Many parents establish a trust for their children and intend that the trust be a domestic (US) trust. Often, this will be a testamentary trust. That is, one that comes into being upon death of the testator, created pursuant to a Last Will & Testament. Many parents struggle with the decision as to who to appoint as the trustee for their children’s trust. The choice becomes particularly tricky when family members are living outside the US, or when they are non-US citizens. In today’s global economy, this scenario is becoming more and more common. Let’s look at the issues and see why selecting a “foreign” family member may be problematic.
Under the Internal Revenue Code, trusts are by default “foreign trusts” for US income tax reporting purposes unless 2 very particular tests are satisfied. These are the so-called “court test” and the “control test”.
A trust is defined as a “United States person” (therefore, not foreign) if (1) a court within the United States is able to exercise primary supervision over the administration of the trust (the “court test”), and (2) one or more United States persons have the authority to control all substantial decisions of the trust (the “control test”).
Thus, a trust must satisfy both the “court test” and the “control test” in order to be treated as a US person for US income tax and reporting purposes. Any trust that is not a US person will be treated as a “foreign” trust.
- Court Test
The Court Test seeks to ensure that a US court can exercise primary supervision over the administration of the trust. Administration of the trust means the carrying out of the duties imposed by the terms of the trust instrument and applicable law, including maintaining the books and records of the trust, filing tax returns, managing and investing the assets of the trust, defending the trust from suits by creditors, and determining the amount and timing of distributions.
In determining whether a trust satisfies the “court test,” due consideration is given to all of the terms of the trust instrument as well as applicable local law. Just because a trust may be governed by the laws of a particular US state does not mean the trust will be treated as domestic, rather than “foreign”. There’s much more to the inquiry as detailed in the relevant Treasury Regulations. Additional information is at my blog post here. Will a US citizen family member who lives outside of the US and serves as trustee charged with the tasks of maintaining books and records, managing and investing trust assets and the like, cause a US court to lack “primary supervision” over the trust administration? Maybe!
- Control Test
In order to be treated as a US “domestic” trust, in addition to the court test outlined above, the trust must meet the “control test”. Similar to the “court test,” the criteria for satisfying the “control test” are set forth in the Treasury Regulations. Under the control test, one or more United States persons must have the authority to control all substantial decisions of the trust. A “United States person” is defined in Internal Revenue Code Section 7701(a)(30) (the term includes a US citizen or resident, or a US corporation or partnership).
Since “all” substantial decisions must be made by a US person, choosing a non-US family member (i.e., a non-US citizen or foreign national who is a non-US resident) as trustee will mean the trust will fail the control test. As such, the trust will be treated as a “foreign” trust. Remember if a foreign person has control over only one “substantial decision,” foreign trust status will result.
”Substantial decisions” are defined in the regulations to mean “all decisions other than ministerial decisions.” See Treas. Reg. § 301.7701-7(d)(1)(ii). Some examples of substantial decisions include not only the power to determine the timing, amount and selection of beneficiaries, but other administrative actions such as allocations between income and principal, making investment decisions, and compromising claims. It also includes the power to appoint a successor trustee (unless this power is restricted so that it cannot change the trust’s residency) and the power to remove, add, or replace a trustee.
What are the US Tax Consequences of a “Foreign” Trust to US Beneficiaries?
Classification as a “foreign” trust results in some troublesome US income tax consequences to the US beneficiaries of the trust. This is a complex topic, but here is an overview –
- When a US beneficiary receives distributions from a foreign trust, the beneficiary will be taxed to the extent that any trust income, including foreign-source income and capital gains, is included in the distribution. In the usual circumstance, under the tax rules, non-US source income and realized capital gains are not deemed to comprise any part of a trust distribution to a beneficiary unless that income is specifically allocated to the beneficiary. One of the big negatives with the foreign trust rules is a change to this tax treatment. When paid from a foreign trust, any income from non-US sources, as well as capital gain income, are deemed under the tax laws to be part of any taxable income distributed to a US beneficiary.
- Another problem lurks in the background with respect to a “foreign” trust with US beneficiaries when the trust accumulates income. If the trust does not distribute income in the year it is earned, such income becomes what is called undistributed net income (UNI). When the trust makes a distribution to a US beneficiary in a later year that exceeds that year’s trust income, the distribution will have UNI and will be deemed to include the accumulated income and capital gains earned by the foreign trust in earlier years (a so-called “accumulation distribution”). Under the tax rules, the gains do not retain their capital character and will be taxed to the US beneficiary at ordinary income tax rates (current maximum rate of 37%, but under the Biden tax proposals increasing to 39.6%). Accumulation distributions are taxed to the US beneficiary under a very harsh regime called the “throwback tax”. Under this regime, accumulation distributions are taxed at the US beneficiary’s ordinary income tax rate for the years during which it was earned under a formula which tries to impose the US tax that would have been payable by the beneficiary if the accumulations had actually been distributed in the years the income was actually earned by the trust. The amounts of the distribution are “thrown back” to the earlier tax years when the trust earned the income, and tax is calculated accordingly. Furthermore, a non-deductible interest charge will be imposed on the tax that is due with respect to the accumulation distribution. This interest charge is designed to defeat any benefit of US tax deferral while the income was being accumulated tax-free in the foreign trust. The rate is based on the interest rate imposed by the Internal Revenue Service (IRS) on tax underpayments and it is compounded daily.
- Significant reporting obligations are triggered with “foreign” trusts. Hefty penalties are imposed for failure to comply. For example, a US beneficiary who receives a distribution from a foreign trust but fails to file Form 3520 (“Annual Return to Report Transactions with Foreign Trusts”) can be charged with a failure-to-file penalty equal to 35 percent of the gross distribution. My earlier blog posts explain in detail the filing requirements with respect to “foreign” trusts. My blog post here covered the US tax filing and reporting requirements for US grantors to foreign trusts, and this post provided a summary of relevant US tax filings imposed on the foreign trust’s fiduciary or trustee; my post here looks at the rules with respect to filings required of the US beneficiary of a foreign trust
Relief for Unintentional Conversion from Domestic to “Foreign” Status
The IRS has recognized that a domestic trust can inadvertently become a foreign trust due to changes in the identity of the trustee and relevant treasury regulations (see section (d)(2)) provide a cure. Under the regulations, a 12-month grace period is granted within which an unintentional conversion to “foreign” status can be cured (e.g., the trust can replace the foreign trustee with a US trustee). Please note that a change of trustee due to removal or appointment is not considered to be inadvertent/unintentional under the regulations. Under the regulations, an inadvertent change means the death, incapacity, resignation, change in residency or other change with respect to a person that has a power to make a substantial decision of the trust that would cause a change to the residency of the trust but that was not intended to change the residency of the trust.
Be Smart
The brief summary of some of the tax effects of foreign trusts in today’s blog post demonstrates that the US tax rules become far more complex with “foreign” trusts. The price tag includes huge penalties for failure to file required information returns, increased compliance costs, higher taxes including hefty interest charges. Trustee selection directly impacts the tax treatment of a trust and is full of tax traps. Be careful out there. Get the help you need with proper tax advice. I have decades of experience helping international families navigate the complexities of the US tax laws. I am happy to assist you.
Foundations
Last but not least, foreign “foundations” are often treated for US tax purposes as a foreign “trust”. These entities share characteristics of both a corporation and a trust. They can offer greater stability and protection of assets and are becoming more and more popular as estate planning and asset protection vehicles.
Two US states have now enacted “foundations” regimes, so it is possible to create a US “foundation”. The legislation is quite new.
You can learn more about foundations in my discussion with Jimmy Sexton LLM on his recent podcasts here and here.
Posted April 8, 2021
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