Planning Considerations for U.S. Beneficiaries of Foreign Trusts
High net worth individuals will typically utilize trust planning as a means of preserving assets and providing income and principal to future generations. Properly structured trusts can also be used to minimize exposure to U.S. estate and other wealth transfer type taxes. Trusts can be formed pursuant to domestic law or pursuant to laws of a foreign country. This article addresses the tax traps associated with trusts that meet the definition of a foreign trust and that are intended to benefit U.S. persons.
For U.S. tax purposes, a trust is classified as either a domestic trust or a foreign trust. To help determine a trust’s classification the IRS has provided a “court test” and a “control test.” A trust will usually be considered a foreign trust if it fails either of these tests.
Court Test: To satisfy the court test, a U.S. court must have the authority to address and exercise primary supervision over all substantial issues about the administration of the trust. Thus, a trust agreement that is governed exclusively under the laws of a foreign court will ordinarily not be considered a U.S. trust.
Control Test: Under the control test, one or more U.S. persons must have the authority to control all substantial decisions of the trust. A trust will be deemed to satisfy the control test if there is a U.S. trustee that is able to control all decisions relating to trust distributions and trust investment decisions and there is no foreign person that is able to veto the U.S. trustee’s actions.
Foreign Trust Tax Situs - Income Tax Concern
Domestic trusts are generally subject to U.S. income tax on their worldwide income. Depending on the terms of the trust, the income tax on the income earned during the year will be paid by the trust, the grantor or the beneficiaries. A domestic trust that accumulates income instead of distributing it to the beneficiaries will normally incur the income tax on the retained ordinary and capital gain income.
In contrast, a foreign trust that is created by a foreigner (who is not a U.S. tax resident) is only subject to U.S. taxation on U.S. source income. U.S. source income includes income from the active conduct of a U.S. trade or business and U.S. portfolio income. Income from certain types of U.S. debt obligations, bank saving accounts and capital gains from the disposition of intangible assets are often exempt from U.S. taxation.
A U.S. beneficiary of a foreign trust is generally not subject to U.S. income tax until such time the beneficiary receives a distribution. Thus, it is possible for a foreign trust to accumulate income for many years without being subject to U.S. income tax. The tax trap faced by U.S. beneficiaries is that the accumulated income is ultimately subject to a tax and interest charge once it is distributed from the foreign trust. The toll charge on the accumulated income can be significant for a trust that has accumulated income for a number of years.
Fortunately, a trust will not be considered to have accumulated income during the lifetime of the trust settlor if the settlor retained certain rights over the trust property or the right to revoke the trust. In this case, the trust income will be attributable to the foreign settlor and not to the U.S. beneficiary. In such a case, the U.S. beneficiary will only have exposure to U.S. taxation on the accumulated income subsequent to the demise of the foreign trust settlor.
Foreign Trust Status - Estate Tax Concern
If foreigner creates a foreign trust and retains the beneficial enjoyment of the trust assets then for U.S. estate tax purposes the trust is ignored at the time of death. This could potentially lead to a tax trap in the form of a U.S. estate tax on assets owned by the foreign trust that have a U.S. situs. A planning strategy used to avoid this potential exposure to U.S. estate tax is to have the settlor’s assets held by an offshore corporation whose shares are owned by the foreign trust.
Holding assets of a foreign trust in an offshore corporation can pose potential tax problems for a U.S. beneficiary of a foreign trust. This will typically be the case if the settlor has established a foreign trust and has retained powers over the trust that could subject the assets to U.S. estate tax at the settlor’s death. The offshore corporation will be treated for U.S. income tax purposes as a “controlled foreign corporation” or “passive foreign investment company.” These companies are viewed as potentially abusive by the IRS and may require that the U.S. beneficiaries of the foreign trust report income on a current basis. This could result in phantom income on which the U.S. beneficiary would owe income tax with no guarantee of having access to trust funds to pay the income tax.
The trustee of the foreign trust should quickly contact a U.S. tax advisor upon learning that the foreign settlor has died or is in poor health. Depending on the facts and circumstances, it may be possible to modify the offshore company’s holdings and liquidate the offshore company to avoid tax issues associated with controlled foreign companies and passive foreign investment companies.
Advanced planning is also recommended for U.S. persons who expect to receive inheritances or gifts from foreign family members that include shares of offshore companies.