The Tax Implications of a Foreign Trust
The issue of foreign trusts comes up in estate planning during a number of different situations. For example, if you name a successor trustee who is not a US person, your trust will become a foreign trust. Or, if you want to own US assets but you are not a US person, it may be recommended to own the assets through a foreign trust. Or, if you want to pass foreign assets to US beneficiaries, you may also a foreign trust.
For the purposes of this article, when I refer to a “US person,” I am discussing income tax residency and thus, I will use the term “NRA” to describe a non-US person (i.e., an individual who is not regarded as a US income tax resident). For a more detailed description of the differences between a US income tax resident and a US estate tax domiciliary, please read my article, entitled, “Estate Planning for the Non-Citizen.”
Domestic Trusts vs. Foreign Trusts
To put it simply, all trusts are considered foreign trusts unless both the “control test” and the “court test” are met. If a trust can meet both requirements, only then is it considered 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 is governed under the laws of the United States, even if it was created by a U.S. person, even if all of its assets are located in the U.S. and even if all of its beneficiaries are U.S. persons! Therefore, all it takes for a trust to be foreign is for a single NRA to have control over one “substantial” type of trust decision.
A US trust is taxed, just like a US tax resident, on their worldwide assets.
A foreign trust is taxed, just like an NRA, only on US-sourced income, in which case there will be a withholding.
Therefore, if you are an NRA leaving both domestic and foreign assets to your beneficiaries by way of a trust, you should consider a foreign trust since a US trust will cause the foreign assets to be taxed back to the U.S. (US trusts are taxed on worldwide income).
Taxation of Foreign Trusts
Regardless of whether a trust is foreign or domestic, there are only two ways that a trust can be taxed: as a grantor trust, or as a non-grantor trust.
It is important to determine the pros and cons of whether a foreign trust should be taxed as a grantor trust or as a non-grantor trust. For example, if a foreign trust has a US beneficiary, it is always preferred that the trust be taxed as a grantor trust.
Foreign Grantor Trust
A trust established by an NRA will be characterized as a grantor trust only: (1) if the trust is revocable, or (2) the grantor and/or his spouse are the sole beneficiaries of the trust during the grantor’s lifetime. 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). Also, if a U.S. grantor establishes a foreign trust for the benefit of U.S. beneficiaries, it will be treated as a grantor trust under I.R.C. §679.
One point to note here is that if an NRA establishes a foreign grantor trust, then this can present estate tax planning issues if the assets in the trust are greater than $60,000, since at the grantor’s death, the assets will be includable in the grantor’s estate. Thus, it may be necessary to tax it as a non-grantor trust if estate taxes will be an issue.
Upon termination of grantor trust status (i.e., at the death of the grantor), the trust becomes a foreign non-grantor trust and Section 684 imposes a tax on the unrealized appreciation. However, if that occurs because of the death of the grantor, the step-up in basis under Section 1014 should avoid having any gain to which Section 684 would apply.
Foreign Non-Grantor Trust
Any foreign trust that does not meet the definition of a grantor trust is a foreign non-grantor trust (“FNGT”). Similarly, at the death of the grantors, a foreign grantor trust becomes an FNGT.
Here, the rules get more complicated.
First, the trustee of an FNGT must provide the beneficiaries with a Foreign Non-Grantor Trust Beneficiary Statement, and distributions made to U.S. beneficiaries are reported on Form 3520, regardless of the amount.
Second, we have the issue of potential tax on accumulated income. Generally, if an FNGT distributes the current year’s income to a US beneficiary, the income is taxed to the beneficiary (including capital gains), but the income will retain its character. If the foreign trust accumulates income, then there is no US income tax; however, when the trust does distribute an amount not exceeding the current year’s income, then the income is taxed to the beneficiaries, including capital gains. However, if the trust accumulates income and then distributes to the beneficiaries an amount in excess of the current year’s income, then accumulated income is carried out to the beneficiaries as follows:
- All capital gains realized by the trust in prior years are carried out to the beneficiary at ordinary income tax rates;
- An interest charge is imposed on the tax due by the beneficiary on accumulated income from the date that income was originally earned by the trust; and
- There are throwback rules, which generally seek to tax a beneficiary on the income accumulated but at the tax bracket they were in for the years in which the income was earned by the trust, using a relatively complex formula.
Given the complex tax treatments potentially involved in an FNGT, many people try to avoid these issues by various methods:
- If Grantors are Alive: Keep the trust revocable or name the grantor and/or his spouse as a beneficiary, in which case the trust will qualify as a foreign grantor trust.
- If Grantors have Passed: First, if you are going to keep a FNGT, then pay all current income to US beneficiaries to avoid accumulation rules. Second, avoid the FNGT by domesticating the trust and making it a domestic trust instead of a foreign trust by fulfilling both the “control test” and “court test” listed above.
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” (i.e., tax residents of the US) 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.
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