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By Robert E. Ward, Esq. Ward Chisholm, P.C. Bethesda, Maryland
A prior commentary explained the limited reporting by financial institutions for trusts organized in the United States and how administration of those trusts should be approached so as to minimize CRS and FinCEN reporting to foreign governments. This commentary addresses U.S. tax considerations and planning to minimize the impact of U.S. income and estate taxation on the trust income and assets.
Income Taxation: In order to minimize U.S. income taxation, status as a U.S. person for U.S. income tax purposes is to be avoided. Whether a trust is a U.S. or foreign person for U.S. income tax purposes is determined by an objective test comprised of two prongs, both of which must be satisfied. Violation of either causes a trust — even one organized and administered in the United States — to be a foreign person. First, a court within the United States is able to exercise primary supervision over the administration of the trust (the “Court Test”). “Administration” is defined by Treasury regulations to refer to “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.” The Treasury regulations provide a safe harbor under which a trust will satisfy the Court Test if three conditions are met:
In addition to satisfying the Court Test, one or more U.S. persons must have the authority to control all substantial decisions of the trust (the “Control Test”) in order for the trust to be considered a U.S. person. Treasury regulations distinguish ministerial decisions from substantial decisions and provide a non-exclusive list of substantial decisions:
Any trust that fails either the Court Test or the Control Test will be treated as a foreign trust. A foreign trust will only be subject to U.S. income taxation on its U.S.-source income.
Income Tax Planning: In order to minimize the U.S. income tax rate to which the U.S.-source income is subject, the income of the trust is best taxed to a foreign settlor. This is because trusts are subject to very “thin” income tax brackets.
The foreign settlor of a trust will be treated as the owner of (and taxable on) the income of the trust in only two circumstances. The first circumstance occurs when distributions from the trust (whether income or capital) during the lifetime of the settlor may be made only to the settlor or the settlor's spouse. The second circumstance occurs when the settlor has the power to unilaterally (or with the consent of a related or subordinate party) revest the trust assets in the settlor. A “related or subordinate party” is defined by §672 to be any individual or entity that does not have a beneficial interest in the trust and is:
The circumstances described above notwithstanding, unless the settlor has made a gratuitous transfer to the trust, the settlor will not be treated as the owner of the capital and income of the trust for U.S. income tax purposes. If the trust is settled by a distribution from another trust, the settlor of the transferor trust will be treated as the owner of the capital and income of the transferee trust unless the person or entity at whose direction the transferee trust was settled (usually a trustee of the transferor trust) had powers broad enough to be characterized as a general power of appointment. A general power of appointment is defined by §2041 as a power to appoint assets to oneself, one's creditors, one's estate, or the creditors of one's estate.
Estate Taxation: As stated above, the foreign status of a trust established in the United States for U.S. income tax purposes will not insulate the trust from U.S. income taxation on U.S.-source income. Similarly, the foreign status of the trust for U.S. estate tax purposes will not protect the settlor of the trust from U.S. estate taxation if: (1) the settlor is also a beneficiary of the trust, and (2) the trust owns assets present or deemed to be present in the United States. Individuals who are not citizens or domiciled in the United States are nonetheless subject to U.S. estate taxation on tangible assets present in the United States (real property and tangible personal property) and intangible assets deemed to be property within the United States (“U.S. Situs Assets”). U.S. Situs Assets include shares of U.S. corporations and debt obligations of U.S. persons (other than portfolio debt obligations). Even in circumstances in which the settlor is not a beneficiary of the trust, if the trust is subject to revocation or amendment by the settlor and contains U.S. Situs Assets, the U.S. Situs Assets will be subject to U.S. estate taxation at the settlor's death. Even if the settlor of the trust is not a beneficiary, if the settlor retains a general power of appointment (as defined above) over the assets of the trust and the trust holds U.S. Situs Assets, the U.S. Situs Assets will be subject to U.S. estate taxation at the settlor's death.
Opportunities for Basis Increases: The cost basis of the trust assets will be adjusted to fair market value at the settlor's death in certain circumstances. In order to achieve such a basis adjustment, the assets of the trust need not be subject to U.S. estate taxation at the settlor's death.
It should be unnecessary to explain (although human experience clearly dictates otherwise) that the use of a trust to evade foreign or U.S. income tax laws, engage in money laundering, or otherwise violate foreign or U.S. laws is to be avoided. Review or explanation of those laws is beyond the scope of this commentary. However, a word to the wise should be sufficient.
Copyright © 2016 Tax Management Inc. All Rights Reserved.
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