Foreign trust taxation is complicated due to how the US treats various types of foreign trusts.
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 fore 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.
But creating a foreign trust for tax purposes does not necessarily mean that income within the trust will be tax free – even if your foreign trust is located in a “tax haven” jurisdiction with a zero percent tax rate.
Foreign Trust Taxation: Foreign Grantor Trusts
For US tax purposes, the grantor is considered the owner of the foreign trust.
This means that the grantor is required to report and pay US tax (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.
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.
However, foreign trusts are still a great tool for US persons seeking asset protection.
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 Nevis trust.
The US person is considered the owner of the trust for US tax purposes 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 foreign (non-Nevis) judgements.
To my knowledge, a Nevis trust has never been pierced.
In addition to asset protection, foreign trusts can also help you accomplish your estate planning and privacy goals.
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.
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 Trust Taxation: Foreign Non Grantor Trusts
The foreign trust itself, not the grantor, is required to pay tax on US source income only.
However, 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, which is often beneficial – 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.
Technically, there are some planning strategies that can help mitigate the throwback tax.
But a trustee of a foreign non grantor trust must be aware of the throwback tax and exercise great caution when planning distributions.
There are specific ordering rules that determine the composition of distributions–you can’t choose to distribute only corpus, example, if there is distributable net income or accumulated income.
Achieving your foreign trust taxation goals will likely require expert advice.
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