You know what sucks worse than tax? Double tax! Or worse, triple tax! And I can’t think of another “entity” that poses more taxation risk for U.S. persons than foreign trusts (including foreign foundations). Don’t get me wrong, I am a huge advocate of foreign trusts. They can provide unparalleled estate planning, succession planning, wealth protection, privacy, and tax minimization benefits.
That said, achieving these benefits requires expert advice and trust drafting. Unfortunately, these are rarities in today’s world where trusts have been so highly commoditized. Today the governing documents of trusts are generally hobbled together from templates by amateurs rather than custom drafted by experienced professionals with the requisite expertise for client’s situation. While this certainly saves money, the results are assuredly subpar—if not outright atrocious.
I was recently reminded of an often overlooked—or unknown—taxation danger posed by foreign trusts while writing an article for Bloomberg Tax’s Estates, Gifts, and Trusts Journal.
The culprit is Internal Revenue Code (IRC) section 684, which states that U.S. persons who transfer assets to a foreign trust must recognize gain, but not loss, on the transfer. In short, if a U.S. person transfers appreciated assets to a foreign trust, they must pay tax on the appreciation. If they transfer depreciated assets—tough—they can’t claim the loss.
As with most tax laws, there are exceptions to IRC 684. Two to be precise. Let’s examine them:
- When a U.S. person transfers assets to a foreign trust that either has or does not prohibit U.S. beneficiaries, the U.S. transferor will be treated as the owner of the transferred assets for U.S. income tax purposes—regardless of whether the transfer was completed gift. So long as the U.S. transferor continues to be treated as the owner of the assets transferred to foreign the trust for tax purposes, IRC 684 is not triggered.
- The transfer of assets to a foreign trust by a U.S. person can be either a completed or uncompleted gift. Completed gifts are subject to gift tax. A completed gift occurs where the transferor:
a. Does not continue to possess or enjoy the property, or retain a right to the income from the property; or
b. Does not retain a power of appointment.
Completed gifts remove the transferred assets from the transferor’s estate. Uncompleted gifts do not.
If the assets transferred to the foreign trust will be included in the U.S. transferor’s estate, IRC 684 is not triggered.
Let me illustrate how all this works.
Assume Joe, a U.S. person, transfers assets to a foreign trust for the benefit of his family, some of whom are U.S. persons. Joe does not continue to possess or enjoy the transferred property, or retain a right to the income from the property, or retain a power of appointment.
Tax 1 (Gift Tax) – The transfer is completed gift and subject to gift tax since Joe didn’t continue to possess or enjoy the transferred property, or retain a right to the income from the property, or retain a power of appointment.
Tax 2 (Income Tax) – Because the trust has U.S. beneficiaries, Joe will continue to be treated as the owner of the transferred assets for U.S. income tax purposes and will be liable for income tax on the income generated by transferred assets.
Tax 3 (IRC 684) – IRC 684 was not triggered when Joe transferred assets to the foreign trust because he continued to be treated as the owner of the transferred assets for U.S. income tax purposes. What happens when Joe dies though? Since he will no longer treated as the owner of the transferred assets for U.S. income tax purposes and the gift was a completed gift (transferred outside of his estate), the assets will be deemed to have been transferred just before his death for IRC 684 purposes. Any appreciation will be subject to tax. There is no step-up in basis with gifted assets so Joe’s original basis will apply in calculating any gain. This outcome would be the same if Joe expatriated rather than died.
Here is another illustration of IRC 684 in action. Assume the same facts as above, except the foreign trust prohibits U.S. beneficiaries. In this scenario, the gift tax would apply because it is a completed gift. Joe would, however, not continue to be treated as the owner of the transferred assets for U.S. income tax purposes because U.S. beneficiaries are prohibited. Therefore, IRC 684 is triggered, and the transfer is subject to both gift tax and capital gains tax on any appreciation of the transferred assets. Joe would, however, not be liable for U.S. income taxes on the income generated by the transferred assets.
The interaction of IRC 684 with other IRC sections can have far reaching (and dire) tax consequences, including in situations where a non-U.S. person transfers assets to a foreign trust and later becomes a U.S. person.
This post is hardly an in-depth treatise on foreign trust taxation. The point of this post is simply to point out that foreign trust taxation is minefield. Absent expert advice and drafting, the tax consequences can be dire and unintended.
Don’t fall behind!
Stay current with strategic international tax and wealth planning tips, commentary, and war stories! Subscribe to our email list bellow!