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Trusts are often used by successful families to provide long-term succession planning and centralized asset management. However, U.S. tax regulations can adversely affect U.S. residents, green card holders, and income tax residents who may or may benefit from income and capital gains in non-U.S. Trusts (and their underlying holding companies). However, non-US American patriarchs and matriarchs with US family members can significantly improve the position of their US family members by setting up a so-called “Foreign Grantor Trust” (hereinafter “FGT”).
Advantages of an FGT
A properly structured and managed FGT provides extremely affordable US tax treatment for US family members, including:
- No annual tax or reporting on trust income or gains (unless derived from US sources) during the lifetime of the trustor;
- No annual taxation or reporting on investments classified as Passive Foreign Investment Corporations (“PFICs”) and / or companies that may otherwise be classified as Controlled Foreign Companies (“CFC”) during the life of the settlor;
- Tax-free distributions to US family members during the settler’s lifetime (although the recipient is required to provide information); and
- Eliminate future US gift and inheritance taxes on trust assets (provided US situation assets, if any, are held through a non-US holding company that is classified as a corporation for US tax purposes).
Disadvantages of direct gifts and non-funders overseas trusts
These benefits are particularly attractive when compared to transferring assets directly to U.S. family members or currently transferring assets to a trust that does not qualify for FGT status. Assets currently transferred to:
- U.S. family members would be taxed on future income and gains from those assets and would be subject to the U.S. gift and inheritance tax system, which currently includes a 40% tax on the assets of any future gifts or bequests of U.S. family members.
- Any non-US trust that does not qualify for Foreign Grantor Trust status would be classified as a Foreign Non-Grantor Trust and would generally be US family members subject to taxation on current annual income and profits as well Subject to adverse tax rates and compounding of interest expense on trust income and gains that were not distributed in the year and could result in ongoing taxes and / or reporting obligations for US family members on any PFIC or CFC assets held by the trust .
Trust structuring for further US considerations
While in many cases it should be relatively easy to structure a trust to qualify for FGT status, there are a number of related, but additional, trust design and structure considerations that need to be addressed:
- If US family members are granted certain powers or rights under the trust, they could be subject to US income, gift, or inheritance taxes either while the settlor was alive or after the settlor’s death.
- Generally, if the trust directly holds U.S. Situus assets, those assets are subject to U.S. inheritance tax on the settler’s death (and gift tax if transferred to family members during the settler’s lifetime).
- Generally, if the settlor owns US situus assets and transfers those assets to the trust, US inheritance tax would be levied on the trust after the settlor’s death, even if those assets were sold long ago and the trust neither directly nor was it indirectly owned by US Situus assets at the time of the settler’s death.
- Such a burden of inheritance and gift taxes can generally be avoided by using a non-US holding company to own US assets.
- In most cases it will be desirable to structure the FGT so that assets held directly by the trust are automatically “base boosted” to current market value upon the death of the trustor. Any subsequent sale of these directly held assets will reduce the amount of profits realized by the trust, thereby reducing the tax liability on distributions to U.S. family members.
After the settler’s death
After the settlor’s death, the FGT is automatically converted to the status of a “foreign non-grantor trust” (hereinafter “FNGT”). Aside from other considerations about trust assets classified as PFIC or CFC, in general terms,
- Income and profits distributed to US family members in the year would generally be taxed as if those amounts had accrued directly to those persons; and
- Income and profits that are realized but not distributed to US family members until a later year are then generally subject to taxation under the so-called “throwback” rules as “undistributed net income” (“UNI”), these amounts being im Interest rates, even if they were originally capital gains, are generally taxable on ordinary income and are generally subject to an additional interest charge that is compounded over the period in which these amounts have been accrued in the trust.
Rather than owning fixed assets directly, non-US trusts often choose to hire a non-US holding company to own such assets. In addition, as noted above, it is generally the case with U.S. location assets that those assets should be held through a non-U.S. Holding company in order to eliminate the U.S. inheritance tax burden that would otherwise apply to that U.S. location asset Assets would apply. However, using a holding company can create income and profit tax complications for beneficiaries of U.S. family members in view of the settler’s death.
If more than half of the holding company’s ownership is attributed to US family members by the trust, then depending on general facts and circumstances at the time of the settlor’s death, that holding company would generally be classified as a CFC, creating US taxes and reporting Trade-offs for US family members in relation to income and profits accruing within the holding company after the settler’s death.
Before 2018 it was generally the case that (after the death of the settlor) the current CFC tax burdens of the US family members could be eliminated by a so-called “check the box” option to classify the holding company as liquidated / not for the USA treats tax purposes in a manner that does not create a CFC tax burden for the beneficiaries of the US family members, while at the same time protecting US situus assets held by the holding company from US inheritance tax burdens related to the death of the settlor will.
Under current law, however, such a check-the-box option could itself generate a CFC tax for the US family members (generally based on the amount of built-in gains in the holding company’s assets and the timing of the year). on which the settlers passed). So, if the holding company owns a mix of US and non-US Situs assets, the tax cost of protecting US Situus assets from inheritance tax will generally become a one-time CFC tax charge for the without additional planning US family members after the settlers pass by.
In general, in cases where the holding company does not own US Situus Assets, it should be possible to select the box so that there is no CFC tax burden on the US family members.
Assuming that it is not possible to eliminate US Situus assets, several strategies can be considered, each of which would improve the position in different ways, including:
- selling and buying back assets annually to “add” to the holding company’s base of those assets;
- Isolation of US situation assets in a separate non-US holding company (which holding company itself does not own any non-US situation assets); and
- Creation of certain types of multi-tier holding structures to enable check-the-box elections to be conducted in a manner that should by itself enable most, but not necessarily all, of capital gains not to be taxable under CFC rules.
If the trust has a material interest (directly or indirectly) in “trading” or “operating companies”, additional CFC considerations may apply.
Depending on the general facts and circumstances after the settlor’s death, if the trust holds PFICs (directly, or through, or with respect to holding companies), the beneficiaries of U.S. family members on the disposal of those PFICs may be subject to tax and compound interest or may collect such PFICs themselves Distributions before (possibly even if such amounts are not currently distributed even to the beneficiaries of U.S. family members). Generally speaking:
- Holding companies through which trusts indirectly own investments can themselves be classified as PFICs. For example, a fixed asset holding company that is not classified as a CFC may be classified as a PFIC.
- most non-US collective investment schemes such as non-US mutual funds, non-US ETFs, non-US hedge funds, and certain non-US private equity funds are classified as PFICs.
How best to deal with PFICs will depend on a number of factors, including the mix and needs of U.S. and non-U.S. Family members, whether the trust has been structured to qualify for a base upgrade as the PFICs hold (e.g. holding company, it also owned US Situs Asses) and how the check-box planning in connection with the death of the settler is implemented.
We would be happy to discuss with you how a “Foreign Grantor Trust” structure can best be tailored to the particular circumstances of individual families.
The content of this article is intended to provide general guidance on the subject. Expert advice should be sought regarding your specific circumstances.
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