Foreign Tax Credits

Trusts are entitled to a Foreign Tax Credit (FTC) on foreign taxes paid on income also taxed in the U.S.

Regulation §1.642(a)(2)-1 permits an estate or trust to take a credit for taxes paid (to the extent allowed by IRC §901) but “only for so much of those taxes as are not properly allocable under that section to the beneficiaries.” This complements IRC §901(b)(5) which allows a beneficiary to take a FTC to the extent “of his proportionate share of the taxes … [that] the estate or trust paid or accrued during the taxable year…”

There is no detailed explanation of “properly allocable”, so reason must prevail. Let’s assume that the FTC resulted from foreign dividends in a brokerage account. When the foreign dividends are taxed in the trust, then the trust will try to take the FTC. When the foreign dividends are passed out as part of DNI, then the FTC must follow the dividends.

Generally this works to a trust beneficiary’s benefit: when a beneficiary must report (and pay tax on) dividends, the beneficiary can try to claim the FTC.

However, there is no good reason to forgo allocating the FTC just because the trust is paying tax and the beneficiary is not. Example: a simple trust is paying tax on capital gains and the income was passed out to the income beneficiary. However, the income beneficiary had no tax liability due to losses offsetting his foreign dividends. Unfortunately, there is no way to “property allocate” the FTC to the trust (which would enjoy the credit) even though the FTC is not used by the beneficiary.