A covered expatriate’s interest in a non-grantor trust is not subject to the “mark-to-market tax”. Instead, the taxable portion of distributions to a covered expatriate, who was a beneficiary (but not an owner) of a trust on the day before the expatriation date are subject to a 30% withholding tax.
Under HEART (tax legislation), a trustee shall withhold tax (at 30%) from the taxable portion of a distribution from a non-grantor trust to a covered expatriate.
The “taxable portion” is that part of a distribution that would be taxable if the expatriate remained a U.S. person.
If the trust distributes appreciated property, gain is recognized to the trust as if it had sold the property to the expatriate.
Under HEART, a withholding tax is imposed on post-expatriation taxable distributions to a covered expatriate from any trust of which the expatriate was a beneficiary immediately prior to expatriation.
If a trust that was a non-grantor trust (prior to expatriation) becomes a grantor trust (as to a covered expatriate), following expatriation, the conversion of status will be treated as a taxable distribution to the covered expatriate to the extent of his interest in the trust as an owner.
Trust Valuation Election
A covered expatriate may elect to obtain a letter ruling from the IRS as to the value of his interest in a non-grantor trust as of the day before his expatriation date.
Under the valuation ruling, the covered expatriate will be considered to have received the value of his trust interest immediately prior to expatriation, and tax will be due on his trust interest with his tax return, for the period ending on his expatriation date.
Once the tax is paid, no subsequent distribution will be subject to the 30% withholding tax (under an IRC Section 887A). The covered expatriate will be entitled to claim trust benefits vis-à-vis any distribution from the trust under an applicable income tax treaty.
Election – Advantage
The advantage of this election is that it limits the taxation of distributions from non-grantor trusts to the value of the trust interest existing at the date of expatriation (the trust interest is no longer subject to an indefinite tax).
Election – Disadvantage
Upon expatriation, the IRS has no ability to collect the withholding tax from a foreign non-grantor trust re: covered expatriate’s trust beneficial interest.