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With increasing global mobility of high-net-worth individuals and families, it’s becoming more common for a U.S. fiduciary to be the trustee of a trust that’s governed by the laws of a U.S. state and has non-U.S. beneficiaries. Consider a retired, non-U.S. married couple that immigrates to the United States and has children who remain non-U.S. individuals. If that couple sets up a typical core estate plan with a trust and U.S. trustee, on their deaths, there would likely be one or more discretionary trusts for their non-U.S. children. Another circumstance could arise when a non-U.S. individual settles a gift trust with a U.S. trustee having U.S. children as its beneficiaries and non-U.S. children as contingent beneficiaries in the event the U.S. children (and their descendants) predecease the non-U.S. children.
The above represents two of a myriad of examples when a U.S. trustee may question how U.S. federal income tax law impacts the trust and non-U.S. beneficiaries. Here’s digestible guidance on the U.S. trustee’s—and non-U.S. beneficiaries’—U.S. federal tax payment and filing obligations, as well as a brief overview of non-U.S. tax regimes that may apply. As with any U.S. tax analysis, determining the lay of the land is the starting point: Who are our taxpayers, and what are their U.S. tax classifications? Here, we have a trust and individual beneficiaries.
The Trust Classification
A trust is either: (1) a grantor trust or a nongrantor trust; and (2) domestic or foreign. If a trust is a nongrantor trust, then it’s either a simple trust or a complex trust, but in either case, a nongrantor trust is a separate taxable entity under the Internal Revenue Code. Determining whether a trust is a grantor trust or nongrantor trust is a complicated analysis generally dependent on the powers and limitations set forth in the trust instrument and tax residency of the settlor. I’ll only focus on a nongrantor trust.
Treasury Regulations Section 301.7701-7 sets forth whether a trust is domestic or foreign. A trust is domestic if the trust satisfies both the court test and control test. The court test is satisfied if a court within the United States is able to exercise primary supervision over the administration of the trust. The control test is satisfied if one or more United States persons have the authority to control all substantial decisions of the trust—“all” is the most operative word in the control test. That is, it only takes one non-U.S. person, acting in any capacity, to hold a single substantial decision to cause a trust to be foreign.
The list of what constitutes a substantial decision isn’t exhaustive. More common substantial decisions immediately subject to scrutiny for foreign trust status include: (1) whether and when to distribute income or corpus; (2) the amount of any distributions; and (3) whether to remove, add or replace a trustee. Trying to cause a trust to constitute a domestic trust when there are non-U.S. beneficiaries is routinely a drafting exercise in controlling the control test. For example, if tax planning leads to a domestic trust, the draft trust instrument should preclude a non-U.S. beneficiary from having, among other powers, the unilateral right to remove the trustee.
There are significant differences with respect to the tax payment and filing obligations of a trust and its beneficiaries depending on whether a trust constitutes a domestic grantor trust, domestic nongrantor trust, foreign grantor trust or foreign nongrantor trust. The certainty is that any trust under typical circumstances can only constitute one of the four types listed. I’ll focus on a domestic nongrantor trust.
Residency of Individual Beneficiaries
Broadly speaking, individuals—that is, human beings and not entities—who aren’t U.S. citizens are subject to U.S. federal income and transfer taxes in different manners depending on their residency under the Internal Revenue Code. Residency is determined differently for U.S. federal income tax purposes than it is for U.S. federal transfer tax purposes. For U.S. federal income tax purposes, objective standards dictate residency; for U.S. federal transfer tax purposes, a subjective standard is determinative—domicile.
For U.S. federal income taxes, individuals who aren’t U.S. citizens are generally residents of the United States if they’re either a lawful permanent resident—a green card holder—or they meet the substantial presence test by physically spending a sufficient amount of time in the United States. Generally, individuals meet the substantial presence test if they’re present in the United States on at least 31 days during the calendar year and at least 183 days during the current year and two preceding years using a weighted formula. There are many exceptions. For example, in certain circumstances, individuals may be deemed to give up their green card. Alternatively, individuals may be physically present in the United States, but their days of physical presence aren’t counted toward the substantial presence test. This is typically the case for non-U.S. individuals who come to the United States on an education visa; while physically present in the United States for at least 183 days in any calendar year, such non-U.S. individuals generally don’t constitute residents of the United States.1
It’s imperative that a U.S. trustee determines the U.S. federal income tax residency of individual beneficiaries, particularly when there’s a cross-border element involved. A U.S. trustee should request that each individual beneficiary complete the appropriate withholding certificate. For non-U.S. individuals, the appropriate withholding certificate is a Form W-8BEN—Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting (Individuals). A U.S. trustee may rely on the Form W-8BEN unless such trustee has actual knowledge or a reason to know the Form W-8BEN is incorrect.
Form W-8BEN has useful information beyond the tax residency of the individual; the Form W-8BEN can also serve as a basis for claiming tax treaty benefits, something that a U.S trustee should know when making distributions. This article assumes that the U.S. trustee determined that one or more beneficiaries of the domestic nongrantor trust is a non-U.S. individual.
Trust Obligations
A domestic nongrantor trust must file a Form 1041—U.S. Income Tax Return for Estates and Trusts—if such trust has a beneficiary who’s a non-U.S. individual. This is the case regardless of the amount of income earned by the trust in any given taxable year. For a calendar year domestic nongrantor trust, the Form 1041 is due on April 15 following the close of each calendar year. A U.S. trustee may apply for a 51/2 month extension by timely filing a Form 7004—Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns—making the extended due date Sept. 30. Due to the existence of the non-U.S. beneficiaries, a U.S. trustee will have withholding, payment and additional reporting obligations beyond the Form 1041.
A U.S. trustee is generally required to withhold tax on certain items of income earned by the trust when the trustee makes a distribution to a non-U.S. beneficiary. As will be described below, the types of income subject to withholding, as well as the rate at which the withholding occurs, tracks how a non-U.S. individual is subject to U.S. federal income tax. With various exceptions, items of income subject to withholding include U.S. source interest, dividends, rents, royalties and certain other fixed or determinable annual or periodic income (FDAP income). With a possible reduction under an applicable income tax treaty, the U.S. trustee must withhold 30% of the gross amount of the income subject to withholding that’s distributed to the non-U.S. beneficiary. The non-U.S. beneficiary should set forth any reduction under an applicable income tax treaty on the Form W-8BEN transmitted to the U.S. trustee.
Any amounts withheld by a U.S. trustee in respect of distributions made to a non-U.S. beneficiary require the U.S. trustee to file: (1) a Form 1042—Annual Withholding Tax Return for U.S. Source Income of Foreign Persons; and (2) potentially multiple Forms 1042-S—Foreign Person’s U.S. Source Income Subject to Withholding. A U.S. trustee only files one
Form 1042, which sets forth the U.S. trustee’s aggregate withholding done during a taxable year. On the other hand, a U.S. trustee must file a separate Form 1042-S for each type of income and for every non-U.S. beneficiary who received (or was required to receive) a distribution consisting of such income. The U.S. trustee should provide a copy of each Form 1042-S to the applicable non-U.S. beneficiary. The Form 1042 and Form 1042-S are due on March 15 following the end of the calendar year. The U.S. trustee can extend the due date of the Form 1042 to Sept. 15 by timely filing Form 7004; the U.S. trustee can extend the due date of the Form 1042-S to April 15 by timely filing the Form 8809.
The tax withheld by a U.S. trustee should be deposited within three business days after the end of a “quarter-monthly period,” which is the seventh, 15th, 22nd and last day of the month. It may make sense for a U.S. trustee to make distributions to non-U.S. beneficiaries on the first, eighth, 16th or 23rd of any given month to leave the maximum amount of time to deposit the withheld amount. In either case, Treasury requires the U.S. trustee to use the Electronic Federal Tax Payment System to deposit the tax withheld. To the extent tax is properly withheld by the U.S. trustee, it may relieve non-U.S. beneficiaries of their U.S. federal tax obligations.
Non-U.S. Beneficiary Obligations
It’s beneficial for both the U.S. trustee and non-U.S. beneficiaries to understand the U.S. federal tax filing and payment obligations of such beneficiaries, regardless of whether it’s a fiduciary duty of the U.S. trustee to notify those beneficiaries. Educating the non-U.S. beneficiaries prevents the U.S. trustee from unintentionally increasing non-U.S. beneficiaries’ anxiety when sending them a Form 1042-S. In fact, some non-U.S. individuals would rather pay more U.S. federal income tax than have their name reported on any given form that’s transmitted to the Internal Revenue Service. Nonetheless, a basic understanding of the principles on which a non-U.S. individual is subject to U.S. federal income tax is helpful to understand such individual’s U.S. federal tax payment and filing obligations.
Non-U.S. individuals are subject to U.S. federal income tax on their: (1) FDAP income, or (2) certain active U.S. business income which, in tax parlance, is income effectively connected with a U.S. trade or business. Active U.S. business income is subject to U.S. federal income tax on a net basis at graduated marginal rates, meaning that the non-U.S. individual is allowed deductions and credits against such income provided such individual filed an income tax return within a certain time frame. Tracking the withholding discussion above, FDAP income is subject to a flat 30% tax on a gross basis, with possible reduction under an applicable income tax treaty.
A non-U.S. individual has U.S. federal income tax payment and reporting obligations if that individual has income from U.S. sources or is engaged (or is generally considered to be engaged) in a U.S. trade or business. An exception exists for reporting when the individual isn’t engaged in a U.S. trade or business and the withholding agent fully satisfies the individual’s U.S. tax liability through its withholding obligations. In the context of a trust, this means that non-U.S. beneficiaries won’t be required to file a U.S. tax return if those beneficiaries aren’t otherwise engaged in a U.S. trade or business and their U.S. tax liability is fully withheld by the U.S. trustee.
If a non-U.S. beneficiary is otherwise engaged in a U.S. trade or business—or the non-U.S. beneficiary’s tax liability isn’t fully withheld by the withholding agent—then such beneficiary is required to file a Form 1040-NR—U.S. Nonresident Alien Income Tax Return. The due date of the Form 1040-NR depends on whether the non-U.S. beneficiary received wages subject to withholding. If so, the due date of the Form 1040-NR is April 15 following the close of the calendar year. Otherwise, the due date of the Form 1040-NR is June 15 following the close of the calendar year.
Jurisdictional Considerations
Overlaying the increased complexity of a domestic nongrantor trust with a non-U.S. beneficiary are the tax laws of the non-U.S. jurisdiction where the beneficiary lives. U.S. trustees should seek competent local counsel in the non-U.S. jurisdiction because the advice may dictate, in part, how the U.S. trustee administers the trust.2
As a threshold matter, the most immediate conflict involving trusts comes down to whether the non-U.S. jurisdiction is based on common law or civil law. The internal laws of most any common law jurisdiction embody the concept of a trust. Civil law jurisdictions normally don’t have the concept of a trust. This is the case with Brazil. On the other hand, some civil law jurisdictions do recognize the existence of trusts settled in a different jurisdiction. This is the case with France, a country that imposes additional and onerous reporting requirements due to the existence of such trust.
Another fundamental difference is whether the non-U.S. jurisdiction imposes an estate or inheritance tax. Fundamentally, an estate tax is imposed on the value of a decedent’s estate whereas an inheritance tax is based on the relation of the beneficiary in respect of the deceased. For example, Japan is a civil law jurisdiction that has an inheritance tax regime whose internal laws can ignore the existence of the trust for purposes of its income and inheritance tax.
Cross-border elements with a U.S.-based trust structure create complexity, and there are many forks in the road and nuances abound. For example, the U.S. trustee may in fact be administering a foreign nongrantor trust, which has different reporting and payment obligations altogether, including punitive regimes applicable to U.S. beneficiaries. Or, a non-U.S. beneficiary may be an expatriate of the United States, which can cause different withholding obligations to the U.S. trustee. In all cases, the U.S. trustee should be patient and seek competent U.S. and local counsel to navigate the rules and make reasonable trade-offs.
Endnotes
1. “Non-U.S.,” as used this article, means an individual who’s neither a U.S. citizen nor resident of the United States for U.S. income and transfer tax purposes.
2. There are a multitude of different regimes in other countries, such as forced heirship laws and other marital property regimes. However, this article only briefly discusses different taxing regimes and their impact on U.S. trusts.