An effective strategy for a foreign individual with family in the U.S. is to fund a foreign trust with offshore assets and U.S. intangibles. Funding the trust triggers no U.S. gift tax and the trust shelters all income earned on foreign assets and U.S. capital gains. The foreign trust may also allow for tax free distributions to the foreign grantor’s family in the U.S.
Many offshore grantors intend to move to the U.S., to be close to loved ones. This article discusses how to move to the U.S. without sacrificing the income and transfer tax benefits of funding a foreign trust for U.S. beneficiaries.
Income Tax and the U.S. Grantor
Internal Revenue Code (IRC) §679 (deemed grantor status) and §684 (deemed sales provisions) prevent U.S. grantors from sheltering foreign offshore income in a foreign trusts (taxable as an NRNC). Section 684 generally taxes the gratuitous transfer of property by a U.S. person to a foreign trust (with no U.S. beneficiary). The transfer is treated as a deemed sale or exchange of the assets placed in trust. IRC Section 684 triggers taxable gain (but not loss) on the excess of fair market value over tax basis.[2]
A deemed sale of assets contributed to a foreign trust is deferred during the grantor status of the foreign trust.[3] Grantor trusts are disregarded for U.S. income tax purposes. Trust assets are therefore treated as owned by the grantor for tax purposes.[4] The foreign trust may be taxed as grantor pursuant to either (i) IRC §676 (power to revoke) and §672(f) (based on retained control of trust assets by the grantor) or (ii) IRC §679. Thus, 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.[5]
Deemed grantor status of foreign trusts (under §679) funded by U.S. settlors (avoiding IRC §684 deemed sale) does not apply to foreign trusts with no U.S. beneficiary. If a U.S. beneficiary is added, deemed sale may be avoided. If a foreign trust may be amended to add a U.S. beneficiary, trust assets will be deemed recontributed upon the U.S. residency of the beneficiary.[6]
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.[7]
Death of U.S. Grantor
During the life of the U.S. grantor, grantor trust assets generate taxable U.S. income (including income from foreign situs assets) to the U.S. grantor. A deemed sale of trust assets is triggered upon the death of the grantor. Grantor status of the foreign trust thus ends upon the earlier of (i) the foreign trust no longer having a U.S. beneficiary or (ii) the death of the grantor.[8] Technically, deemed sale of trust assets is triggered upon loss of grantor status.
The application of U.S. Estate Tax, upon the death of the grantor, triggers two potential income tax outcomes under §684.[11] If trust assets are not includable in the gross estate of the U.S. grantor, they are deemed sold immediately prior to the U.S. grantor’s death.[12] Following the deemed sale, trust assets receive a basis step-up, for the gain (but not loss).[13]
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.[14] Thus, estate tax exposure eliminates income tax otherwise arising from the deemed sale at death of a U.S. grantor. After trust assets are deemed sold, or subject to U.S. estate tax, the foreign trust is treated as an independent foreign non-grantor trust for federal income tax purposes.
Income Tax and the NRNC 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.[15] Neither §684 nor Code §679 apply to transfers by a NRNC to a foreign trust. Only U.S. source income earned by U.S. based trust assets is taxed by the U.S.[16]
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.[17] As a foreign taxpayer, the foreign trust incurs no capital gains tax unrelated to real estate.
Foreign non-grantor trusts are subject to U.S. income tax only on the following types of income: income effectively connected with a U.S. trade or business;[18] disposition of U.S. real property interests;[19] and fixed or determinable annual or periodic income from U.S. sources (i.e. interest, dividends, rents, annuities, etc.).[20]
U.S. Beneficiaries
Foreign trusts funded by a NRNC avoid U.S. income tax on foreign income and U.S. capital gains (sheltering gifts to U.S. beneficiaries). If a NRNC funds a foreign trust for the benefit of a U.S. person, the trust will be treated as either a foreign grantor trust (deemed owned by the settlor) or a foreign non-grantor trust, for U.S. income tax purposes.
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 IRS cannot reach foreign-source income and U.S. capital gains, as long as the grantor remains a NRNC. Trust income distributed to U.S. beneficiaries may therefore be sheltered from U.S. tax if the foreign trust is classified as grantor for federal income tax purposes.[21] U.S. beneficiaries therefore recognize no tax on distributions, as trust assets of a grantor trust are deemed owned for income tax purposes by the foreign grantor.[22]
NRNCs may establish grantor trust status (for 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.[23]
2. The grantor or the grantor’s spouse is the sole beneficiary of the trust during the life of the grantor[24]
3. The trust was created before Sept.19, 1995 (regarding assets in trust as of such date), if the trust qualifies as a grantor trust, pursuant to §676 or §677.[25]
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.
If the trust is not grantor, it is regarded as an independent taxpayer. U.S. beneficiaries are taxed on distributions, of both U.S. and foreign source trust income. U.S. beneficiaries, however, recognize no income tax until trust distributions (limited to distributable net income) are made.[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 §667.[27] This paradigm ensures that prior year’s foreign trust income does not escape U.S. income tax.
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 a NRNC of foreign situs property and U.S. intangibles, including publicly traded stock, are not subject to U.S. gift tax. Acquiring U.S. tangible assets in a foreign corporation converts U.S. based tangible assets to an intangible entity. The foreign corporation (owner) may be gifted free of gift tax. The strategy avoids gift tax (otherwise applicable to the direct transfer of U.S. tangible assets).
Immigration by NRNC Grantor
NRNC grantors often contemplate a 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.
An NRNC who intends to move to the U.S. raises a number of issues. 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 §684 deemed sale and the Code §679 deemed grantor trust rules).[28] §684 and §679 thus apply to an NRNC grantor who becomes a U.S. resident within five years of funding a foreign trust.[29]
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 U.S. residency. The deemed re-transfer triggers either (i) the deemed sale rules of Code §684 (if the trust has no U.S. beneficiary) or (ii) grantor status under Code §679 (if the foreign trust has a U.S. beneficiary). In the event of grantor status, either (i) deemed sale of trust assets (under Code §684) or (ii) (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 deemed sale of trust assets under IRC §684.
The first strategy is for the foreign grantor to wait five years to establish U.S. domicile. 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.[30] After (five years of 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. Any NRNC trust beneficiaries avoid U.S. tax on distributions of foreign source income.
As NRNCs typically fail to wait five years to obtain U.S. residency, the NRNC must deal with the deemed re-transfer of trust assets to the foreign trust, as of establishing U.S. residency. If the foreign trust has U.S. beneficiaries, IRC §684 does not immediately trigger a deemed sale. Instead, IRC 679(a)(1) makes the foreign trust grantor during the lifetime of the NRNC grantor, who is 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.
The second strategy for the grantor who cannot delay immigration is to domesticate the foreign trust before death of the grantor. In such event, trust assets will avoid the imposition of IRC §684, as the deemed sale rule only applies to foreign trusts. Unlike a foreign trust, the domesticated trust will recognize U.S. income on all its assets, wherever located.
If the income tax exposure to foreign-source earnings is intolerable, the grantor may instead opt to abandon U.S. domicile. Abandonment will preserve the trust’s foreign status and avoid tax on foreign-source income and U.S. capital gains (until distributed to a U.S. beneficiary).
Five-Year (Income Tax) Lookback Does Not Apply to Transfer Taxes
In any case, trust assets avoid U.S. estate and gift tax for assets irrevocably transferred by an NRNC to the foreign trust, outside the net of federal transfer taxes.[31] Deemed sale, grantor status and domestication (income tax issues) do not alter the immigrant’s avoidance of U.S. Estate or Gift tax. Estate tax may be avoided even if the trust requires domestication (to avoid exposure of trust assets to the mark-to-market deemed sale).
Conclusion
NRNCs and foreign trusts pay no U.S. tax on foreign source income or capital gains (unrelated to real estate). With proper planning, a foreign trust may benefit a U.S. family by sheltering foreign-source income and avoiding U.S. estate tax. Offshore NRNC beneficiaries pay no tax on foreign-source trust income and U.S. beneficiaries defer U.S. income tax until trust distributions.
[1] I.R.C. §§641(b), 872(a).
[2] I.R.C. §684(a).
[3] Treas. Reg. §1.684-3(a)
[4] IRC §684(b).
[5] IRC §679(a)(1)
[6] Treas. Reg. §1.679-2(a)(4)(ii)(A).
[7] See Treas. Reg. §1.679-2(c)(2).
[8] Treas. Reg. §§1.684-2(e) (death of grantor); 1.679-2(c)(2) (no U.S. beneficiary for foreign trust).
[9] Treas. Reg. §1.684-3(c)
[10] Treas. Reg. §§1.684-1(b)(3) (as the trust is no longer a foreign trust); 301.7701-7(a) (definition of domestic trust)
[11] IRC §684(c); Treas. Reg. §1.684-3(c)(1); Treas. Reg. §1.684-2(e).
[12] IRC §684(c).
[13] Treas. Reg. §1.684-1(a).
[14] Treas. Reg. §1.684-3(c)
[15] 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%.
[16] Unless IRC §672(f) (grantor status) applies to the trust.
[17] See IRC §872(a).
[18] IRC §871(b).
[19] IRC §897(a).
[20] IRC §871(a).
[21] The strategy is generally explained in the December Florida Bar Journal Article – Foreign Grantor Trust Planning: A Flexible Planning Structure for U.S. Income Tax.
[22] IRC §§671-679.
[23] IRC §672(f)(2)(A)(i).
[24] IRC §672(f)(2)(A)(ii).
[25] Treas. Reg. §§1.672(f)-3(a)(3); 1.672(f)-3(b)(3).
[26] IRC §652; §662.
[27] IRC §652; §662.
[28] IRC §679(a)(4); IRC §684(a) (if there is no U.S. beneficiary of the foreign trust)
[29] See IRC §679(a)(4); Treas. Reg. §1.679-5(a).
[30] 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 brother “B” before moving to the U.S. If B funds a trust for A and his family less than 5 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).
[31] See IRC §2001 and IRC §2501
