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Pre-Immigration Planning with the Foreign Trust: The Intersection of Income and Estate Tax

Mar 04 2024

Article Written for:  Florida Bar Journal

A foreign trust is generally treated as a non-resident/non-citizen (NRNC) for U.S. tax purposes. Foreign trusts are therefore subject to U.S. income tax only on U.S. source income.[1]

A common strategy for a foreign grantor with family in the U.S. is to fund a foreign trust with offshore assets and U.S. intangibles. Funding the trust is free from U.S. gift tax and the trust shelters income earned on foreign assets and U.S. capital gains. Depending on its structure, the foreign trust may also allow for tax free distributions to the foreign grantor’s family in the U.S.

Although funding a foreign trust for U.S. beneficiaries is a viable strategy, many offshore grantors intend to move to the U.S. to be close to loved ones. This article provides an overview of how the patriarch or matriarch may move to the U.S. without sacrificing the income and transfer tax benefits of the foreign trust benefitting U.S. beneficiaries.

Income Tax and the U.S. Grantor

As background, federal income tax is generally recognized on the transfer by a U.S. (income tax) resident of property to a foreign trust. Internal Revenue Code §684 generally treats the gratuitous transfer of property by a U.S. person to a foreign trust (with no U.S. beneficiary) as a deemed sale or exchange of the assets contributed to the trust. Section 684 triggers taxable gain (but not loss) on the excess of fair market value over tax basis.[2]

The §684 deemed sale of trust assets does not apply to transfers to grantor trusts. As grantor trusts are disregarded for U.S. income tax purposes, trust assets remain owned by the grantor.[3] The foreign trust may be taxed as “grantor” pursuant to either 1) I.R.C. §676 and §672(f) (based on retained control of trust assets by the foreign grantor and the grantor’s spouse being sole beneficiaries); or 2) I.R.C. §679 (deemed grantor status of foreign trusts formed by a U.S. citizen or resident for a U.S. beneficiary). The funding of a foreign trust by a U.S. citizen or permanent resident for the benefit of any U.S. beneficiary (including the grantor) has no immediate U.S. income tax implications.[4]

Deemed grantor status of foreign trusts funded by U.S. settlors (avoiding I.R.C. §684 deemed sale under I.R.C. §679) does not apply to foreign trusts without U.S. beneficiaries. Potential U.S. beneficiaries and future beneficiaries are, however, counted. If a foreign trust may be amended (under its terms or by the law of its situs) to add a U.S. person as a beneficiary, trust assets will be deemed recontributed upon the U.S. residency of a beneficiary. The trust is then deemed a foreign grantor trust (assuming all other criteria for foreign grantor status is satisfied).[5] Thus, if a U.S. beneficiary may be added, the effects of I.R.C. §684 (deemed sale rules for a U.S. grantor) and §667 (accumulation tax for U.S. beneficiaries of a foreign non-grantor trust) may be avoided.

The determination of whether a foreign trust has U.S. beneficiaries (making the trust disregarded as “grantor” under code §679) is made annually.[6] A foreign trust created by a U.S. resident as non-grantor (with no U.S. beneficiaries) may obtain grantor status if a beneficiary obtains U.S. residency within five years of the grantor funding the trust.[7] In such event, the U.S. grantor must recognize all accumulated trust income in the taxable year in which an NRNC beneficiary becomes a U.S. resident.[8] The U.S. grantor recognizes all income of the foreign trust for each subsequent year the foreign trust remains grantor.

If, however, a foreign beneficiary becomes a U.S. resident more than five years after the trust is funded, the trust is not treated as having a U.S. beneficiary for purposes of code §679.[9] Planning to avoid the imposition §684 (deemed sale) is only possible if assets are contributed to the foreign trust less than five years before a trust beneficiary becomes a U.S. income tax resident. Note, however, that this exception is not available if the beneficiary was previously a U.S. resident.[10]
If a foreign trust ceases to have a U.S. beneficiary, the U.S. grantor is treated as having made a taxable transfer to the foreign trust. Capital gains tax is triggered on the first day of the first taxable year following the last taxable year the trust had a U.S. beneficiary. The gain triggered by deemed sale of trust assets (under code §684) includes appreciation since contribution to the trust.[11]

Death of U.S. Grantor

The §679/§684 legislation is the last of a series of compromises that were drafted to prevent U.S. grantors from sheltering foreign offshore income in a foreign trust (taxable as an NRNC). Deemed sale of assets contributed under §684 is deferred if the grantor remains owner of trust assets for income tax purposes (assuming there are U.S. beneficiaries).[12] A U.S. grantor may, thus, fund a foreign trust for a U.S. beneficiary without initially triggering deemed capital gains. During the life of the grantor, trust assets generate taxable U.S. income (including income from foreign situs assets) to the U.S. grantor (permitting tax free distributions to U.S. beneficiaries), and trigger deemed sale of trust assets upon the death of the grantor.

Grantor status of the foreign trust status ends upon the earlier of 1) the foreign trust no longer having a U.S. beneficiary, or 2) the death of the grantor.[13] Technically, deemed sale of trust assets is triggered upon loss of grantor status. Interestingly, the application of the “mark-to-market” deemed sale provisions (income tax) of I.R.C. §684 (triggered upon the death of a U.S. grantor) hinges on the inclusion of trust assets (in the foreign trust) in the grantor’s U.S. taxable estate.[14] Moreover, if the foreign trust is domesticated to the U.S. before either event, I.R.C. §684 becomes inapplicable (as the mark-to-market deemed sale is not imposed on the then domestic trust).[15]

The application of the U.S. estate tax, upon the death of the grantor, triggers two potential income tax outcomes.[16] If trust assets are not includable in the gross estate of the U.S. grantor, they are deemed sold under code §684 (immediately prior to U.S. grantor’s death).[17] Following the deemed sale, trust assets receive a basis step-up for the gain (but not loss).[18]

Foreign trust assets includable in the U.S. grantor’s gross estate are not subject to deemed sale under code §684 (upon the grantor’s death) and no gain is recognized. Trust assets are subject to estate tax and receive a fair market value step-up in basis on the grantor’s death.[19] Thus, estate tax exposure eliminates income tax otherwise arising from the deemed sale of assets (triggered by the death of a U.S. grantor). This is an uncommon integration/coordination of the U.S. estate and income tax regimes and (as explained below) is a pivotal factor in planning the U.S. immigration of a foreign grantor.

After trust assets are deemed sold (or subject to U.S. estate tax with no gain recognized), the trust is treated as an independent foreign non-grantor trust for federal income tax purposes (unless, of course, the trust is domesticated).

Income Tax and the Non-Resident Non-Citizen Grantor

Foreign trusts (not treated as grantor trusts) generally incur taxable income like NRNC individuals (with certain limitations on credits and deductions, unique to trusts).[20] Neither code §684 (deemed sales provisions) nor code §679 (deemed grantor status) apply to transfers by an NRNC to a foreign trust. Only U.S. source income (earned by U.S.-based trust assets) is taxed by the U.S.[21]
U.S. gross income of a foreign non-grantor trust consists only of 1) income derived from sources within the U.S. (not effectively connected with the conduct of a U.S. business) and 2) income effectively connected with the conduct of a U.S. business.[22] As a foreign taxpayer, the foreign trust incurs no capital gains tax (unrelated to real estate).

Foreign non-grantor trusts are, thus, subject to U.S. income tax only on the following types of income: 1) Income effectively connected with a U.S. trade or business;[23] 2) disposition of U.S. real property interests;[24] and 3) fixed or determinable annual or periodic income (FDAPI) from U.S. sources (i.e., interest, dividends, rents, annuities, etc.).[25]

U.S. Beneficiaries

The U.S. taxation of foreign trusts funded by an NRNC (avoiding U.S. income tax on foreign income and U.S. capital gains) is a long-established strategy of tax-sheltered gifting to U.S. beneficiaries. If an NRNC funds a foreign trust for the benefit of a U.S. person, the trust will be treated as either a foreign grantor trust or a foreign non-grantor trust, for U.S. income tax purposes.

If the trust is nongrantor, it is regarded as an independent taxpayer. U.S. beneficiaries are taxed only on distributions of both U.S. and foreign source trust income. U.S. beneficiaries, however, recognize no income tax until trust distributions are made. Distributions from foreign trusts to U.S. beneficiaries (citizens and income tax residents) therefore carry out taxable distributable net income to the U.S. beneficiary. [26]

A U.S. beneficiary in receipt of a distribution from a foreign trust is taxed on his or her share of distributable net income (DNI). If the distribution exceeds DNI in the year of receipt, an accumulation distribution has occurred (triggering additional accumulation tax under I.R.C. §667).[27] This paradigm ensures that prior years foreign trust income does not escape U.S. income tax.

As discussed above, grantor trusts (generally controlled by NRNC founder) are disregarded for U.S. income tax purposes. U.S. beneficiaries recognize no tax on distributions, as trust assets of a grantor trust are deemed owned (for income tax purposes) by the grantor.[28] NRNC grantors do not recognize U.S. income tax on foreign source income or U.S. capital gains (on sales unrelated to real estate). The foreign grantor may, thus, limit IRS reach over foreign source income and U.S. capital gains, as long as the grantor remains an NRNC. All trust income distributed to U.S. beneficiaries may therefore be sheltered entirely from U.S. tax if the foreign trust is classified as “grantor” for federal income tax purposes.[29]

To avoid subjecting U.S. beneficiaries (taxed by the U.S. on income earned worldwide) to taxable distributions by a foreign trust, the tax on accumulated trust income, and capital gains, NRNC settlors generally form the foreign trust as a foreign grantor trust.

Since 1996, NRNCs may establish grantor trust status (or a foreign trust) by satisfying one of three exceptions to non-grantor status: 1) The grantor may revoke the trust without the consent of any person;[30] 2) the grantor or the grantor’s spouse is the sole beneficiary of the trust during the life of the grantor;[31] and 3) the trust was created before September 19, 1995 (regarding assets in trust as of such date), if the trust qualifies as a grantor trust, under code §676 or code §677.[32]
Upon the death of the NRNC grantor, the offshore grantor trust loses its grantor trust status. Trust income from U.S. sources (to the extent taxable) is then recognized by the trust (an independent taxpayer). Thereafter, U.S. beneficiaries will be taxed on distributions from the foreign trust.

A Note on Tangible U.S. Gifts to Trust

Gifts of U.S. tangible property by an NRNC are subject to U.S. gift tax. Transfers by an NRNC of foreign situs property and U.S. intangibles (including publicly traded stock) are not subject to U.S. gift tax. The general strategy of acquiring U.S. tangible assets in a foreign corporation converts U.S.-based tangible assets to intangibles. The strategy avoids gift tax (otherwise applicable to the direct transfer of U.S. tangible assets). Indirect transfers of U.S. tangible property (through a foreign corporation) breaks the legal nexus to the U.S. and avoids U.S. gift tax.

Immigration by NRNC Grantor

Our experience suggests that the NRNC grantor typically intends to move to the U.S. (to be with family, i.e., the U.S.-based trust beneficiaries). Planning for the grantor’s death (as a potential U.S. resident or citizen) is therefore required.

If the NRNC (with U.S. beneficiaries) intends to move to the U.S., a number of issues are raised. If the NRNC grantor establishes U.S. residency within five years of funding the foreign trust, trust assets may be exposed to U.S. income tax (under the code §684 deemed sale and the code §679 deemed grantor trust rules).[33] Section 684 and §679, thus, apply to an NRNC grantor who becomes a U.S. resident within five years of funding a foreign trust.[34]

The immigrant grantor who becomes a U.S. (income tax) resident within five years of funding a foreign trust is treated as having re-transferred property to the foreign trust on the date of establishing residency. The deemed re-transfer triggers either 1) the deemed sale rules of code §684 (if the trust has no U.S. beneficiaries), or 2) grantor status under code §679 (if the foreign trust has a U.S. beneficiary). In the event of grantor status, either deemed sale of trust assets (under code §684) or (if no prior estate tax planning took place) exposure to U.S. estate tax, will be triggered upon the death of the immigrating grantor. There are two strategies the proposed immigrating grantor may implement to avoid the imposition of I.R.C. §684.

The first strategy is for the foreign grantor to wait five years to establish U.S. domicile (as I.R.C. §684 becomes inapplicable after the fifth anniversary of funding the foreign trust). If an NRNC funds a foreign trust more than five years prior to establishing U.S. residency, no deemed re-transfer (or associated gain) is triggered.[35] After the grantor establishes U. S. residency (five or more years after funding), the trust will continue to earn foreign source income on a tax-free basis (assuming the trust avoids grantor status). If trust beneficiaries are U.S. residents, no U.S. income tax is imposed on such beneficiaries until the trust makes distributions. NRA beneficiaries avoid U.S. tax on distributions of foreign source income.

As NRNCs typically fail to wait five years to obtain U.S. residency (as they want to be with their U.S.-based family), the NRNC must deal with the deemed transfer of trust assets to the foreign trust, as of the date of obtaining U.S. residency. As the foreign trust will likely have U.S. beneficiaries, I.R.C. §684 does not immediately trigger a deemed sale. Instead, I.R.C. §679(a)(1) makes the foreign trust grantor during the lifetime of the NRNC grantor (now a U.S. person for federal income taxes). As long as the foreign trust has U.S. beneficiaries, the imposition of the §684 deemed sale is delayed until the death of the grantor.

If the NRNC grantor fails to wait-out the five-year funding period before obtaining U.S. residency, the grantor may domesticate the foreign trust before his or her death. In such event, trust assets will avoid the imposition of I.R.C. §684 (as the deemed sale rule only applies to foreign trusts).

The domesticated trust will, however, then recognize U.S. income on all its assets, wherever located. Moreover, all future distributions of income to trust beneficiaries will be governed under Subchapter J Title A of the Internal Revenue Code, subjecting all trust to income tax on earnings worldwide. If the income tax exposure to foreign source earnings is intolerable, the grantor may opt to abandon U.S. domicile to preserve the trusts’ foreign status and avoid deemed sale at death.

Compliance for Foreign Trusts

Immigrants deemed by code §679 to own (for income tax purposes) property transferred to a foreign trust within five years of U.S. residency must report such transfers (deemed or actual) on IRS Form 3520.[36] The U.S. residency starting date triggers the filing requirements necessary to inform the IRS of facts potentially causing the deemed sale of assets held by a foreign trust. Trust income accruing before U.S. residency is not subject to U.S. tax and not reportable (except to the extent of U.S. source income).

Five-Year (Income Tax) Lookback Does Not Apply to Transfer Taxes

In any case, trust assets avoid U.S. estate and gift tax (as assets were, if properly structured, irrevocably transferred by an NRNC to the foreign trust outside the net of federal transfer taxes).[37] Deemed sale, grantor status, and domestication (income tax issues) do not alter the immigrant’s avoidance of U.S. estate or gift tax (governed under Subtitle B of the code). When summarizing code §679, the U.S. House of Representatives confirmed that:

an inter vivos trust which is treated as owned by a U.S. person under this provision [§679)] is not treated as owned by the estate of that person upon his death. These rules [only] apply for income tax purposes. Whether the corpus of the inter vivos trust is included in the estate for the U.S. person depends on the estate tax provisions of the [c]ode. Such provisions, as well as the gift tax provisions of the [c]ode, are unaffected by this amendment.[38]

Thus, the pre-immigration trust is also a very effective estate tax avoidance device. Estate tax may be avoided even if the trust requires domestication (to avoid exposure of trust assets to the mark-to-market deemed sale, if the grantor immigrates to the U.S. prior to the passage of five years of funding the foreign trust). The estate tax avoided often more than compensates for having to domesticate the foreign trust prior to death of the grantor.

Conclusion

NRNCs pay no U.S. tax on foreign source income or capital gains (unrelated to real estate). A potential immigrant to the U.S. may fund a foreign trust, which is afforded the same NRNC tax benefits. With proper planning, the foreign trust may benefit an NRNC’s family in the U.S. (and abroad) by sheltering foreign source income and avoiding U.S. estate tax. Offshore beneficiaries pay no tax on foreign source trust income and U.S. beneficiaries defer U.S. tax until trust distributions.

[1] I.R.C. §§641(b), 872(a).

[2] I.R.C. §684(a).

[3] I.R.C. §684(b).

[4] I.R.C. §679(a)(1).

[5] Treas. Reg. §1.679-2(a)(4)(ii)(A).

[6] See Treas. Reg. §1.679-2(a).

[7] See Treas. Reg. §1.679-2(a)(3).

[8] See Treas. Reg. §1.679-2(c)(1).

[9] Treas. Reg. §1.679-2(c)(3).

[10] See Treas. Reg. §1.679-2(a)(3), Ex. 2.

[11] See Treas. Reg. §1.679-2(c)(2).

[12] Treas. Reg. §1.684-3(a).

[13] Treas. Reg. §§1.684-2(e) (death of grantor), 1.679-2(c)(2) (no U.S. beneficiary for foreign trust).

[14] Treas. Reg. §1.684-3(c).

[15] Treas. Reg. §§1.684-1(b)(3) (as the trust is no longer a foreign trust), 301.7701-7(a) (definition of domestic trust).

[16] I.R.C. §684(c); Treas. Reg. §1.684-3(c)(1); Treas. Reg. §1.684-2(e).

[17] I.R.C. §684(c).

[18] Treas. Reg. §1.684-1(a).

[19] Treas. Reg. §1.684-3(c).

[20] I.R.C. §§641(b), 872(a). See I.R.C. §§642, 643, 651, and 661 regarding special rules for credits and deductions for trusts. All U.S. source income earned by a non-grantor foreign trust is subject to tax rates applicable to trusts under code §1(e). The rates are as follows:
Taxable Income Tax Due
$0 – $2,600 10% of taxable income
$2,601 – $9,300 $260 + 24% of the amount over $2,600
$9,301 – $12,750 $1,868 + 35% of the amount over $9,300
$12,751+ $3,705.50 + 37% of the amount over $12,750
Applicable tax treaties may reduce U.S. income tax on foreign (non-grantor) trusts, if the trust is resident of a treaty partner country. For example, most U.S. income tax treaties reduce the tax imposed on passive dividends from 30% to 15%.

[21] Unless I.R.C. §672(f) (grantor status) applies to the trust.

[22] See I.R.C. §872(a).

[23] I.R.C. §871(b).

[24] I.R.C. §897(a).

[25] I.R.C. §871(a).

[26] I.R.C. §§652 and 662.

[27] Id.

[28] I.R.C. §§671-679.

[29] The strategy is generally explained in Christopher Callahan and Scott Snyder, Foreign Grantor Trust Planning: A Flexible Planning Structure for U.S. Income Tax, 97 Fla. B. J. 30 (Nov./Dec. 2023).

[30] I.R.C. §672(f)(2)(A)(i).

[31] I.R.C. §672(f)(2)(A)(ii).

[32] Treas. Reg. §§1.672(f)-3(a)(3), 1.672(f)-3(b)(3).

[33] I.R.C. §679(a)(4); I.R.C. §684(a) (if there is no U.S. beneficiary of the foreign trust).

[34] See I.R.C. §679(a)(4); Treas. Reg. §1.679-5(a).

[35] Note that Internal Revenue Code §679 applies to direct as well as indirect transfers. For example, consider a proposed immigrant “A” who gives assets to his or her brother “B” before moving to the U.S. If B funds a trust for A and his or her family less than five years before A moves to the U.S., A will be treated as the owner of the trust assets for income tax purposes. A’s only defense would require proof that B was not acting as an intermediary. See Treas. Reg. §679-3(c).

[36] See IRS Form 3520, Annual Return to Report transactions with Foreign Trusts and Receipt of Certain Foreign Gifts.

[37] See I.R.C. §2001 and I.R.C. §2501.

[38] See P.L. 94-455, Tax Reform Act of 1976, HR. Rpt. No. 658, 94th Cong., 1st Sess. at 209 (Nov. 12, 1975). The Senate report contains the same language. P.L. 94-455, Tax Reform Act of 1976, S. Rpt. No. 938, 94th Cong., 2nd Sess. At 218 (June 10, 1976). Furthermore, this interpretation was affirmed when the IRS quoted the same language in PLR 9332006 (1992).

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