out of the pursuit of non-grantor foreign trusts and compiling income in the trusts in prior years for future year distributions to US beneficiaries — the US Government developed the Throwback Trust tax rules. Similar to PFIC tax treatment, while the throwback rule is not defined per se as a penalty, it operates as one. The throwback rule operates as a penalty for leaving certain monies (DNI) in the trust, which were not previously distributed to the Trust Beneficiaries in the year the trust income was earned, by tacking on interest and removing CG from DNI (CG qualifies as DNI for foreign non-grantor trusts). Let’s explore the basics of DNI, UNI, and the Throwback Rule.

*We have a separate article containing a sample throwback tax rule calculation.

General Taxation of Foreign Non-Grantor Trust

At the outset, it is important to note that the income tax rules of foreign non-grantor trusts are very complex. These are just the basic rules in order to give you a baseline on how the throwback rule operations — but there are always exceptions, exclusions, and limitations to consider.  A non-grantor trust operates as a separate person with a separate Tax ID. Income that is earned in the trust is taxable to the trust (whereas in a Grantor Trust, the income is taxable to the grantor and the trust is not a separate person for tax purposes). When it is a non-grantor foreign trust, the US tax implications are more limited based on the US person status of the beneficiary and whether the income generated is Domestic or Foreign. The Trust may distribute income to the Beneficiaries (who are then taxed on the income which usually retains the same character, subject to the UNI rules below). Alternatively, when the principal is distributed (as opposed ot income), it is not a taxable event — as it is not income.

DNI (Distributable Net Income)

The two main components of the Throwback Rule are UNI and DNI.

Let’s start with DNI: Trust accounting can be complicated, so let’s try to break it down as simply as possible. There are two main categories of trusts: Grantor and Non-Grantor. A Grantor Trust is not a separate individual, and therefore the income associated with a grantor trust is taxable when earned to the grantor. Conversely, a Non-Grantor Trust is a separate “person” with a separate Tax ID number. The income earned by the non-grantor trust is taxable to the trust. But, similar to how a business operates, the trust can take certain deductions, such as income distributed out to the beneficiaries.  The beneficiaries pay income tax on the income distribution, and for the most part, the income keeps the same character (e.g., qualified dividends) as when it was earned. This is the basics of DNI.

UNI (Undistributed Net Income) Throwback Tax Rule

Unlike DNI which is distributed to the beneficiaries, UNI is undistributed Net Income, and as the name implies — it is trust income that is not distributed but rather held in the trust for a future date for the distribution. Therefore, this is income that would otherwise qualify as a DNI for distribution to the Beneficiaries (Who are then taxed on the income). 

Internal Revenue Code Section 665 & Throwback Tax Rule

IRC 665(a) and (b) define the rules for the Throwback Rule:

I.R.C. § 665(a) Undistributed Net Income

• • • — For purposes of this subpart, the term “undistributed net income” for any taxable year means the amount by which distributable net income of the trust for such taxable year exceeds the sum of—

      • I.R.C. § 665(a)(1) — the amounts for such taxable year specified in paragraphs (1) and (2) of section 661(a), and I.R.C.

      • 665(a)(2) — the amount of taxes imposed on the trust attributable to such distributable net income.

    • I.R.C. § 665(b) Accumulation Distribution — For purposes of this subpart, except as provided in subsection (c), the term “accumulation distribution” means, for any taxable year of the trust, the amount by which—

      • I.R.C. § 665(b)(1) — the amounts specified in paragraph (2) of section 661(a) for such taxable year, exceed

      • I.R.C. § 665(b)(2) — distributable net income for such year reduced (but not below zero) by the amounts specified in paragraph (1) of section 661(a).

    • For purposes of section 667 (other than subsection (c) thereof, relating to multiple trusts), the amounts specified in paragraph (2) of section 661(a) shall not include amounts properly paid, credited, or required to be distributed to a beneficiary from a trust (other than a foreign trust) as income accumulated before the birth of such beneficiary or before such beneficiary attains the age of 21. If the amounts properly paid, credited, or required to be distributed by the trust for the taxable year do not exceed the income of the trust for such year, there shall be no accumulation distribution for such year.

Throwback Tax Rule 665 (a) and (b)

The Throwback Tax Rule primarily applies to Foreign Trusts and serves to strip the trust of the benefits the income category (such as LTCG or QD) at the time the trust earned the money by requiring interest (along with other re-categorization of Capital Gains). When DNI was not distributed to the beneficiaries in the year earned — but rather a later year — then it becomes UNI. When the UNI is distributed, it will have accrued interest which serves to offset the preferred category at a reduced tax rate.  And, just moving the trust to the US does not negate the previously accumulated UNI, so it is important for Taxpayers to plan for any tax implications involving UNI.

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