Basically, any trust not considered a grantor trust is by default a non-grantor trust and treated as its own taxpayer. For example, the result of a grantor dying is a non-grantor trust because no one other than the grantor may be substituted as the “owner” of the trust. In this case the foreign trust is not taxed on income and may deduct any amount of distribution up to distributable net income. In determining the taxable income of a non-grantor trust, it is important to understand the concept of distributable net income (DNI).
DNI is the income of the trust for the year from all sources figured under U.S. income taxing principles but the DNI concept also characterizes distributions. Beneficiaries are taxed on trust distributions made out of DNI. Distributions are treated first as DNI of the current year, which is taxable to the U.S. beneficiary. Then, if distributions exceed the DNI in the current year, they are treated as coming from the earliest year from which there remains DNI and taxed to the U.S. beneficiary with an interest charge. Finally, distributions are last made from the corpus and are thus nontaxable.
In the event that such distributions exceed the DNI for the current year, this “accumulation distribution” triggers the “throw back rule.” In other words, a distribution of prior year’s undistributed net income that the trust has accumulated triggers an income tax (including an interest charge) for previous years even though the beneficiary may never have received anything from the trust in those years. Thus, the throwback rule is designed to cause the beneficiary to pay approximately the same income tax that would have been imposed if the trustees had distributed income to the beneficiaries on an annual basis rather than accumulating income in the trust. However, credit is given for foreign taxes paid as well as any U.S. withholding.
Despite the above, if a trust only distributes a percentage of the DNI for a particular year, the tax attributes are divided proportionately according to the percentage. Similarly, if distributions are made to several beneficiaries, the tax attributes are also divided up proportionately.