The role of the family office continues to evolve to meet the changing needs of high-net-worth and ultra-high-net-worth (UHNW) families who are increasingly “global citizens.” Single family offices oversee the myriad of accounting, legal, employment, privacy, security and personnel issues that arise when counseling those who have amassed significant wealth. Family offices serving multi-national families today are required to navigate complex tax intricacies with increasing regulations and scrutiny in the face of continuously evolving global tax and disclosure regimes, as well as manage financial, personal risk and privacy considerations for their families.
Along with our forthcoming second part of this article, we’ll provide insight into advising clients and their family offices on managing tax implications as family members move globally, navigating both the challenges posed by existing structures in place at the time of the move and pre-migration planning that may be advantageous to adopt in five areas: (1) trust planning and structuring involving beneficiaries and assets in multiple jurisdictions; (2) planning for the acquisition of residences across jurisdictions and the tax residency considerations in relation thereto; (3) cross-border premarital agreements and marital property regimes; (4) addressing privacy and security issues for high profile clients while complying with public registry requirements across jurisdictions; and (5) considerations for personnel and employment issues for families with international staff.
We’ll initially focus on trust planning for multi-jurisdictional families, particularly the U.S. tax implications of mobile settlors, trustees and beneficiaries along with some non-U.S. tax and reporting issues. The balance of the issues will be addressed in the second part of the article. Underlying all of the issues discussed is the absolute need to partner with expert tax, legal and, where appropriate, immigration counsel and other advisors in each jurisdiction where a family has assets, family members or other exposures to minimize both the tax cost of unexpected characterization and taxation and the reputational risk of improper reporting or structuring that’s locally viewed as improper.
Cross-Border Trust Planning
In the United States, trusts are the most commonly deployed tool in gift and estate tax planning and succession planning and are widely used in income tax planning and privacy planning. While trusts and trust-like structures are used to varying degrees throughout the world, their recognition and tax treatment as well as the implications of a change in residence of a beneficiary, settlor or powerholder can often be unexpected to those used to looking at trusts through a purely U.S. domestic lens.
Foreign and Domestic Trusts
To provide grounding for the way trusts operate in the cross-border context, it’s important to understand when a trust will be characterized as a foreign trust for U.S. income tax purposes. The Internal Revenue Code defines a foreign trust for U.S. income tax purposes by exclusion—any trust that isn’t a domestic trust is a foreign trust.1 Thus, you need only to understand the test for a domestic trust to discern whether a trust is foreign or domestic for U.S. tax purposes. A trust is a domestic trust, and thus a U.S. person, only if it meets both (1) the court test, and (2) the control test.2 If a trust fails to meet either of these tests, the trust is a foreign trust. If a trust is a grantor trust, whether attributable to a U.S. grantor or a foreign grantor, the court test and the control test won’t be determinative and instead the grantor’s residency will be controlling for income taxation of the trust’s assets. Note that the residency of the beneficiaries of the trust won’t bear on the classification of the trust as foreign or domestic for U.S. federal income tax purposes but may be relevant for determining income tax residency of the trust at the state level.
Court test vs. control test. The court test is met if a court within the United States is able to exercise primary supervision over the trust’s administration. The control test is met if all substantial trust decisions are within the control of U.S. persons. “Substantial decisions” of a trust are such non-ministerial decisions that persons are authorized or required to make under the terms of the trust instrument and applicable law.3 When several persons hold such powers, a majority of U.S. persons must hold the authority to make substantial trust decisions and no non-U.S. person may hold a veto power for the test to be satisfied. As trust drafting evolves and responsibilities are apportioned among trustees, advisors, protectors, approvers and numerous other fiduciary and non-fiduciary roles, including the grantor (referred to collectively as powerholders), give careful consideration to the question of who is required to act, or who can veto an action, and whether such person is a U.S. person. Note that the applicable test is whether the powerholders are U.S. persons—thus, for example, a U.S. citizen who relocates abroad will, nonetheless, remain a U.S. person by virtue of their citizenship, and their migration won’t cause a migration of the trust from domestic to foreign for U.S. income tax purposes. However, consider whether the person’s new place of residency will permit such jurisdiction to also assert taxing authority over the trust based on the powerholder’s residency in that jurisdiction. For example, in the United Kingdom, a domestic U.S. revocable trust will become U.K. tax resident when the settlor/trustee becomes U.K. tax resident, exposing the trust to U.K. income tax and potentially a U.K. exit tax on gains if the settlor/trustee ceases to be U.K. tax resident.4
It’s worth noting that a trust could be characterized as a foreign trust for U.S. federal tax purposes, while, at the same time, characterized as a tax resident of a state within the United States for state income tax purposes. For example, a trust that fails the court test could be a California tax resident if it were to have California resident beneficiaries or fiduciaries. A trust is a California resident for income tax purposes “if the fiduciary or beneficiary (other than a beneficiary whose interest in such trust is contingent) is a resident, regardless of the residence of the settlor.”5 Hawaii has a rule similar to that of California,6 while a number of states, including New York, look to the residence of the settlor at the time the trust became irrevocable, rather than to the residence of the fiduciaries or beneficiaries.7
While the court test and control test are both objective, and it shouldn’t be difficult to maintain a deliberate jurisdiction (whether foreign or domestic) in relation to the court test, the control test can cause inadvertent migrations of trusts, both into and out of the United States with transitory powerholders. Protective language can be included in a trust to avoid an inadvertent migration by requiring a majority of powerholders at all times to be U.S. persons (if seeking a domestic trust) or disqualifying any U.S. person from serving as a powerholder (if seeking to maintain a foreign trust).
Taxation. A foreign trust is taxed in the same manner as a nonresident alien individual who isn’t present in the United States at any time.8 If a domestic trust ceases to meet either the court test or the control test and becomes a foreign trust, it’s treated as if a transfer then occurred to a foreign trust and as if a sale or exchange occurred for the then-fair market value (FMV) of the trust assets, with any gain recognized by the transferor (the domestic trust).9 This mark-to-market exit tax is similar to the U.K. capital gains tax imposed when a trust that had been controlled by U.K. resident trustees ceases to be U.K. resident as a result of a change in trustees.10
Even if protective language is included to ensure that a trust maintains its status as a domestic trust for U.S. tax purposes, that trust could become subject to taxation and reporting obligations in another jurisdiction as a result of a change in the residence of the settlor, a beneficiary or the trustee. For example, if the settlor of a trust becomes tax resident in France, the trusts created by the settlor will be brought into the French income tax system and, even with respect to irrevocable trusts, into the French inheritance tax system. Under the French Tax Code, trusts are generally disregarded for inheritance tax and gift tax purposes and are deemed to remain owned by the settlor.11 The disconnect between the French gift and inheritance tax treatment and U.S. gift and estate tax treatment of completed gift irrevocable trusts creates the likelihood of double taxation with no relief with respect to such trusts created by a U.S. settlor who later becomes a French tax resident. In addition, even if there’s an insufficient connection for taxation, in France, a trust with any nexus with France (a trustee, settlor, beneficiary or beneficiary deemed settlor, who’s a French tax resident, any assets situated in France or the trustee establishing an ongoing relationship with French business professionals including financial institutions, accountants or attorneys) is subject to reporting obligations.12 These reporting obligations are applicable even if the only nexus with France is a contingent remainder beneficiary of a U.S. parent’s revocable trust. While French trust reporting obligations are broad, the register isn’t broadly available to the public.13
Throwback rule. A foreign trust that acquires U.S. tax resident beneficiaries won’t become fully subject to U.S. income tax; however, it may become subject to the throwback rule for undistributed net income (UNI).14 The throwback rule was eliminated for most domestic trusts in 1997 but continues to apply to distributions in excess of current year income from foreign non-grantor trusts and is designed to prevent U.S. taxpayers from benefiting from tax-free growth inside foreign trusts. The throwback rule accomplishes this by approximating the tax that would have been paid over the accumulation period and then imposing a non-deductible interest charge on the approximated tax after providing a credit for foreign tax paid by the trust.15
For purposes of determining whether there are accumulations subject to the throwback rule, the distributable net income (DNI) of foreign non-grantor trusts is generally computed in the same way as for domestic trusts; however, the DNI of foreign trusts includes worldwide income, including U.S. source income that would ordinarily be exempt from tax under treaty provisions, and capital gains income, even if not allocated to income by the trustee.16 The UNI of a foreign non-grantor trust is the amount by which DNI, reduced by trust-level tax paid, exceeds actual distributions; however, capital gains that are included in DNI are treated as ordinary income for purposes of determining UNI.17 It’s important to understand that certain benefits that wouldn’t ordinarily be considered “distributions” in a domestic trust context will, nevertheless, carry out DNI or UNI from a foreign trust. Loans of cash or marketable securities will be deemed distributions of the full amount of the loan unless the loan is structured as a “qualified obligation.”18 In addition, uncompensated use of trust assets, such as a residence, works of art or other non-liquid assets, will be deemed to be distributions of the FMV of the use of the asset.19
There are some solutions that won’t cleanse UNI, and the trust will continue to be subject to the throwback rule.20 Distributing UNI first to a foreign “intermediary” who then transfers the distributed assets to a U.S. beneficiary won’t avoid the application of the throwback rule.21 With some advance notice, a foreign trust with significant accumulations could be restructured to reduce or eliminate the throwback reporting and tax burden. Through a decanting, or otherwise, a separate UNI trust could be created for the non-U.S. beneficiaries of the trust, and all current year DNI and all UNI of the original trust could be distributed to the UNI trust. In years when there’s a U.S. beneficiary, the original trust could distribute all DNI, whether to the U.S. or non-U.S. beneficiaries of the original trust. Because distributions in satisfaction of a specific or pecuniary gift that must be satisfied in three or fewer installments don’t carry out DNI or UNI, the trust could be drafted to require a pecuniary or specific gift to a separate trust for exclusively U.S. beneficiaries after a certain period of accumulation. If there isn’t sufficient notice that a trust will acquire one or more U.S. beneficiaries, the distributions to the U.S. beneficiaries could be limited to current year DNI.
PFIC and CFC Interests. Predictably, foreign trusts most often hold interests in foreign corporations, whether those interests are in family holding structures, active family businesses or foreign mutual funds or hedge funds. Unpredictably, at least for many foreign trustees, is the fact that trust investments that were very unremarkable prior to a beneficiary becoming a U.S. tax resident become quite problematic. The special taxation regimes for passive foreign investment companies (PFICs) (that is, foreign corporations with respect to which either: (1) at least 75% of its gross income is passive income, or (2) at least 50% of its assets produce or are held for the production of passive income)22 and controlled foreign corporations (CFCs) (that is, foreign corporations in which U.S. shareholders own more than 50% of the voting rights or value of the corporation)23 will become applicable to distributions to the U.S. tax resident beneficiary. Because of this U.S. control component, CFCs aren’t found as often in foreign trusts as PFICs.
Once a corporation meets either of the PFIC tests during the time that a U.S. person has an interest in the corporation, the corporation will remain a PFIC for U.S. tax purposes. Most foreign hedge funds and mutual funds are properly characterized as PFICs because they would primarily produce passive investment income. Similarly, a foreign family holding company will most often be characterized as a PFIC if it simply holds a family’s investment portfolio, even if that portfolio otherwise consists of publicly traded securities that wouldn’t be considered PFICs if held directly by the trust. Like the throwback rule for trusts, the U.S. tax treatment of PFIC interests provides an anti-deferral mechanism by applying an interest charge on the PFIC return over the holding period. In addition, capital gains of PFICs are taxed at the highest ordinary income rates, and capital losses from PFICs can’t be used to offset other capital gains.24 This tax treatment can be avoided if the PFIC is willing to provide complete financial information and a timely election is made to treat the PFIC as a qualified electing fund, which causes the U.S. taxpayer to recognize current year ordinary income and capital gains income annually, as if it had actually been distributed, without regard to whether any distribution is made.25 A mark-to-market election is also available to avoid the standard tax treatment of PFICs when the PFIC is regularly traded on a qualified exchange.26
In cases in which it isn’t practical or is too costly to restructure a foreign trust’s investment portfolio or holding company structure for a single beneficiary who’s become U.S. tax resident, the corporate anti-deferral rules may be unavoidable and will be made even more complex by the intervening foreign trust structure, which is likely to be a purely discretionary trust with no fixed interests. While the IRC and final Treasury regulations published in January 2021 state that PFIC interests held by trusts are to be deemed to be owned proportionately by the trust’s beneficiaries, it’s unclear how the proportionate allocation would be made in the context of a purely discretionary trust.27 The Treasury Department acknowledged in the preamble to the final PFIC regulations that additional guidance is needed on the ownership attribution rules and the interplay between the PFIC rules and subchapter J. The preamble to the final PFIC regulations goes on to state that “[t]he Treasury Department and IRS are also aware that in some cases, the application of the PFIC attribution rules may impose tax on U.S. beneficiaries of foreign trusts that never receive the related distributions.” Until there’s additional guidance, the only solution to this problem is for trustees of foreign non-grantor trusts to avoid holding interests in PFICs while there are any U.S. beneficiaries of the trust.
Informational reporting. In addition to being subject to income taxation on distributions received or deemed received from the foreign trust, the U.S. resident beneficiary will be subject to informational reporting. The U.S. beneficiary will be required to report any distributions from a foreign trust or any uncompensated use of trust assets on a Form 3520 and, if the trust holds any PFIC interests, will be required to file a Form 8621. It’s important that the beneficiary’s family office ensure that all foreign financial accounts over which the beneficiary has signatory authority or in which the beneficiary has a financial interest are reported on timely filed report of foreign bank and financial accounts (FBARs). There may be a tension between the U.S. reporting requirements and the family’s desire to protect younger family members from a full understanding of the assets belonging to them. However, the Internal Revenue Service has been aggressively prosecuting FBAR violations and will likely seek to classify more violations as willful violations following the U.S. Supreme Court decision in Bittner v. United States,28 which limited non-willful violations to a per form (or per year) penalty, rather than to a per account penalty, because willful violations aren’t so limited.29
Trust-like wealth transfer structures. Non-U.S. family members moving into the United States may not only be beneficiaries of foreign trusts, but they may also have interests in wealth transfer structures not as easily classified for U.S. tax purposes. Family offices should be aware that a structure that’s common, especially in a civil law country, may raise classification issues and income tax basis and/or estate tax inclusion issues once the structure touches the United States.
Stiftungs (that is, German foundations) and non-charitable foundations, which are used frequently for wealth transfer planning in civil law countries, could be characterized as trusts, and perhaps grantor trusts if the funders of the foundations become U.S. tax residents. If the funder of the foundation becomes tax resident in the United States within five years of funding30 and if it’s not otherwise appropriate to characterize the foundation as a corporation, the foundation would likely be characterized as a grantor trust for U.S. purposes, with an entirely unanticipated income tax result if the funder isn’t entitled to any distributions from the foundation. A non-charitable foundation may also be characterized as a grantor trust even if the funder arrives in the United States more than five years after funding if: (1) the assets of the foundation may be distributed to the funder; (2) are actually distributed to discharge the legal obligations of the funder;31 or (3) a committee or protector holds a power to add beneficiaries,32 which is common in non-charitable foundations. If it’s important that the foundation not be treated as a trust, the family office should consider making a timely Form 8832 entity classification election to cause the foundation to be taxed as a corporation and be prepared to provide substantiating evidence that the foundation has separate legal existence as well as support in the organizational documents for a purpose of engaging in commercial or economic activities. In evaluating whether a foundation is properly characterized as a trust or a corporation, the IRS will consider the purpose of the foundation and whether it’s more trust-like in its objective of holding assets for the benefit of beneficiaries or whether it’s more corporate-like in its objective of carrying on business activities and, whether, under local law of formation, the foundation is permitted to carry on commercial activities.
Fideicomisos are needed when purchasing Mexican property in the “restricted zone” of Mexico, which is land located within 100 kilometers of a national border and within 50 kilometers of any ocean. While similar to a trust, the Treasury Department has issued a revenue ruling stating that within certain fact patterns, fideicomisos aren’t trusts33 and confirmed that ruling more recently in a private letter ruling.34 Note that careful coordination with Mexican counsel is necessary to determine the optimal structure for ownership of the beneficial interest in the fideicomiso to manage the Mexican tax cost of the transfers of the beneficial interest.
Split-interest or bare interest/usufruct planning is a common wealth transfer planning structure throughout civil law jurisdictions. Carefully consider the estate tax treatment when the creator of the split-interest who retains the usufruct interest becomes domiciled in the United States as there’s likely U.S. estate tax inclusion as a result of the retained use rights. Also give thought to the U.S. income tax basis of the property when the bare interest holder becomes U.S. income tax resident given the exposure to capital gains tax on the resident’s worldwide assets.
Residence Planning
If a family member has acquired personal residential property outside their “primary” residency jurisdiction, understand the duration of time the family member will spend in the alternate location and the ties the family member plans to establish in such jurisdiction to ensure an inadvertent income tax residency and/or estate tax residency (domicile) doesn’t attach to them based on their connections.
U.S. Income Tax Residency
For a non-U.S. person spending time in the United States, the substantial presence test (sometimes more familiar as the “day counting test”) will enable an individual who’s neither a U.S. citizen nor a U.S. lawful permanent resident to properly track their time spent in the United States to either avoid or, if desired, invoke, U.S. income taxation as a U.S. tax resident. An individual who isn’t a U.S. citizen and isn’t a U.S. lawful permanent resident will, nonetheless, be a U.S. resident for income tax purposes if: (1) the individual is present in the United States for 31 days during the current tax year; and (2) the sum of (i) the days present in the current tax year, (ii) one-third of the days present in the preceding tax year, and (iii) one-sixth of the days present in the second preceding tax year equals or exceeds 183.35 Once a U.S. income tax resident, the United States would assert taxing authority over the resident’s worldwide income.
Residency under this test may be avoided if the individual hasn’t taken steps toward becoming a lawful permanent resident or citizen, was present fewer than 183 days in the current calendar year, has a tax home in a foreign country and can establish a “closer connection” to such foreign country.36 The closer connection test is a more subjective analysis than the objective substantial presence test and more closely resembles the factors involved in both discerning an individual’s domicile (for estate and gift tax purposes) and the residency tie-breaker factors found within double tax agreements (treaties) with foreign jurisdictions. The test includes considering the individual’s permanent home, social and political ties, banking activities, driver’s license and voter registration, as well as the location of family members.
Treaty Relief
When a family member moves to another jurisdiction, even when that individual would be treated as a tax resident under the domestic law of that new jurisdiction, the family’s advisors should investigate whether there’s a double tax agreement (DTA), that is, a tax treaty, between the two jurisdictions. When a treaty is in effect, the treaty can operate to: (1) resolve which one country has priority jurisdiction to tax (the “tie-breaker” rule), when the taxpayer would otherwise be a tax resident under the laws of both jurisdictions, (2) address what sources of income may be taxed by each country and, in some instances, agreed on rates of tax, and (3) address what credits each country has agreed to provide against its own tax for income tax paid to the other country.
As noted above, the tie-breaker rule under a DTA applies a more subjective test focused on the taxpayer’s ties and connections to each jurisdiction, by looking to the country where the taxpayer has a permanent home; then, if not determinative, moving to the location where the taxpayer maintains closer personal and economic relations (center of vital interests); then, proceeding to examine the taxpayer’s habitual abode; then, looking to the taxpayer’s nationality or citizenship; and if no such factors have been determinative, then, by a mutual agreement reached between the two countries. While the DTAs are most often based on the language of the Organisation for Economic Co-operation and Development model convention, treaties are negotiated agreements and have been entered into at various times over the last 90 years, thus the language varies from agreement to agreement, and each DTA must be separately examined. When a DTA is in effect between the two countries, asserting treaty relief using the tie-breaker rule may relieve the family member of the burden of tax residency in both jurisdictions, notwithstanding that the family member might have otherwise been treated as tax resident under the domestic laws of each jurisdiction. Importantly, family office advisors of U.S. lawful permanent residents (green card holders) should understand that relief from double taxation under a tie-breaker rule won’t be available to the lawful permanent resident without causing that individual to be deemed to have expatriated from the United States.37
Estate Tax Residency
The family office advisor should be mindful that a member of the family taking up residence, or acquiring property in another jurisdiction, may implicate estate and gift tax considerations, not just income tax considerations. A U.S. citizen or resident will be subject to the U.S. estate and gift tax on their worldwide assets.38 A non-U.S. citizen, non-U.S. domiciliary will only be subject to U.S. transfer tax on U.S. situs property.39
Though the term “resident” is used once again, in this context, resident is meant as “domiciliary.” Unlike the objective day counting test, domicile is a subjective test that requires a facts-and-circumstances analysis. The Treasury regulations explain:
A person acquires domicile in a place by living there, for even a brief period of time, with no definite present intention of later removing therefrom. Residence without the requisite intention to remain indefinitely will not suffice to constitute domicile, nor will intention to change domicile effect such a change unless accompanied by actual removal.40
More to Come
While this discussion has focused primarily on the direct tax impacts, both for individuals and trusts, on migratory family members, numerous other considerations arise for the UHNW family that’s gone “global,” including the efficacy of marital property agreements when crossing borders, privacy considerations and structures that will be respected in each jurisdiction and security concerns, as well as personnel and employment issues when traveling internationally with staff. The second part of this article, available later this year, will help family office advisors navigate these practical concerns that arise when advising families across jurisdictions.
Endnotes
1. Internal Revenue Code Section 7701(a)(30)(E).
2. IRC Section 7701(a)(31)(B).
3. Treasury Regulations Section 301.7701-7(d)(1)(ii).
4. Taxation of Chargeable Gains Act Section 80 (1992).
5. California Revenue and Taxation Code Section 17742.
6. Hawaii Revised Statutes Section 235-1 (definition of “resident trust”).
7. New York Tax Law Section 605(b)(3).
8. IRC Section 641(b).
9. IRC Section 684(c).
10. Supra note 4.
11. Article 792-0 bis of the French tax code (FTC).
12. Article 1649 AB of the FTC and Articles 369 to 369 AB of Annex II to the FTC.
13. Conseil Constitutionnel (constitutional court), Oct. 21, 2016, n° 2016-591 struck down the rule allowing public access. Ordinance No. 2020-115 allows access to the register to judicial authorities, customs authorities, police authorities, tax authorities and financial authorities as well as to those responsible for the control of money laundering obligations; financial institutions subject to anti-money-laundering rules and “any natural or legal person who can demonstrate a legitimate interest in the fight against money laundering.”
14. IRC Sections 666 through 668.
15. Ibid.
16. IRC Sections 643(a)(3) and 643(a)(6).
17. IRC Section 665.
18. IRC Section 643(i). A “qualified obligation” must: (1) be in writing, (2) have a term not exceeding five years, and (3) have all payments on the obligation denominated in U.S. dollars.
19. Ibid.
20. Revenue Ruling 91-6.
21. Treas. Regs. Section 1.643(h)-1.
22. IRC Section 1297.
23. IRC Section 957.
24. IRC Section 1291.
25. IRC Sections 1293 through 1295.
26. IRC Section 1296.
27. IRC Section 1298(a)(3); Treas. Regs. Section 1.1291-1(b)(8)(iii)(C).
28. Bittner v. United States (Supreme Court 21-1195, Feb. 28, 2023).
29. 31 U.S.C. Section 5321(a)(5).
30. IRC Section 679(a)(4).
31. IRC Section 677.
32. IRC Section 674(c).
33. Rev. Rul. 2013-14.
34. Private Letter Ruling 201245003 (Nov. 9, 2012).
35. IRC Section 7701(b)(3)(A).
36. Section 7701(b)(3)(B).
37. Section 7701(b)(6), IRC Section 877A.
38. IRC Sections 2001 and 2031(a).
39. IRC Sections 2101(a), 2103 and 2104(b).
40. Treas. Regs. Section 20.0-1(b)(1).