This article covers how US law might treat your foreign trust.
The information below is relevant to US citizens, green card holders, non resident aliens, and anyone who might set up a trust for the benefit of someone subject to the US tax system.
First things first.
What is a trust?
Contrary to popular belief, a trust is NOT an entity like a corporation or an LLC.
Rather, a trust is simply a contract.
What is a foreign trust?
In general, a “foreign trust” simply means a trust that is “formed” in a jurisdiction other than your home country.
But as we’ll discuss further below, a trust can be legally formed (or, “settled”) in the US but be treated as a foreign trust for US tax purposes.
Who are the parties to a trust?
The “settlor” or “grantor” is the person who transfers legal ownership of their assets to the trustee, placing them “inside” the trust.
The trustee is the person or party responsible for holding and administering the trust’s assets. In many jurisdictions, trusts can have more than one trustee.
Beneficiaries are generally named by the settlor and benefit from the trust – typically, by receiving a distribution from the trust and/or by having use of trust assets.
Trusts may have a protector – someone responsible for overseeing the trustee. Generally, a protector has the power to replace a trustee for certain reasons or for no reason at all.
Professional Trust Company or Private Trust Company… Which is better?
Many people can fulfill the trustee position for your trust.
But people most commonly use a professional trust company or a private trust company.
Just like it sounds, a professional trust company is in the business of serving as trustees of trusts.
Generally, professional trust companies are highly regulated by the jurisdiction in which they are located. To protect the public at large, governments often require them to be licensed, bonded, and insured.
A private trust company (PTC), on the other hand, is a private entity generally established by the grantor to serve as a trustee for the family trust.
Generally, private trust companies can only serve as trustee for certain people and families – they are not permitted to hold themselves out as in the business of providing trustee services.
Private trust companies are typically subject to fewer regulations compared to professional trust companies. At times, they might be exempted from regulation altogether.
What is best for you?
It depends on your goals with your foreign trust.
If you are looking to maximize asset protection, then you will probably be best served by going with a professional trust company.
Why?
The distinction between the grantor and beneficiaries and the trustee is clear.
However, things can be unclear with a private trust company.
Sure, the private trust company is formed as a separate legal entity. But the grantor, his family members, business partners, etc. often serve as its manager.
Regardless of how the decision-making process is structured, a private trust company should provide the grantor direct control or significant influence over trust assets.
This is why the private trust company works best for those looking to maximize control but can be a liability regarding asset protection.
The problem is, a court could potentially claim that the trust is merely the “alter ego” of the grantor and find a way to seize control over the trust’s assets.
Your advisor should help you find the right balance between control and asset protection.
What about taxes?
Some person or entity must own the shares in the private trust company.
Depending on their location, this could have negative consequences regarding economic substance regulations and complicated tax reporting.
Additionally, if the private trust company has US owners, they may owe US taxes due to tax rules relating to controlled foreign corporations (CFCs) and Subpart F income.
In short, achieving your desired tax outcome with a private trust company is likely easier said than done.
Both professional trust companies and private trust companies come with many advantages and disadvantages relating to important matters like succession planning, estate planning, privacy, speed, cost, etc.
Foreign Grantor Trust v Foreign Non Grantor Trust
Before we discuss the differences between a foreign grantor trust and a foreign non grantor trust, it’s important to discuss the rather unique way US law handles trusts.
Under some circumstances, a trust can simultaneously be both “foreign” and “domestic.”
For purposes of asset protection and legal ownership of assets, a “foreign trust” is simply a trust that is formed outside of someone’s home jurisdiction.
For example, an American creates a “foreign” (meaning, non-US) trust for legal purposes upon settling a trust in Nevis or the Cook Islands.
However, US tax law is rather tricky. Just because a trust is foreign for legal purposes doesn’t mean it is foreign for tax purposes. There is a unique way to determine whether a trust is foreign for tax purposes.
The IRS relies on the “Court Test” and the “Control Test” to determine if a trust is domestic or foreign for tax purposes.
Court Test – A US court can exercise primary supervision over trust administration.
- Essentially, this means that a trust is 100% under the jurisdiction of a US court.
Control Test – US persons control all substantial trust decisions.
- Essentially, this means that the trustee is a US person.
If both tests are met, then a trust is “domestic” for tax purposes.
All other trusts are foreign for tax purposes.
By failing the Court Test and/or the Control Test, it is possible for non-US persons to settle a trust Wyoming that is foreign for tax purposes.
With respect to US law, there are two types of foreign trusts – foreign grantor trusts and foreign non grantor trusts.
With that out of the way, let’s cover each type of foreign trust.
Foreign Grantor Trust: US Grantor
A foreign grantor trust is created when a US grantor makes a gratuitous transfer to a foreign trust with one or more US beneficiaries or potential US beneficiaries.
The IRS is very strict with its definition of “potential US beneficiaries.”
Any potential of a US beneficiary, however remote, is enough to force a classification as a foreign grantor trust.
Foreign Grantor Trust: Nonresident Alien Grantor
In limited circumstances, a nonresident alien grantor may form a foreign grantor trust.
For example, a foreign grantor trust is created if the trust instrument contains a provision stating that distributions can only be made to the grantor or the grantor’s spouse during the grantor’s lifetime.
A nonresident alien is someone who is not a US citizen and does not meet the green card rest or the substantial presence test.
So, what is a foreign non grantor trust?
All foreign trusts that are not foreign grantor trusts.
You can read more about foreign grantor trusts and non foreign grantor trusts by clicking here.
Foreign Trust Taxation
Foreign grantor trusts and foreign non grantor trusts are taxed differently.
With foreign grantor trusts, the grantor is considered the owner of the foreign trust for tax purposes.
This means that the grantor, not the trust, is required to report and pay US tax on the trust’s income (based on the portion owned).
For example, if a grantor is deemed to own 75% of the trust, then he must pay 75% of the tax liability.
Foreign Grantor Trust: US Grantors
US grantors are required to pay tax on the trust’s worldwide income.
Unfortunately, this virtually eliminates any potential tax benefit of setting up a foreign trust for US persons.
However, foreign trusts are still a great tool for US persons seeking asset protection.
Why?
Because US grantors are considered the owner of a foreign trust for tax purposes but not in terms of legal title.
For example, suppose a US person places a stock portfolio inside a trust in Nevis.
The US person is considered the owner of the trust and is responsible for taxes due on the profits generated by the stock portfolio.
However, the trustee of the Nevis trust is technically the legal owner of the stock portfolio.
Someone would need to “pierce” the trust to gain control over the stock portfolio.
Essentially, this means that a court would set-aside the trust instrument and force the trustee to use trust assets as directed for the benefit of a creditor.
Piercing the trust requires the plaintiff to win a local court case in Nevis since it does not recognize judgments from foreign (non-Nevis) jurisdictions.
To my knowledge, a Nevis trust has never been pierced.
Foreign Grantor Trust: Non Resident Alien Grantor
Non resident alien grantors are required to pay taxes only on “US sourced income” as defined by Section 861 of the tax code – meaning, income that is “sourced” or attributed to activities within the US.
However, non resident alien grantors are NOT required to pay US taxes on “foreign sourced” income.
Regardless of whether a foreign grantor trust has a US grantor or non resident alien grantor, US beneficiaries are NOT liable for tax on distributions if they obtain a “Foreign Grantor Trust Beneficiary Statement” from the trustee and attach it to Form 3520 (more on this below).
Foreign Non Grantor Trust
The taxation of foreign non grantor trusts is rather different.
The foreign trust itself, not the grantor, is required to pay tax on US source income.
No US tax is owed on foreign sourced income.
Things can get a little tricky with distributions to US beneficiaries.
Distributions of corpus (trust assets) are not taxable (unless they came from a covered expatriate transferor).
Distributions of current distributable net income are taxable. The income retains its character – for example, income from the sale of stock is taxed at capital gains tax rates.
Complications arise when foreign non grantor trusts fail to distribute all income generated during the year. Distributions of accumulated income (that is, income from prior years) is subject to a very complicated “throwback tax” – a tax so punitive that it can virtually eat up an entire distribution.
You can read more about the taxation of foreign trusts by clicking here.
Foreign Trust Reporting: IRS Form 3520-A & IRS Form 3520
US tax law imposes significant responsibilities on parties involved with foreign trusts – including grantors, beneficiaries, and trustees.
In many circumstances, these parties will need to file Form 3520 or Form 3520-A.
Foreign Trust Reporting: Foreign Grantor Trusts With US Grantor
Trustee Obligations – The trustee of a foreign grantor trust with a US grantor must file IRS Form 3520-A (Annual Information Return of Foreign Trust with a US Owner) to report certain information.
The trustee must also send a “Foreign Grantor Trust Owner Statement” to all US owners of the trust.
Additionally, the trustee must send a “Foreign Grantor Trust Beneficiary Statement” to each US beneficiary who received a distribution during the year.
“Distributions” include loans to US beneficiaries (other than loans considered “qualified obligations”) and also include the uncompensated use of trust property.
For example, a beneficiary who stays in a home owned by a trust has received a deemed distribution equal to the fair rental value of the property for the relevant number of nights.
US Grantor Obligations – If a trustee fails to file Form 3520-A as required, penalties are imposed on the US grantor. However, these penalties can be avoided if the US grantor signs and files Form 3520-A.
IRS Form 3520 must not be confused with IRS Form 3520-A.
Form 3520 (Annual Return To Report Transactions with Foreign Trusts and Receipt Of Certain Foreign Gifts) is used to report any transfers to a foreign trust, to report ownership of a foreign trust (even if no transfer is made to the trust during that tax year).
As described above, US grantors are treated as US owners of a foreign trust for tax purposes and are responsible for paying US income tax on their portion of the trust’s income.
For example, suppose someone is a 75% owner of a foreign trust. This person is responsible for paying 75% of all taxes due on the trust’s income.
When required, US owners must also file information returns like Form 8938 and may have to file an FBAR for accounts held by the trust.
Beneficiary Obligations – Beneficiaries must file Form 3520 to report receiving a distribution. The distribution will not be taxed provided they attach the “Foreign Grantor Trust Beneficiary Statement” to it.
Foreign Trust Reporting: Foreign Grantor Trusts With Non Resident Alien Grantor
Trustee Obligations – Trustees of foreign grantor trusts are not required to file Form 3520-A.
However, they should send a “Foreign Grantor Trust Beneficiary Statement” to all beneficiaries who received distributions.
Grantor Obligations – Because they are not a “US person,” non resident alien grantors are only required to pay tax on “US sourced” income – this is done by filing Form 1040-NR.
If the trust has no “US sourced income,” then the grantor has no filing requirement.
Beneficiary Obligations – US beneficiaries are not liable for tax on distributions from the trust provided a “Foreign Grantor Trust Beneficiary Statement” is obtained and attached to Form 3520.
If a US beneficiary fails to attach a “Foreign Grantor Trust Beneficiary Statement” to their Form 3520, then the US beneficiary will owe tax on the distributions received from the trust.
Foreign Trust Reporting: Foreign Non Grantor Trusts
The distinction between grantor and non grantor trusts comes down to who owes tax liability.
Under US law, foreign non grantor trusts are not considered to have an “owner.”
Thus, the trust itself (NOT the settlor) is required to pay tax on US source income.
It sounds a little strange, but a foreign non grantor trust still has a grantor.
Trustee Obligations – Trustees of foreign non grantor trusts are not required to file Form 3520-A.
However, they should send a “Foreign Non Grantor Trust Beneficiary Statement” to all beneficiaries who received distributions.
If the trust earns US sourced income, the trustee is responsible for filing Form 1040-NR (Nonresident Alien Income Tax Return) to report and pay any taxes due.
Grantor Obligations – Grantors of foreign non grantor trusts have no tax obligations to the US.
Beneficiary Obligations – Beneficiaries of a foreign non grantor trust must file Form 3520 to report receiving a distribution from the trust.
They should include the “Foreign Non Grantor Trust Beneficiary Statement” they receive from the trustee with their tax filings.
They must report and pay tax on the current year trust income – including the fair rental value of trust property to used (such as staying in a home owned by the trust).
Additionally, US beneficiaries must report and pay tax on accumulated trust income (which will likely be subject to the punitive throwback tax).
You can read more about Form 3520 and Form 3520-A by clicking here.
US Persons & Foreign Bank Accounts Reporting Requirements
The US has strict reporting requirements for US persons with foreign financial assets and activities.
Two primary reporting obligations are the Report of Foreign Bank and Financial Accounts (FBAR) and Foreign Account Tax Compliance Act (FATCA).
FBAR
Each “US person” with a “financial interest in,” or a “signatory authority over,” certain financial accounts located in a foreign country must file Form 114 (Report of Foreign Bank and Financial Accounts (FBAR).
“US persons” include:
- US citizens
- Green card holder
- Anyone meeting the Substantial Presence Test
A “financial interest” can be direct (e.g. a foreign bank account in your name) or indirect such as:
- An account in someone else’s name that contains your money
- An entity in which the US person owns more than 50%
- A trust for US tax purposes
- Plus many others
Signatory Authority is the authority of an individual (alone or in conjunction with another individual) to control the disposition of assets held in a foreign financial account by direct communication (writing or otherwise) to the bank or other financial institution that maintains the financial account.
Foreign Financial Accounts include (but are not limited to):
- Foreign bank accounts
- Foreign brokerage accounts
- Foreign life insurance or annuity contracts with a cash value
- Certain foreign pensions and retirement accounts
- Foreign mutual funds
- Foreign escrow
- Foreign financial agency
FBAR Threshold
The threshold for FBAR reporting requirements is quite low – reporting obligations are triggered when the aggregate value of your “foreign financial accounts” exceeds $10,000 at any time during the calendar year.
Given their purpose and nature, this threshold is easily met by virtually every foreign trust.
Who must file an FBAR?
Typically, trustees have a financial interest in / signatory authority over the trust’s foreign accounts. Thus, US trustees meeting the criteria must file an FBAR.
Under some circumstances, US beneficiaries might also have a financial interest in / signatory authority over the trust’s foreign accounts.
Most commonly, this often applies to:
- Beneficiaries with a greater than 50% beneficial interest in the trust, or
- Beneficiaries of a discretionary trust who received more than 50% of distributions on the year
Counterintuitively, a trust formed in the US is a “US person” for FBAR purposes even if it is a “foreign trust” for tax purposes.
If so, they too must satisfy FBAR reporting obligations.
US grantors are treated as US owners of foreign trusts.
US owners also include anyone who transfers property to a trust – even if they do not acquire the full rights and status of a grantor.
US owners of a foreign trust are deemed to have a “financial interest” in the trust’s foreign financial account – as a result, US owners must also satisfy FBAR requirements.
FATCA
Your foreign trust will also be subject to Foreign Account Tax Compliance Act (FATCA) reporting obligations.
Your foreign trust will either be classified as a “Foreign Financial Institution” (FFI) or a “Non-Financial Foreign Entity” (NFFE).
Each is defined in the tax code and treasury regulations.
In most circumstances, your trust will be an FFI if it is professionally managed by a financial institution (such as a professional trust company). At times, a private trust company is considered an FFI (which makes the trust an FFI) – this must be examined on a case by case basis.
Beware that Intergovernmental Agreements (IGAs) related to FATCA often modify the definition of an FFI and the FATCA reporting requirements demanded of your trust.
Conclusion
Properly setting up a foreign trust that will achieve your goals requires expert advice.
Click here to schedule your consultation and speak with one of our experienced consultants.