Using Foreign Trusts for Domestic Planning

Transcription

1 Using Foreign Trusts for Domestic Planning December 4, 2012 CalCPA Education Foundation Peter Trieu, Esq., LLM and Company

2 Introduction Definition U.S. Taxation Planning Opportunities Reporting Requirements 2

3 What is a Foreign Trust? A foreign trust is any trust that is not a domestic trust. IRC 7701(a)(31)(B). A trust is a domestic trust if both court test and control test are met. IRC 7701(a)(30)(E). Court Test- a court within the U.S. is able to exercise primary supervision Control Test- only U.S. persons have authority to control all substantial trust decisions 3

4 Court Test A U.S. court includes any court of the federal government, any state or local government, or the District of Columbia. Reg (c)(3)(i). 7(c)(3)(i). A U.S. court is able to exercise primary jurisdiction over a trust if, upon petition by a proper party, the court has or would have the authority under applicable law to render orders or judgments resolving issues concerning substantially all issues regarding the administration of the trust. Regs (c)(3)(iii) 7(c)(3)(iii), (iv). It is advisable to include in the trust agreement a declaration that the law of a specific U.S. situs apply in all matters of construction and interpretation, and that the administration of the trust occurs within the designated U.S. situs. 4

5 Court Test (Cont d) d)- Safe Harbors A trust is deemed to satisfy the U.S. Court Test if the appropriate ate fiduciary registers the trust in a U.S. court under a state statute substantially similar to Article VII, Trust Administration, of the Uniform Probate Code e (UPC). Regs (c)(4)(i)(A) 7(c)(4)(i)(A). Registration must be in principal place of administration A trust established under a decedent's will probated within the United States satisfies the U.S. Court Test if all of the fiduciaries have h been qualified as trustees of the trust by a U.S. court. Regs (c)(4)(i)(B). A trust satisfies the U.S. Court Test if the fiduciaries or beneficiaries take steps with a U.S. court to cause the administration of the trust to be subject to the primary supervision of the court. Regs (c)(4)(i)(C) 7(c)(4)(i)(C). A trust is deemed to satisfy the U.S. Court Test under the safe harbor rule, if: (a) the trust instrument does not direct that the trust be administered a outside of the United States; (b) the trust in fact is administered exclusively within the United States; and (c) the trust is not subject to an automatic migration provision. Regs (c)(1) 7(c)(1). 5

6 Court Test (Cont d) d)- Migration A trust does not satisfy the U.S. Court Test if the trust instrument contains a provision whereby the trust would be removed from the U.S. jurisdiction if a U.S. court attempted to assert jurisdiction or otherwise supervise the administration of the trust, directly or indirectly. Regs (c)(4)(ii). Example: C, a U.S. citizen, executes a trust instrument for his own benefit and the benefit of D, his U.S. spouse. The trust instrument provides that the trust is to be administered in State Y, a state within the United U States, by DC, a State Y corporation. The trust instrument further provides that in the event that a creditor sues the trustee in a U.S. court, the trust will migrate from State Y to Country Z, a foreign jurisdiction, so that no U.S. court will have jurisdiction over the trust. A court within the United States is not able to exercise primary supervision over the administration of the trust because the U.S. court's jurisdiction over the administration of the trust is automatically terminated in the event the court attempts to assert jurisdiction. Therefore, the trust fails to satisfy the U.S. Court Test from the time of its creation and is a foreign trust. Regs (c)(5) 7(c)(5), Ex. 2. 6

7 Control Test The Control Test requires that one or more U.S. persons control all of the trust's substantial decisions. The power to control does not exist if someone else has the power to veto the substantial decisions. Regs (d)(1)(iii) 7(d)(1)(iii). The actions of the grantor or of any trust protector, protector, special trustee, or investment manager with control over the trust must be considered in determining whether the trust is a U.S. or a foreign trust. 7

8 Control Test (Cont d) d)- Restrictions U.S. persons do not control the substantial decisions of the trust if an attempt by any governmental agency or creditor to collect information from or assert a claim against the trust would cause one or more substantial decisions of the trust no longer to be controlled by U.S. persons. Regs (d)(3) 7(d)(3). Such a change in control is commonly included in a foreign situs asset protection trust, to prevent a creditor of the grantor from seeking redress against the trust funds through the U.S. courts. 8

9 Control Test (Cont d) d)- Substantial Decisions Substantial decisions of a trust are nonministerial decisions that persons are authorized or required to make under the terms of the trust instrument and applicable law. Regs (d)(1)(ii) 7(d)(1)(ii). Substantial decisions include the following: Regs (d)(1)(ii)(A) 7(d)(1)(ii)(A) (J). whether and when to distribute income or corpus; the amount of any distributions; the selection of a beneficiary; the power to make investment decisions; whether a receipt is allocable to income or principal; whether to terminate the trust; whether to compromise, arbitrate, or abandon claims of the trust; whether to sue on behalf of the trust or to defend suits against the trust; and whether to remove, add, or replace a trustee. Decisions that are ministerial include decisions such as bookkeeping, the collection of rents, and the execution of investment decisions. Regs (d)(1)(ii) 7(d)(1)(ii). 9

10 Control Test (Cont d) d)- Inadvertently Foreign An inadvertent change in any person with the power to make a substantial stantial decision that would change the residency of the trust can be corrected rected by the trust within 12 months and avoid a change in the trust's residency. Regs (d)(2)(i) 7(d)(2)(i). Example 1: A trust that satisfies the U.S. Court Test has three fiduciaries, X, Y, and Z. X and Y are U.S. citizens and Z is a nonresident alien.. Decisions are made by majority vote of the fiduciaries. The trust instrument nt provides that upon the death or resignation of any of the fiduciaries, D, a nonresident alien, is the successor fiduciary. X dies and D becomes a fiduciary of the trust. Two months after X dies, E, a U.S. person, replaces D as a fiduciary of the trust. During the period after X's death and a before E begins to serve, the trust satisfies the Control Test and remains s a domestic trust. If D has not been replaced and remains a fiduciary of the t trust after 12-month period, the trust is deemed to have become a foreign trust on the date X died. Regs (d)(2)(i) 7(d)(2)(i), (iii), Ex. 1, Ex 2. 10

11 Outbound and Inbound Trusts Outbound foreign trust- created by the transfer of assets by a U.S. person to a foreign trust or to a domestic trust that later becomes a foreign trust. Inbound foreign trust- created by a transfer of assets by a foreign person to a foreign trust that has U.S. beneficiaries, or using U.S. assets. 11

12 Outbound- Grantor Trusts The U.S. grantor of a foreign trust that has one or more U.S. beneficiaries is treated as the owner of the trust's assets, under the grantor trust rules. IRC 679. A nonresident alien individual who becomes a resident of the United States within 5 years after transferring property to a foreign trust t will be treated as if he or she made the transfer on the residency starting date. IRC 679(a)(4). Status applies regardless of the terms of the trust and regardless of any powers or interests the U.S. grantor or any other person may have with respect to trust income and corpus. Grantor is taxable on the income of a trust even if he never receives eives any distributions and has no control or power. Grantor is taxable on trust income only in those years in which there is a U.S. beneficiary. 12

13 Outbound- Grantor Trusts Exceptions A transfer by reason of the death of the transferor is excepted. IRC 679(a)(2)(A). Income of a foreign testamentary trust created by a U.S. person is not taxed to the estate of the U.S. person. A transfer made for fair market value is excepted. IRC 679(a)(2)(B). A transfer is for fair market value only to the extent of the value of property received from the trust, services rendered by the trust, or the right to use property of the trust. Regs (b)(1) 4(b)(1). A U.S. person who is a related person to a foreign trust, is deemed not to have received fair market value for the property transferred to the foreign f trust, to the extent of any consideration that is an obligation of the trust or of a related person, other than a qualified obligation. Regs (c) 4(c). The value of obligations (other than qualified obligations ) ) received by a transferor will not be counted towards the receipt of fair market value, where the t loan is made or guaranteed by the grantor, owner, or beneficiary of the trust, or by related persons such as siblings, spouses, children, controlled corporations. Qualified obligations- (1) in writing; (2) does not exceed 5 year term; (3) denominated in U.S. dollars; (4) yield to maturity not less than 100% AFR; (5)( SOL extended for 3 years after maturity date; (6) loan reported on Form Regs (d)(1) 4(d)(1). 13

14 Outbound- Transfers of Appreciated Assets Any transfer of property by a U.S. person to a foreign trust or estate is, for federal income tax purposes, treated as a sale or exchange made for an amount a equal to the fair market value of the property transferred. IRC 684(a). Transferor must recognize as gain the excess of the fair market value of the property transferred over the transferor's adjusted basis. A U.S. person may not recognize loss on the transfer of an asset to a foreign trust. Exception: Gain should not be recognized on transfers to a foreign trust that has a U.S. beneficiary, because the grantor would be deemed to own the trust under 679. IRC 684(b). Exception: Gain is not recognized on a transfer to a foreign trust or estate that occurs at the transferor's death. Regs (c) 3(c). Exception: Gain is not recognized on a transfer to an unrelated foreign trust in exchange for assets equal in fair market value to the transferred d assets. Regs (d) 3(d). A domestic trust that becomes a foreign trust is deemed to have transferred all of its assets to a foreign trust, to the extent that those assets are attributable a to transfers by U.S. persons. IRC 684(c). 14

15 Inbound Inbound transfers to a foreign trust Trusts created by nonresident alien for the benefit of one or more U.S. beneficiaries; Trusts created by nonresident alien in anticipation of migration to the United States; Transfers of U.S. assets to foreign trusts for the benefit of foreign beneficiaries. Transfers by a foreign person of foreign assets to a foreign trust for the sole benefit of foreign beneficiaries has no nexus with the United States. 15

16 Inbound- Nongrantor Trusts A trust is treated as a grantor trust only if the person deemed to own the trust is a U.S. citizen or resident. 672(f)(1) 672(f)(1). Exception- power to revest absolutely in the grantor exercisable solely by the grantor. 672(f)(2)(A)(i) 672(f)(2)(A)(i). Exception- the only amounts distributable from trust during the lifetime of the grantor are amounts distributable to the grantor or the spouse of the grantor. 672(f)(2)(A)(ii) 672(f)(2)(A)(ii). A U.S. beneficiary of a trust created by a foreign grantor is, nonetheless, n treated as the grantor of the trust to the extent the U.S. beneficiary has made prior gifts to the foreign grantor. 672(f)(5) 672(f)(5). Example 1: X, a nonresident alien, owns all of the shares of FC, a foreign corporation. X contributes property to FC, which then creates a foreign trust, FT, for the benefit of X and X's children. FT is revocable by FC without the approval or consent of any other person. FC funds FT with the property received from X. X and X's family move to the United States. X is treated as the owner of FT because X is a U.S. beneficiary who contributed property to a foreign person (FC) to create a trust for X. Regs (f) 1.672(f)-5(a)(2) 5(a)(2), Ex

17 Inbound- Migration to U.S. A nonresident alien individual who becomes a resident of the United States within 5 years after transferring property to a foreign trust will be treated as if he or she made the transfer on the residency starting date. IRC 679(a)(4). Example- On Jan. 1, 2003, X, a nonresident alien individual, transfers property p to a foreign trust. Four years later, X becomes a resident of the United States. tes. X is treated as a U.S. transferor and is deemed to transfer the property to the foreign trust on Jan. 1, Regs (c) 5(c), Ex A nonresident alien individual who is treated as owning any portion of a trust under the grantor trust rules and who subsequently ceases to be so treated, is treated as having made the original transfer to the foreign trust immediately before the trust ceases to be treated as owned by the individual. Regs (b)(1) 5(b)(1). Example- On Jan. 1, 2002, X, a nonresident alien individual, transfers property p to a foreign trust, reserving the power to revest absolutely in X the title to such property transferred. On Jan. 1, 2008, the terms of the foreign trust are amended to remove X's power to revoke the trust and to revest title to the property transferred, and X ceases to be treated as the owner of the trust. On Jan. 1, 2010, X becomes a resident of the United States. X is treated as having originally transferred the property to the trust on Jan. 1, Because this date is within five year's of X's residency starting date, X is deemed to have made a transfer to the foreign trust on Jan. 1, 2010, his residency starting date. Regs (c) 5(c), Ex

18 Inbound- Income Taxation Income of grantor trusts are taxed to grantor. Income of nongrantor trusts are taxed to trust, beneficiaries or both. All of the income of a simple nongrantor foreign trust will be taxed to the beneficiaries, and the trust receives a deduction for f its current income that it must pay to the beneficiaries, whether or not that income is actually distributed. IRC 651(a) 651(a), 652. The beneficiaries of a complex foreign trust include in their gross income all income that the trust is required to distribute and all a income actually distributed. IRC 662(a) 662(a).. The trust receives a deduction for that portion of its current income that the trust is required to distribute plus that portion of its current income that t the trustee actually distributes to the beneficiaries. IRC 661(a) 661(a); Regs (a) 1.661(a)-1. 18

19 Inbound- Simple v. Complex A simple trust: IRC 651(a) 651(a); Regs (a) 1.651(a)-1. all income must be distributed currently; no amounts may be paid, permanently set aside for, or used for a charitable beneficiary; and no distributions are made other than of current income (i.e., no distributions of accumulated income or corpus). A complex trust is one that is not simple. 19

20 Inbound- DNI Each beneficiary must include in his or her gross income an amount equal to that beneficiary's pro rata share of the trust's DNI. IRC 662(a)(2) 662(a)(2). A distribution in excess of the trust's DNI is treated either as a nontaxable distribution of principal or a distribution of income accumulated from prior years taxable under the throwback rule. Id. Distributable Net Income (DNI)= Taxable income computed without the deduction for distributions to beneficiaries and the personal exemption, and increased by any tax-exempt interest. IRC 643(a) 643(a). Capital gains/losses of a domestic trust are normally excluded from f DNI. Capital gains/losses of a nongrantor foreign trust are normally included in DNI. IRC 643(a)(6)(C) 643(a)(6)(C). 20

21 Inbound- Taxation of Distributions The U.S. income tax consequences of an income distribution to the beneficiaries of a nongrantor foreign trust depend upon few factors: the distribution represents current income (DNI) or accumulated income (UNI); the beneficiary is a U.S. person or a foreign person; and the trust's income is from sources within or without the United States. The U.S. beneficiaries of a nongrantor foreign trust include in their gross income any trust distributions of U.S. and foreign income, to the e extent of the beneficiaries' share of the trust's DNI. IRC 652(a) 652(a), 662(a). Loans of cash or marketable securities by a foreign trust to a U.S. U grantor or beneficiary, or someone related, is treated as a distribution in the full amount of the loan. IRC 643(i). Exception- qualified obligations.. Notice Uncompensated use of trust property by a U.S. grantor or beneficiary, iary, or someone related, is treated as a distribution. IRC 643(i). The foreign beneficiaries of a nongrantor foreign trust are subject to U.S. income taxes on the trust's U.S. source income, and must include in their gross income the lesser of: (1) the amount of income the trust actually a distributes or is required to distribute to the beneficiary; or (2) the beneficiary's share of the trust's DNI. 21

22 Inbound- Throwback Rule A nondeductible interest charge is imposed on the beneficiary's tax on an accumulation distribution from a foreign trust for each year of accumulation. IRC 668. Interest charge is in addition to tax on the distribution. A foreign trust makes an accumulation distribution in any year in which the trust distributes more than its current year's DNI, if it has Undistributed Net Income (UNI). IRC 665(b) 665(b). UNI is the amount by which the trust's DNI for a given taxable year y exceeds the sum of the trust's distributions for that year and the federal income i taxes imposed on such income. Computing the accumulation distribution tax: IRC 667(b)(1) 667(b)(1). Determine the number of preceding taxable years of the trust to which the distribution is attributable. Average the number years of which income accumulated. Average the annual accumulation. Compute increase in tax. Compute partial tax on accumulation distribution. 22

23 Inbound- Throwback Rule (Cont d) Example: A foreign trust makes an accumulation distribution in The trust had UNI of $50,000 in 2004, $25,000 in 2006, and $30,000 in Assume sume that the individual receiving the distribution is and has been in the 28% marginal income tax bracket. Assume that the interest rate on unpaid income taxes during the entire period of accumulation was 6%. The interest charge and total tax is computed as follows: $50,000 (2004 UNI) 8 (number of years between 2004 and 2012) $400,000 $25,000 (1997 UNI) 6 (number of years between 2006 and 2012) $150,000 $30,000 (1998 UNI) 5 (number of years between 2007 and 2012) $150,000 Sum of the above $700,000 Sum divided by $105,000 (aggregate of the UNIs) Period for computing interest (rounded to the nearest half year) 7 years Partial tax (28% $105,000) $29,400 Interest rate (7 6%) 42% Interest charge $12,348 Total tax plus interest charge $41,748 23

24 Planning with Foreign Trusts A U.S. grantor and one or more U.S. beneficiaries Grantor trust under 679; Accumulation distributions subject to the interest charge in nongrantor ngrantor period. A foreign grantor and one or more U.S. beneficiaries Grantor trust status allows tax-free accumulation and distribution of income/corpus; Nongrantor trust status still allows tax-free accumulation, but distributions subject to interest charge Consider making distributions only when beneficiaries are non-u.s. Consider domesticating trust to avoid interest charge. Creation prior to migration to U.S. may result in grantor trust status. Avoid result by creating 5 years prior to migration Embrace result, and reap benefits of reducing estate for estate gift tax purposes tax- free A U.S. grantor and foreign beneficiaries Nongrantor trust (i.e. 679 does not apply); Gain must be recognized under

25 Asset Protection Trusts Goals of an asset protection trust are to assure that the trust funds are administered for the benefit of the grantor and the grantor's family while simultaneously eliminating the access of the grantor's r's creditors to the trust funds Trustee granted broad discretion to distribute trust funds for the t benefit of both the grantor and family members. Asset protection trusts are typically grantor trusts because the grantor and his or her spouse are usually discretionary beneficiaries of income and principal or because the beneficial enjoyment of the t corpus or the income is subject to a power of disposition. Such trusts are also typically grantor trusts under 679,, having U.S. beneficiaries. As a grantor trust, gain should not be recognized on transfers of o appreciated property to the trust under

26 Reporting Requirements A U.S. transferor must file a return (Form 3520) reporting any reportable event with respect to a foreign trust. IRC A reportable event includes: Creation of a foreign trust by a U.S. person, whether or not the trust has U.S. beneficiaries; The transfer of money or property to a foreign trust by a U.S. person, p including a transfer on account of the death of the U.S. person; and Death of a U.S. citizen or resident, if the foreign trust was treated as a grantor trust, in whole or in part with respect to the U.S. decedent, or if the trust was included in the U.S. decedent's gross estate, in whole or in part. Penalty equal to the greater of $10,000 or 35% of the gross reportable amount may be imposed for the failure to file a timely Form 3520 or the failure e to include all required information on such a timely-filed return. IRC A nongrantor U.S. person who receives a distribution, directly or indirectly, from a foreign trust is required to file Form 3520, reporting the distributions. ibutions. IRC 6048(c). A U.S. person who is deemed to own a foreign trust under the grantor trust rules must have trust file an annual return (Form 3520-A) setting forth a full and complete accounting of all trust activities, trust operations and other relevant r information. IRC 6048(b)(1) 6048(b)(1). A U.S. owner is subject to a penalty of the greater of $10,000 or 5% of the gross value of the portion of the trust he or she is deemed to own if the trust does not furnish the information. IRC

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