The Use of Offshore Trusts

This is an area requiring great care and planning if there is a United States grantor or any possible US beneficiaries. Prior to certain US tax law changes, a US person was able to establish a trust in a foreign, tax-neutral jurisdiction that could generally accumulate income and capital gains without paying tax at the trust level. These would ultimately be taxed only at the time of distribution to US persons. The value of tax deferral and the time value of money was very significant. Imagine no tax being paid for twenty or thirty years while the assets in the trust continued to grow and grow. Comparable tax deferral was not available with the use of US trusts, since a US trust is itself, a separate taxpaying entity. The law was thus changed to make the use of foreign trusts created by US grantors with a US beneficiary (or even the possibility of a US beneficiary) highly inadvisable.

A US grantor who establishes a foreign trust with a US beneficiary will himself generally be taxed directly on the trust’s income (including capital gains) even if the trust makes no distributions to anyone! It is very important to note that when a foreign trust is funded by a US person, the trust will automatically be treated as having a US beneficiary unless the trust document specifically prohibits all US persons, including the US grantor, from benefiting from the trust at any point in time. Without this critical language in the trust instrument, a foreign trust created by a US person will be taxed as discussed, that is, the US grantor will pay tax each year on all the income earned by the trust regardless of whether or to whom, trust distributions were made.

Foreign Trusts

Sometimes a foreign trust will be created by a non-US grantor and will have a US beneficiary. Since the grantor is not a US person, the rule above will not apply. In this situation, far more complicated rules come into play. Depending on the precise facts, various tax scenarios can result from application of these highly complex rules. Some scenarios can be very tax advantageous. Others can be a complete disaster. Professional advice from a qualified US taxation attorney or accountant should always be sought.

If you enjoy spending a lot of time filing US tax forms and disclosing your financial activities to the US tax authorities then you will be very happy that such detailed information reporting and disclosure requirements are firmly mandated for offshore trust structures. Civil and criminal sanctions can apply for a failure to properly report to the IRS about an offshore trust. The various players all may have filing obligations. For example, the trust grantor, the trustee, and the trust beneficiaries. Ignorance is generally not a defense.

Foreign Trusts – US Tax and Information Filings

Some of the more relevant filing requirements are outlined below:

1. IRS Form 1040: Schedule B, Part III A US person must complete this section of the individual tax return if he was a grantor of, or transferor to, a foreign trust. Those US persons receiving distributions from a foreign trust must also complete this section.

2. IRS Form 3520: U.S. Informational Return – Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts. US persons use this Form (for, among other things) to report certain transactions with foreign trusts, including those who receive any distributions from a foreign trust during the year.

3. IRS Form 3520-A Annual Information Return of Foreign Trust with a US Owner. A foreign trust having a US owner is required to annually file Form 3520-A.

4. IRS Form 709: Gift Tax Return. In some cases, Gift Tax can apply upon the transfer of assets to the trust.

5. TDF 90-22.1: Report of Foreign Bank and Financial Accounts (Commonly called “FBAR”) The following US persons must file this report annually: persons with a financial interest in bank, securities or other financial accounts in a foreign country which is in excess of $10,000 in the aggregate, and those with signature authority in such accounts. If a US person is treated as the tax owner of the foreign trust which has offshore accounts, the US person may have to file this form. A US beneficiary of a foreign trust who has a beneficial interest in more than 50%of the assets or income of a trust that owns foreign financial accounts must also file the FBAR.

In accordance with Circular 230 Disclosure