Foreign Trust Tax Rules By Vernon K. Jacobs, CPA  & J. Richard Duke, J.D., LLM

It used to be legal for U.S. citizens and residents to defer taxes with a foreign trust, if it was an irrevocable trust and if the trust settlor/grantor retained no powers over the disposition of the trust assets. In 1976, the rules were changed. Now, because of U.S. Internal Revenue Code Section 679, U.S. persons who form (settle) a foreign trust that has any U.S. beneficiary are treated as the owner of the assets in the trust for income tax purposes. These trusts are now described as 'tax neutral' and are used for asset protection from future litigation rather than for tax avoidance. Many of the promoters of phony foreign trust arrangements are showing their prospective customers outdated laws, regulations or court cases.

For non-U.S. persons in many countries, it is still legal to avoid domestic income taxes and estate taxes (or forced heirship) with the use of a foreign trust. If that foreign trust is located in a low tax jurisdiction (tax haven), the income earned by the trust assets are treated as the income of the trust rather than of the trust settlor and/or beneficiaries.

There is still one tax advantage to a U.S. person in creating a foreign trust through their will. After the death of a U.S. grantor, a foreign trust ceases to be subject to U.S. income taxes until the funds are distributed to a U.S. person. And, if the trust is established in a country without a statute of limitations, it can be used as a  perpetual  (dynasty) trust that accumulates and distributes assets to multiple generations. Such a trust can be funded by testamentary disposition or if it is created while the grantor is living, it will cease to be a grantor trust following the grantor's death.

Until some very recent regulations issued by the IRS, most tax professionals believed that it was possible to create a foreign trust so that it would have no U.S. beneficiaries during the lifetime of the grantor and hence it would not be subject to the income tax treatment of IRC section 679. By creating an irrevocable foreign trust with no U.S. beneficciary during the lifetime of the grantor (or the grantor's spouse), any income accumulated in the trust during the lifeime of the grantor or spouse would not be subject to tax by the U.S. grantor. Nor would the trust assets be included in the estate of the trust grantor or spouse. However, regulations issued by the IRS in September, 2000 indicate that this kind of trust can't ever have any U.S. beneficiary -- even after the death of the U.S. grantor and spouse.

Prior to the U.S. Small Business Job Protection Act of 1996, it was possible for foreign persons who were migrating to the U.S. to establish a trust in a country outside the U.S. and to avoid the U.S. grantor trust rules. Now, for trusts settled after February 6, 1995, the grantor of a foreign trust will be deemed to have formed the trust on the date he or she becomes a U.S. resident - unless the trust was formed at least five years before the residency starting date.

Prior to the 1996 law, a trust was deemed to be a domestic trust or a foreign trust based on the preponderance of facts relating to the administration of the trust, the jurisdiction to which the trust would seek judicial recourse, the residence of the trustee and other related facts. Now, a straight-forward two part test is used to determine if a trust is a U.S. domestic trust or a foreign trust. A trust is deemed to be a domestic trust if

1. a U.S. court can exercise primary jurisdiction over  the administration of the trust, and if
2. one or more U.S. persons have the authority to control all substantial decisions of the trust.

Form 3520 must be filed with the income tax return of the grantor of a foreign trust for each year and Form 3520-A must be filed with the grantor's tax return each year thereafter.

Any U.S. beneficiary of a foreign trust must file a form 3520 with his or her tax return in any year in which the beneficiary receives a distribution of any kind.

Any distribution from a foreign trust to a U.S. beneficiary may be treated as taxable income unless the required reports are filed and substantiate that the distributions are not income to the beneficiary.

The penalties for failing to file the reports are severe.

Beneficiaries and grantors of a foreign trust are deemed to be the shareholders of any corporations in which the trust is a shareholder or to be the partners of any partnership in which the trust is a partner.

If the foreign trust is a 10% or greater shareholder of a controlled foreign corporation, the U.S. grantor is deemed to be the beneficial shareholder and must file the Form 5471 for shareholders of a controlled foreign corporation or foreign personal holding companies.

If the foreign trust is an investor in a foreign investment company, unit trust or mutual fund, the grantor of the trust is deemed to be a shareholder of a passive foreign investment company and must file Form 8621 with his or her tax return.
 

About the authors: Vernon Jacobs is a CPA who provides tax accounting and consulting services for clients with international interests.   J. Richard Duke, JD, LLM is an attorney who specializes in international tax law and is an Adjunct Professor of international tax law. Sponsored by Offshore Press, Inc. Copyright, 2006, All rights reserved. Offshore Press, Inc., Box 8194, Prairie Village, KS 66208. (913) 362-9667. Email to Offshore Press  Vernon K. Jacobs, Webauthor.