Foreign Trusts With U.S. Beneficiaries
By: Morris Law Group - November 29, 2014
As estate planning attorneys in South Florida, we have seen a shift in estate planning services we provide. With the rise of foreign individuals migrating to South Florida we are hearing more accents and seeing more ways to best use our estate planning techniques. More “hybrid” families are emerging, whereby there are family members offshore (typically the parents) with their children (or at least some of their children) being domiciled in the U.S.
This raises an estate planning quandary. On one hand, it is not beneficial for U.S. individuals to be beneficiaries of offshore structures, while on the other hand it is disadvantageous for foreign individuals to have U.S. structures...or is it?
U.S. individuals must report their worldwide assets and they pay taxes on their global income.¹ They also currently get a $5.34 Million Dollar exclusion (indexed for inflation) prior to incurring a wealth transfer tax (i.e. estate and gift tax). Since the United States can only tax the person (i.e. a U.S. Individual) or the property (U.S. situs property), non-U.S. individuals are only taxed on their U.S. source income.² Similarly, non-U.S. domiciliaries, for wealth transfer tax purposes, are taxed only on their U.S. situs assets (with a mere $60,000 exclusion).
A trust is a widely recognized estate planning tool used in virtually every common law jurisdiction. For purposes of this discussion, trusts come in two flavors; Domestic Trusts and Foreign Trusts. Within both of those categories we have two subcategories, Grantor and non-Grantor Trusts. From the U.S. standpoint, there are different income tax and reporting requirements involved depending on whether the trust created is Foreign or Domestic, Grantor or non-Grantor. This article will focus on how this characterization will affect the U.S. beneficiaries of these trusts.
Domestic v. Foreign Trusts:
A U.S. (“Domestic”) Trust is generally subject to U.S. income taxation and reporting on its worldwide assets and income.³ Depending if the trust is a Grantor or a non-Grantor trust will determine to whom the income will be attributable (i.e. either the Grantor will pick up all the income, or it could be attributable to the trust itself, or even to the beneficiaries). With that said, generally, the Grantor will pick up all the income in a Grantor trust.
Similar to a non-U.S. (“Foreign”) individual, a Foreign Trust is only subject to income taxation on income earned in the U.S.; U.S. source income includes, but it not limited to, income from an active trade or business in the U.S.; interest paid by U.S. residents and U.S. corporations; dividends paid from a U.S. corporation; personal services performed in the U.S.; rents an royalties from property located in the U.S.; and the disposition of a U.S. real property interest.5
In order for a trust to be a Domestic trust the trust must meet both of the following tests:
- Court Test - A court within the U.S. is able to exercise primary supervision over the administration of the trust (i.e. the applicable law of the trust is the law of a sate in the United States)6; and
- Control Test - One or more U.S. persons have the authority to control all substantial decisions of the trust.7;
If both of these tests are not met, the trust will be considered a Foreign Trust for tax purposes and thus only taxed on its U.S. source income (as mentioned above). This makes for an interesting estate planning technique; one can create a trust, with the law of a state in the U.S. applying (Florida for arguments sake) and have a foreign person having the substantial decision making ability! (i.e. a foreign Trustee) This is a common planning tool when we have clients where all of the beneficiaries are U.S., or clients who are immigrating to the U.S and we want more flexibility with their estate plan. Also, this affords the foreign client the ability to maintain control of the assets during his or her life, as they can be the Trustee of their own trust. This will depend on the clients personal objectives, be it estate planning versus asset protection.
Grantor v. Non-Grantor Foreign Trusts:
After the determination has been made to have either a Domestic or a Foreign trust, one must then take into consideration the second category of trusts, specifically as it pertains to foreign trusts with U.S. beneficiaries. As mentioned above, there are significant income tax and reporting differences when it comes to having U.S. beneficiaries of a Foreign Grantor Trust versus a Foreign non-Grantor Trust. Here is a brief overview of both scenarios.
A trust will be a foreign Grantor Trust if either of these conditions are met:
- the Grantor reserves the right to revoke and said power is exercisable solely by the Grantor, without approval or consent of any other person;8
- the amounts of income and principal of the trust are only distributable to the Grantor or the Grantor's spouse.9
In either of these two situations, the trust will be deemed a Foreign Grantor Trust with all the income attributable to the Grantor. Similarly, gifts from the Foreign Grantor Trust to a U.S. beneficiary should be deemed tax-free gifts (however the U.S. beneficiary may have reporting requirements relating to the gift). Any trust that is not a Foreign Grantor trust will be considered a Foreign non-Grantor trust and as such will be viewed from a tax perspective as a nonresident alien individual who is not present in the U.S. at any time for tax purposes.10; If this is the case, then a Foreign non-Grantor trust, for tax purposes, will only be taxed on U.S. source income.
While this classification seems great from a tax perspective, there are a few pitfalls to having U.S. beneficiaries of Foreign non-Grantor Trusts. Some of the issues include; Distributable Net Income (also known as DNI)11; Loans to U.S. beneficiaries from Foreign non-Grantor Trust12; The Throwback Tax regime for the accumulation of income in a Foreign non-Grantor Trust13; and the special taxing regimes of Controlled Foreign Corporations (“CFC”) and Passive Foreign Investment Company (“PFIC”) which will tax certain types of income whether or not there was a distribution made to the U.S. beneficiary.
Separate and apart from the tax ramifications, it would be remiss if we also did not mention some of the various reporting requirements of the U.S. beneficiaries. Said reporting requirements shall include, but not be limited to; reporting on IRS form 3520 any distributions from a Foreign Trust to a U.S. person, or a gift over $100,000 from a Foreign Trust to a U.S. person; Foreign Bank Account Reporting (“FBAR”) which is triggered when a U.S. person has a reportable financial interest or signature authority over a foreign financial account; and the Foreign Account Tax Compliance Act (“FATCA”) reporting whereby foreign finical institutions must report information about their U.S. account holders or the institution or entity will face a 30% withholding penalty.
Suffice it to say, when there are U.S. beneficiaries of Foreign Trusts there are several pitfalls to avoid. No one case is the same and each client’s facts will change the planning outcome. Whether you are the beneficiary of a foreign trust or are thinking about your family dynamics and the best way to inherit from a foreign person, feel free to contact our office for more information.
¹Subject to treaty benefits and/or Foreign Tax Credits, if applicable and available
²Subject to treaty benefits if applicable and available
4 IRC 641(b)
5 IRC 861
6 Treas. Reg. 301.7701-7(a)(1)(i)
7 Treas. Reg. 301.7701-7(a)(1)(ii)
8 IRC 672 (f)(2)(A)(i)
9 IRC 672 (f)(2)(A)(ii)
10 IRC 641(b)
11 IRC 643(a)(6)
12 IRC 643(i)(1)
13 IRC 667
** Disclaimer Required by IRS Circular 230** Unless otherwise expressly approved in advance by the undersigned, any discussion of federal tax matters herein is not intended and cannot be used 1) to avoid penalties under the Federal tax laws, or 2) to promote, market or recommend to another party any transaction or tax-related matter addressed.