Does a U.S. beneficiary of a foreign-owned foreign grantor trust file Form 8938?

Hello and welcome to The Friday Edition. I’m Phil Hodgen and I like writing about international tax stuff.

Here’s a quickie for tax season and all of you return preparers out there in the trenches: intuitively you’d think that a Form 8938 is not required, but maybe your intuition may be wrong. Foreign parent is the owner of a foreign grantor trust and you are preparing Form 1040 for the U.S. citizen child.

In a nutshell:

• Government’s view (probably). A U.S. person who is a lifetime beneficiary of a foreign grantor trust owned by a foreign person because the trust is revocable has an “interest in a specified foreign financial asset” (namely a beneficial interest in the foreign grantor trust), triggering a requirement to report it on Form 8938.
• My view (not seriously tested). Such a U.S. beneficiary does not have an “interest in the foreign trust” because Parent’s power to revoke the trust and revest assets in Parent means that at best the beneficiary has a hope and an expectancy–not an actual property interest in the trust. Nothing to report on Form 8938.
• Depends on the trust’s language. The “nothing to report on Form 8938 for the U.S. beneficiary” position is stronger if the U.S. beneficiary cannot receive distributions from the trust during Parent’s lifetime. The only time that the U.S. beneficiary receives anything is after Parent dies.
• Dirty Harry notwithstanding. The filing burden is negligible. You’re probably filing Form 8938 anyway for the U.S. beneficiary. “Do you feel lucky, punk?” Nah. Why even add a potential tripwire for future pain/agony with the IRS? Just add this item to Form 8938.

The Ubiquitous Inbound Foreign Grantor Trust

I set these things up all the time. Wealthy parents are nonresident aliens, and their kids become U.S. residents or citizens. How do you optimize the income tax and estate tax consequences for the eventual wealth transfer of foreign assets from nonresidents to U.S. beneficiaries?

Foreign grantor trusts are a classic tool. In brief:

1. Parent is a nonresident alien.
2. Parent creates and funds a foreign trust. Parent alone can revest title to the trust property in Parent, without the consent of anyone else. Parent is treated as the owner of the trust under IRC §672(f)(2)(A)(i); Treas. Reg. §1.672(f)-3(a)(1).
3. The trust owns foreign assets.
4. During Parent’s lifetime, the trust pays income to Parent, or as Parent directs.
5. Child is a U.S. citizen.
6. Child is the remainder beneficiary: Child takes the trust property at Parent’s death. Whether Child is also a lifetime beneficiary is a variable you can play with.
7. In the current tax year, there is no mandatory distribution required from the trust to Child, and there is no actual distribution, either.

From a U.S. income tax point of view, Parent receives the trust’s income during his/her lifetime and bears the tax liability. IRC §671. Foreign source income received by a nonresident alien is out of the U.S. government’s reach. IRC §872(a). And when Parent dies, the assets will get a basis step-up. IRC §1014(a), (b)(2). Neato.

And the assets are foreign situs assets owned (through a revocable trust) by a nonresident-noncitizen decedent (Parent), so no U.S. estate tax either. IRC §§2103, 2104(b). Certain terms and conditions apply, of course. Watch out for the wrinkles in the Code.

Question: Does Child File Form 8938?

You are preparing Child’s U.S. income tax return. Must you report Child as owning a beneficial interest in the trust on Form 8938?

Form 8938 Reporting Requirements: IRC §6038D(a)

The basic filing requirement is found in IRC §6038D(a) and the associated regulations. There is a minimum threshold of “specified foreign financial assets” that the taxpayer must own; let’s assume that Child satisfies that threshold requirement without reference to the trust.

1. The rule: an individual who is a “specified person” and “holds any interest in a specified foreign financial asset” reports it if the aggregate value exceeds the threshold. IRC §6038D(a); Treas. Reg. §1.6038D-2(a)(1).
2. “Specified foreign financial asset” includes “any interest in a foreign entity.” A foreign trust (grantor or not) is a foreign entity, and “[a]n interest in a foreign trust” is a specified foreign financial asset. IRC §6038D(b)(2)(C); Treas. Reg. §1.6038D-3(b)(1)(iii), (d)(4).
3. Assume every condition is met except one. The conditions assumed:
   • Child is a U.S. citizen, so a specified person. Treas. Reg. §1.6038D-1(a)(1), (a)(2)(i).
   • Child must file an income tax return. Treas. Reg. §1.6038D-2(a)(7).
   • Child’s aggregate specified foreign financial assets exceed his/her threshold.
   • The trust is a foreign trust, and so a foreign entity. IRC §7701(a)(31)(B); Treas. Reg. §1.6038D-1(a)(10).
   • Child knows of the trust, or has reason to know of it. Treas. Reg. §1.6038D-3(c).
   • Child is not treated as an owner of any part of the trust. IRC §672(f)(5); Treas. Reg. §1.672(f)-5.

The one requirement that is unknown: does a named beneficiary (Child, in this case) of a revocable trust “[have] any interest in” the trust? That phrase comes from Treas. Reg. §1.6038D-2(a)(1).

There are some grantor trust rules in the §6038D regulations that apply to the owner, not to a beneficiary. Treas. Reg. §1.6038D-2(b)(4)(ii); Treas. Reg. §1.6038D-7(a)(2). Parent is the owner and is not a specified person.

Other than those grantor trust rules, which matter to Parent and not to Child, IRC §6038D and the regulations talk about “foreign trusts” generally and do not distinguish between foreign nongrantor trusts and foreign grantor trusts.

So Child is treated like any other beneficiary of a foreign trust.

The Open Question: Does Child Have an “Interest” in the Trust?

Imagine that Parent wrote a will, naming Child to inherit all assets upon Parent’s death. Would that create a property ownership right for Child in Parent’s property? Obviously not: Parent can revoke or revise the will at any time and cut Child out of all inheritances. So we would not say that Child has an “interest” in Parent’s property.

Now consider our situation: the foreign grantor trust is revocable. Parent can take all of the trust’s assets back and retitle them in Parent’s name. Child will inherit the trust assets eventually, but only if Parent leaves the assets in the trust and doesn’t amend or revoke the trust. Child is in the same position as with a will: Child EXPECTS to inherit assets, but has nothing that Parent cannot take away.

You’d think it would be easy to figure this out in the context of filing requirements for Form 8938. You’d be wrong. (Either that or I have a very busy brain). Here are the outcomes:

1. If, as a matter of law, Child does not have an interest in the trust, Child has no specified foreign financial asset. No Form 8938 reporting of the trust.
2. If, as a matter of law, Child does have an interest, Child reports it on Form 8938.

The filing requirements are that simple. And if Child has a reporting requirement, the value of the interest in the foreign trust will not matter. A specified foreign financial asset “is subject to reporting even if the specified foreign financial asset does not have a positive value.” Treas. Reg. §1.6038D-2(a)(5).

Analysis: “Child Has an Interest in the Foreign Grantor Trust”

The government-side argument is drawn from the plain language of the Internal Revenue Code and the Treasury Regulations.

Treas. Reg. §1.6038D-2(b)(4)(iv):

Interest in a foreign trust or foreign estate. See § 1.6038D-3(c) to determine whether an interest in a foreign trust or foreign estate is a specified foreign financial asset. See § 1.6038D-5(f) to determine the maximum value of an interest in a foreign trust or foreign estate.

This tells us to go look at another reg to see if an interest in a foreign trust or foreign estate is a specified foreign financial asset. Note the assumption: it is assuming you have already decided that the taxpayer has an interest in the foreign trust.

Treas. Reg. §1.6038D-3(c) says an interest in a foreign trust is only a specified foreign financial asset (to be reported on Form 8938) if the taxpayer knows, or has reason to know, of the interest.

Special rule for interests in foreign trusts and foreign estates. An interest in a foreign trust or a foreign estate is not a specified foreign financial asset of a specified person unless the person knows, or has reason to know based on readily accessible information, of the interest. Receipt of a distribution from the foreign trust or foreign estate constitutes actual knowledge for this purpose.

We assume Child knows about the trust. But also note: the Regulation assumes that you already figured out that Child has an “interest” in the foreign grantor trust.

The Regulations don’t give us specific guidance on how you figure out whether someone has an “interest” in a trust. No guidance about trusts specifically in the Code or Regs means we have to look at the general rule. Treas. Reg. §1.6038D-2(b)(1) tells us the general rule:

In general. A specified person has an interest in a specified foreign financial asset if any income, gains, losses, deductions, credits, gross proceeds, or distributions attributable to the holding or disposition of the specified foreign financial asset are or would be required to be reported, included, or otherwise reflected by the specified person on an annual return. A specified person has an interest in a specified foreign financial asset even if no income, gains, losses, deductions, credits, gross proceeds, or distributions are attributable to the holding or disposition of the specified foreign financial asset for the taxable year.

This says that if certain things would hit Child’s income tax return, then Child “has an interest in a specified foreign financial asset,” namely an interest in the trust.

By assumption and design, this is a foreign grantor trust and all of the items of income, deductions, etc. are attributed to the owner, Parent. IRC §671. No income, deduction, credit, etc. of the trust will be included on Child’s income tax return.

Distributions are another question entirely. If a distribution from the foreign grantor trust to Child “would be required to be reported, included, or otherwise reflected” on Child’s income tax return, then Child “has an interest in a specified foreign financial asset,” namely an interest in the foreign grantor trust.

How does a distribution from a foreign grantor trust where nonresident alien Parent is the owner of the trust get reported on Child’s Form 1040?

Distributions received from foreign trusts are reported on Form 3520. IRC §6048(c)(1). That is a separate return—it is not Child’s “annual return” as that phrase is used in Treas. Reg. §1.6038D-2(b)(1). “Annual return” means the income tax return of the individual. Treas. Reg. §1.6038D-1(a)(11).

But there is a place on Form 1040, Schedule B, Part III, line 8 that asks:

During 2025, did you receive a distribution from, or were you the grantor of, or transferor to, a foreign trust?

It’s just a checkbox. But it’s on Child’s income tax return. So a transfer of property from the trust to Child would be a “distribution,” and it would be “otherwise reflected” on Child’s annual return. Under the general rule of Treas. Reg. §1.6038D-2(b)(1), that means Child holds an interest in the trust. And the regulation is phrased in the hypothetical: it covers distributions that “are or would be” required to be reported, included, or otherwise reflected. It does not require an actual trust distribution. The last sentence confirms it (emphasis added):

A specified person has an interest in a specified foreign financial asset even if no income, gains, losses, deductions, credits, gross proceeds, or distributions are attributable to the holding or disposition of the specified foreign financial asset for the taxable year.

I know what you’re saying. Isn’t a transfer from a foreign grantor trust a gift from the owner, not a trust distribution? For income tax and gift tax, yes: the beneficiary treats it “as if it came directly from the owner.” Instructions for Form 3520, line 29; Treas. Reg. §25.2511-2(f).

But for reporting, the Code says the opposite. IRC §6048(d)(1) says:

For purposes of this section, in determining whether a United States person makes a transfer to, or receives a distribution from, a foreign trust, the fact that a portion of such trust is treated as owned by another person under the rules of subpart E of part I of subchapter J of chapter 1 shall be disregarded.

So yes, for income tax and gift tax, the transfer of property from the trust is treated as a gift from Parent to Child. But for reporting, it is a distribution from a foreign trust, and Child reports it on Form 3520. And the Schedule B instructions for line 8 borrow the Form 3520 meaning of “distribution”: “If you received a distribution from a foreign trust, you must provide additional information. … See the Instructions for Form 3520 at IRS.gov/Form3520 for details.” So a transfer that Form 3520 treats as a distribution is a distribution for line 8 too. We are back where we started: a real or hypothetical distribution from the trust would require Child to check the box on Schedule B, line 8, so the distribution would be “otherwise reflected” on Child’s annual return. Under the general rule, Child holds an interest in the foreign grantor trust.

As a consequence, we can say that if Child is a beneficiary of Parent’s foreign grantor trust during Parent’s lifetime, Child holds an interest in the trust. The interest in the trust is a specified foreign financial asset. Therefore, Child holds a specified foreign financial asset, and must report it on Form 8938.

Analysis: “Child Does Not Have an Interest in the Foreign Grantor Trust”

I think that a beneficiary of a revocable trust does not have an “interest” in the trust. Such a beneficiary is a beneficiary in name only.

As a remainder beneficiary, Child receives something only after a series of (fortunate and unfortunate) events: Parent does not amend or revoke the trust, Parent leaves the assets in the trust, and Parent dies. Then and only then does Child have an “interest” in the trust. And if Child is also a lifetime beneficiary, Child receives something only when a distribution is actually made. Until then, Parent can take everything back.

We determine what the taxpayer owns by using local law. Federal law then determines the tax consequences of a transaction, or the reporting requirements that apply to that asset. As the Supreme Court put it: “State law creates legal interests and rights. The federal revenue acts designate what interests or rights, so created, shall be taxed.” Morgan v. Commissioner, 309 U.S. 78, 80 (1940).

The government will point to the rest of that passage: once a right created by local law is the thing the federal statute reaches, federal law controls, whatever label state law puts on it. Fair enough. But that rule needs a right to work on. If local law gives Child no rights at all, there is nothing for federal law to classify.

This raises the first random variable: which local law do we use to interpret the trust and the parties’ rights in the trust? The trust document will tell you. But for my explanation, I am going to use California law because I’m in California and California law gives me a result that I like. You will have to apply your own governing law to determine what a named beneficiary in a revocable trust actually has: a property right, or mere hope.

California law generally (not specific to trusts) starts with a clean statement. Cal. Civ. Code §700 says:

A mere possibility, such as the expectancy of an heir apparent, is not to be deemed an interest of any kind.

Being named as a beneficiary of a revocable trust creates only a mere possibility of eventual inheritance or of receiving a distribution. The reason is Parent’s power to revoke. Parent can take it all away at any time, just as Parent could rewrite a will and cut Child out. Child is in the position of the heir apparent in §700: Child expects something, but owns nothing.

Cal. Prob. Code §15800(a)(1) says that for revocable trusts, the person holding the power to revoke is the only beneficiary.

Except to the extent that the trust instrument otherwise provides or where the joint action of the settlor and all beneficiaries is required, during the time that a trust is revocable and at least one person holding the power to revoke the trust, in whole or in part, is competent, the following shall apply:

​(1) The person holding the power to revoke, and not the beneficiary, has the rights afforded beneficiaries under this division.

Thus, if California law were the governing law for Parent’s foreign grantor trust, we would assert that Parent (who holds the power to revoke) has the rights afforded beneficiaries. Child, who is a beneficiary, does not have any such rights.

My position is that, as a matter of California law, Child has no rights as a beneficiary. So Child does not have “[a]n interest in a foreign trust.” Treas. Reg. §1.6038D-3(d)(4). Without that interest, there is no specified foreign financial asset. Therefore, Child does not report an interest in Parent’s foreign grantor trust on Form 8938, because Child does not own one.

What about the government’s Schedule B argument? Two answers.

• First, Treas. Reg. §1.6038D-2(b)(1) tells you when a person holds a specified foreign financial asset. It assumes that the asset exists. If Child has no “interest in a foreign trust,” there is no asset, and you never get to the holding test.
• Second, the link from Form 3520 to Schedule B is thin. IRC §6048(d)(1), which makes a grantor trust transfer a “distribution,” applies only “[f]or purposes of this section,” meaning §6048 and Form 3520. Schedule B is part of the income tax return. Only a form instruction (“See the Instructions for Form 3520”) carries the §6048 meaning over to line 8. For income tax, the transfer is a gift from Parent, not a trust distribution.

Conclusion: Report on Form 8938 or Not?

So there you go. If I read the Code and Regulations for the Form 8938 filing obligation, there is at least a plausible argument that the U.S. beneficiary of a foreign-owned foreign grantor trust must report an “interest” in the trust as a specified foreign financial asset.

On the other hand, if you’re willing to go through the legal analysis of your particular trust document and its governing law, maybe you will come to the conclusion I came to under California law: Child has no interest, so there is nothing to report on Child’s Form 8938.

It costs you time and money in the middle of tax season to do the legal analysis of the trust. Maybe your client doesn’t want to pay a lawyer a few grand to give you a reporting position opinion. That’s fair.

The marginal cost of adding an item to Form 8938 that you are filing already is low. The downside (if you do not report and your reporting position is wrong) is $10,000 and an open statute of limitations. Sanity suggests reporting. Under our facts, the maximum value of the beneficial interest in the foreign trust will be $0. Treas. Reg. §1.6038D-5(f)(2)(i).

The usual disclaimers apply. “So you hate waffles?” meme applies.