Trusts created in the United States require special consideration and care if the trust agreement allows for distributions to be made to an Israeli resident beneficiary. Israeli trust tax laws apply to any trust whenever a single beneficiary resides in Israel. These tax laws came into effect in Israel in 2014, and they apply to any U.S. trust with an Israeli resident beneficiary, including trusts created before 2014.1
Further, Israeli law applies even if the only nexus to Israel is the residence of a beneficiary. This means a trust can be created by a U.S. resident with assets located exclusively in the United States and managed by a U.S. resident trustee for mostly U.S. resident beneficiaries. With only a single Israeli resident beneficiary, the trust can owe taxes to Israel on all trust income, not just the portion distributed to or available for the benefit of the Israeli resident beneficiary.2
In the United States, many trusts are drafted as grantor trusts that are intentionally defective for incometax purposes. These are known as “intentionally defective grantor trusts” (IDGTs).3 When Israeli law also applies, the trustee must simultaneously comply with U.S. tax laws that impose the tax on the grantor during the grantor’s lifetime and Israeli tax laws that impose the tax on the trustee of the trust.
The trustee must walk this tightrope to ensure tax efficiency and compliance. But it’s also a malpractice trap for the estate-planning attorney who may draft the trust agreement in a way that either triggers premature taxation or over-taxation of the trust in Israel. For this reason, we focus exclusively on the unique tax issues presented by IDGTs and related drafting considerations. A well-executed plan will delay taxation in Israel whenever possible and minimize the ultimate tax liability to Israel.
Overview of IDGTs
Estate-planning attorneys in the United States use IDGTs in almost all of their trust planning engagements.
We frequently use IDGTs to help clients with taxable estates make taxable gifts while retaining the income tax liability associated with the assets contributed to trust. These types of IDGTs remove assets from a grantor’s taxable estate, while leaving the legal liability for income taxation with the grantor at the grantor’s personal income tax rate. The initial contribution to the IDGT creates a taxable gift that must be reported to the Internal Revenue Service and will reduce the estate tax credit on the grantor’s death. The payment of the income taxes for the trust, though, isn’t considered a taxable gift because the grantor is legally obligated under the Internal Revenue Code to make those payments. This allows the trust assets to grow at a faster rate, all outside of the grantor’s taxable estate on death. This planning technique infuriates some regulators and lawmakers in the United States because it effectively allows for an additional monetary benefit to the IDGT without creating additional taxable gifts by the grantor.4 While regulators talk about closing this tax loophole,5 as long as this planning technique remains in effect, estate-planning attorneys will continue to use it with frequency to reduce the taxable estates of their high-net-worth clients.
Even in non-taxable estates, IDGTs are an incredibly valuable tool. For clients without taxable estate issues, we’re creating IDGTs that are intentionally defective not only for income tax purposes but also for estate tax purposes. The most common IDGT of this type would be a revocable living trust. These trusts are frequently used to avoid probate of a will on death. Another common type of IDGT is irrevocable for elder law planning purposes when the grantor retains enough rights to create estate tax inclusion and qualify for a step-up in basis, but enough rights are waived to protect the underlying assets from being considered “countable assets” under state Medicaid rules.
Regardless of the purpose, the income tax benefit of all IDGTs remains the same. They serve as pass-through vehicles during the grantor’s lifetime so income tax liability in the United States remains with the grantor and will be reported on the grantor’s Form 1040 income tax return. On death, if the assets remain in further trust, depending on the terms of the trust, the income will either be: (1) retained by the trust and taxed at trust income tax rates (which are rather punitive under U.S. law); or (2) distributed to the beneficiary and taxed at each beneficiary’s individual tax rate.
Israeli Taxation of U.S. IDGTs
Effective Jan. 1, 2014, Israel required, for the first time, registration of all trusts with an Israeli resident beneficiary6 and created a new regulatory system for categorizing trusts and taxing trust income. The trust classification applied under the Israeli Tax Ordinance determines the timing and rate of the tax, as well as possible exemptions or credits.7
Since the 2014 amendments, U.S. IDGTs fall into one of two classifications under Israeli tax law:
- Foreign resident trusts (FRTs);8 or
- Israeli resident beneficiary trusts (IRBTs).9 (Potential qualification for sub-category of relatives trusts.)10
FRT. An FRT, whether managed by an Israeli or foreign trustee (that is, a non-resident of Israel):
- Is settled by a non-resident of Israel; and
- Has beneficiaries who are non-residents of Israel or registered Israeli charities. The trust must not have had any Israeli resident beneficiaries at any time since its settlement.
U.S. practitioners want their IDGTs to qualify as FRTs whenever possible because there are no registration or reporting obligations unless the trust holds Israeli assets or receives Israeli source income.
IRBT. An IRBT is established by a non-resident of Israel, and at least one of the trust beneficiaries is an Israeli resident.11 Trusts that fall within this category have significant registration and taxation issues, but those may be lessened if the trust further qualifies as a relatives trust.
Relatives trust. To qualify as a relatives trust, the grantor (or spouse at the time of settlement or asset contribution) must still be alive and the beneficiaries must be immediate family members of the grantor, with “immediate family” defined as a spouse, parent, grandparent, child or grandchild.12 If any one of these criteria isn’t met, the trust loses relatives trust status and reverts to the tax rules for standard IRBTs.
The advantage of being a relatives trust is that the trustee has a choice between paying a distribution tax or an annual tax and only on the portion that’s allocated to the Israeli beneficiary as opposed to all the trust income. These taxes on the share of the Israeli beneficiary are:
- Distribution tax: Distributions to Israeli residents will be taxed at the rate of 30% of the amount distributed unless the trustee provides evidence of the income and capital portions of the distribution. The part of the distribution that’s capital isn’t taxable. Notwithstanding, the Israeli Tax Authority’s (ITA) position is that income is distributed before capital.
- Annual taxation: The trust is taxed at the rate of 25% on income in the tax year in which the income accrued. On annual tax payments on income by the trust, distributions to the beneficiary aren’t subject to additional taxes.
The election of distribution taxation or annual taxation, once chosen by the trustee, is irreversible. Care must be taken at this juncture to make the most tax-efficient election. Additionally, if the Israeli resident beneficiaries of the trust are new immigrants to Israel, the tax for a relatives trust can be delayed under provisions of the 10-year tax holiday for new Israeli residents.13
Once an IRBT loses the protection of relatives trust status, the trust is taxed similar to an Israeli resident trust, and all the income of the trust is taxable in Israel, not just the income allocated to the Israeli beneficiary.14 This is true even if all income is foreign source income and even if only one beneficiary is a resident of Israel. Because income distributed to U.S. resident beneficiaries will be taxable to them on their U.S. income tax returns, the trustee needs to take care to minimize this additional tax burden in Israel.
To comply with Israeli tax law, the trustee must start by registering the trust in Israel, regardless if an IRBT is a relatives trust or not. On establishing a relatives trust, the trustee is required to notify the ITA (Form 147) within 60 days of the date on which the trust first became a relatives trust.15 The trustee must also make the tax election at this time (Form 154).
Identifying potential credits or offsets to taxes will be the next crucial step to avoiding taxation in both the United States and Israel. Tax credits are complicated when the relevant taxpayer in each jurisdiction isn’t the same. In the United States, the taxpayer of an IDGT is the grantor while alive, and then on death, the taxpayer is either the trust for undistributed income or the beneficiary for distributed income. In Israel, as a general rule, the taxpayer is the trustee. In 2016, the ITA published Circular 3/2016 (the Circular) to provide guidance on these offset and credit issues. Among many issues, the Circular clarified, with limited exception, that the tax paid to a foreign tax authority on the trust income will be available for credit against the Israeli tax due16—irrespective of whether the taxpayer in either country is the trust itself, the settlor or the beneficiary.17
The nuances relating to tax credits could be the subject of its own article, but knowing at least these broad trust classifications and what triggers registration and potential taxation is the first step in guiding clients regarding when and how to create a trust that could potentially enure to the benefit of an Israeli resident. “Trust Classifications,” p. 16, is a resource to help understand what class of trust is created when and the related registration and tax responsibilities associated with each trust.
Drafting Recommendations
If you’re working with a client and know at the IDGT drafting stage that a trust beneficiary resides in Israel or is likely to reside in Israel, you should consider doing certain things to avoid triggering Israel’s registration and tax compliance rules during the grantor’s lifetime.
Because revocable trusts are for the primary benefit of the grantor in most instances, consider removing any provisions of the trust agreement that permit gifting. Alternatively, consider narrowing the universe of permissible gift objects, such as only allowing gifting to a spouse or descendants whom the client knows will remain U.S. residents. On the death of the grantor and the grantor’s spouse, clients and U.S. practitioners should work with local Israeli counsel to minimize exposure to U.S. and Israeli taxes. This includes revocable trusts that distribute assets outright to the beneficiaries. Until such a revocable trust is terminated, the ITA may consider this to be an IRBT. If the revocable trust provides that assets shall continue in trust, consider creating a subtrust for each beneficiary so that only the assets in the subtrust for the Israeli resident beneficiary are subject to Israeli taxes.
For irrevocable trusts for the benefit of descendants, consider creating separate trusts or subtrusts for each beneficiary rather than one pot trust. This will avoid subjecting all the trust assets to Israeli taxation just because one beneficiary or branch of the family tree resides in Israel. Only the assets in the trust benefiting the Israeli resident will be subject to Israeli tax liability and registration.
Example: Consider a married couple with three children. Each spouse is the grantor and trustee of a revocable trust for their own benefit. The couple wants their three children and their descendants to benefit from the trusts without favoring any one child. During the grantor’s lifetime, the grantor is the beneficiary of their own trust. The trustees have the power to gift trust assets to the grantor’s spouse. On the grantor’s death, the trust assets shall continue in trust for the grantor’s spouse, or if the grantor’s spouse predeceases, then for the grantor’s children and descendants. Israeli law doesn’t consider contingent remaindermen (that is, their position relies on another beneficiary’s death) as trust beneficiaries.
- At the time the trust is created, one child is an Israeli resident. During the lifetime of the grantor, and the grantor’s spouse if the grantor predeceases, none of the children or their descendants are included as beneficiaries nor do the trustees have the power to gift trust assets to the children or descendants while the grantor and/or spouse is alive. In this way, the trust qualifies as an FRT under Israeli tax law and is never exposed to Israeli tax. On the death of the surviving spouse (or if the grantor is the surviving spouse), the trust assets are divided into equal shares and distributed to a separate trust for the benefit of each child and that child’s descendants so that the smallest portion of the total trust assets are exposed to Israeli taxes.
- Sometime after the trust is created, one child moves to Israel. When the couple created their revocable trusts, all three children were U.S. residents, and the trust agreements allowed gifting to all three children during the grantor’s lifetime. Sometime after creating their trusts, one child moves to Israel. Although this is a revocable trust, under Israeli tax law, the grantor can’t escape Israeli tax liability by amending the trust after the child became an Israeli resident. Because the child is a permissible beneficiary of the trust (that is, the trustee has the discretion to make gifts to the child), the trust has an Israeli resident beneficiary and must be registered with the ITA as an IRBT. New immigrant rules may apply where applicable.
- Sometime after the trust is created, one child announces their intention to move to Israel. The couple can amend their trusts before the child becomes an Israeli beneficiary to preserve their trust status as foreign resident trusts under Israeli tax law and avoid Israeli tax and registration. The couple must amend their trusts to remove the child as a permissible beneficiary during the lives of the grantor and the surviving spouse. To avoid a harsh result to the family plan, the grantors should consider removing all three children (and their descendants) as trust beneficiaries during the grantor and spouse’s lifetimes. The final distribution scheme of equally dividing the trust assets into three subtrusts on the death of the grantor or surviving spouse can remain intact.
Advance Planning Needed
In every planning engagement, we commonly ask clients at the outset whether they have any intention of moving. (This is especially true for New York practitioners, where clients will commonly move out of state to be more income and estate tax efficient). In considering the potential of Israeli taxation of U.S. IDGTs, we should always ask clients about any intentions their loved ones may have of moving out of state or out of the country. And certainly, for any clients that already present with this issue of loved ones residing abroad, especially in Israel, care must be taken at the drafting stage to avoid prematurely triggering taxation during our clients’ lifetimes and to ensure that on death, any ongoing trusts are created in the most tax-efficient way possible to avoid paying unnecessary taxes to Israel.
It’s important to know that when a U.S. person creates any kind of grantor trust, that trust will be subject to Israeli income tax if just one beneficiary moves to Israel. So long as the grantor is living, only the share of the beneficiary who becomes an Israeli resident will be affected. However, after the grantor dies, the entire trust becomes subject to Israeli income tax on the trust’s worldwide income for which the trustee is the responsible taxpayer regardless of the location of the assets or trust situs. While the grantor is alive, the grantor is liable to pay U.S. income taxes, and the trustee is liable to pay Israeli income taxes, when relevant. After the grantor’s death, the trustee is responsible to pay U.S. income taxes based on U.S. assets (or pass the income to the beneficiaries) and Israeli taxes based on the trust’s worldwide income. Despite the 2016 guidance issued by the ITA,18 double taxation is still possible if sufficient information isn’t provided to Israel and U.S. tax authorities. Retain counsel in both jurisdictions to properly navigate this issue with as much advance planning as possible.
Clients must rely on local practitioners to interpret the guidance and effectively provide the client’s U.S. tax information to the ITA and vice versa. We hope you now have the knowledge to spot the issues that require working with local practitioners when drafting a trust for U.S. persons with a beneficiary who may become an Israeli resident.19
— The authors acknowledge and thank Anastazia Anna Sienty, associate at Hollis Laidlaw & Simon P.C. in Mount Kisco, N.Y., and Shai Dover, owner of Shai Dover Accounting Firm in Tel Aviv, Israel, for their assistance with this article.
Endnotes
1. Amendment 197 of the Israeli Tax Ordinance was enacted on Aug. 1, 2013, effective Jan. 1, 2014; see also Alon Kaplan, Lyat Eyal and Shai Dover, “Israel’s Trust Revolution,” Trust Quarterly Review (June 10, 2014), at p. 8.
2. An Israeli beneficiary trust, not qualifying as a family trust.
3. Grantor trust status is determined under Internal Revenue Code Sections 671-679; a grantor trust is a trust in which income is taxed to the grantor because the grantor is deemed owner of the trust property for federal income tax purposes when the grantor retains one or more powers defined in IRC Sections 671-679 or a third person who’s non-adverse to the grantor holds an interest or control over the trust that can be attributable to the grantor (for example, a grantor’s spouse).
4. Jesse Hubers, “The Grantor Trust Rules: An Exploited Mismatch,” The Tax Advisor (Nov. 1, 2021).
5. Matthew Erskine, “How to Prepare for Big Tax Changes,” Forbes (Oct. 5, 2021).
6. In November 2021, committee recommendations were submitted to Israel’s Commissioner to reform international taxation. These recommendations are expected to significantly change this area. At present, Israel’s Tax Ordinance defines an Israeli “resident” as an individual whose center of living is in Israel. This test analyzes an individual’s location of a permanent home, place of residence of the individual and their family, place where the individual regularly works or is employed, location of active and material economic interests, place where the individual is active in various organizations, associations or institutions and employment by certain official bodies. Notably, tax status isn’t connected to an individual’s citizenship. Because this center of living test is mostly subjective, the Israeli Tax Authority (ITA) published additional objective criteria that deems Israeli residency to start at the earliest the date stamped on the certificate issued by the Aliya and Integration Ministry, the date the individual started living in a permanent home in Israel or the date any member of the individual’s family (spouse, children under age 18) started living in a permanent home in Israel. A rebuttable presumption of Israeli residency will apply in either of the following objective circumstances: (1) the individual is present in Israel at least 183 days in a tax year ending Dec. 31, or (2) the individual is present in Israel at least 30 days in the current tax year and 425 days cumulative in the current and two preceding tax years.
7. Israel Tax Ordinance [New Version] (the Tax Ordinance) Part A, Section 1.
8. Tax Ordinance Section 75i.
9. Tax Ordinance Section 75h1.
10. Tax Ordinance Section 75h1(b).
11. Tax Ordinance Section 75h.
12. Any broader family relationship (that is, siblings, nieces, nephews, aunts and uncles) will only permit classification as a relatives trust on the submission of evidence to the tax assessment office of the tax authority that such a trust was settled in good faith and that the beneficiary didn’t provide consideration for such settlement in their favor.
13. In 2008, the ITA introduced a special tax regime designed to encourage individuals to relocate or return to Israel. Individuals who became Israeli tax residents for the first time after Jan. 1, 2007 are eligible for a 10-year tax exemption on all non-Israeli sourced income and capital gains and a 10-year exemption from any reporting on income from foreign assets and on the assets themselves. This exemption also applies to an Israeli beneficiary’s share of a relatives trust if all grantors/settlors and all beneficiaries are eligible for the 10-year tax exemption. See Alon Kaplan, Lyat Eyal and Daniel Paserman, “Israel Taxation of Trusts,” Trusts & Estates (July 2016). After this 10-year tax holiday, the trustee must elect whether the relatives trust be taxed at the distribution taxation route or annual taxation on the portion of the foreign income allocated to the Israeli beneficiary and thereafter report and pay tax accordingly. Dave Wolf and Mirit Hoffman, “Israel: Trusts and Taxes—Double Trouble?” (Jan. 10, 2019), at p. 1, www.mondaq.com/tax-authorities/770828/trusts-and-taxes-double-trouble.
14. Tax Ordinance Section 75h1(h).
15. Tax Ordinance Section 75h1(d)(3).
16. See also Tax Ruling 3792/16 on the tax credit for foreign taxes in a “relatives trust” classified as a grantor trust in the United States.
17. Israeli Tax Circular 3/2016, Section 3.2.7.
18. Israel Tax Authority Circular 3/2016.
19. This article isn’t meant to provide a full understanding of the intersection of U.S. and Israeli income tax and trust law.