Selecting a trustee to manage and distribute trust assets to beneficiaries upon your death just became a little more complicated. If you are deciding whether to name an individual who is not a U.S. citizen or U.S. permanent resident as a successor trustee, there are a number of factors to consider.
To begin with, a trust is a binding legal contract, so the trustee has a legal obligation to follow your instructions and to manage the trust funds in a reasonable and prudent manner. A trustee’s duties can continue for many years and they can require expertise in collecting estate assets, investing money, paying bills, filing accountings and managing money for beneficiaries.
While the naming of a non-U.S. citizen, non-U.S. resident as trustee will have no impact on the creation of your trust, it could have a great impact on trust administration. The selection of a successor trustee for a living trust requires practical thinking. But before a trustee can be chosen, it is crucial to understand the difference between a domestic trust and a foreign trust.
To put it simply, a trust is a “foreign trust” if it is not treated as a “domestic trust.” A trust will be considered domestic if a U.S. court can exercise primary supervision over trust administration (the court test) and one or more U.S. persons have the authority to control all substantial trust decisions (the control test). Under these tests, a trust may be a foreign trust even if it was created by a U.S. person, all of its assets are located in the U.S. and all of its beneficiaries are U.S. persons. All it takes for a trust to be foreign is for one non-U.S. citizen, non-U.S. resident to have control over one “substantial” type of trust decision. If a determination is made that a trust is foreign, an analysis must be conducted to ascertain whether the trust is a foreign grantor trust or a foreign nongrantor trust.
Foreign Grantor Trust
A trust established by a nonresident alien person will be characterized as a grantor trust only (1) if the trust is revocable, or (2) the amounts distributable during the life of the grantor are distributable only to the grantor and/or the spouse of the grantor. Under these circumstances, the income of the trust is taxed to the grantor (i.e., the person who made a gratuitous transfer of assets to the trust).
If a U.S. grantor establishes a foreign trust for the benefit of U.S. beneficiaries, it is treated as a grantor trust under I.R.C. §679. Upon termination of grantor trust status (i.e., at the death of the grantor), Section 684 imposes a tax on the unrealized appreciation. However, if that occurs because of the death of the grantor, the stepup in basis under Section 1014 should avoid having any gain to which Section 684 would apply.
A foreign grantor trust will generally become a foreign nongrantor trust upon the death of the grantor. A U.S. person who receives a distribution from a foreign grantor trust must include Form 3520 with his or her tax return if the distribution is in excess of $100,000.00. Form 3520 is due at the same time as the U.S. person’s income tax return is due for the year in which such transfer took place. Failure to file may subject a transferor to a penalty equal to 35% of the amount transferred.
Foreign Nongrantor Trust
Any foreign trust that does not meet the definition of a grantor trust is a foreign nongrantor trust (“FNGT”). A foreign nongrantor trust is taxed as if it were a non-resident, non-citizen individual who is not present in the U.S. at any time. The trustee must provide the beneficiaries with a Foreign Nongrantor Trust Beneficiary Statement, and distributions made to U.S. beneficiaries are reported on Form 3520, regardless of the amount.
A U.S. beneficiary will be subject to tax on distributions to the beneficiary of “distributable net income” (“DNI”) from the FNGT. The character of such DNI distributions will reflect the character of the income as received by the FNGT. If a FNGT accumulates its income and distributes the accumulation in later years in excess of DNI, the U.S. beneficiary will be subject to the “throwback rules”, which generally seek to treat a beneficiary as having received the income in the year in which it was earned by the trust, using a relatively complex formula. The beneficiary may be required to pay a “throwback tax” (a “catch up” tax) and an interest charge on the deferral. Furthermore, such throwback distributions will be taxed at ordinary income tax rates. The throwback rules will not apply to amounts accumulated when the trust was an FGT.
To avoid the negative results that may come about if a foreign trust is created, it will be necessary to appoint one or more “U.S. persons” that have the authority to control all substantial decisions of your trust (I.R.C. Section 7701(a)(30)(E)(ii)). This would mean that if you wish to have a non-U.S.citizen who is not a U.S. taxpayer as a trustee, they would be limited to purely administrative tasks such as bookkeeping, collection of rents and carrying out investment decisions.
If you wish to name a non-U.S. citizen who is not a U.S. taxpayer as a trustee, then additional language will need to be added to your trust to make sure that “foreign trust” status is not triggered.
This article is a service of Bridge Law LLP. We are an award-winning law firm that specializes in business and estate planning for clients like you. The goal for every family is to stay educated on all topics like this, avoid probate, avoid estate taxes, and build a legacy for you and your loved ones. What sets our firm apart is that we build lasting, lifelong relationships with our clients. They rely on us to keep them updated, provide sound legal counsel, and be there for them immediately if any problems should ever arise. The best part is we don’t charge hourly fees to our families, so you never have to worry about speaking to us. If you’re ready to keep your family out of Court, contact us today to schedule an initial consultation or visit our website at www.bridgelawllp.com.