A large number of clients I see are interested in ways to preserve their estate. Whether it is for a spouse, partner, children, or their dog, the client wants to make sure their hard-earned money remains protected and eventually benefits their heirs per their intentions.
I am always disheartened when I hear that a client has been done a disservice by an advisor who didn’t understand the intricacies of international taxation. Unfortunately, there are a lot of do-it-yourselfers and advisors that know just enough to be a danger to themselves and their clients; the story in this blog is a prime example, of just that.
A U.S. citizen, I will call Charles, contacted me in February, not just to prepare his taxes, but to get some guidance on the best way to protect his sizeable portfolio, reap tax benefits, and ensure his heirs would benefit. His plan was to place the portfolio in a foreign trust for the benefit of his U.S. citizen children. Charles explained that he had initially settled on a foreign trust because, based on his research, they offered better asset protection than domestic trusts. But his accountant gave him some misinformation that made him reconsider.
Based on Charles’ research, he had believed that when he transferred the assets to the foreign trust, it would be considered a completed gift. His understanding was that once the completed gift was made, which would be subject to gift tax, that the portfolio would belong to the trust, rather than him, and that the trust, rather he, would be required to pay tax on the portfolio’s income. And the biggest bonus Charles thought, was that because he had chosen the tax-free jurisdiction of the Cook Islands for the trust, all future income of the portfolio would be tax-free.
Charles had a gross misunderstanding of how foreign trusts with U.S. settlors and beneficiaries are taxed. His bubble was burst when his accountant informed him that if a U.S. person transfers assets to a foreign trust, even if an irrevocable one, with U.S. beneficiaries (which his children are) then the transferor of the assets is treated as the owner of those assets for income tax purposes. In other words, he would have to continue to pay U.S. income taxes on the trust’s portfolio income. Based on this correct information, Charles scrapped the foreign trust idea and went with a U.S. irrevocable trust, which is subject to compressed tax rates.
Luckily for Charles, his accountant did give him correct information. Unfortunately, his accountant, not being an international tax expert, missed a little-known strategy. The method allows you to transfer assets to a foreign trust with U.S. beneficiaries where neither you, nor the beneficiaries, have to pay tax on the trust’s income until a distribution is made to the beneficiaries, or they receive the benefits of its assets. The exception involves selling the assets to the foreign trust pursuant to an instalment sale. There may be capital gains tax if there is an unrealized gain built into the assets, but the long-term savings may make it worth it!
With the new information I provided, Charles is now in the process of revisiting the foreign trust idea. While Charles’ advisor didn’t give him incorrect information, he did not give him complete information. Had Charles spent the time and money to seek out an international tax specialist, he would have not only gotten correct advice but the benefit of a specialist’s additional knowledge that non-specialists lack.