Often, trusts established by non-U.S. citizen decedents under their U.S. wills or revocable trusts to care for minor children become foreign trusts by accident. This triggers significant tax and reporting consequences. But there are solutions.
It's very common for non-U.S. citizens who live and work in the United States to create a U.S. will or revocable trust. Sometimes, they take these actions because they've become long-term U.S. residents and have accumulated substantial assets here, including a home. Sometimes, it's because they've been properly advised that even if their only assets in the United States are a house and bank account, they likely need a U.S. will establishing a U.S. qualified domestic trust to avoid U.S. estate taxes upon the death of the first spouse to die. If these clients have children who are minors, they're then advised to establish trusts for those children to avoid court-supervised guardianship proceedings should both spouses die while the children are young. Their choice of trustee often is a parent or sibling who resides in their home country, even if their children were born in the United States, are being schooled in the United States, are rooted here, and will remain here.
So far, all of this makes perfect sense — for estate tax planning purposes. But what about income tax planning? The clients' choice of a foreign trustee causes the children's trusts to be classified under U.S. income tax laws as foreign trusts — with lots of ensuing complications.
Under Internal Revenue Code rules promulgated in 1996, trusts are by default “foreign trusts” for U.S. income tax reporting purposes unless a U.S. court exercises both primary supervision over the administration of the trust (the “court test”), and one or more U.S. persons have authority to control all substantial decisions of the trust (the “control test”).1 The choice of a foreign trustee causes the trust to flunk the control test because a non-U.S. person controls substantial decisions of the trust. Being classified as a foreign trust causes some problematic U.S. income tax consequences, including:
U.S. beneficiaries who receive distributions from the trust will be taxed to the extent that any trust income, including foreign-source income and capital gains, is included in the distribution.2 Normally, non-U.S. source income and realized capital gains are not deemed to constitute any part of a distribution to a beneficiary unless specifically allocated to a beneficiary.3 The foreign trust rules change this tax treatment and non-U.S. source income, as well as capital gains, are deemed to be part of any taxable income distributed to a U.S. beneficiary.4 Thankfully, the income retains its character so that capital gains are taxed at lower applicable rates.5
Trust income not distributed in the year it is earned becomes undistributed net income (UNI). If, in a later year, a trust distribution to a U.S. beneficiary exceeds that year's trust income, the distribution carries out UNI and is deemed to include the accumulated income and capital gains realized by the foreign trust in prior years. These gains do not retain their character but rather are taxable to the U.S. beneficiary at ordinary income tax rates.6
Also, to the extent that a distribution to a U.S. beneficiary exceeds the current year's trust income, an interest charge will be assessed on the tax that is due with respect to the accumulated income and capital gains that are now deemed distributed.7 This charge is based upon the interest rate imposed upon underpayments of federal income tax and is compounded daily.8
Finally, accumulated income and capital gains are taxable to the U.S. beneficiary at the beneficiary's tax rate for the years during which it was earned under a complex formula designed to capture the U.S. tax that would have been payable if the accumulations had been distributed in the years earned (the “throwback tax”).9
Foreign trusts also trigger additional reporting obligations that carry heavy penalties for failure to comply. A U.S. beneficiary who receives a distribution from a foreign trust must file Form 3520 (“Annual Return to Report Transactions with Foreign Trusts”) reporting the distribution and the character of the distribution.10 The failure-to-file penalty is equal to 35 percent of the gross distribution.11 The foreign trust trustee must file Form 1040NR and, according to the instructions, “change the form to reflect the provisions of Subchapter J, Chapter 1 of the Internal Revenue Code,” because the form is designed to report income of nonresident alien individuals and not trusts.12
The non-U.S. citizen client who created the problematic plan that produces these income tax results does not face them himself during his lifetime if he establishes a revocable trust in the United States. He also doesn't encounter them if he funds an irrevocable offshore trust for the benefit of his children during his lifetime. This is because, by virtue of his U.S. residence, he is a “U.S. person” for U.S. income tax purposes,13 and a U.S. person who directly or indirectly transfers property to a foreign trust is treated as the owner of the trust for income tax purposes if there is a U.S. beneficiary of the trust.14 This means the foreign trust, like the U.S. revocable trust, is a grantor trust, which is disregarded for income tax purposes, leaving all income, deductions, credits and gain to be reported as that of the grantor.15 Not surprisingly, then, his surviving family will be caught unaware upon his death.
Recognizing, however, that a domestic trust can inadvertently become a foreign trust through changes in the identity of the trustee, U.S. Treasury Regulations provide for a 12-month period within which to cure the unintentional conversion.16 The trust can replace the foreign trustee with a U.S. person trustee, or the foreign person can become a U.S. person during these 12 months. The foreign person can effectuate the cure simply by making the United States his place of residence; he need not become a U.S. citizen.17
Rather than rely upon the 12-month cure period, however, a trust agreement should provide for a means to remove a non-U.S. person trustee to assure that the trust qualifies as a domestic trust. Trustee removal and appointment provisions are critical and should be reserved to individuals or entities in the United States. As a safeguard, the probate court of the decedent's place of domicile should be given this authority expressly, in the event no one named is able or available to exercise the power.
Another tax-planning concern arises for non-U.S. citizen clients who use a typical U.S.-style revocable trust as their estate-planning instrument. So long as the client falls within the tax definition of a U.S. person (satisfied by U.S. citizenship or U.S. income tax residence), a lifetime transfer to a revocable trust or even an offshore trust has no adverse U.S. income tax result, because the trust is deemed a grantor trust.18 In addition to avoiding the UNI and throwback rules, there is no recognition of capital gain when appreciated property (like a house) is transferred to the trust. However, if the non-U.S. citizen client ceases to be a U.S. income tax resident, even a revocable trust may cease to be a grantor trust on the date (but immediately before) his U.S. income tax residency terminates, resulting in a deemed transfer of (and recognition of gain on) all of the trust's appreciated assets.19 This might occur, for example, to a corporate executive who is transferred temporarily to a foreign country where he establishes residence, or he takes a treaty position asserting residence in the foreign country.
If the reason for termination of grantor trust status is the non-U.S. citizen's death, there is no deemed sale, thus no gain recognition, if the assets of the trust are includible in his estate for federal estate tax purposes.20 If the assets of the trust are not includible in his taxable estate, for example, if he created and funded an irrevocable gifting trust for estate tax planning purposes during his lifetime that names a foreign trustee, there is no estate tax inclusion and there will be a deemed transfer upon the death of the grantor, thus attracting capital gains tax.21 Fortunately, the cure provisions found in the Treasury Regulations also apply to the deemed disposition tax, so that the replacement of the foreign trustee with a U.S. trustee within 12 months of the grantor's death will remove the immediate recognition of U.S. capital gains tax.22
To avoid these problems, it might seem to make sense to allow the foreign trustee to appoint a U.S. co-trustee or to grant certain reserved powers over the trust to a foreign family member in lieu of naming them as trustee (for example, reserving to them the power to remove and replace the U.S. trustee.) But this will not solve the problem. A trust is defined as foreign unless it satisfies both the court test and the control test. If a trust has both a foreign trustee and a U.S. person trustee, to fall within the safe harbor provisions of the Treasury Regulations governing the court test, the trust must “in fact” be administered exclusively within the United States. That means the U.S. trustee must maintain the books and records of the trust, file the trust tax returns, manage and invest the trust assets, and determine the amount and timing of trust distributions.23 The safe harbor provisions of the control test are even more difficult to satisfy, as they provide that, in addition to making decisions related to distributions, the U.S. trustee must be entirely responsible for: selecting beneficiaries, making investment decisions, and deciding whether to allocate receipts to income or principal, terminate the trust, pursue claims of the trust, sue on behalf of or defend suits against the trust, and remove, add or replace a trustee or name a successor trustee.24
Suppose there is no U.S. person that the client feels confident to name, or the foreign trustee refuses to relinquish his role and the trust is a foreign trust? There are more solutions if the trust is either drafted with the assumption that it will eventually migrate, or if careful trust administration and distribution decisions are made.
If the client is adamant about naming a foreign trustee, the distribution provisions of the trust could require that all of the distributable net income (DNI) of the trust be distributed at least annually to the beneficiaries. Although capital gains are not part of the DNI of a domestic trust, they are includible in the DNI of a foreign trust.25 Forcing the distribution of DNI prevents the accumulation of gains as UNI in the foreign trust. Even if the trust instrument itself does not expressly require annual payments of DNI, so long as the income allocation and distribution language is broad enough and does not specifically preclude certain distributions, the trustee can pay out all of the current income of the trust (including capital gains) to the U.S. beneficiary, who then includes the distribution in his taxable income. Because the income is recognized in the same year it's earned, it retains its character as ordinary income or capital gains. If these distributions would create adverse estate tax consequences for the U.S. beneficiary whose gross estate is being augmented by increased annual payments, the foreign trust could make the distributions to a domestic trust for the benefit of the U.S. beneficiary. This trust should be drafted to avoid estate tax inclusion in the beneficiary's U.S. estate.
If there are other beneficiaries of the foreign trust who are not U.S. citizens or residents, another option is to have the trustee clear out the UNI accumulated in the foreign trust by distributing it to the non-U.S. beneficiary in one year and making distributions to the U.S. beneficiary in the following year. Under the separate share rules, it is important that these distributions be made in different taxable years of the trust.26 In clearing distributions from foreign trusts, it's helpful to keep in mind that the IRC allows a trustee to elect to treat a distribution made within the first 65 days of any taxable year as made on the last day of the preceding taxable year.27 This gives the trustee some time to sort through the actual income of the trust after the close of the tax year — to ensure that he has not missed anything.
If the U.S. beneficiary is not a U.S. citizen and plans to leave the United States shortly (perhaps he is finishing his education here and, upon graduation, intends to return to his home country), the trustee could wait to make distributions to that beneficiary until he terminates his U.S. residence — when current and accumulated income and gains can be paid without U.S. income taxation. While the beneficiary is still a U.S. tax resident, the trust could purchase a house and tangibles, allowing the beneficiary to use such property for his benefit.
The trustee must be careful, however, about making loans of cash or marketable securities to the beneficiary. These are treated as distributions and taxed accordingly, unless they meet the IRC criteria of a “qualified obligation.”28 The criteria includes the need for a written agreement, a term not to exceed five years, payment in U.S. dollars, a stated interest rate between 100 percent and 130 percent of the applicable federal rate (AFR), reporting the loan on an IRS Form 3520 for each year the loan remains outstanding, and extending the statute of limitations three years beyond the loan's maturity date.29
Another drafting option of particular use when it's expected that a non-U.S. citizen beneficiary will eventually leave the United States is to provide in the trust instrument for a required distribution of a specific sum of money or specific property that is not payable in more than three installments. The IRC specifically excludes such distributions from DNI, provided the trust doesn't require that the distributions be paid from income.30 These distributions can be used to tide over a beneficiary while he is still a U.S. resident.
Frequently, non-U.S. citizens residing in the United States due to prolonged work assignments or for personal reasons do not have U.S. citizen or resident trustees to appoint in their estate-planning documents. While the optimal tax results and least complications are achieved by assuring the appointment of only U.S. persons designated by the client to act as trustee, the next best alternative is to contemplate solutions in the trust document by including trustee removal and appointment provisions that are reserved to U.S. persons, mandating certain distributions or providing the trustee with sufficient discretion so that clearing distributions can be made, and allowing for disproportionate distributions to be made among U.S. and non-U.S. beneficiaries in different taxable years of the trust.
Finally, when all else fails, the use of trust-owned property and qualified loans can be implemented to more effectively administer a foreign trust.
- Internal Revenue Code Sections 7701(a)(30)(E) and 7701(a)(31).
- IRC Sections 643(b) and 643(a)(6).
- IRC Sections 662 and 643(a)(3).
- IRC Section 643(a)(6).
- IRC Sections 643(a) and 643(b).
- IRC Sections 665 and 666. This tax treatment is in contrast to that of foreign grantor trusts and domestic trusts, the undistributed income and gains of which are taxed to the trust in the year earned and constitute additions to principal, that, when later distributed, are not taxable to the beneficiary.
- IRC Section 668.
- IRC Section 6621(a)(2).
- IRC Sections 666 and 667.
- IRC Section 6048(c).
- IRC Section 6677(a).
- IRS Instructions to Form 1040NR.
- IRC Section 7701(a)(30)(A).
- IRC Section 679(a). The determination of whether a foreign trust has a U.S. beneficiary is made on an annual basis, and a foreign trust is treated as having a U.S. beneficiary for a taxable year unless no part of the income or corpus of the trust may be paid or accumulated to or for the benefit of, directly or indirectly, a U.S. person. Treasury Regulations Section 1.679-2(a)(1).
- IRC Section 671.
- Treas. Regs. Section 301.7701-7(d)(2). An extension of time may be granted by making a written application to the district director having jurisdiction over the trust's return that sets forth reasonable actions that have been taken to prevent the change in trust residence and circumstances beyond the trust's control that have prevented it from complying within the 12-month prescribed period.
- IRC Section 7701(a)(30)(A).
- IRC Section 679(a).
- Treas. Regs. Sections 1.684-4 and 1.684-2(e). IRC Section 672(f) provides that the grantor trust rules of Subpart E do not apply to a foreign grantor unless the grantor has the power to revoke the trust and revest title to the trust property in himself without the approval or consent of any other person or with the consent of a related or subordinate party who is subservient to the wishes of the grantor, or trust income and principal may only be distributed to the grantor and his spouse during the grantor's lifetime. These are narrowly construed requirements that can be thwarted by incapacity clauses and powers of appointment in the trust instrument.
- Treas. Regs. Section 1.684-3(c).
- Treas. Regs. Section 1.684-3(g), Example 3.
- Treas. Regs. Section 1.684-4(c).
- Treas. Regs. Section 301.7701-7(c).
- Treas. Regs. Section 301.7701-7(d).
- IRC Section 643(a); Treas. Regs. Section 1.643(a)-6(a)(3).
- IRC Section 662(b); IRC Section 663(c).
- IRC Section 663(b).
- IRC Section 643(i) and IRS Notice 97-34.
- IRS Notice 97-34.
- IRC Section 663(a)(1).