Foreign Trusts Pose Headaches for US Transferors and Beneficiaries

Although foreign trusts can provide greater asset protection, they can also create tax problems for US residents, citizens, and entities including corporations and partnerships, according to Jimmy Sexton, Esquire Group’s Jimmy Sexton.

US clients have been using foreign trusts and foundations as a means of protecting their assets for years. With good reason: foreign asset protection trusts can often offer greater asset protection than domestic asset trusts. Many foreign asset protection trust jurisdictions have firewall provisions that do not recognize foreign judgments and are therefore out of the US court’s jurisdiction.

Although foreign trusts can provide better asset protection, they can also create tax problems for US residents and citizens as well as entities like corporations or partnerships that transfer property (US transferors). The reason is that US transferors may be subject to three levels of tax. They can be liable to gift tax on complete gifts to the trust, income taxes on trust assets they own, or capital gains tax on highly appreciated transferred assets.

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Gift Tax

If a US transferor of property transfers it to a foreign trust, gift tax may arise. Most foreign and domestic asset protection trusts are self-settled irrevocable discretionary trusts that have independent trustees. Transfers of property to these trusts are often considered complete gifts and subject to gift taxes. Under Internal Revenue Code Section 2203, a completed gift is one in which the US transferor has lost all rights to the property or the income.

Income Tax

The income tax on the income earned from the transferred property can be continued to be payable by US transferors under Section 679. If the foreign trust is allowed to have US beneficiaries, this will occur. For US income tax purposes, the foreign trust will be treated as a foreign grantor trust and the US grantor (grantor), will continue to be treated the same way.

It is possible for a foreign trust to have beneficiaries in the United States. A trust could be considered to have a beneficiary in the USA, even if their interest is contingent. Foreign trusts that have US beneficiaries, but prohibit them from being allowed to do so would be likely to be considered to have US beneficiaries.

Capital Gains Tax

Capital gains tax can be levied on US transfers if the assets are appreciated under Section 684. Section 684 tax applies when property is transferred from the US to a foreign trust trust, which cannot have beneficiaries in the US, or when the US transferor/grantor ceases to be treated as the owner for income tax purposes. The most common example is the death the US transferor/grantor.

Conclusion

The above tax provisions allow US transferors to be subject to any of the three levels of tax. First, gift tax will apply if the transfer is a complete gift. The US transferor will still be subject to income tax on the income earned from the property transferred if it has US beneficiaries or is allowed to have them. Capital gains tax will be applied to any appreciation of transferred assets upon transfer of property to a foreign trust that does not allow US beneficiaries, or upon the US transferor being no longer treated as the owner for US income tax purposes. This could occur upon the death or cessation US residency, but it can also happen at the time of expatriation.

These tax provisions are extremely important and should not be underestimated. It is possible that more than one can apply simultaneously. For example, if a US transferor gave appreciated property to a foreign trust that had prohibited US beneficiaries, they would be subject to both capital gains and gift tax.

You can also have all three taxes apply to the same transaction. Let’s suppose that a US transferor gives a complete gift to a foreign trust, with US beneficiaries. The US transferor would be subject to gift tax as well as income tax on the income earned from the transferred property. Capital gains tax will be due if the US transferor ceases being treated as the owner the transferred assets. US transferors must also file certain IRS International Information Returns such as Forms 3520 or Forms 3520A.

Proper planning is key to achieving a better tax result. To determine whether a foreign trust is worth the tax consequences, or if a domestic trust might be more suitable for the situation, you must weigh the advantages and disadvantages of each.