UNITED STATES TAX ISSUES

As a follow up to our July column on U.S. beneficiaries of foreign trusts we are focusing this month on the Trust Beneficiary Statement that you should receive from the Trustee.

Are You a U.S. Beneficiary of a Foreign Trust?

Do you receive a Foreign Grantor Trust Beneficiary Statement or Foreign Non-Grantor Trust Beneficiary Statement from the trustee?

Trustees of trusts with a U.S. beneficiary should be keeping two sets of accounts; 1) a notional U.S. tax account and the other 2) a “fiduciary” account. Only with information from both of these accounts can a U.S. beneficiary determine how to report and include in income a distribution from a foreign trust for U.S. tax purposes. Why? U.S. Fiduciary income tax rules that apply to foreign trusts are based on fiduciary accounting principles. A financial statement based on generally accepted accounting principles does not provide sufficient information for a U.S. beneficiary to properly compute the tax on a distribution.

A trustee has a basic duty under both United Kingdom and United States trust law to keep proper trust accounts. This is more than a duty to keep financial statements; it is a duty to keep capital and income in accordance with applicable law. The information provided to the U.S. beneficiary by the trustee must allow the U.S. beneficiary to identify what portion of the distribution is current income, which portion is accumulated income and which portion is a return of capital.

If the information you receive from the trustee does not allow you to do that, the Internal Revenue Service will assume that the distribution consists entirely of accumulated income which usually results in adverse tax consequences. The U.S. beneficiary will be subject to a “throwback” tax. Under the “throwback” rules the distribution is carried back to the year in which the income was accumulated by the trust, the distribution is deemed to be all ordinary income and taxed as though the U.S. beneficiary had received it in the year it was accumulated. Penalty interest is also assessed on this deemed late payment of tax. Depending on the circumstances, these additional charges can push the effective tax on an accumulation distribution above 50%.

Consequently, if you are you a U.S. beneficiary of a foreign trust it is incumbent upon you to obtain either a Foreign Grantor Trust Beneficiary Statement or Foreign Non-Grantor Trust Beneficiary Statement from the trustee and obtain an assurance from the trustee that the information contained therein is in accordance with U.S. fiduciary accounting principles.

What Tax Cuts Expire on December 31, 2012?

The 10% tax bracket. Repeal of the phase out of personal exemption and itemized deductions. The 15% maximum tax rate on qualified dividend income and long term capital gains. The 35% estate and gift tax top rate. The 2% cut in the employee portion of Social Security tax. The higher alternative minimum tax exemptions. Direct IRA payouts to charity. The itemized deduction for State sales tax. The deduction for $250 for classroom supplies purchased by a teacher. The $5,120,000 estate/gift tax exemption. It is likely that these and other expiring tax cuts will not be addressed until after the November 2012 election.

2013 Medicare Tax Increases

Certain aspects of the Health Care Reform law that was passed 4 years ago will tax effect in 2013. A Medicare tax increase of 0.9% will be imposed on individual taxpayers with compensation exceeding $200,000 and married couples filing jointly with compensation exceeding $250,000.

Individual tax payers with adjusted gross income exceeding $200,000 and married couples filing jointly with adjusted gross income exceeding $250,000 (the foreign earned income and foreign housing exclusion will be added back to other income for purposes of this computation) will pay an additional 3.8% Medicare tax surcharge on investment income such as dividends, capital gains, interest, royalties, annuities and rental income.

Currently, only medical expenses in excess of 7.5% of adjusted gross income can be deducted. Starting in 2013 the disallowance will increase to 10% of adjusted gross income.

Penalty for Failure to Have Health Care Insurance

Starting in 2014 individuals who are uninsured will owe a maximum penalty tax of $285 that will increase to $2,085 in 2016. How will the IRS know whether you have health insurance? Starting in 2014 your health insurance provider will send you a Form 1099 verifying that you have health insurance coverage. You then will need to attach the Form 1099 to your tax return as you do now with Form W-2. This system has been in effect in Massachusetts who requires residents to prove they have health care coverage for a few years.

Can You Let Your Local Fire Department Burn Your House Down (For Practice) and Then Claim a Charitable Deduction For the Fair Market Value of Your House?

In a split decision the Tax Court ruled “no.” The majority premise was that the owner had given the fire department a license to use the property, hence no charitable deduction. The minority opinion was that if the fair market value of the house exceeded the cost of the demolition, than a charitable deduction was allowable for the excess.

Tax Audits

The IRS added another 600 agents to its international division in 2011 and will add a further 300 agents in 2012.

What are your chances of being audited? About 12.5% if your income is in excess of $1,000,000.  About 4% if your income is between $200,000 and $1,000,000. About 1% if your income is under $200,000.

Pursuant to the requirements relating to practice before the Internal Revenue Service, any tax advice in this communication is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties imposed under the United States Internal Revenue Code, or (ii) promoting, marketing or recommending to another person any tax related manner.

The tax advice given by this column is, by necessity, general in nature. You should, of course, check with your own U.S. tax consultant as to how specific transactions affect you since tax advice varies with individual circumstances.

James Paul Sabo, CPA, is the President of ETS Ltd., PO Box HM 1574, Hamilton HM GX, Bermuda. Questions should be sent to: jsabo@expatriatetaxservices.com