New Foreign Trust Tax Form Project: 1041NR

IRS representatives recently approved a joint project with the AICPA Foreign Trust Task Force.1 Together they will design a new Form 1041NR, U.S. Income Tax Return for Foreign Estates and Trusts, which tax return preparers and IRS personnel will find easier to understand, prepare, and process. This article summarizes the objectives, complexity, and expected rewards for this ambitious endeavor.

Importance of New Tax Form Project

In December 2006 and January 2007, the Real Property, Probate and Trust Law Section of the American Bar Association (ABA RPPTL) and the AICPA, respectively, submitted comments to the IRS in response to its request regarding foreign trust tax reporting issues.2 One of the high-priority items suggested by the AICPA Trust, Estate & Gift Tax Technical Resource Panel was the creation of a new Form 1041NR, which could report the tax information of foreign trusts, much like Form 1041, U.S. Income Tax Return for Estates and Trusts, for domestic trusts. Such reporting would avoid the current confusion encountered when reporting “trust information” on Form 1040NR, U.S. Nonresident Alien Income Tax Return, which is designed primarily for individual taxpayers. The Service would enjoy a double benefit: fewer mistakes in return processing and increased tax compliance by taxpayers.

Both the AICPA and ABA RPPTL acknowledge that foreign trusts are currently required to file Form 1040NR. In addition, certain foreign trusts and their U.S. beneficiaries must file Forms 3520-A, Annual Information Return of Foreign Trusts with a U.S. Owner, and 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts, respectively. For foreign nongrantor trusts (in which the trust settlor is not considered the trust owner for U.S. tax purposes), both the AICPA and ABA RPPTL urged that the IRS issue a new Form 1041NR. This new form will be designed specifically for foreign trust reporting, computations, and disclosure of tax information for easier preparation and processing. For example, the current Form 1040NR has no designated line for customary trust tax deductions from gross income, such as fiduciary fees, charitable deductions (as reported on Schedule A of Form 1041), legal/accounting fees, or an income distribution deduction.
   
Further limitations of the current Form 1040NR include:

• No mechanism to allocate federal tax payments to trust beneficiaries (per Sec. 643(d)) if the fiduciary elects to do so. The current procedure with a domestic trust is to file Form 1041-T, Allocation of Estimated Tax Payments to Beneficiaries, with an allocation of the payments to each beneficiary.
• No designated Schedule K-1 to report the beneficiary’s portion of the distributable net income if the beneficiary is subject to U.S. tax return reporting.
• No designated schedule to properly calculate the additional tax, unique for foreign trusts, if subject to throwback rules. Such tax (and the corresponding interest charge under Sec. 668) results from an “accumulation distribution” of a prior year’s income.
• No way in which the IRS can determine whether an accumulation distribution has been made. Such reporting is currently done on a foreign trust beneficiary statement provided by the trust and on Form 3520 by a U.S. beneficiary. However, because this information is not reportable on Form 1040NR, possible errors or omissions could occur with respect to the tax computation.

The new form is sure to benefit preparers, fiduciaries, beneficiaries, and the IRS.

Unexpected Benefits of New Tax Form

The essence of compliance with regard to foreign trusts (and their beneficiaries) is the federal tax withholding mechanism statutorily established under Secs. 1441, 1444, 1445, and 1446. In most instances, withholding agents are collecting the federal taxes. However, because the mechanism is not perfect or perfectly complied with, the compliance relies on taxpayers to report and pay the proper tax, even if withholding tax was not collected by the withholding agent(s).

Due to a lack of detailed guidance and the misfit of Form 1040NR to foreign trust reporting, that form is prepared inconsistently with respect to foreign trusts. The new form will improve tax compliance because it conforms to the “look” of a trust-entity tax form. Whether a fiduciary hires a knowledgeable return preparer in the United States or in a foreign country, the new form will resemble the current fiduciary tax return (domestic trust Form 1041).

One benefit for practitioners using the new tax form will be the ability to adhere to extensive and complicated reporting requirements in a fiduciary return format with which they are more familiar. As a result, taxpayers will face fewer harsh penalties for noncompliance. The Service has provided a common mechanism that will become a win-win situtation at a time when its attitude has hardened toward U.S. taxpayers who have failed to properly report foreign trust transactions. The IRS has demonstrated a less forgiving approach to penalty abatement. Recent statutory penalty provisions in the foreign transaction area make it imperative that fiduciaries and beneficiaries get their tax reporting right the first time. A properly designed 1041NR should make compliance easier and more consistent.

Scope of the New Form Project

The complexity and breadth of this project will require a disciplined and coordinated effort among representatives of the AICPA, the ABA, and the IRS. In many respects the foreign trust tax laws and IRS regulations are more intricate and complicated than U.S. individual tax laws. The added complexity is a consequence of the lack of information reporting in international transactions, submission to international law interpretations, and changes in residence (migration of fiduciaries and beneficiaries). Individuals who are legal residents of more than one country are subject to each country’s taxing jurisdiction. Under U.S. tax law, the term “resident” is different for federal gift and estate taxes than it is for income tax purposes.3 The scope of the Form 1041NR project will encompass many legal issues and substantiation of facts that must be incorporated in the form(s) and instructions, including Forms 3520 and 3520-A.

With the collaborative efforts of the team members, all facets of tax, trust, and disclosure laws will be analyzed in designing the Form 1041NR to ensure that the laws are enforced to protect both the government’s interest in efficient tax administration and taxpayer rights.
The Future

International law is clear that no jurisdiction bears a unilateral obligation to assist another jurisdiction in collecting taxes. The Organisation for Economic Co-operation and Development (OECD), currently with 30 wealthy-country members, has been working to oblige smaller finance centers by helping its members with tax enforcement. The OECD report, Tax Co-operation: Towards a Level Playing Field, includes a 200-page analysis of information collection and exchange practices of 82 foreign countries.4

The 1041NR project team members will review the various OECD reports that demonstrate global tax enforcement capability through:

• Government access (globally) to beneficial ownership and financial data; and
• Cross-border exchange of data on request by global tax authorities.

Conclusion

It is evident that the 1041NR project will entail more coordinated efforts, possibly developed incrementally over years, by team members than the Form 709 joint project of 2003. Success will depend on the best efforts of AICPA, ABA, and IRS team members. All members realize that this project is necessary as the number of foreign transactions and dollar amounts increase annually. The Service is to be commended for its bold decision to embark on this collaborative project.