Use of an Accommodation Party  By Vernon K. Jacobs, CPA  & J. Richard Duke, J.D., LLM

A foreign trust that does not have any U.S. beneficiaries or is not funded (settled) by a U.S. person is treated as a non-resident alien for U.S. tax purposes. Like a foreign corporation, it can invest in U.S. government securities and certain U.S. bank and S&L accounts on a tax free basis. Any gains on buying or selling U.S. securities are also tax free to a non-resident alien. In addition, any income or gains from investing in any non-U.S. investments would be tax free if the trust were domiciled in a tax haven. Even if some U.S. persons are beneficiaries of the income in the foreign trust, the assets in the trust are not subject to any estate taxes when a beneficiary dies - unless the beneficiary has some kind of measurable interest in the trust. If it is a discretionary income interest, the assets are not subject to U.S. estate taxes. Obviously, a lot of U.S. taxpayers would like to have one of those foreign trusts. On the surface, it's fairly easy to create a foreign trust. Before 1976, it was becoming a very popular thing to do. Since 1976, it seems a lot of U.S. taxpayers have created foreign trusts but have not complied with the U.S. tax laws. So the Congress changed the reporting obligations in 1996 for U.S. grantors and U.S. beneficiaries of a foreign trust. Since 1977, the U.S. tax law has included a section (IRC § 679) that treats a foreign trust with a U.S. grantor and any U.S. beneficiary as a "grantor" trust. What that means is that the settlor who creates and funds the trust is treated as the owner of the assets in the trust and is taxed on any income earned by those assets - as if the trust did not exist. In most respects, it's the same tax treatment as a revocable living trust. With a domestic trust, this tax treatment occurs if the grantor retains some power over the trust assets or retains a right to recover some of the income or principal in the trust. But with a foreign trust, you could create an irrevocable trust in which you retain absolutely no powers of any kind and you are still subject to income tax on the income of the trust. We're not saying that's fair. It's just part of the law that makes it difficult for U.S. investors to save taxes with a foreign trust. The U.S. congress does not want U.S. taxpayers to quit paying taxes on their investment income just because they put the assets into a foreign trust. Because of the rule that the foreign trust must have a U.S. grantor or a U.S. beneficiary, many seemingly clever people have tried to find ways to create a foreign trust through nominees, agents, foreign corporations or other deceptive arrangements. Most of these arrangements fail because the U.S. tax law looks through these intermediate parties to the person who has the real influence. In the case of a foreign trust, if you are the person with the money, the IRS will treat you as the trust grantor no matter how many intermediate entities you interject in the arrangement. For example, one popular arrangement is to have a foreign person create a foreign corporation (IBC) and to then have the corporation form a foreign trust. Since the corporation is a non-resident alien, the promoter argues that the trust does not have a U.S. grantor. That won't fly with the IRS or the U.S. tax courts. In the first place, the corporation is a mere agent, alter ego or nominee for the U.S. taxpayer. In that case, the corporation would be ignored and the taxpayer would be found to be the grantor of a foreign trust. Or, the trust may be treated by the IRS as an agent of the foreign corporation and the U.S. grantor would be treated as the sole shareholder of a controlled foreign corporation that is a Passive Foreign Investment Company and a Foreign Personal Holding Company. No matter how you cut it, the income belongs on the tax return of the U.S. person who put up the cash or whatever assets were used to fund the trust. There are many variations on the ways in which promoters or consultants try to help you to bypass the rules relating to a foreign trust. One way is to claim that there are no U.S. beneficiaries during your lifetime. While it is possible to do this, it is not also possible to make any distributions to any U.S. person during your lifetime or the lifetime of your spouse -- or for a full year thereafter . Another arrangement that strikes us as rather ghoulish is to pretend that the taxpayer's parents are the grantor's of the trust. Assuming the parents aren't well to do, they are given the funds to create the trust, but not enough to create any gift tax problems. Then, the taxpayer basically waits until the parent dies, at which time there is an ostensible foreign trust without a U.S. grantor. At that point, the taxpayer engages in a variety of financial transactions with the trust that is intended to transfer profits or equity into the trust and out of the U.S. tax system. We believe the IRS will take the position that the taxpayer is the real grantor of the foreign trust and that the parent of the taxpayer is merely an accommodation party. Special Rules for Treating a Foreign Person as Owner.    A foreign person is not treated as the owner of a foreign trust for tax purposes,  subject to three exceptions:  (i) the foreign trust includes an absolute power to the foreign grantor to revest title of the trust assets in himself.  This power may be exercised solely by the grantor without the approval or consent of any other person or with the consent of a related or subordinate party, subservient to the grantor  (such a trust is revocable to the foreign grantor meaning that the foreign grantor may terminate the trust or leave the assets at his death to his desired beneficiaries); (ii) the foreign trust specifically states that distributions can only be made to the grantor or the grantor's spouse; or (iii) a trust making distributions that are taxable and reported by a U.S. person as compensation for services rendered.  If the requirements of one of the three exceptions are not met, the U.S. tax law finds some U.S. person or persons to tax or treats the trust as a foreign non-grantor trust subject to the accumulation distribution rules,  and subjects distributions to an interest charge.   An Accomodation Party is Not a Grantor.  If a person creates or funds a trust for another, both persons are treated as grantors for income tax purposes.   However, a person who creates a trust but makes no gratuitous transfer to the trust is not treated as the owner of any portion of the trust under I.R.C. §§ 671-677 or 679.   In addition, a person who funds a trust with an amount that is directly repaid to such person within a reasonable period of time, and makes no other transfers to the trust that constitute gratuitous transfers, is not treated as owner of any portion of the trust for income tax purposes under I.R.C. §§ 671-677 or 679. An accomodation party who creates or funds a trust for another is not treated as a grantor.   Thus, if a foreign person creates a trust for the benefit of a U.S. person, the U.S. person is treated as the grantor, not the foreign person. Vernon Jacobs & Richard Duke Co-authors of The Offshore Tax Seminar Manual Reprinted in part from The Offshore Tax Seminar Manual Copyright, 2002, All rights reserved. http://www.offshorepress.com/offshoretaxmanual.htm 1   This is an issue in which the IRS is taking a position that we believe is inconsistent with the law. 2  I.R.C. § 672(f)(1).  Also, a grantor does not include a foreign person who is acting as an accommodation party for another person.  Treas. Reg. § 1.671-2(e)(3). 3  I.R.C. § 672(f)(2). 4  I.R.C. §§ 665-667. 5   I.R.C. § 668. 6  Treas. Reg. § 1.671-2(e)(6), Example 6. 7   Treas. Reg. § 1.671-2(e)(1). 8  Id. 9   Treas. Reg. § 1.671-2(e)(3). 10  Treas. Reg. § 1.671-2(e)(5), Example 3.

About the authors: Vernon Jacobs is a CPA who provides tax accounting and consulting services for clients with international interests. He edits and publishes the online International Wealth Protection Reports ..  J. Richard Duke , JD, LLM is an attorney who specializes in international tax law and is an Adjunct J. Richard Duke is a Professor of international tax law. and a practicing attorney in the international specialty.  He is a Consulting Editor for the online International Wealth Protection Reports Sponsored by Offshore Press, Inc .., Copyright, 2002, all rights reserved. Offshore Press, Inc., Box 8194, Prairie Village, KS 66208. Phone (913) 362-9667. Email to Offshore Press   Vernon K. Jacobs, Webauthor . .