U.S. Taxation of Foreign Estates, Trusts and Beneficiaries (Portfolio 854)

Tax Management Portfolio, U.S. Taxation of Foreign Estates, Trusts and Beneficiaries, No. 854-4th, gives a survey of the history of trusts, explains in detail the U.S. federal income, estate, and gift taxation of foreign trusts and estates and their grantors and beneficiaries. To view this Portfolio, visit Bloomberg Tax for a free trial.

Description

Tax Management Portfolio, U.S. Taxation of Foreign Estates, Trusts and Beneficiaries, No. 854-4th, gives a survey of the history of trusts, explains in detail the U.S. federal income, estate, and gift taxation of foreign trusts and estates and their grantors and beneficiaries. The Portfolio also provides a secondary discussion of select U.S. state taxation analogues. An entity is subject to U.S. income taxation as a “foreign trust” or “foreign estate” if it is classified respectively as such under several U.S. tax code sections.

Congress continues to perceive abuses of the Internal Revenue Code through the use of foreign trusts. Therefore foreign trusts, their grantors and their beneficiaries are subject to a number of special substantive and reporting provisions of the Internal Revenue Code and the Bank Secrecy Act. For example, §679 imposes a look-through for income tax purposes, taxing a U.S. grantor of a foreign trust that has a U.S. beneficiary or potential U.S. beneficiary as the deemed owner of the trust assets. Also, §684 causes a U.S. grantor to recognize gain on the transfer of appreciated property to a foreign trust. As well, §672(f) denies look-through, grantor trust status to the extent that it would cause a foreign trust to be taxed as owned by a non-U.S. person, and may make any U.S. beneficiaries of such a trust taxable as the deemed owners to the extent such beneficiary has made transfers to the trust.

The U.S. beneficiaries of a nongrantor foreign trust are generally taxable on the current (in the year experienced) and distributed income of the trust in the same manner as the beneficiaries of domestic trusts. Taxation of U.S. beneficiaries on accumulation distributions from a foreign trust, however, is different. For example, the “throwback rules,” now largely repealed for domestic trusts, still apply generally in the context of foreign trusts. The “throwback rules” impose an augmented scheme of taxation on the nongrantor foreign trust's distributed, accumulated trust income, amounting to lost value of the offshore accumulation through the devices of interest charges and lost gain treatment.

Absent treaty obligations or proper planning, U.S. estate taxes are imposed upon the transfer of U.S. situs property of a nonresident noncitizen decedent, and on the transfer of any property, without regard to situs, of a U.S. resident noncitizen. Although most of the usual deductions are allowed, the marital deduction is not unless the surviving spouse is a U.S. citizen. The foreign estate of a nonresident noncitizen is also subject to a greatly reduced unified credit. The foreign estate is generally subject to the same income tax rules as a nonresident alien individual, but with an additional deduction for distributions to beneficiaries. In the case of a nonresident noncitizen, U.S. federal gift taxes only apply to gifts of U.S. situs tangible personal property and U.S. situs realty. Finally, the generation-skipping transfer tax only applies to a nonresident noncitizen to the extent the initial transfer was subject to U.S. estate or gift tax.

This Portfolio may be cited as Heimos, 854-4th T.M., U.S. Taxation of Foreign Estates, Trusts and Beneficiaries.


Authors

Michael A. Heimos, Esq.

Michael A. Heimos, B.A., Benedictine College (cum laude, 1991); J.D., University of Denver College of Law (1995); founding attorney, Michael A. Heimos PC (formerly known as Dean & Heimos LLC and Mullin Dean & Heimos LLP) (1995-present); member, Tax Management Estates, Gifts and Trusts Advisory Board; member, Society of Trust and Estate Practitioners (STEP); author, 806 T.M., Immigration and Expatriation Law for the Estate Planner; author, 837T.M., Non-Citizens: Estate, Gift and Generation-Skipping Taxation ; author, Chapter 38 — U.S. Taxation of Foreign Nationals, Immigration Law for the Colorado Practitioner (Colorado Bar Association); author of articles and commentaries for Bloomberg BNA Tax Management, Asset Protection Journal, American in Britain, and the American Bar Association's Asset Protection Strategies; author of chapters for compilations published by West Group Publishing and Chancellor.

The author wishes to thank the following for their assistance: Christopher Reimer, Esq., Long Reimer Winegar Beppler LLP; Thomas St. G. Bissell, Esq.; and Mark Kloempken, Reference Librarian, Washington University School of Law (St. Louis).

Table of Contents

Detailed Analysis
I. Introduction and General History of Trusts
II. Foreign Trusts and U.S. Taxation: A Brief History
Introductory Material
A. Foreign Trusts Before 1962
B. The Revenue Act of 1962
C. The Tax Reform Act of 1976
D. The Revenue Reconciliation Act of 1990
E. The Small Business Job Protection Act of 1996 and the Taxpayer Relief Act of 1997
F. The Hiring Incentives to Restore Employment Act of 2010
III. What Constitutes a Foreign Trust (§7701)
Introductory Material
A. Definition of a “Trust”
B. State and Foreign Law Trusts that Are Not Trusts for U.S. Federal Tax Purposes
1. Generally
2. Business Trusts
3. Investment Trusts
a. One-Class Investment Trusts
b. Multiple-Class Investment Trusts
4. Liquidating Trusts
5. “Sham” Trusts
6. Exotic Entities
C. What Makes a Trust “Foreign”
1. Pre-1997 Subjective Rule
2. Post-1996 Objective Rule — The U.S. Court and Control Tests
a. The U.S. Court Test
(1) Generally
(2) Trust Registration
(3) Testamentary Trusts
(4) Petition to a U.S. Court (Inter Vivos Trusts)
(5) Co-Supervision by U.S. and Foreign Courts
(6) Automatic Migration Clauses
(7) Supervision of Administration by Multiple Courts
b. The Control Test
(1) “Control”
(2) “Substantial Decisions”
(3) Safe Harbor for Certain Domestic Trusts
c. Elective Domestic Status
IV. Outbound Foreign Trusts (§679 and §684)
Introductory Material
A. Grantor Trust Status of Foreign Trusts Created by and for a U.S. Person
1. Generally
2. Transferor Must Be a “U.S. Person”
a. Foreign Transferors Who Become U.S. Persons
b. Transfers of Community Property
c. Expatriating U.S. Transferors
3. Required Transfer
a. Generally
b. The Testamentary Transfer Exception
c. Transfers for Fair Market Value
(1) Transfers Before February 7, 1995
(2) Transfers After February 6, 1995
(a) Generally
(b) Transfers for Partial Consideration
(c) Debt Obligations Generally
(d) Qualified Debt Obligations
(i) Changing the Terms
(ii) Principal Payment
d. Transfers to Charitable or Employee Benefit Trusts
e. Indirect Transfers
(1) Transfers from Grantor Trusts
(2) Indirect Transfers Through Intermediaries
(3) Constructive Transfer by Assumption or Satisfaction of Trust's Debt
(4) Constructive Transfer by Guarantee of Trust's Debt
(5) Transfers to Entities Owned by a Foreign Trust
f. Outbound Trust Migration as a Deemed Transfer
4. Trust Must Be a “Foreign Trust”
5. Trust Must Have a U.S. Beneficiary
a. Scope of Inquiry
b. Discretionary Beneficiaries
c. Beneficiaries Who Could Become U.S. Persons
d. Indirect U.S. Beneficiaries
e. Annual Determination and the Five-Year Rule
f. Effect of Acquiring a U.S. Beneficiary
g. Drafting for §679
h. Conflict Between §679 and §678
i. Deemed Transfer on Grantor's Immigration
6. Outbound Migrations of Domestic Trusts
7. Amount of Trust Income Taxable to the Grantor Under §679
B. Transfers by U.S. Persons of Appreciated Assets to Nongrantor Foreign Trusts
1. Transfers Before August 5, 1997
2. Transfers After August 4, 1997
a. Indirect and Constructive Transfers
b. Transfers by Grantor Trusts
c. Transfers to a Foreign Grantor Trust
d. Transfers to a Charitable Trust
e. Transfers at Transferor's Death
f. Transfers for Fair Market Value
g. Transfers to Certain State Law Trusts Not Taxed as Trusts for Income Tax Purposes
h. Outbound Trust Migration
i. Exchanges Under §1032
C. Certain Foreign “Qualified Revocable Trusts”
V. Inbound Transfers and Taxation of U.S. Income of Nongrantor Foreign Trusts
Introductory Material
A. No Grantor Trust Status for Foreign Grantors
1. Background
2. U.S. Beneficiary as Grantor
3. Partial Ownership
4. Trusts Created by Certain Foreign Corporations
5. Certain Revocable Trusts
a. Generally
b. “Grantor”
(1) “Gratuitous Transfer”
(2) Special Purpose Trusts
(3) Accommodation Grantors
c. 183-Day Rule
6. Irrevocable Trusts Benefiting Only Grantor and/or Grantor's Spouse
a. Generally
b. Distributions for Support
7. Compensatory Trusts
8. Effective Date Protection (Certain Trusts in Existence on September 19, 1995)
9. Recharacterization of Certain Gifts
a. Generally
b. Purported Gift Defined
c. Gift or Bequest Through Partnership or Foreign Corporation
d. Charitable Contributions
e. Gift or Bequest Through Intermediary Trust
f. Discretion to Further Recharacterize
g. De Minimis Rule
10. Recharacterizing Beneficiary as Grantor of Inbound Trust
a. Generally
b. Different Tax Years
c. Entity Characterization
d. Effective Date of Recharacterization Rules
11. Effective Date
B. Grantor Trust Status and Inbound Grantors
C. Income Taxation of U.S. Income of Nongrantor Foreign Trusts
1. The Distribution Deduction
a. Generally
b. Simple Versus Complex Trusts
c. Computation of DNI
(1) Worldwide Income
(2) Capital Gains
d. Distributions Through Intermediaries
(1) Generally
(2) When Distribution Through Intermediary Is Deemed Made
(3) Grantor as Intermediary
(4) De Minimis Rule
(5) Effective Date
2. Taxation of Nongrantor Foreign Trusts on Different Types of Income
a. Generally
b. Income Effectively Connected with a U.S. Trade or Business
c. Fixed or Determinable Annual or Periodical Income
d. Capital Gains
e. Gains from the Sale of U.S. Real Property Interests
f. Alternative Minimum Tax on Items of Tax Preference
D. Income Taxation of Current Distributions
1. Distributions to U.S. Beneficiaries
a. Loans to U.S. Beneficiaries and Grantors
(1) Generally
(2) Relevant Definitions
(3) Related Persons
(4) Tax-Exempt Grantors
(5) Qualified Obligations
b. Distributions Through Intermediaries
c. Credit for Foreign Taxes
(1) Nongrantor Foreign Trusts
(a) Generally
(b) Beneficiary's Foreign Tax Credit for Accumulation Distributions
(c) Beneficiary's Foreign Tax Credit for Current Distributions
(2) Foreign Trusts Deemed Owned by U.S. Beneficiaries
d. Alternative Minimum Tax
2. Distributions to Foreign Beneficiaries
a. Foreign-Source Income
b. U.S.-Source Income
(1) Effectively Connected Income
(2) Fixed or Determinable Annual or Periodical Income
(3) Treaty Benefit Issues
(4) Credits for U.S. Taxes Paid by Trust
3. Distributions to Former U.S. Citizens and Residents
E. Income Taxation of Accumulation Distributions from Foreign Trusts
1. Background
2. The Throwback Rule
a. “Accumulation Distribution” and “Undistributed Net Income”
b. The Character Rule
c. The Interest Charge
d. Credit for Foreign Taxes Paid by Trust
e. Planning Distributions to Avoid Throwback Rule and Interest Charge
F. Gains Recognized on Certain Pre-August 6, 1997 Sales and Exchanges
G. Beneficiaries Changing Nationality During Tax Year
VI. U.S. Wealth Transfer Taxes on Foreign Transfers to Foreign Trusts
Introductory Material
A. Gift Tax
B. Generation-Skipping Transfer Tax
1. Direct Skip Transfers
2. Taxable Terminations and Distributions
3. Planning Considerations
C. Estate Tax
VII. Reporting Requirements for Foreign Trusts
Introductory Material
A. Outbound Transfers to and Interests in Foreign Trusts (Form 3520)
1. Generally
2. Reportable Events
a. “Grantor”
b. “Beneficiary”
c. “Obligation”
3. Filing Dates
4. Penalties
a. “Gross Reportable Amount”
b. Responsible Party
c. Reasonable Cause Exception
d. Deficiency Procedures
B. Deemed Owners of Foreign Grantor Trusts (Form 3520-A)
1. Filing Dates
2. Penalties
a. “Gross Reportable Amount”
b. Responsible Party
c. Reasonable Cause Exception
d. Deficiency Procedures
e. Appointment of U.S. Agent
C. U.S. Beneficiaries of Foreign Trusts
1. General Return Information
a. “Distribution”
b. Charitable and Compensation Trusts
2. Beneficiary Statements
3. Filing Dates
4. Penalties
a. “Gross Reportable Amount”
b. Responsible Party
c. Reasonable Cause Exception
d. Deficiency Procedures
D. U.S. Recipients of Foreign Gifts
1. Reportable Gifts
2. Dollar Limitations
a. Gifts from Foreign Estates and Individuals
b. Gifts from Foreign Corporations or Partnerships
c. Aggregation of Transfers
3. Data Required
4. Filing Dates
5. Penalties
a. Responsible Party
b. Reasonable Cause Exception
E. Notice Concerning Fiduciary Relationship (Form 56)
F. Fiduciary Income Tax Returns (Form 1040NR)
G. Accumulation Distributions (Form 4970)
H. Withholding Tax Returns for U.S.-Source Income of Foreign Persons (Form 1042-S)
I. Foreign Investment in U.S. Real Property
J. Foreign Bank Accounts (FinCEN Form 114)
K. Foreign Financial Assets (Form 8938)
L. U.S. Recipients of Gifts or Bequests from Expatriates (Form 708)
VIII. The Situs of Foreign Trusts
A. Selecting a Foreign Situs
1. Substantive Trust Law Existence and Development
2. Tax Burden on Trust
3. Currency and Currency Controls
4. Political and Economic Stability of Situs Country
5. Asset Protection Laws
6. Availability of Communications Facilities
7. Availability of Competent Trustees
8. Split Situs and Governing Law
B. Changing the Situs
1. Methods of Relocating a Foreign Trust
2. Tax Consequences
a. Termination and Recreation as a Domestic Trust
(1) Tax Consequences Under Change-of-Form View
(2) Tax Consequences Under Split-Transaction View
b. Decanting
(1) Tax Consequences Under Change-of-Form View
(2) Tax Consequences Under Split-Transaction View
c. Changing Trustee and Situs of Administration
3. Changing the Situs of a Trust from One Foreign Country to Another
a. Tax Consequences of Termination and Recreation
(1) Tax Treatment Under Change-of-Form View
(2) Tax Treatment Under Split-Transaction View
b. Decanting a Trust from One Foreign Country to Another
IX. Drafting, Executing, and Administering Foreign Trusts
Introductory Material
A. Drafting to Assure that Trust Is a Foreign Entity
1. Violating the Control Test
2. Violating the U.S. Court Test
B. Unfavorable Situs and the Force Majeure Clause
C. Drafting Trustee's Investment Powers
D. Distribution Provisions
E. Avoiding U.S. Beneficiaries
F. Selecting Assets to Fund Trust
X. Special Planning Uses of Foreign Trusts
Introductory Material
A. Trusts with U.S. Grantors and U.S. Beneficiaries
B. Trusts with Foreign Grantors
C. Trusts with U.S. Grantors and Foreign Beneficiaries
D. Foreign Asset Protection Trusts
1. Structure of Asset Protection Trusts
a. Distribution Authority
b. Right to Revoke
c. Right to Change Trustees
d. Trust Protector
2. Situs of Trust
3. Creditors' Rights Problems Under U.S. Law
4. Tax Issues
a. Grantor Trust Status and Gain Recognition Under §684
b. Gift and Generation-Skipping Transfer Taxes
c. Withholding Taxes
E. Abusive Foreign Trusts
XI. Investments by Foreign Trusts
Introductory Material
A. Foreign Life Insurance Trusts
1. U.S. Estate Taxation
2. Transfer for Value Problems Under §684
3. Income Taxation of U.S. Beneficiaries
B. Foreign Mutual Funds
XII. Foreign Estates
Introductory Material
A. The Definitional Problem
1. Definition of an “Estate”
2. What Makes an Estate “Foreign”
a. For Income Tax Purposes
b. For Estate Tax Purposes
B. U.S. Estate Taxation of Foreign Estates
1. The Gross Estate
2. Deductions
3. Computation and Credits
4. Estate and Gift Tax Treaties
C. U.S. Income Taxation of Foreign Estates
1. Income Taxation of Estates Generally
2. Foreign Income of Foreign Estates
a. Taxation of the Estate and Foreign Beneficiaries
b. Taxation of U.S. Beneficiaries
3. U.S. Income of Foreign Estates
a. Taxation of the Estate and Foreign Beneficiaries
(1) Determination of Trade or Business
(2) Capital Gains
(3) Fixed or Determinable Annual or Periodical Income
b. Taxation of U.S. Beneficiaries
c. Transfers by U.S. Persons of Appreciated Assets to Foreign Estates
D. Reporting Requirements for Foreign Estates
1. U.S. Recipients of Bequests from Foreign Estates (Form 3520)
2. Notice Concerning Fiduciary Relationship (Form 56)
3. Fiduciary Income Tax Returns (Form 1040NR)
4. Estate Tax Returns (Form 706-NA)
5. Transfer Certificates
6. Foreign Investment in U.S. Real Property
7. Foreign Bank Accounts (FinCEN Form 114)
8. Foreign Financial Assets (Form 8938)
9. U.S. Recipients of Bequests from Estates of Expatriates (Form 708)
XIII. Collection and Enforcement
Introductory Material
A. Liability of Foreign Fiduciary for U.S. Taxes
B. Extraterritorial Enforcement of IRS Levies by U.S. Courts
C. Extraterritorial Enforcement of IRS Assessments Through Foreign Courts
1. Enforcement of IRS Assessments Through Foreign Courts
2. Enforcement of U.S. Tax Laws Through Tax Treaties

Working Papers

Table of Worksheets
Worksheet 1 Sample Foreign Irrevocable Discretionary Trust
Worksheet 2 Sample Deed of Exclusion of U.S. Beneficiaries
Worksheet 3 Sample Force Majeure Clause
Worksheet 4 Sample Rule Against Perpetuities Clauses
Worksheet 5 Sample Provision Restraining Transfers of Community Property
Worksheet 6 Sample Decanting Provision
Worksheet 7 Sample Foreign Court Supervision Provision
Worksheet 8 Sample Foreign Trustee Provision
Worksheet 9 Sample Variable Annuity Contract
Worksheet 10 Foreign Jurisdiction Comparison for Asset Protection Trusts
Worksheet 11 FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR)
Worksheet 12 Summary of U.S. Income Tax Reporting Requirements Applicable to Foreign Trusts