A No-Go — Foreign Trust with A US Beneficiary

Often, persons living abroad are asked to help care for an elderly parent who lives in the USA.  Similar situations can arise for other family members, some of whom may be US citizens living outside of America, but who need assistance due to age or health-related issues. Quite often the care required is simply a matter of handling the person’s financial matters, a task which they may not feel comfortable to do alone.  This can be accomplished by using a properly drafted power of attorney. It can also be done if the person in need of help creates a trust. Use of the trust adds the possibility of estate planning for the individual’s assets.

This blog post will focus on use of the trust vehicle to assist with parental care or other family planning when the beneficiaries are US persons. In a typical example, an elderly parent would create the trust with his/her own assets, the parent may retain the right to amend or revoke the trust and will name themselves as the trust beneficiary to receive income and principal as needed.  As the term implies, the trustee who is chosen to administer the trust will be a trusted person, since the beneficiary himself does not feel comfortable managing the assets. Upon death, the trust instrument can direct to whom the assets should pass or whether they should remain in trust for future generations. Quite often the trust will remain in place after death of the primary beneficiary. Use of such a trust may be a good idea not only to safeguard the assets and provide an estate planning vehicle, but one which will also offer great reassurance and comfort to the primary beneficiary.

Trouble – Foreign Trust with A US Beneficiary

In creating this kind of trust for US beneficiaries one has to be very careful to ensure that the trust is not considered a “foreign” trust.  In our example, this should not be a concern while the US individual (e.g., elderly parent) who funded the trust is alive, since in the circumstance described above, the trust should be treated as a so-called “grantor trust”.  With a “grantor trust” the US tax owner of the income and principal is the grantor or creator of the trust because of the powers and control he has retained over the assets.  Items of income and deduction are generally declared on the grantor’s income tax return. Upon death of the grantor, however, the trust will become a nongrantor trust and this is when US tax problems may arise. The problems will arise only if the trust is a “foreign” (as opposed to a US “domestic”) trust, if the trust does not currently distribute income in the year it is earned and later makes what is called an “accumulation distribution” to any US beneficiaries.

While this post points out the pitfalls of a US person creating a foreign trust for US beneficiaries, depending on the facts of each situation, it may surprisingly be beneficial in certain instances to use such a foreign trust.

Throwback Tax Rules

Under certain tax rules (IRC Section 6048), any distribution of income or principal from a foreign trust to a US beneficiary will be treated as a so-called “accumulation distribution” includible in the gross income of the beneficiary unless adequate records are provided to the IRS to determine the proper treatment of the distribution. These accumulation distributions carry very negative US income tax consequences under the Throwback Tax regime (contained in IRC Sections 665-668).  A distribution from a foreign trust that is taxable to a US beneficiary as an “accumulation distribution” carries severe tax consequences under the Throwback rules, compounded interest charges as well as very complex US tax filings.  Phil Hodgen gives a good summary of the hideous complexity in calculating the tax.  Even though one of the requisite forms, Form 4970 looks deceptively easy, it is not; furthermore, the accompanying Form 3520 will really take you to task! In summary, if you have a foreign trust in this type of situation, it will not benefit anyone other than the taxman (and the tax return preparer who will charge significant fees to get the required returns prepared).  It certainly will not benefit the trust’s US beneficiaries.

So, how do you know if you have a foreign trust? Part II of this blog post will give you the scoop.  But here’s a hint, if the trustee or protector is a former American who has expatriated, whether by giving up citizenship or a green card, you have a problem.

Posted May 16, 2019

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