In the past few years, there’s been an increased use of the United States as a place to govern the administration of trusts. This is largely driven by the Organisation for Economic Co-operation and Development’s implementation of the Common Reporting Standard (CRS), under which jurisdictions agree to exchange financial account information with each other in an effort to combat offshore tax evasion. Almost 100 jurisdictions have agreed to participate in CRS, but the United States continues to be a non-participating jurisdiction, resulting in a number of existing foreign governed law trusts being transitioned, or domesticated, to the United States.
As a preliminary matter, domestication of a trust generally refers to either having a foreign governed law trust’s assets decanted (or appointed) to a trust governed by a particular U.S. state law or changing the classification of a foreign trust to a domestic trust for U.S. federal tax purposes. This type of change in classification typically involves changing the governing law of the trust and replacing the foreign trustee with a U.S. taxpayer as trustee. Advisors should consider and discuss with their clients all of the tax and non-tax reasons in favor of, or in some cases against, the domestication of a foreign trust. It could be possible that an advisor will be called on to justify her recommendation for making such a transition.
Benefits of Domestication
Here are some reasons in favor of domestication:
1. Minimize tax burdens for U.S. beneficiaries. Typically, foreign trusts established by a non-U.S. taxpayer and structured as a grantor trust can have numerous U.S. federal income tax advantages for the U.S. beneficiaries of such trusts. The main advantage is no U.S. federal income tax consequences to the U.S. beneficiary while the trust’s income is treated as being taxed to the settlor of the foreign trust. The grantor trust benefit ceases on the death (or sometimes earlier) of the non-U.S. taxpayer settlor and, at that time, the trust becomes a foreign non-grantor trust. If the trust remains a foreign non-grantor trust, the application of the throwback tax rules can begin applying if the foreign trust is a discretionary trust (as well as other anti-deferral regimes, such as the controlled foreign corporation rules and the passive foreign investment company rules to the extent of the underlying assets of the foreign trust). While a discussion of the throwback tax rules is outside the scope of this article, it’s generally understood that such rules punitively tax the U.S. beneficiary’s receipt of a distribution from the foreign non-grantor trust to the extent the distribution includes accumulated income.
The most often used strategy to minimize the application of the throwback tax rules is to domesticate the foreign trust and have it be classified as a domestic trust for U.S. federal tax purposes. Such planning removes the application of the throwback tax rules on future accumulated income of the trust received by the U.S. beneficiary because domestic trusts are generally no longer subject to the throwback tax rules. While one planning strategy is to annually distribute all of a foreign trust’s taxable income, if distributed to a U.S. beneficiary, this approach could eventually trigger a higher U.S. federal estate tax liability for a U.S. beneficiary’s gross estate if such annually distributed income isn’t exhausted by the time of the U.S. beneficiary’s death. By domesticating the foreign trust into a domestic trust, the taxable income of the trust can accumulate, and the wealth generated inside of the trust can be protected from U.S. federal estate tax exposure on the death of the U.S. beneficiary.
2. Reduce compliance issues for U.S. beneficiaries. Foreign trusts can generate a heavy compliance burden on U.S. beneficiaries who derive benefits from them. Some of these U.S. federal reporting requirements can include: (1) FinCen Form 114; (2) Internal Revenue Service Form 3520/Beneficiary Statement; and (3) IRS Form 8938.
In addition to cost savings to the U.S. beneficiary in preparation of her annual U.S. federal tax return, there’s also a benefit of saving the time to gather and review the information needed for these forms. There’s also the benefit of not having to incur the time and stress of making sure everything is filed correctly and on time and less risk of hefty penalties if an error is made (even if it’s an error made in good faith). Finally, there may be less risk of an audit because these forms most likely create a higher profile for the U.S. beneficiary within the IRS than would a domestic trust.
3. Reduce compliance burden on foreign trust. A foreign trust being administered outside of the United States will have to comply with the requirements of the Foreign Account Tax Compliance Act. With CRS and other transparency-related disclosure rules being implemented across the world, there are additional compliance burdens on foreign trusts that incur the need to engage professionals to advise properly. Most of these compliance burdens wouldn’t apply if the trust were a domestic trust.
Foreign trustees don’t generally prepare annual trust accountings, or if prepared, they typically don’t follow U.S. federal tax principles. It can be a costly exercise to use a foreign trustee’s bank and financial records to calculate a foreign trust’s taxable income each year so that a U.S. beneficiary can properly prepare his tax return. In some cases, foreign financial institutions for an additional cost produce a “draft” IRS Form 1099 even though such form wouldn’t be filed with the IRS. Although this can be a good tool for the U.S. beneficiary to later track a foreign trust’s income, it can also create confusion for the IRS because the IRS can’t match the information on the return with any information that it already has in its system.
The above-described compliance costs will in turn lead to either higher trust administration costs or higher professional fees. Moving a foreign trust to the United States could reduce these compliance burdens and save money for the ultimate benefit of the beneficiaries.
4. Tax credit issues. When a foreign trust is earning non-U.S. source income, the application of the foreign tax credit rules to U.S. beneficiaries who receive distributions from a foreign trust aren’t clear and are difficult to apply. A foreign non-grantor trust may have also had U.S. withholding taxes applied on the trust’s U.S. source income. From a practical standpoint, foreign financial institutions typically can’t substantiate and prove the exact amount of U.S. withholding tax on IRS Form 1042, which puts any credit at risk from being able to be claimed by a U.S. beneficiary.
If the foreign trust is domesticated, the complexities of the foreign tax rules would be reduced, or even eliminated entirely, if the domestic trust invested in all U.S. financial assets. Further, if all of the money managers are located in the United States, then each of them would be required to issue a Form 1099 each year, and each of those forms would be filed electronically with the IRS. There also would be no issues with regard to U.S. withholding tax. The IRS could easily match those electronically filed Forms 1099 and U.S. tax withheld with the proposed new domestic trust’s U.S. federal income tax return.
5. Investment considerations. If the assets of a foreign non-grantor trust with U.S. beneficiaries were managed in the United States, U.S. money managers would likely be much more sensitive to U.S. tax-efficient investing than investment managers outside the United States. They also would be more likely to have specific strategies available for U.S. tax-efficient investing. For example, money managers located outside the United States may not be able to sell tax-free municipal bonds (bonds of municipalities located within the United States).
A foreign non-grantor trust that invests in U.S. stocks would be subject to U.S. withholding tax at a 30% tax rate (subject to the application of a treaty, which is rare in most foreign trust structures). If the trust were a domestic trust, it would be eligible for the lower qualified dividends tax rate of 20% (plus 3.8% Medicare tax). As such, if the portfolio is highly invested in U.S. stocks, it could be more tax and administratively efficient to be a domestic non-grantor trust.
Foreign trusts are generally invested in assets valued and taxed in one or more currencies other than U.S. dollars. The conversion from U.S. dollars to another currency and vice versa creates tax complexities and reporting uncertainties from a U.S. federal tax point of view (as to whether there’s a currency gain or loss, whether the amount of gain or loss should be converted to U.S. dollars on the date of sale and purchase and what exchange rate should be used). Furthermore, a foreign trust could be unnecessarily exposed to currency risks if the beneficiaries will spend their money only or primarily in U.S. dollars.
6. Other non-tax considerations. With increased global transparency, there’s a negative perception of low tax jurisdictions that are popular places for foreign trusts to be established. On the other hand, the United States is generally not negatively perceived in this context and has a strong reputation with respect to its trust laws. More U.S. states are competing with each other as to having the best trust laws and are generally comparable, if not better, than certain offshore trust jurisdictions.
As mentioned above, non-U.S. persons now are considering more the possibility of establishing a trust in the United States even though neither the settlor nor the beneficiaries are U.S. persons. The United States can provide a sense of security to those who are from jurisdictions whose country is going through economic and political turmoil. Furthermore, while the United States doesn’t participate with the CRS, it’s attractive for its sense of privacy to families who have legitimate security risks in their home countries (but are otherwise tax compliant).
Risks of Domestication
There are times when it may be better not to domesticate a trust:
1. When accumulation can be positive. As discussed earlier, the accumulation of income in foreign non-grantor trusts could result in additional U.S. federal income tax exposures to U.S. beneficiaries. However, with the right set of facts, maintaining the foreign trust in a low tax or no-tax jurisdiction could result in a substantial increase in the U.S. beneficiary’s share, as compared to domesticating the trust and having the same income taxed as high as 37% (plus the potential application of the 3.8% Medicare tax). This requires careful planning, and all of the risks should be discussed with the client.
2. Majority are non-U.S. beneficiaries. It’s possible that a foreign non-grantor trust may have a mixture of U.S. beneficiaries and beneficiaries who are non-U.S. taxpayers (non-U.S. beneficiaries). The reasons in favor of domesticating a foreign trust may not necessarily apply to the non-U.S. beneficiaries. In fact, if a foreign trust were to domesticate, it could unnecessarily result in a tax burden on what the non-U.S. beneficiaries ultimately receive from the trust. If the non-U.S. beneficiary isn’t taxed on a foreign trust’s income until an actual distribution is received, and her home country doesn’t have a throwback tax set of rules or a type of controlled foreign corporation rules that apply to trusts, having a foreign trust maintained in a low tax jurisdiction can allow the trust to grow tax deferred. If a foreign non-grantor trust became a domestic non-grantor trust, the trust would become subject to U.S. federal income tax on its worldwide income, depleting the trust assets by the U.S. federal taxes paid. In such cases, it would be advisable to consider domesticating only a portion of the foreign trust as it relates to the U.S. beneficiaries so that overall fairness is maintained among the beneficiaries. In some cases, it may make sense from a tax planning point of view for the entire trust to remain as a foreign trust.
3. Asset protection. Many offshore trust jurisdictions have very favorable asset protection laws. Some U.S. states have comparable asset protection laws, but many of the foreign jurisdictions require additional procedural hurdles for the creditor causing the potential deterrence against a creditor making a claim.
Some of the offshore trust jurisdiction laws protect against forced heirship claims and/or marital claims, making it easier to legitimately disinherit family members. However, a majority of the U.S. states provide some degree of protection to heirs and ex-spouses such that domestic trusts are an easier target to pierce for such type of claims negating domesticating a foreign trust.
4. Ethical or criminal issues. Like any other client situation, an advisor needs to be mindful of her ethical and professional obligations. With the United States not being a party to CRS, there’s debate whether it’s ethical to assist a foreign client whose sole motivation for establishing a trust in the United States is to avoid CRS reporting. If a U.S. lawyer knows or suspects that the client would be doing this to avoid home country reporting and tax obligations, there could be professional misconduct issues if the advisor is considered to be furthering an illegal or fraudulent action. Under U.S. federal case law, there may be even the risk of prosecution in the United States for any advisor.1 Be wary if the client has no other connections to the United States. Sometimes you just have to say “no” to the client.
Other Issues to Consider
While the scales may tip in favor of domesticating a foreign trust, it’s still possible in certain situations that the best course of action is not to domesticate a trust. When advising a client on the domestication of a foreign trust, a plethora of other issues will need to be considered as well, such as the proper mechanics for domestication and the restructuring of any underlying assets. The advisor should be also considering who’s her client and make this clear from the outset of the relationship. In these types of representations, the lines can be blurred among the foreign trustee, the settlor if still alive, the U.S. beneficiaries (if any) and the new U.S. trustee that will come aboard. Most importantly, make sure to work with foreign counsel so as not to cause any unnecessary mishaps in the jurisdiction governing the existing foreign trust.
—Reproduced with permission from Tax Management International Journal, 47 TM International Journal 378 (June 8, 2018), http://www.bna.com.
Endnote
1. See generally Pasquintino v. United States, 544 U.S. 349 (2005).