Using a “Foreign Grantor Trust” – I Heard of it, but Hmmmm … I Want to Know More

Most tax practitioners and wealth planning professionals have heard of the “foreign grantor trust” (FGT) but many are unsure of what it is, how it works, or what it can accomplish in US tax planning.  My post today provides an overview.

The use of a so-called “foreign grantor trust” is a traditional planning technique that typically involves a non-US person (technically, a “nonresident alien” individual) settling a foreign trust for the current or eventual benefit of US (and also possibly non-US) family members. The trust is structured in a manner which generally treats the foreign creator (or “grantor”) of the trust as the “tax owner” of the trust assets for US income tax purposes. The trust as an “entity” is disregarded for tax purposes. What this means is that there is no US income tax assessed on non-US source income earned by the trust.   While the foreign grantor is alive, income can be accumulated in the trust without imposition of US income tax, with the trust thus serving as a vehicle for significant tax savings.  As more fully set out below, distributions can be made to US beneficiaries tax-free.

Treatment of US Beneficiaries

When a non-US individual creates a foreign trust and, for example, has retained the absolute right to revoke the trust, in which case the property would revert back to him, so-called FGT status would result under US tax principles. FGT status will remain only during the life of the grantor, and terminates at the death of the grantor.  More on this later.

US beneficiaries receiving amounts from the FGT would be treated as if they received non-taxable distributions from the trust. How nice for them!  For US purposes, the recipients would not be taxed on these amounts, since the foreign grantor is treated as the taxpayer under US tax principles.  Remember, assuming only non-US source income is being earned by the trust, there is no US tax to the grantor.

Tax information reporting on IRS Form 3520, however, would be required of the US recipient receiving a distribution.  The US beneficiary will have an obligation to file Form 3520 to report receipt of any and all distributions from a foreign trust, even if the amount is just $1!  On the other hand, if the FGT were to make a distribution first to the foreign individual grantor, who in turn then makes a gift to the US beneficiary, the beneficiary need not file Form 3520 until the aggregate value of all foreign gifts exceeded $100,000 during the year.

Furthermore, with this type of example involving a revocable trust, additional tax benefits could accrue to the US beneficiaries after the death of the grantor with respect to any US-situs assets held in the trust. Such assets (such as US real property, or stock in a US corporation) can receive a very favorable basis that is “stepped-up” to the fair market value at the date of death of the grantor. Non-US situs assets in the trust would not receive this beneficial treatment. The basis in such assets would be the basis the particular asset had in the hands of the grantor; this is a so-called “carryover” basis.

Achieving FGT Status

In order to be treated as a FGT with a non-US owner/grantor, either of two conditions must be satisfied:

  • the grantor must have the power to revoke the trust, exercisable solely by the grantor without the approval or consent of any other person (or, with the consent of a related or subordinated party who is subservient to the grantor), or
  • the only amounts distributable from the trust (whether income or corpus) during the lifetime of the grantor are amounts distributable to the grantor or the spouse of the grantor.

Death of Foreign Grantor

Upon the death of the non-US grantor, the trust’s US tax status automatically converts to so-called ‘foreign non-grantor trust’ status.  Assuming the trust held only non-US situs assets, this conversion would not have adverse tax consequences to the non-US decedent/grantor.  If US assets are held in the FGT and have a fair market value over US$60,000 a US estate tax return, Form 706-NA will be due for the estate of the non-US decedent/grantor. It is due nine months following the date of death. The executor of the estate has responsibility for filing the Form 706-NA, but if no executor, personal representative or administrator is appointed, qualified and acting in the United States, every person in actual or constructive possession of any property of the decedent is considered an executor and must file a return. This can include the trustee of a foreign trust owning US situs assets.

Planning must be in place for the eventuality of the grantor’s passing, since negative tax consequences could occur to US beneficiaries under the so-called Throwback Tax regime, which applies to foreign non-grantor trusts.   (Remember, at death of the foreign grantor, the FGT automatically converts to  foreign non-grantor trust status).  Under the Throwback rules, a distribution to a US beneficiary of income earned by the trust in a prior year when the trust qualifies as a foreign non-grantor trust, could be treated as a so-called “accumulation distribution” includible in the beneficiary’s gross income.

Accumulation distributions carry very negative US income tax consequences including compounded interest charges and, of course, involve complex tax filings.  Upon death of the grantor, it may be wise to consider terminating the trust or changing the situs of the trust to the US, where it would be treated as a “domestic” US trust. The Throwback Tax regime does not apply to a US trust.  Flexible planning for such events should be drafted in the trust documents from the outset and should take into account the grantor’s wishes for succession planning.

Once the trust becomes a non-grantor trust, careful attention must be paid to proper tax reporting.  Complex tax filings are required of US beneficiaries of a foreign non-grantor trust and very harsh penalties apply for missing the boat.  More detail at my US tax blog post here.

Planning is Key

When US persons are involved with a foreign trust in any way, special US tax concerns arise. A failure to recognize and adequately address the US tax issues can lead to very harsh tax consequences, but proper planning with a foreign trust within the maze of US tax rules can lead to very beneficial results.  Clearly, an experienced US tax advisor is needed when international planning involves use of a foreign trust (or foreign foundation, which may be treated for US tax purposes as a foreign trust).  Let me know if you need help with your structuring or reporting duties.

Posted October 1, 2020

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