Explaining a Foreign Trust In Easy-to-Understand Language
In this global economy, it’s becoming increasingly common for U.S. citizens and residents to have financial ties overseas. These financial ties often come in the form of foreign bank accounts, real estate holdings, and trusts.
Foreign trusts in particular are subject to special rules under the Internal Revenue Code (“IRC”). However, understanding what constitutes a foreign trust and its treatment under the IRC can be difficult even for the most seasoned lawyer.
What Is A Trust?
The Internal Revenue Service (“IRS”) defines a trust as “an arrangement created either by a will or by an inter vivos declaration [in other words, a declaration during the life of the person setting up a trust] whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts.”[1]
In the United States, trusts are formed under state law. Thus, the law of the particular state in which the trust has been or will be formed must be consulted for any particulars regarding trust formation and administration. However, below are some general definitions that may prove helpful in the discussion that follows:
- “Settlor” or “Grantor”: The “settlor” or “grantor” is the person who creates a trust;[2]
- “Trustee”: The “trustee” is the person who holds title to the property in the trust;[3]
“Beneficiary”: The “beneficiary” is the person for whose benefit the trustee holds the property in the trust.[4]
Is A Trust Domestic Or Foreign?
The IRC defines a foreign trust as any trust that is not domestic.[5] A trust is domestic if it meets the Court Test and the Control Test:
- The Court Test: A trust meets the Court Test if “a court within the United States is able to exercise primary supervision over the administration of the trust.”[6] A court has “primary supervision” if it “has or would have the authority to determine substantially all issues regarding the administration of the entire trust.”[7] Treasury Regulations provide a safe harbor for passing the court test if the trust instrument do not require it to be administered outside the U.S and the trust must in fact be administered exclusively in the United States.[8] A trust generally will not pass the court test if the trust instrument contains to an automatic migration provision that would cause the trust to migrate from the United States upon a United States court’s attempt to assert jurisdiction over the trust’s administration.[9]
- The Control Test: A trust meets the Control Test if one or more U.S. persons have authority to control substantial decisions of the trust without any other person having the right to veto any decisions.[10] A “U.S. person” means a U.S. citizen or resident, domestic partnership, domestic corporation, domestic estate, or domestic trust.[11]Substantial decisions include income distribution from the trust, termination of the trust and whether to add or remove a trustee.[12]
As can be seen, the determination of whether a trust is domestic or foreign is nuanced and usually decided on a case-by-case basis based on the trust instrument and applicable law.[13]
Grantor Versus Non-Grantor Foreign Trusts
Once a trust is determined to be foreign, it is also important to figure out whether it’s a grantor or non-grantor trust under the IRC.
- Grantor Trust: A grantor trust generally is: 1) a trust in which the grantor maintains one or more incidents of ownership over the property that the grantor transferred to the trust; 2) a trust in which some other person has the power to vest that property or the income from that property in themselves; or 3) foreign trust to which a U.S. grantor has directly or indirectly transferred property if that trust has a U.S. beneficiary during the taxable year.[14] Conversely, the grantor or person with power to vest property or income of a grantor trust in themselves is generally treated as the owner and therefore taxed on the income of the trust.[15]
- Non-Grantor Trust: A non-grantor trust is any trust that is not a grantor trust and is taxed on any income generated by the property held by the trust.[16] Non-grantor trusts are generally taxed in the same way as individuals, with a foreign non-grantor trust being treated in the same way as a nonresident alien individual who is not present in the United States within the taxable year.[17] Thus, domestic non-grantor trusts generally are taxed on worldwide income.[18] Foreign non-grantor trusts are taxed only taxed on U.S. source income and income that is effectively connected with the conduct of a U.S. trade or business.[19] If the non-grantor trust is or becomes foreign, then a U.S. grantor’s transfer of property to the trust could result in immediate taxation to the grantor.[20]
What Are The IRS Requirements For Reporting Foreign Trusts?
The IRS imposes various reporting requirements for foreign trusts. U.S. persons who create a foreign trust, or have involvement with a foreign trust such as certain beneficiaries, are required to report foreign trust information on a IRS form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts.[21] Foreign trusts treated as owned by U.S. persons under the grantor trust rules set out above also must file a Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner. Failure to comply with the reporting requirements for foreign trusts can result in significant penalties.[22]
Need Answers To Foreign Trust Questions?
Freeman Law is a world-renowned law firm specializing in complex tax planning and litigation. The firm represents clients of all sizes, from Fortune 100 fastest-growing companies to family-owned businesses, to individuals with estate planning questions. Freeman Law can help answer all your foreign trust questions in a language you can understand. Leave the detailed foreign trust research to the legal and tax professionals at Freeman Law.
[1] Treas. Reg. § 301.7701-4(a).
[2] Restatement (Third) of Trusts § 3(1), Comment a. (2003).
[3] Restatement (Third) of Trusts § 3(3), Comment c. (2003).
[4] Restatement (Third) of Trusts § 3(4), Comment d. (2003).
[6] Id. § 7701(a)(30)(E)(i); Treas. Reg. § 301.7701-7(a)(1)(i).
[7] Treas. Reg. § 301.7701-7(c)(3)(iv).
[8] Id. § 301.7701-7(c).
[9] Id. § 301.7701-7(c)(4)(ii).
[10] I.R.C. § 7701(a)(30)(E)(ii); Treas. Reg. § 301.7701-7(a)(1)(ii).
[11] I.R.C. § 7701(a)(30); Treas. Reg. § 301.7701-7(d)(1)(i).
[12] Treas. Reg. § 301.7701-7(d)(1)(ii).
[13] Treas. Reg. § 301.7701-7(b).
[16] Id. § 671(a).
[19] See I.R.C. §§ 871, 881, 882.
[21] See id. § 6048; Notice 97-34.
[22] See id. § 6677.
Have a question? Contact Jason Freeman, Freeman Law, Texas.
