Estate Tax Planning for Cross-Border Families and Foreign Nationals

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Multi-national families have numerous issues associated with Nonresident Alien Parents who are considering transferring their wealth to their U.S.-resident children. The Nonresident Alien Parents’ goal is to pass the assets to the children when the surviving parent dies, and ensure that successive wealth transfers to future generations are made without U.S. estate tax, or generation-skipping transfer tax while minimizing U.S. income tax on investment income.

Residence of a Trust

A trust will be considered domestic if:

(i) a U.S. court can exercise primary supervision over trust administration (the “Court Test”), and

(ii) U.S. persons control all substantial trust decisions (the “Control Test”).

All other trusts are foreign. (Treas. Reg. §§ 7701(a)(30)(E) & 7701(a)(31)). These trust residency definitions are effective for taxable trust years beginning after December 31, 1996.

The regulations contain a “safe harbor” test under which a trust is considered to meet the Court Test if:

(i) the trust deed does not direct that the trust be administered outside the United States;

(ii) the trust is, in fact, administered exclusively in the United States; and

(iii) the trust is not subject to an automatic “flee clause” pursuant to which the trust migrates from the United States in the event that a U.S. court attempts to assert jurisdiction over the trust’s administration.

The Control Test will be considered to be satisfied if U.S. persons control all substantial decisions affecting the trust and no foreign person acting in any capacity can overcome the decisions of the controlling U.S. persons.

A Foreign Grantor Trust

The Nonresident Alien Parents could create a revocable trust, with the provisions to them for their lifetime with the remainder to their US children. This trust is fully revocable, until the surviving parent dies.

As a “Grantor Trust” the Nonresident Alien Parents are treated as the owners of the trust assets. This is achieved by satisfying the requirements of IRC §672(f). The simplest way is to make the trust fully revocable by the Nonresident Alien Parents (IRC §672(f)(2)(A)).

The Nonresident Alien Parents’ have no exposure to U.S. income or estate tax, unless they hold U.S. assets in the trust.

Alternatively, the same structure could also be used to avoid solely US Gift and Estate Taxes by having the trust own a foreign corporation, which in turn owns U.S. stocks and bonds, U.S. real estate or other U.S. situs assets; however the US situs assets would be subject to US income tax on income produced from these investments.

Upon Death of Nonresident Alien Parents – Foreign Trust Becomes a Non-Grantor Trust

The trust is designed to continue as revocable until after both parents have died. After the death of the last parent to die, the beneficiaries are the U.S-resident children and grandchildren. At that point for US tax purposes it will be considered as a “Foreign Non-Grantor Trust,” because it is a foreign trust which is managed outside the United States (IRC §7710(a)(30)(E)).

For U.S. income tax purposes, a foreign Non-Grantor trust is only subject to US tax on its US source income and foreign source income is not subject to US tax. However, foreign source income will be subject to tax when the U.S. beneficiary receives a distribution of trust income. For estate tax purposes, the trust assets will receive a step-up in basis to fair market value calculated at the time of the surviving parent’s death.

The Throwback Rule

The tax-free accumulation of foreign source income inside a this Foreign Non-Grantor Trust, is subject to the “Throwback Tax” (IRC Sec. 667). Throwback Rules apply when a foreign trust makes an “accumulation distribution” to a United States beneficiary and that trust has “undistributed net income” from one or more of its preceding taxable years.

IRC Section 665(b) defines an “accumulation distribution” as any distribution of “any other amounts properly paid or credited or required to be distributed” to the beneficiary, to the extent that it exceeds both the trust’s distributable net income for that year (reduced by any amount required to be distributed currently) and the trust’s net accounting income for the year.

All Distributions of “Accumulated Income” are taxed at:

• Ordinary Income Rates and

• Subject to an Interest Charge for Failing to Pay Tax in Prior Years.

There is no way to efficiently accumulate income for future generations of U.S. resident beneficiaries with a Foreign Grantor Trust.

Throwback Rule – Planning

One solution to the throwback rule is to eliminate the Foreign Non-Grantor Trust, as soon as possible, by domesticating it. The throwback rules only apply to Foreign Trusts. This can be achieved by:

1. Transfering all of the administrative powers to a U.S.‑resident trustee and bring the trust within the reach of U.S. courts, which satisfies the requirements of the “Court Test.”

2. Alternatively, the assets contained in the Foreign Non-Grantor trust can be distributed to a new domestic trust with similar distribution provisions.

You now have a domestic irrevocable trust, also known as a dynasty trust, that is funded with assets carrying step-up basis as of the date of death of the surviving parent.

A second solution to the throwback rules involves electing to have the Non-Grantor Trust treated as part of the Nonresident Alien Parents’ estate. If both the executor (if any) of an estate and the trustee of a qualified revocable trust elect the treatment provided in IRC §645, such trust shall be treated and taxed as part of such estate (and not as a separate trust) for all taxable years of the estate ending after the date of the decedent’s death and two years after surviving spouse’s death.

Non-US source income and capital gains realized by the electing trust and distributed to the US Beneficiary can be received by the US Beneficiary entirely tax-free. Furthermore, the Us Beneficiary is considered to receive “corpus” of the estate of the decedent, rather than DNI.

These are just a few general alternatives for Estate Tax Planning for Cross-Border Families and Foreign Nationals. Your actual Estate Tax Planning for Cross-Border Families needs to be customized to address your particular family situation.

In accordance with Circular 230 Disclosure

Mr. Marini concentrates his practice in Representation before the IRS and All Other Tax Authorities, IRS Collections, Offers in Compromise, Installment Payment Plans, Appeals, Sales Tax Audits, International and Tax Law, Asset Protection and Estate Planning.

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