INSIGHT: Foreign Grantor Trust Transition Planning

In these uncertain times, it is critical that advance planning continue to play a leading role in optimizing tax strategies. Foreign grantor trust planning is no exception. Understanding the present and future impacts U.S. tax rules may have upon the transition of a foreign grantor trust (i.e., from grantor to non-grantor trust) are critical. Lack of proper action can create future tax inefficiencies that may have to be borne by U.S. beneficiaries.

Foreign Grantor Trusts

Since 1996, U.S. tax law has typically disallowed foreign individuals from being grantors of trusts with U.S. beneficiaries. However, several exceptions exist to this general rule that allow for foreign grantor trust creation. Pursuant to tax code Section 672(f), a foreign trust with U.S. beneficiaries will be considered a foreign grantor trust in cases where:

• Grantor has the power to revoke the trust without the consent of any person, or with the consent of a bound third party. (Upon grantor’s incapacity, his/her guardian must possess a power of revocation.)

• Grantor and/or grantor’s spouse are the sole beneficiaries of the trust during grantor’s life. In these instances, grantor/grantor’s spouse could receive distributions from the trust and gift these distribution to U.S. person(s). These gifts may be reportable, depending upon the amount, but will not be taxable.

• The trust was created on or before Sept. 19, 1995.

Grantor trusts, as opposed to non-grantor trusts, are desirable from a U.S. tax perspective because they are considered to be separate or disregarded entities. This designation both alleviates reporting requirements and allows for the trust’s income to be taxed to the grantor’s individual level, rather than the trust level (at marginally higher rates). Accordingly, trust settlors often seek to create grantor trusts when setting up the terms of the instruments, where feasible. However, upon death of the grantor, foreign grantor trusts will default to foreign non-grantor trusts. Absent planning, this change may create adverse U.S. tax implications.

Foreign Non-Grantor Trusts

The major drawback of a foreign non-grantor trust is the treatment of income that is accumulated in the trust and then distributed to U.S. beneficiaries in future years. We can illustrate this point by considering hypothetical distributions to the U.S. beneficiary in conjunction with analyzing foreign grantor trust accumulated income rules.

All income generated by a foreign non-grantor trust in the current year is considered to be distributable net income, or “DNI”. When a foreign non-grantor trust distributes current year trust income (including capital gains) to a U.S. beneficiary, that income is currently taxable to the beneficiary and it retains its character (i.e., ordinary or capital gains) to the extent of this DNI. All subsequent distributions are considered to be distributions of corpus and are not taxed (assuming the trust has no accumulated income from prior years, see below).

Any DNI not distributed within 65 days of the end of the year is recharacterized as undistributed net income, or “UNI.” Generally, a foreign non-grantor trust pays no U.S. income tax on that income (except perhaps withholding tax on U.S.-source income) and there is no U.S. income tax currently payable by a beneficiary. However, the foreign trust is building up UNI which will have tax consequences if it is distributed to a U.S. beneficiary in the future.

When a foreign trust with UNI pays a future distribution to a beneficiary greater than that year’s DNI, past accumulated income is carried out to the beneficiaries. That accumulated income (or UNI) paid to U.S. beneficiaries is fully subject to U.S. income tax, and also carries with it the following adverse impacts:

• The accumulated earnings distribution is subject to a “throwback tax.” (The value of the accumulation distribution is allocated to preceding years in which the amount of DNI exceeded distributions, modified based on the taxes the trust paid that are attributable to that value, and taxed as an increase to income tax within the computation years.)

• An interest charge is imposed on the tax due on the accumulated income calculated as of the date the income was originally earned by the trust. This interest charge is tied to the rate applicable to underpayment of tax and is compounded on a daily basis.

• Capital gains realized by the trust in past years are taxed at marginal ordinary income tax rates (up to 37%) instead of capital gains rates.

Under U.S. tax law, the throwback tax can be levied up to 100% of the UNI income distribution itself. In cases where accumulated earnings grow for many years, the tax burden associated with distributions of UNI can be severe.

Trust Transition Planning

In light of the above, the following planning options are among those available for foreign grantor trusts to take to mitigate these consequences:

(1) Distribute trust proceeds to U.S. beneficiaries immediately

One option is to simply distribute, via trust mechanism or by the trustee, the foreign trust income immediately upon death of the grantor. The distribution will be subject to current U.S. taxation, but will prevent the future accumulation of trust income and throwback tax application.

(2) Distribute trust proceeds to foreign beneficiaries first

A second option, if there are multiple beneficiaries in the trust, is to make all distributions first to foreign beneficiaries. Assuming these distributions can successfully exhaust DNI and UNI, all subsequent distributions to U.S. beneficiaries will consist of tax-free trust principal.

(3) Undergo trust restructuring

A third, albeit more complicated, option would be to undergo trust restructuring. Specifically, the foreign non-grantor trust can create a foreign subtrust. In principle, the transfer of trust income from the original trust to the subtrust can, if effectuated properly, cleanse the UNI taint prior to distributions. It should be noted that individual issues must be vetted to ensure successful structuring without triggering adverse tax (e.g., subtrust’s trustee should afford the trustee absolute discretion to distribute to multiple beneficiaries). For this reason, it is recommended that tax professionals be consulted if exploring this option.

As with any tax matters, proper steps should be analyzed and considered prior to any foreign grantor trust triggering events to minimize tax burdens on beneficiaries. Proper planning in advance can mitigate these issues and maximize trust corpus for future generations.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Jack C. Millhouse is an international tax manager at FGMK LLC in Chicago.