SMSF is seen as a Foreign Grantor Trust by the IRS. A Foreign Grantor Trust is defined as a US person owning a Trust outside the US.
For instance, Susan and Tim are a married couple living in Australia. Susan is a US person and holds an interest in SMSF. The IRS considers SMSF as a Trust hence Trust forms, PFICs for mutual funds/ETFs, and other schedules are required to report Susan’s portion of income and expenses.
PFIC (Passive Foreign Investment Company) is a corporation, located outside the United States, which exhibits either at least 75% of the corporation’s gross income is passive or at least 50% of the company’s assets are investments, which produce income in the form of earned interest, dividends, or capital gains. If a US person holds PFIC (Mutual Funds or ETFs), they are required to file PFIC forms to report each mutual fund/ETF on their US tax return and pay PFIC tax liability. There can be significant compliance costs for preparing PFIC forms.
Susan also received Australian dividend income with franking credit. The IRS does not recognize franking credit as a tax credit hence she had to pay tax in the US on the dividend income.
Furthermore, SMSF pays tax in Australia at around 15%, and there may be a tax liability for Susan if her US marginal tax rate is more than 15%.
Therefore, it’s crucial to consult our qualified Enrolled Agents and Chartered Accountants before setting up an SMSF, purchasing Mutual funds/ETFs, or distributing income.
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