Tips From the Pros: Domestic Trust Situs Opportunities for International Families

International families are establishing domestic trusts at a record pace.¹ Previously, these families set up trusts in the United States only if they had family and/or assets in the United States. This strategy still remains popular for international families, but now they’re also using domestic trusts even if they don’t have U.S. family or U.S. situs assets.

 

 

Foreign Grantor Trusts

Many international (non-U.S. citizen/non-resident alien (NRA)) grantors are establishing foreign grantor trusts (FGTs) with trustees in the United States for foreign beneficiaries and foreign property. Usually, the grantors choose modern domestic trust jurisdictions² due to their trust protector, directed trust, privacy, tax and other modern trust statutes. These FGTs are generally revocable during the grantor’s lifetime. The grantor is typically the NRA and/or NRA’s spouse. The FGTs typically hold offshore entities that may own the NRA’s foreign assets. If there are no U.S. situs assets, the FGT has all the protection of a U.S. trustee with domestic situs but pays no U.S. taxes. If the offshore entity holds U.S. situs income-producing assets, they’re subject to the 30 percent U.S. withholding tax at the offshore entity level.³ Additionally, if U.S. securities are involved, they won’t generally be subject to capital gains taxes unless the NRA is in the United States for 183 days or more during the calendar year. The NRA grantor(s) are usually the beneficiaries of these FGTs so that they’re paid income and principal during their lifetimes. At the death of the NRA grantor(s), these FGTs are typically left outright or passed to another trust for the benefit of the descendants, usually the children. 

These FGTs are frequently established by NRAs who are residents of countries with political instability or subject to the risk of political instability and/or possible forced heirship⁴ issues. The NRAs prefer U.S. trust situs for the FGT versus an offshore island that may be blacklisted or strong armed by the NRA’s resident country. Consequently, the FGT is a very powerful and popular option for these NRA families whether or not the assets are U.S. sitused. 

 

Domestic Dynasty Trusts 

If the NRA has U.S. family (that is, citizen or green card children, grandchildren or other relatives), the NRA has an unlimited estate, gift and generation-skipping transfer (GST) exemption versus the $5.43 million exemption for a U.S. citizen.⁵ Consequently, these NRAs can gift an unlimited amount into a domestic NRA dynasty trust usually sitused in one of the modern trust jurisdictions. The unlimited gift exemption generally only applies if NRAs are gifting non-U.S. situs assets.⁶ The most popular option is cash.⁷ U.S. insurance bought on either the NRA’s life and/or on the lives of the U.S. beneficiaries is also a popular investment for these trusts.⁸ The life insurance wrapper converts the trust to a zero tax dynasty trust both for income and capital gains generated within the trust, as well as for trust distributions because they’re in the form of non-taxable life insurance policy loans.

Many NRAs have currently funded offshore trusts administered by foreign trustees, with the NRA and his spouse as primary beneficiaries and their children as contingent beneficiaries. If their children are U.S. citizens or green card holders—and the NRA grantor dies, and the trust assets remain offshore for the benefit of the U.S. beneficiaries—then the U.S. tax reporting⁹ and taxes¹⁰ become extremely burdensome for the U.S. beneficiaries. Consequently, the NRAs will generally set up a pour over NRA dynasty trust, nominally funded with $10 during their lifetime, in one of the modern domestic dynasty trust jurisdictions. These trusts are then fully funded at the NRA grantor’s death, at which point the foreign offshore trust pours over into the U.S. domestic NRA pour over dynasty trust for the benefit of the U.S. beneficiaries, thus avoiding the burdensome U.S. taxes and reporting. 

Another common scenario is when one NRA parent dies and the second NRA parent decides to move to the United States to be with the U.S. beneficiary children and become a green card holder and/or citizen. The surviving NRA parent may look to gift assets to a self-settled¹¹ NRA dynasty trust and/or change the situs of a foreign trust¹² to the United States prior to moving to the United States, while that parent has unlimited estate, gift and GST  tax exemptions for non-U.S. situs assets. By using a self-settled dynasty trust, the NRA can also be a permissible discretionary beneficiary of the trust.

 

Real Estate

Many NRAs purchase real estate in the United States for themselves and/or their families. Seven percent of the total home sales in the United States are to foreign buyers, totaling $92.2 billion of U.S. real estate sold.¹³ U.S. real estate is frequently purchased in a U.S. dynasty trust or an offshore entity to avoid U.S. estate taxes. The domestic dynasty trust also generally avoids any possible imputed rental income for use of the property by the beneficiaries, although the NRA grantor may have to pay rent if he also uses the real estate. If the NRA purchases U.S. real estate outright, he only has a $60,000 U.S. estate tax exemption for U.S. situs property. Consequently, he may need to purchase U.S. life insurance to pay for the estate taxes owed on the real estate at his death.

 

Domestic Life Insurance

Domestic life insurance is an exempt U.S. situs asset not subject to U.S. estate taxes. Consequently, the proceeds from a life insurance policy paid by a U.S. insurer on the life of a non-U.S. individual aren’t U.S. situs property for estate tax purposes.¹⁴ However, most domestic insurance companies require that the NRA have a tie to the United States to secure the insurance. Thus, a domestic trust, although not required to save U.S. estate taxes, is frequently used to serve this purpose. If the policy is large enough and/or private placement life insurance is purchased, then the NRA frequently chooses a low premium tax modern domestic trust jurisdiction.¹⁵ 

 

Pre-Immigration Trusts

Pre-immigration trusts are also a popular alternative for an NRA who’s a corporate executive transferring to the United States for work purposes. Typically, before moving to the United States, the NRA grantor would use the unlimited gift, estate and GST tax exemptions to fund a pre-immigration trust in a self-settled domestic trust jurisdiction. Since the trust is self-settled, the NRA grantor would generally name himself as a permissible discretionary beneficiary, so he can also benefit from the trust. Life insurance provides a favorable funding option for these pre-immigration trusts.

 

Qualified Domestic Trust

One of the more frequently used trusts for a U.S. citizen spouse married to an NRA spouse is the qualified domestic trust (QDT). Generally, there’s a 100 percent marital deduction for assets passing from an NRA spouse to a U.S. citizen spouse at death. However, there isn’t a 100 percent estate tax marital deduction if the surviving spouse isn’t a U.S. citizen, unless the assets pass to a QDT.¹⁶ 

 

Private Family Trust Companies

Lastly, many international families are establishing private family trust companies in the United States not only to act as the families’ domestic trustee, but also for privacy, political stability, blacklisting and family governance reasons.      

 

Endnotes

1. Al W. King III, “The Top Ten Reasons International Families Establish U.S. Trusts—Why? How? Once a No-No, Now Commonplace,” Fourth Annual STEP/UCLA School of Law Institute on Tax, Estate Planning and the Economy (Jan. 22, 2015).

2. Alaska, Delaware, Nevada, New Hampshire, South Dakota and Wyoming.

3. Internal Revenue Code Section 871(a). Also, U.S. dividend tax rates may be reduced from 30 percent to special rates as low as 15 percent, depending on the treaty.

4. Many foreign countries have forced heirship laws/rules or orders possibly negatively effecting a trust or disposition of property. The modern domestic dynasty trust jurisdictions (see supra note 2) generally have statutes that specifically exclude forced heirship claims enabling clients from foreign civil law jurisdictions to leave assets in trust to beneficiaries of their choice, thus overriding their home countries statutes, if properly structured.

5. Treasury Regulations Section 26-2663-2.

6. IRC Sections 2104 and 2105, Treas. Regs. Sections 20.2104 and 20.2105. The gift by a non-resident alien of real or tangible U.S. situs property is taxed at the  same rate as the estate tax if the gift exceeds the $14,000 exclusion amount, which is the equivalent to a $60,000 exemption. U.S. securities are intangible property so aren’t generally subject to gift tax. The applicable gift tax return is typically the IRS Form 709-NA. 

7. IRC Section 2104(C).

8. Treas. Regs. Section 20.2105-1(8).

9. IRC Section 6048(C); Form 3520.

10. IRC Sections 665-668, “Accumulated Earnings Tax and Throwback Rules.”

11. A self-settled trust generally allows the grantor to be a permissible discretionary beneficiary of an irrevocable trust without causing estate tax inclusion issues. All the modern domestic dynasty trust jurisdictions (see supra note 2) have self-settled trust statutes. There are 15 self-settled trust jurisdictions in the United States, including the modern trust jurisdictions.

12. Generally, the situs of a foreign (offshore/non-U.S. law) trust can be changed to U.S. situs with the following procedure:

– The domestic trustee reviews the existing trust and the newly drafted domestic trust;

– The domestic trustee declares the new U.S. trust (or offshore trustee declares);

– The purpose of the new trust is part of the declaration;

– The foreign trustee pays over trust assets with a deed of distribution to thenew domestic trust. Please note that changing the situs involves potential tax issues similar to decanting, that is, undistributed net income, accumulations distributions, throwback rules and extensive reporting obligations.

13. See supra note 1.

14. Treas. Regs. Section 20.2105-1(8).

15. Alaska (10 basis points) and South Dakota (8 basis points) are the two lowest premium tax jurisdictions. Most jurisdictions average 200 basis points for their state premium tax. See also Al W. King III and Pierce H. McDowell III, “State Premium Tax Planning,” Trusts & Estates (June 2011), at p. 25.

16. Qualified domestic trust requirements are: 

– All trust income paid to surviving spouse for life;

– Principal distributions: only to surviving spouse during life;

– Distributions taxed at deceased spouse’s highest estate tax rate; and

– Principal also subject to estate taxes at death of second spouse.

Note that the U.S. trustee generally has the power to withhold estate taxes on any distributions and, for a trust over $2 million, usually needs an institutional trustee or to post a bond.