Multi-national families have numerous issues
associated with Nonresident Alien Parents who are considering transferring
their wealth to their U.S.-resident children. The Nonresident Alien Parents’ goal
is to pass the assets to the children when the surviving parent dies, and
ensure that successive wealth transfers to future generations are made without
U.S. estate tax, or generation-skipping transfer tax while minimizing U.S.
income tax on investment income.
Residence of a Trust
A
trust will be considered domestic
if:
(i)
a U.S. court can
exercise primary supervision over trust administration (the "Court Test”),
and
(ii)
U.S. persons control
all substantial trust decisions (the "Control Test").
All
other trusts are foreign. (Treas. Reg.
§§ 7701(a)(30)(E) & 7701(a)(31)). These
trust residency definitions are effective for taxable trust years beginning
after December 31, 1996.
The
regulations contain a "safe harbor" test under which a trust is
considered to meet the Court Test if:
(i)
the trust deed does
not direct that the trust be administered outside the United States;
(ii)
the trust is, in fact,
administered exclusively in the United States; and
(iii)
the trust is not
subject to an automatic "flee clause" pursuant to which the trust
migrates from the United States in the event that a U.S. court attempts to
assert jurisdiction over the trust's administration.
The
Control Test will be considered to be satisfied if U.S. persons control all
substantial decisions affecting the trust and no foreign person acting in any
capacity can overcome the decisions of the controlling U.S. persons.
A Foreign Grantor Trust
The Nonresident Alien
Parents could create a revocable trust, with the provisions to them for their
lifetime with the remainder to their US children. This trust is fully revocable, until the
surviving parent dies.
As a “Grantor Trust”
the Nonresident Alien Parents are treated as the owners of the trust assets.
This is achieved by satisfying the requirements of IRC §672(f). The simplest way is to make the trust fully
revocable by the Nonresident Alien Parents (IRC §672(f)(2)(A)).
The Nonresident Alien Parents’
have no exposure to U.S. income or estate tax, unless they hold U.S. assets in
the trust.
Alternatively, the
same structure could also be used to avoid solely US Gift and Estate Taxes by
having the trust own a foreign corporation, which in turn owns U.S. stocks and
bonds, U.S. real estate or other U.S. situs assets; however the US situs assets
would be subject to US income tax on income produced from these investments.
Upon Death of Nonresident Alien
Parents - Foreign Trust Becomes a
Non-Grantor Trust
The trust is designed
to continue as revocable until after both parents have died. After the death
of the last parent to die, the beneficiaries are the U.S-resident children and
grandchildren. At that point for US tax purposes it will be considered as a
“Foreign Non-Grantor Trust,” because it is a foreign trust which is managed outside
the United States (IRC §7710(a)(30)(E)).
For U.S. income tax purposes, a foreign Non-Grantor trust is only subject to US tax on its US source income and foreign source income is not subject to US tax. However, foreign source income will be subject to tax when the U.S. beneficiary receives a distribution of trust income. For estate tax purposes, the trust assets will receive a step-up in basis to fair market value calculated at the time of the surviving parent’s death.
The Throwback Rule
The tax-free accumulation of foreign source
income inside a this Foreign Non-Grantor Trust, is subject to the “Throwback
Tax” (IRC Sec. 667). Throwback Rules apply when a foreign trust makes an “accumulation distribution” to a
United States beneficiary and that trust has “undistributed net
income” from one or more of its preceding taxable years.
IRC Section 665(b) defines an “accumulation
distribution” as any distribution of “any other amounts properly paid or
credited or required to be distributed” to the beneficiary, to the extent that
it exceeds both the trust’s distributable net income for that year (reduced by
any amount required to be distributed currently) and the trust’s net accounting
income for the year.
All Distributions of “Accumulated Income” are
taxed at:
- Ordinary Income Rates and
- Subject to an Interest Charge for Failing to Pay Tax in Prior Years.
There is no way to
efficiently accumulate income for future generations of U.S. resident
beneficiaries with a Foreign Grantor Trust.
Throwback Rule -
Planning
One solution to the throwback rule is to
eliminate the Foreign Non-Grantor Trust, as soon as possible, by domesticating it. The throwback
rules only apply to Foreign Trusts. This can be achieved by:
1.
Transfering all of the
administrative powers to a U.S.‑resident trustee and bring the trust within the
reach of U.S. courts, which satisfies the requirements of the "Court
Test."
2.
Alternatively, the
assets contained in the Foreign Non-Grantor trust can be distributed to a new
domestic trust with similar distribution provisions.
You now have a domestic irrevocable trust, also known as a dynasty
trust, that is funded with assets carrying step-up basis as of the date of
death of the surviving parent.
A second solution to the throwback rules involves
electing to have the Non-Grantor Trust treated as part of the Nonresident
Alien Parents' estate. If
both the executor (if any) of an estate and the trustee of a qualified
revocable trust elect the treatment provided in IRC §645, such trust shall be
treated and taxed as part of such estate (and not as a separate trust) for all
taxable years of the estate ending after the date of the decedent’s death and
two years after surviving spouse's death.
Non-US source income and
capital gains realized by the electing trust and distributed to the US
Beneficiary can be received by the US Beneficiary entirely tax-free. Furthermore, the
Us Beneficiary is considered to receive “corpus” of the estate of the
decedent, rather than DNI.
These are just a few general alternatives for Estate Tax Planning for Cross-Border Families and Foreign Nationals. Your actual Estate Tax Planning for Cross-Border Families needs to be customized to address your particular family
situation.
Want To Know More About
Cross Border Estate Planning
Using Dynasty Trusts or IRC §645?
Contact the Tax Lawyers at
Marini & Associates, P.A.
for a FREE Tax Consultation
Toll Free at 888-8TaxAid ( 888 882-9243)
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