Chartered Wealth Manager
Course Presentation
PLANNING FOR A FOREIGN NON-GRANTOR TRUST
AT THE DEATH OF THE GRANTOR
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.Planning for a Foreign Non-Grantor Trust at the Death of the Grantor of a Foreign Trust
A.Asset Protection Trust
B.Gratuitous Transfer
C.Nongratuitous Transfer
D.Tax Treatment of a Foreign Grantor Trust
E.Transfers of Property to a Foreign Grantor Trust
F.Tax Treatment at Death of the Grantor of a Foreign Grantor Trust
G.Foreign Non-Grantor Trust–Tax Treatment
H.Taxation of Distributions to U.S. Beneficiaries of a Foreign Non-Grantor Trust
I.Taxation of Accumulation Distributions—Prior Law
J.Taxation of Accumulation Distributions—Current Law
K.Undistributed Net Income
L.Reporting Distributions from a Foreign Non-Grantor Trust
II.Accumulation Distribution
A.Calculating an Accumulation Distribution under the Default Method
B.Throwback Tax on an Accumulation Distribution
C.The Throwback Rule
1.Computation of a Partial Tax on an Accumulation Distribution
2.Where Accumulation Distribution Exceeds Undistributed Net Income
D.Specific Gifts
1.Instrument is Required to Provide for a Transfer of a Specific Sum of Money or Specific Property
2.Examples of Specific Sums of Money or Specific Property
3.Examples That Are Not Specific Sums of Money or Specific Property
E.Three Installment Rule
1.Income Earned by Specific Bequest Not Qualified
2.Difficult for Trust Distributions to Qualify
3.Distributions from Trusts That Qualify
F.Avoiding the Throwback Rule and Interest Charge
1.A Number of Planning Possibilities
2.Distribution of Yearly Net Income
3.Distribution of Specific Sum of Money or Property
4.Trustee May Acquire Growth Assets that Pay Little Income or Dividends
5.Acquire Foreign Variable Life Insurance on Lives of Beneficiaries
6.Dynasty Trust and Generation-Skipping Transfer Tax Planning
(a)Choosing Jurisdiction that Abolished the Rule Against Perpetuities
(b)GST Exemption
7.Implementing the Planning Concepts
(a)GST Planning
(b)Acquiring Life Insurance from the GST Exempt Trust
(c)Remainder Distributed Under the Three Installment Rule
(d)Nonexempt Trust Planning
8.Proper Drafting to Implement the Foregoing Planning
(a)Designate Specific Property to be Distributed under the Three Installment Rule
(b)Establishing a Testamentary GST Exempt Trust
(c)Interests Regarding GST Tax
(d)Providing Flexibility for Trustee to Create or Eliminate General Power of Appointment
(e)Creation by Trustee of, and Elimination of, General Power
(f)Provide Flexibility of Trustee to Acquire Life Insurance on the Life of the Settlor or Beneficiaries
G.Obtaining Offshore Life Insurance
1.Life Insurance
2.Provide Flexibility of Trustee to Create Trusts, Partnerships or LLCs for Beneficiaries
(a)Settle a Trust for a Beneficiary
(b)To Form a Partnership or Limited Liability Company for a Beneficiary
(c)Change Situs of Trust so That the GST Exempt Trust May be a Dynasty Trust
(d)Change of Governing Law
Copyright J. Richard Duke (2006).
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PLANNING FOR A FOREIGN NON-GRANTOR TRUST
AT THE DEATH OF THE GRANTOR
I.Planning for a Foreign Non-Grantor Trust at the Death of the Grantor of a Foreign Trust
. A tax-neutral foreign grantor trustused as an asset protection vehicle and to provide access to attractive international investing opportunities becomes a foreign non-grantor trust on the death of the settlor. Through proper draftingof the testamentaryprovisionsandwith appropriateplanning, a foreign non-grantor trust can be structured sothatcapital gains taxesand ordinary incometaxesderived fromnon-U.S. source investmentsmay be substantially reduced for U.S. beneficiaries.Such planning, if implemented with a dynasty trust (one that is exempt from estateand generation-skipping transfer taxes)may resultina significant accumulation of wealth.[i] By navigating the complex rules and reporting requirements regarding distributions from foreign non-grantor trusts, the foreign non-grantor trustprovides an important vehicle for tax efficient multi-generational retention and growth of wealth.
A.AssetProtection Trust
. The general offshore asset protection trust is classified, for U.S. income tax purposes, as a "grantor" trust.This trust is also referred to, for tax purposes, as a foreign grantor trust.
A grantor is a person to the extent such person either creates a trust, or directly or indirectly makes a gratuitous transfer of property to a trust.[ii]In the event a person creates or funds a trust on behalf of another person, both persons are treated as grantors of the trust.[iii]
B.GratuitousTransfer
. A gratuitous transfer is any transfer other than a transfer for fair market value.[iv]A transfer of property to a trust may be considered a gratuitous transfer, whether or not the transfer is a gift for gift tax purposes.[v] A transfer is for fair market value only to the extent of the value of the property received, services rendered, or the right to use property of the trust.[vi]
C.NongratuitousTransfer
. A person who makes a nongratuitous transfer to a trust he settled is not treated as the owner of any portion of the trust under I.R.C. §§ 671-677 or 679.[vii] A nongratuitous transfer to a foreign trust by a U.S. person must be reported on form 3520.[viii] A gratuitous transfer to a trust does not include a distribution to a trust, with respect to an interest held by such trust in certain described trusts,[ix] or an entity (such as a distribution to a trust by a corporation with respect to stock in a transaction described under I.R.C. §301).[x]If a trust makes a gratuitous transfer to another trust, the grantor of the transferor trust is treated as the grantor of the transferee trust.[xi]However, if the transferor trust grants a general power of appointment to another person who, in fact, exercises the power in favor of another trust, the power holder is treated as the grantor of the transferee trust.[xii]
D.TaxTreatment of a Foreign Grantor Trust
. A foreign grantor trust is a foreign trust that is funded by direct or indirect transfers of property by a U.S. person or persons, which trust 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.[xiii]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,"[xiv] meaning that the trust is tax-neutral.
E.Transfersof Property to a Foreign Grantor Trust
. Except as may be provided in Treas. Regs., the transfer of appreciated property by a U.S. person who is treated as the owner, for tax purposes, to a foreign grantor trust is not subject to any recognition of gain.[xv]
F.TaxTreatment at Death of the Grantor of a Foreign Grantor Trust
.[xvi] Treas. Regs. under I.R.C. § 684 provide an exception from gain recognition for transfers by a U.S. person to a foreign trust at death if one condition is met.[xvii]At the death of the U.S. transferor, the basis of the property in the hands of the foreign trust must be determined under I.R.C. § 1014(a).This condition is met for a foreign grantor trust.At the death of the settlor, the foreign trust becomes a foreign non-grantor trust because the settlor, who is treated as the owner and taxed on the trust income, is now deceased.
G.ForeignNon-Grantor Trust–Tax Treatment
. The taxable income of a foreign non-grantor trust is calculated similar to the taxable income of an individual with certain modifications.[xviii]A foreign non-grantor trust is generally treated as an individual who is a nonresident of the U.S. and is not present in the U.S. at any time.[xix]However, foreign non-grantor trusts are also subject to the withholding tax.[xx]The withholding tax can be avoided by structuring the investments to qualify as "portfolio interest" or "portfolio debt" under the I.R.C.[xxi]These debt obligations may be in either bearer or registered form and can pay interest free of the 30% withholding tax.[xxii]In addition, a foreign non-grantor trust is subject to U.S. taxation on: (i) gross income that is effectively connected with a trade or business within the U.S.;[xxiii] and (ii) U.S. source fixed or determinable annual or periodic income (passive income), such as interest, dividends, rents and annuities.[xxiv]
H.Taxationof Distributions to U.S. Beneficiaries of a Foreign Non-Grantor Trust
. For a particular year, a U.S. beneficiary of a foreign non-grantor trust must include in income: (i) the trust income that is required to be distributed from a simple trust to the extent of the beneficiary's share of the distributable net income for the year;[xxv] (ii) the amount of income required to be distributed from a complex trust to the extent of the beneficiary's share of distributable net income for the year;[xxvi] and (iii) other amounts required to be distributed (whether distributed or not) or actual distributions to the beneficiary from a foreign complex trust, to the extent of the beneficiary's share of distributable net income for such year.[xxvii]
I.Taxation of Accumulation Distributions—Prior Law
. Prior to January 1, 1996, U.S. beneficiaries of a foreign non-grantor trust were taxed on their respective shares of trust income that was required to be distributed, as well as other trust income that was paid, credited, or distributed to them.Under the accumulation distribution rules (distribution from the trust in excess of the distributable net income for the tax year), a distribution of previously accumulated income generally was taxed at the U.S. beneficiary's average marginal rate for the prior five years, plus a six percent annual rate of interest, with no compounding.
J.Taxationof Accumulation Distributions—Current Law
. Beginning January 1, 1996, the interest rate applicable to accumulation distributions[xxviii] from a foreign non-grantor trust is the interest rate applicable to underpayments of tax under I.R.C. § 6621(a)(2),[xxix] with daily compounding.[xxx]Interest is determined for a period beginning on the date that is the "applicable number of years" before the date of the distribution and that ends on the date of the distribution.[xxxi]The "applicable number of years" is a weighted average determined by dividing the sum of the "products" with respect to each "undistributed income year" by the aggregate undistributed net income.[xxxii]For each year in which all income is not distributed, the "product" is determined by the undistributed net income for that year[xxxiii] and the sum of the number of tax years between that year and the tax year of the distribution (counting in each case the undistributed income year but not counting the tax year of the distribution).[xxxiv]The term "undistributed income year" means any earlier tax year of the trust for which there is undistributed net income, other than a tax year during all of which the beneficiary receiving the distribution is not a citizen or resident of the U.S.[xxxv]
K.UndistributedNet Income
. Undistributed net income limits the amount of an accumulation distribution that is subject to income taxation.No tax is imposed on accumulation distributions from a foreign non-grantor trust that has no undistributed net income.The undistributed net income for any particular year of a trust is equal to the amount that the distributable net income of the trust for such year exceeds the sum of: (i) the amount of trust accounting income required to be distributed in such year; (ii) amount of income properly paid or credited or required to be distributed for such year; and (iii) the amount of any taxes imposed on the trust that are attributable to the distributable net income of the trust for the year.[xxxvi]
Undistributed net income for a particular year of a trust is reduced by accumulating distributions made in later years to the extent such distributions are deemed to have been made under I.R.C. § 666(a).[xxxvii]A distribution paid or used for charitable purposes in accordance with the provisions of I.R.C. § 642(c) is not treated as an accumulation distribution.[xxxviii]Thus, such distributions do not reduce undistributed net income.
L.ReportingDistributions from a Foreign Non-Grantor Trust
. Except as provided by Treas. Regs., a distribution from a foreign trust includes any gratuitous transfer of money or other property, whether or not the trust is owned by another person and whether or not that person is U.S. or foreign.[xxxix] Distributions include: (i) loans; (ii) gifts; (iii) bequests; and (iv) distributions of income or corpus.[xl] A distribution is reportable by a beneficiary whether actually or constructively received.For example, credit card charges paid by the foreign trust that are guaranteed or secured by the assets of the foreign trust are treated as distributions.[xli] Furthermore, if payment is received by a U.S. person from a foreign trust in exchange for property transferred to the trust or services rendered to the trust, and the fair market value of the payment received exceeds the fair market value of the property transferred or services rendered, the excess is treated as a distribution.[xlii]
A U.S. beneficiary who receives a distribution from a foreign non-grantor trust is required to complete Form 3520, Part III–Distributions to a U.S. Person From a Foreign Trust During the Current Tax Year. If the beneficiary receives a Foreign Non-grantor Trust Beneficiary Statement, he completes either Schedule A–Default Calculation of Trust Distributions (Lines 31-38) of Form 3520, or Schedule B–Actual Calculation of Trust Distributions (Lines 39-47).In addition, a Foreign Non-grantor Trust Beneficiary Statement (no prescribed form) must include six items:[xliii] (i) the first and last day of the taxable year of the foreign trust to which the statement applies; (ii) an explanation of the appropriate U.S. tax treatment of any distribution or deemed distribution for U.S. tax purposes, or sufficient information to enable the U.S. beneficiary to establish the appropriate treatment of any distribution or deemed distribution for U.S. tax purposes; (iii) a statement identifying whether the owner of the trust is a partnership or a foreign corporation; (iv) a statement that the trust will permit either the IRS or the U.S. beneficiary to inspect and copy the trust's permanent books of account, records, and such other documents that are necessary to establish that the trust should be treated for U.S. tax purposes as owned by another person (the statement is not necessary if the trust has appointed a U.S. agent); (v) a description of property (including cash) distributed or deemed distributed to the U.S. person during the taxable year and the fair market value of the property distributed; and (vi) a statement as to whether the foreign trust has appointed a U.S. agent.If the trust has a U.S. agent, the name, address, and taxpayer identification number of the agent must be included.
II.AccumulationDistribution
. An accumulation distribution is a distribution under I.R.C. § 661(a)(2)[xliv] to the extent such distribution exceeds the distributable net income of the trust for the year, reduced by trust accounting income but not below zero, required to be distributed currently.[xlv]
Two exceptions to the foregoing definition of an accumulation distribution are applicable to distributions from foreign non-grantor trusts. The first is for distributions that do not exceed trust accounting income in the year in which distributions are made.[xlvi]The second exception is for a gift of a specific sum of money or specific property described in I.R.C. § 663(a)(1), as discussed in detail below.
A.Calculatingan Accumulation Distribution under the Default Method
. Failure to attach a Foreign Non-grantor Trust Beneficiary Statement requires a U.S. beneficiary to use the "default" method of making the determination of whether or not an accumulation distribution has been received.[xlvii]The default calculation with respect to trust distributions is determined as follows:
Step 1 – Line 31: enter the total distributions received during the current tax year (Line 27);
Step 2 – Line 32: list the number of years that the trust has been a non-grantor trust;
Step 3 – Line 33: enter the total distributions received from the foreign trust during the 3 preceding tax years (or number of years the trust has been a non-grantor trust, if fewer than 3);
Step 4 – Line 34: multiply Line 33 by 1.2;
Step 5 – Line 35: this line provides the average distribution by dividing Line 34 by 3 (or the number of years the trust has been a non-grantor trust, if fewer than 3);
Step 6 – Line 36: enter the smaller of Line 31 or Line 35 to determine the amount treated as ordinary income earned in the current year;
Step 7 – Line 37: subtract Line 36 from Line 31 to determine the amount treated as an accumulation distribution.If the number is zero or less, enter zero (and do not complete the remainder of Part III); and
Step 8 – Line 38: compute the applicable number of years of the trust by dividing Line 32 by 2 (but not entered if Line 37 is zero or less).
Once Schedule A under Part III of Form 3520 is completed by a U.S. beneficiary in any tax year, that beneficiary is required to continue to complete Schedule A for all future years, whether or not that beneficiary can answer affirmatively to Line 30 of Form 3520 for all future years.[xlviii]The only exception to this requirement to report on Schedule A in future years is that Schedule B may be used in the year that a trust terminates, if Line 30 is answered affirmatively.[xlix]
B.ThrowbackTax on an Accumulation Distribution
. Form 4970 (Tax on Accumulation Distribution of Trusts) is required to be completed in order to enter the calculation of the tax on the total of any accumulation distribution.[l]The completion of Form 4970 results in penalizing recipients who receive accumulated distributions from foreign trusts.Where applicable, the Form 4970 is required to be attached to the Form 3520[li] and is required to be filed with the beneficiary's tax return.[lii] A separate Form 4970 is prepared for each foreign trust in which the U.S. beneficiary receives an accumulation distribution during the particular tax year.[liii]
C.TheThrowback Rule
. The purpose of the throwback rule is to impose, on beneficiaries receiving distributions of accumulated income from a foreign trust, approximately the same income taxes that the beneficiaries would have paid if the trust distributed its income currently.
1.Computation of a Partial Tax on an Accumulation Distribution
. The computation of a partial tax on an accumulation distribution under the throwback rule is determined in five steps.Once this is determined, an interest charge is added.Those five steps are as follows:
Step 1 – The number of preceding taxable years of the trust to which the distribution is attributable (thrown back) is determined.[liv]The amount being distributed and required to be included in income is then divided by this number of preceding taxable years.[lv]The distribution is attributable to the years that are the earliest years of the trust in which the trust had undistributed net income.[lvi]