Chartered Wealth Manager
Course Presentation
TAX COMPLIANCE AND REPORTING FOR OFFSHORE TRUSTS
January 27-29, 2006
Ashford Suites, High Point, NC
by
J. Richard Duke, Esq.
Attorney and Professor of Law
Duke Law Firm, P.C.
400 Vestavia Parkway, Suite 100
Birmingham, AL35216-3750
Telephone: (205) 823-3900
Fax: (205) 823-2630
E-mail:
Web site:
St. ThomasUniversitySchool of Law:
Copyright J. Richard Duke (2004).
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TABLE OF CONTENTS
I.General Classifications of Offshore Trusts
A.In General
B.Foreign Grantor Trust (Asset Protection Trust)
C.Foreign Nongrantor Trust
1.Foreign Non-Grantor Trust at Death of U.S. Settlor
2.Can a U.S. Settlor Form a Foreign Non-Grantor Trust?
3.Foreign Non-Grantor Trust Created by a Non-U.S. Person
4.Foreign Irrevocable Trust Created by a Non-U.S. Person
II.Foreign vs. Domestic Trusts
A.In General
B.Classification of a Trust as Domestic or Foreign
1.Court Test
2.Control Test
C.Domestication of Foreign Trusts
D.Questions under Court Test
E.Automatic Migration Provision
F.Jurisdiction of a U.S. Court
G.Mechanism to Remove Control by U.S. Persons
H.Reaction of Courts
I.Respecting the Impossibility Defense
J.Attempts to Control Trusts by a Settlor–i.e., "Game Playing."
K.Arguing That the Protection of the Trust is Destroyed
L.Including Controlling U.S. Persons as Defendants
M.Failed Domestication
N.Conclusion
III.Taxation of the Grantor of a Foreign Trust
A.Treating the Grantor as Owner
1.Reversionary Interests
2.Power to Control Beneficial Enjoyment
3.Administrative Powers
4.Power to Revoke
5.Income for Benefit of a Grantor
6.Foreign Trust Having a U.S. Beneficiary
7.U.S. Transferor
8.U.S. Person
9.Property
10.Person Other Than Grantor Treated as Substantial Owner
B.Grantor Defined
1.Gratuitous Transfer
2.Nongratuitous Transfer
C.An Accommodation Party is not the Grantor Subject to Taxation
D.Person with Power to Withdraw From Trust Settled by Another Person is Not a Grantor
E.Foreign Trust Having One or More U.S. Beneficiaries
1.The Foreign "Grantor" Trust
2.Direct or Indirect Transfer
3.Guarantee on a Loan for the Trust
4.Satisfaction of an Obligation of a Foreign Trust
5.Transfer to an Entity Owned by the Trustee of the Foreign Trust
6.Domestic Trust Becoming a Foreign Trust
7.Definition of U.S. Beneficiary
Beneficiary Further Defined by Treas. Regs.
9.Attribution of Ownership from Controlled Foreign Corporations, Foreign Partnerships
IV.Taxation of Foreign and Domestic Trusts
A.Simple Trust
B.Complex Trust
C.Income
D.Accounting Income
V.Taxation of Foreign Non-Grantor Trusts
A.Distribution Deduction
B.The Concept of Distributable Net Income
C.Distributable Net Income of a Foreign Non-Grantor Trust
D.Treatment of Capital Gains
E.Treatment of Beneficiaries With Respect to Distributable Net Income
F.Distributable Net Income of Complex Trust Exceeding Income Required to Be Distributed
VI.Tax Return Compliance With Respect to a Foreign "Grantor" Trust.
A.Events Requiring Filing
B.Form 3520–Creating or Funding an Offshore Trust
1.Reportable Events
2.Nonreportable Events–Nongratuitous Transfer
3.Responsible Party
C.Form 3520-A–Reporting by U.S. Owner for Trust Operations
1.Information Statements to Owner and Beneficiaries
2.More Than One Owner
3.Limited Agent for Service of Process
D.Miscellaneous Tax Returns With Respect to Foreign "Grantor" Trust
1.SS-4 (Application for Federal Tax Identification Number)
2.Form 56–Notice Concerning Fiduciary Relationship
3.Form 709, U.S. Gift (and Generation-Skipping Transfer) Tax Return
4.Form 1040, Schedule B, Part III
5.TD F 90-22.1–Report of Foreign Bank and Financial Accounts
(a)Financial Interest as Owner or Record of Legal Title
(b)Financial Interest Through Nominee Entity or Trust
(c)Signature or Other Authority
6.FinCEN Form 104
7.FinCEN Form 105
8.Withholding Forms
VII.Tax Return Compliance With Respect to a Foreign "Nongrantor" Trust
A.Events Requiring Filing
B.Form 3520–Creating or Funding a Foreign Nongrantor Trust
1.Reportable Events
(a)Creating Foreign Trust
(b)Gratuitous Transfer
2.Responsible Party
3.Reporting Gain on Transfer of Appreciated Assets
C.Miscellaneous Tax Returns With Respect to Foreign "Nongrantor" Trust
1.Form 56–Notice Concerning Fiduciary Relationship
2.Form 709, U.S. Gift (and Generation-Skipping Transfer) Tax Return
3.Form 1040–Schedule B, Part III
4.TD F 90-22.1–Report of Foreign Bank and Financial Accounts–Apparently Not Required
VIII.Tax Consequences of Transferring Appreciated Property to a Foreign Trust
A.During Lifetime–Gain Not Recognized on Transfer to Foreign Grantor Trust
B.During Lifetime–Gain Recognized on Transfers to Foreign Nongrantor Trust
C.Tax Treatment at Death of the Grantor of a Foreign Grantor Trust
D.Migration of a Domestic Trust to a Foreign Trust
1.Migration of Domestic Grantor Trust During Grantor's Lifetime
2.Migration of Domestic Grantor Trust Upon Death of Grantor
E.Avoiding Gain Recognition
1.Foreign Nongrantor Trust
2.Foreign Grantor Trust With Assets Excluded for Estate Tax Purposes
3.Treating a Person Other Than Settlor as the Owner for Income Tax Purposes
4.Use of Foreign Limited Partnerships or Foreign Limited Liability Companies
F.Inadvertent Migrations
G.Filing Requirement for Migrations
IX.Reporting Requirements for U.S. Beneficiaries
A.Attached Statements
B.Distributions From a Foreign Grantor Trust
C.Distributions from a Foreign Nongrantor Trust
D.Distribution Defined
1.Loans
2.Exception to Treatment of Loan as a Distribution
3.Distributions by Certain Foreign Trusts Through Nominees
E.General Rule–Foreign Person Not Treated as Owner
F.Special Rules for Treating a Foreign Person as Owner
1.Certain Revocable Trusts
2.Certain Trusts That May Distribute Only to Grantor or Grantor's Spouse
3.Compensatory Trusts
4.Trusts Settled by Certain Foreign Corporations
5.An Accommodation Party is Not a Grantor
6.Foreign Person with Right to Withdraw–Not a Grantor
7.Special Rule Where Grantor is Foreign Person
8.Recharacterization of Purported Gifts
G.Consequences of Not Filing Foreign Nongrantor Trust Beneficiary Statement
H.Foreign Trust Treated as Having a U.S. Beneficiary
I.Foreign Trust Acquiring a U.S. Beneficiary
X.U.S. Person Receiving Certain Gifts or Bequests From a Foreign Person
A.Bequests From a Nonresident Alien or a Foreign Estate
B.Gifts From Foreign Corporations or Foreign Partnerships
C.Foreign Donor Acting as Nominee or Intermediary
Copyright J. Richard Duke (2006).
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TAX COMPLIANCE AND REPORTING FOR OFFSHORE TRUSTS
The following materialissubstantiallyfrom Tax Compliance and Reporting for Offshore Trusts, Asset Protection Strategies: Planning with Domestic and Offshore Entities, Chapter 17 (Real Property, Probate and Trust Law Section of the American Bar Association) (2002), J. Richard Duke (author),but has been updated due to changes in the law, final Treasury Regulationsand updates to Internal Revenue Service formsand instructions.
I.GeneralClassifications of Offshore Trusts
A.In General
. U.S. persons who establish or are beneficiaries of foreign trusts are taxed according to the tax classification of the particular foreign trust.[i] The legal classification and tax classification may not be the same. For example, a Liechtenstein or Panamanian foundation whose founder is a U.S. person will be recognized in accordance with the laws of Liechtenstein or Panama for legal purposes; however, the foreign foundation must be classified for U.S. tax purposes as either a foreign trust or a foreign corporation based on the language in the foundation documents.[ii]
B.ForeignGrantor Trust (Asset Protection Trust)
.A foreign grantor trust, which is generally referred to as an asset protection trust, is one that is established and funded by direct or indirect transfers of property by a U.S. person or persons and which includes one or more U.S. beneficiaries.This trust is treated as a so-called grantor trust (a tax neutral trust) and all trust income, gains and losses are passed through to the grantor.[iii]The IRS defines a grantor trust as "any trust to the extent that the assets of the trust are treated as owned by a person other than the trust. See the grantor trust rules in sections 671 through 679. A part of the trust may be treated as a grantor trust to the extent that only a portion of the trust assets are owned by a person other than the trust."[iv]
C.ForeignNongrantor Trust
.A foreign non-grantor trust is a trust in which the income of the trust is not taxed to the grantor, or to any other U.S. person such as a U.S. beneficiary.[v] A foreign non-grantor trust is taxed as a nonresident alien individual and is subject to income tax as an individual. The Internal Revenue Service (hereinafter "IRS") defines a non-grantor trust as "any trust to the extent that the assets of the trust are not treated as owned by a person other than the trust."[vi]
1.ForeignNon-Grantor Trust at Death of U.S. Settlor
. Upon the death of a grantor of a foreign trust, the foreign trust ceases to be a grantor trust (since the grantor is deceased) and becomes a foreign non-grantor trust.However, if, after the settlor's death, the trust instrument grants powers, stated under the provisions of Internal Revenue Code (hereinafter "I.R.C.") §§ 672-678, to U.S. beneficiaries, such beneficiaries shall be treated as grantors of the foreign trust, for income tax purposes.The typical asset protection trust does not give such powers to U.S. beneficiaries.In addition, even if powers are not included in the trust causing any one or more U.S. beneficiaries to be treated as a grantor under I.R.C. § 672-678 and if one or more of the beneficiaries in fact control the trustee, such beneficiary or beneficiaries may be treated as grantors under one or more of the provisions of I.R.C. § 672-678.
2.Cana U.S. Settlor Form a Foreign Non-Grantor Trust?
The issue is whether a foreign trust that specifically states that it can have no U.S. beneficiary in accordance with the provisions of I.R.C. § 679(b) until one taxable year after the deaths of the grantor and the grantor's spouse may be classified for tax purposes as a foreign non-grantor trust.[vii]
(a)Position Apparently Contrary to IRS
. The grantor trust provisions relate to taxation of a "grantor" for income tax purposes. The settlor of a trust, domestic or foreign, is taxed as the "grantor" under the provisions of I.R.C. §§ 671-678 and 679 (foreign trust with a U.S. beneficiary).
(b)Definition of U.S. Beneficiary During Settlor's Lifetime
. The definition of a U.S. beneficiary with respect to a foreign trust, including the cited legislative history, relates to a living "grantor." The focus here in this chapter is on a settlor who dies and the trust instrument specifically excludes U.S. persons as beneficiaries until one taxable year after the deaths of the settlor and the settlor's spouse.
(c)Trust Becomes a Foreign Non-Grantor Trust at Settlor's Death
. At the settlor's death, the trust becomes a foreign non-grantor trust (settlor is deceased). The trust has no grantor, both for legal purposes and tax purposes.Now the question is whether the trust has a U.S. beneficiary at the settlor's death.I.R.C. § 679(b) is entitled "Trusts Acquiring United States Beneficiaries" and provides:
If–(1) subsection (a) [I.R.C. § 679(a)] applies to a trust for the transferor's taxable year, and (2) subsection (a) would have applied to the trust for his immediately preceding taxable year but for the fact that for such preceding taxable year there was no United States beneficiary for any portion of the trust, then … the transferor shall be treated as having income for the taxable year … equal to the undistributed net income (at the close of such immediately preceding taxable year) attributable to the portion of the trust referred to in subsection (a).
(d)Apparent Meaning of I.R.C. § 679(b)
. This provision appears to state that if the foreign trust specifically provides that no U.S. person can become a beneficiary for one taxable year following the deceased transferor's death, income taxation under I.R.C. § 679(a) is not applicable. I.R.C. §§ 679(b) and 672(e)(1), for a married settlor, appear to provide the solution to avoiding classification of that trust as a grantor trust (to the grantor's estate) at the grantor's death.
(e)Grantor Trust Provisions
. I.R.C. §§ 671-679 are the "grantor" trust provisions and tax the grantor of (or transferor to) a trust. A settlor who sets up a foreign trust is subject to these provisions (primarily I.R.C. § 679) and is treated as the grantor. At the death of this settlor, however, the foreign trust becomes a foreign non-grantor trust. Although the provisions[viii] that determine whether a foreign trust has a U.S. beneficiary apply both before and after the death of the settlor, the foreign trust becomes a non-grantor trust at the death of the settlor. The window provided by I.R.C. §§ 679(b) and 672(e)(1) appears to foreclose the foreign trust from being treated as a "grantor" trust at the settlor's (and spouse's) death.
(f)Planning for the Accumulation of Income Problem
. If this contrary position is correct, one problem remains. Under I.R.C. §679(c)(1)(A), no income can be "accumulated during the taxable year for the benefit of a United States person." To deal with this concern while both or either the settlor and the settlor's spouse are living, the trust assets can be invested in capital appreciation assets with low income and all of the income can be distributed to the non-U.S. beneficiary each year in which earned.Thus, no income is accumulated for later distribution to a U.S. beneficiary. The Instructions to Form 3520 address this planning.
(g)IRS Omission
. The IRS, in writing the Treas. Regs. under I.R.C. § 679, failed to refer to I.R.C. § 679(b). Based on conversation of this author with the IRS, it appears to be dangerous to rely upon the reasoning of the foregoing paragraphs (see "Position Apparently Contrary to IRS," supra).[ix]
3.ForeignNon-Grantor Trust Created by a Non-U.S. Person
. A foreign trust created by a non-U.S. person that includes no U.S. beneficiary is a foreign non-grantor trust and the U.S. has no tax authority or jurisdiction over such trust or beneficiaries unless the trustee of the trust invests in the U.S., which may subject certain types of passive income on those investments to withholdings and some trade or business income to withholdings.[x] A foreign non-U.S. person may also create a foreign non-grantor trust that includes a U.S. beneficiary.
4.ForeignIrrevocable Trust Created by a Non-U.S. Person
. An irrevocable trust, as opposed to a revocable trust, created by a non-U.S. person that includes one or more U.S. beneficiaries is classified for tax purposes as a foreign non-grantor trust.[xi]
II.Foreignvs. Domestic Trusts
A.In General
. A trust formed by a U.S. person outside the U.S. is commonly referred to as an offshore trust, international trust, foreign grantor trust, or a foreign non-grantor trust.[xii]The I.R.C. uses the words, "foreign trust."[xiii]The I.R.C., as amended by the Small Business Job Protection Act of 1996,[xiv] provides two tests, as discussed below, to determine whether a trust is a domestic trust.If either of these tests is failed, the trust is a foreign trust.Unlike earlier law, the focus now is on the legal and fiduciary control over a trust, not on the source of trust income or the residency of the parties.[xv]
B.Classificationof a Trust as Domestic or Foreign
. Effective for tax years beginning after December 31, 1996, I.R.C. § 7701(a)(30) classifies a trust for tax purposes as domestic if two tests are met.[xvi] A trust is treated as a domestic trust if: (i) a court within the U.S. can exercise primary supervision over the administration of the trust, and (ii) one or more U.S. persons have the authority to control all substantial decisions of the trust.[xvii]As stated, if either of the foregoing conditions is not satisfied, the trust is treated as a foreign trust.[xviii]The House of Representatives indicates that the first test generally is satisfied if the trust instrument is governed by the laws of a state in the U.S.[xix]The second test is satisfied only if U.S. persons make all substantial decisions with no other person having the power to veto any substantial decisions.[xx]These two tests are referred to as the "court test" and the "control test."
1.CourtTest
. The court test is satisfied for a trust if (i) the trust instrument does not direct that the trust is to be administered outside the U.S.; (ii) the trust is in fact administered exclusively in the U.S.; and (iii) the trust is not subject to an automatic migration provision.[xxi]A court within the U.S. does not have primary supervision over the administration of a trust if the trust instrument provides that an attempt by a U.S. court to assert jurisdiction or otherwise supervise the administration of the trust, directly or indirectly, causes the trust to migrate from the U.S. to a foreign jurisdiction (a "flee" clause).[xxii]However, an automatic migration provision does not fail the court test if the trust instrument provides that the trust migrates from the U.S. only upon a foreign invasion of the U.S. or upon widespread confiscation or nationalization of property in the U.S.[xxiii]
2.ControlTest
. The control test is met if U.S. persons have the authority to "control all substantial decisions" of the trust.
(a)Substantial Decisions
. Those decisions that persons are authorized or required to make under the terms of the trust instrument and applicable law that are not ministerial are deemed substantial decisions.[xxiv] Substantial decisions include, but are not limited to, the following:[xxv] (i)whether and when to distribute income or corpus; (ii) the amount of any distributions; (iii)the selection of a beneficiary; (iv) whether a receipt is allocable to income or principal; (v) whether to terminate the trust; (vi) whether to compromise, arbitrate, or abandon claims of the trust; (vii) whether to sue on behalf of the trust or to defend suits against the trust; (viii) whether to remove, add, or replace a trustee; (ix) whether to appoint a successor trustee to succeed a trustee who had died, resigned, or otherwise ceased to act as a trustee, even if the power to make such a decision is not accompanied by an unrestricted power to remove a trustee, unless the power to make such a decision is limited such that it cannot be exercised in a manner that would change the trust's residency from foreign to domestic, or vice versa; and (x) investment decisions.However, if a U.S. person under I.R.C. § 7701(a)(30) hires an investment advisor for the trust, investment decisions made by the investment advisor will be considered substantial decisions controlled by the U.S. person if the U.S. person can terminate the investment advisor's power to make investment decisions at will.
(b)Ministerial Decisions
. Ministerial decisions include details such as bookkeeping, collection of rents and the execution of investment decisions.[xxvi]
(c)Definition of Control
. Control means having the power, by vote or otherwise, to make all substantial decisions of the trust with no other person having the power to veto any of the substantial decisions.Control is determined by looking at U.S. persons, not just U.S. fiduciaries, who have authority to make all substantial decisions of the trust.[xxvii]U.S. persons are not deemed to be in control of all substantial decisions if an attempt by any governmental agency or creditor to collect information from or assert a claim against the trust causes one or more substantial decisions of the trust to be no longer controlled by such U.S. persons.[xxviii]