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By Thomas S. Bissell, CPA
A previous commentary by this author discussed the estate tax
advantages that can be realized by an alien who plans to move
permanently to the United States and who creates an irrevocable
"drop-off trust" before the move.1 If the alien can
avoid having his or her "domicile" within the United States on the
date the trust is created (and the date contributions are made to
it) and if the trust is managed between the
settlement date and the date of the settlor's death so as to avoid
the so-called "string" provisions of §§2035-2038, then the settlor
will usually avoid being subject to U.S. gift tax on the transfer
of assets to the trust and the trust assets will usually avoid
being subject to U.S. estate tax upon the death of the settlor.
One of the most important decisions that must be made by the
alien settlor is whether to create the trust as a "domestic trust"
within the meaning of §7701(a)(30)(E) or as a "foreign trust"
within the meaning of §7701(a)(31)(B). Although a discussion of the
federal tax rules that apply in determining whether a trust is
"domestic" or "foreign" is beyond the scope of this commentary, in
most cases the settlor and his or her advisors will be able to
structure the trust so that the trust will have the classification
that the settlor desires. Accordingly, this commentary discusses
some of the most important U.S. tax considerations in deciding
whether to make the trust "domestic" or "foreign." It should
be stressed, however, that the decision should never be based
solely on U.S. tax considerations, because there may be important
non-tax considerations that weigh in the opposite direction.
Although each factual situation must be examined on its own
merits, it is likely that in most cases it will be more
advantageous from the standpoint of U.S. federal taxes to arrange
for the trust to be domestic and not foreign. The discussion below
considers: (1) income taxation of the trust's income during the
settlor's life (assuming the settlor continues to be a U.S.
person); (2) IRS reporting rules during the settlor's life; (3)
income taxation of the trust if after a period of time the settlor
moves out of the United States and again becomes a nonresident
alien before he or she dies; (4) possible taxation of unrealized
gains within the trust when the settlor dies; and (5) income
taxation of the trust after the settlor dies.
1. Income Taxation of the Trust During the Settlor's
Life. If the settlor is a beneficiary of the trust, the trust
will be classified as a grantor trust during the settlor's life,
whether it is domestic or foreign. If the settlor is not a
beneficiary and the trust is foreign, it is likely the trust will
still be classified as a grantor trust under the provisions of
§679, which classify a foreign trust that was formed by a U.S.
person, or by a nonresident alien who became a U.S. person within
five years of the formation of the trust, as a grantor trust unless
the terms of the trust prohibit any U.S. person from receiving any
income (whether current or accumulated) or any corpus, either
during the life of the trust or upon its termination.2 Because it is
assumed that the settlor is moving permanently to the United
States, it is highly likely that the trust will benefit family
members who either are already U.S. persons (either U.S. citizens
or resident aliens) or who will move to the United States and
become resident aliens around the same time as the settlor. If the
settlor is not a beneficiary of the trust and the trust is
domestic, the less stringent grantor trust provisions of §§671-678
will apply, and it may be possible for the trust to make
distributions out of its current income that will be taxed at rates
that are lower than the settlor's U.S. tax rate and the trust's
U.S. tax rate.
2. IRS Reporting Rules During the Settlor's Life. The
IRS reporting rules are definitely more stringent if the trust is
foreign rather than domestic. In the case of a foreign trust that
is a grantor trust under §679, either the trustee or the settlor
(who will become a resident alien for U.S. income tax purposes
within some period of time after forming the trust) must file
annual Form 3520-A. Distributions from the trust to the settlor
and/or to other beneficiaries who are U.S. persons may also have to
be reported on Form 3520. IRS Form 8938 may also have to be filed
by the settlor and/or by the beneficiaries (although information
reported on Form 3520 or Form 3520-A would not have to be reported
a second time on Form 8938), and in many cases Treasury Department
Form 90-22.1 (the "Foreign Bank Account Reporting" form, or "FBAR"
form) may have to be filed. Severe penalties can be imposed for
failure to file any of these forms if required.
In contrast, if the trust is a domestic trust, none of these
forms must be filed, either by the trust or (if it is a grantor
trust) by the settlor, except possibly Form 8938 and/or the FBAR
form if the trust has certain foreign financial assets.
3. Income Taxation of the Trust If theSettlor Leaves the
United States. If after living for a period of time in the
United States the settlor decides to move out of the United States
permanently and resume nonresident status for U.S. tax purposes, it
is likely that the "mark-to-market" rules of §684 will impose U.S.
income tax on the unrealized appreciation in the trust's assets if
it is a foreign trust, but not if it is a domestic trust. The
reason is because the settlor's becoming a nonresident alien will
probably have the effect of converting the foreign trust from a
grantor trust under §679 to a non-grantor trust under §672(f)(2).3 However, the
mark-to-market rule of §684 will not apply if the trust is
domestic, because §684 only applies if assets are transferred to a
foreign trust, or if a domestic trust becomes a foreign trust.
Following the settlor's move out of the United States, under
§672(f)(2) the trust is likely to become a non-grantor trust,
whether it is domestic or foreign. As a non-grantor trust, the
trust income is likely to be taxed in a manner similar to the tax
rules that would apply if the settlor had died (as discussed
further in (5), below). To the extent that the settlor receives
distributions from the trust (whether it is a domestic or a foreign
trust), the settlor's U.S. income tax would be determined in the
same manner as that of any other nonresident alien beneficiary.
4. Possible Taxation of Unrealized Gains of the Trust When
the Settlor Dies. Upon the settlor's death, a significant
disadvantage of foreign trust status is that §684 will usually
impose tax on a "mark-to-market" basis on the increase in value of
the trust's assets over their adjusted bases. The reason is
because the trust will cease to be a grantor trust as a result of
the settlor's death.4 If the trust is a
domestic trust, no U.S. income tax will be imposed on the
unrealized appreciation, although at the same time the value of
those assets will not be stepped up to their fair market value
under §1014 (assuming that no U.S. federal estate tax is imposed on
the trust's assets upon the settlor's death).
5. IncomeTaxation of the Trust After the SettlorDies.
Because the trust will no longer be a grantor trust after the
settlor dies, if the trust is a domestic trust, it will be
potentially subject to tax under §1(e) on its worldwide income each
year, but U.S. tax can be shifted to the trust's beneficiaries to
the extent that it is distributed to them currently. Thus, to the
extent that distributions are made to beneficiaries who are U.S.
persons, the distributed income will be taxed to them at the tax
rates that apply to them. To the extent that distributions are made
to nonresident alien beneficiaries out of current income, as a
general rule only certain U.S.-source income will be taxed to them
- probably limited to U.S.-source dividends, since most U.S.-source
interest will be "portfolio" interest exempt from tax under §871(h)
and most capital gains from U.S. securities will be exempt from
U.S. tax under §871(a)(2).5
If the trust has always been a foreign trust,
following the settlor's death the trust and its nonresident alien
beneficiaries will usually be taxed in the same manner as would the
nonresident alien beneficiaries of a domestic trust, as discussed
immediately above, i.e., in most cases only U.S.-source dividends
would be taxed. However, U.S. beneficiaries of the trust could be
subject to the penalty-like provisions of the foreign trust
provisions of the Code to the extent that they ever receive
distributions of income accumulated by the trust during a prior
year - including the interest charge of §668 and the conversion of
accumulated long-term capital gains into ordinary income. They
could also be subject to the deemed distribution rules of §643(i)
if they borrow money from the trust or use certain trust property
rent-free. They could also be subject to IRS reporting on Forms
3520 and 8938, and/or the FBAR filing requirements. Except for
possibly Form 8938 and/or FBAR filing requirements if the trust has
certain foreign financial assets, these rules would not apply if
the trust is domestic.
If the trust is a domestic trust up to the date of the settlor's
death but if at some point thereafter a decision is made to move
the trust's assets into a foreign trust (perhaps through a
"decanting" process), it is likely that the mark-to-market
provisions of §684 would apply to the move. Thereafter, the general
rules described immediately above with respect to foreign trusts
would apply to the trust's nonresident alien and U.S.
This commentary also will appear in the December 2013 issue
of the Tax Management International Journal.
For more information, in the Tax Management Portfolios,
see Danforth and Zaritsky, 819 T.M., Grantor Trusts: Income
Taxation Under Subpart E, Zaritsky and Rosen, 854 T.M.,
U.S. Taxation of Foreign Estates, Trusts and Beneficiaries,
Bissell, 903 T.M., Tax Planning for Portfolio Investment
into the United States by Foreign Individuals and in Tax
Practice Series, see ¶6120, Estate and Trust Income Taxation -
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