INSIGHT: Is Undistributed Net Income a Ticking Time Bomb or Treasure Trove? Planning Strategies for Foreign Nongrantor Trusts

The U.S. tax treatment of distributions from foreign non-grantor trusts (FNGTs) to U.S. beneficiaries varies widely depending on the nature of the distribution. Whereas trust principal may be distributed tax-free, distributions of current income are generally taxed as income earned by the U.S. beneficiary. Notably, distributions of accumulated income earned in prior years (UNI) are subject to disadvantageous tax rates with penalizing interest charges. (See tax code Section 665(a), (b).)

TO CLEANSE OR NOT TO CLEANSE?

With these adverse U.S. tax consequences in mind, advisors usually caution against the accumulation of income within FNGTs altogether. Yet in many cases, by the time U.S. tax advice is sought, an FNGT has already been contaminated with a substantial amount of UNI that has been accruing for years. In such cases, advisors must choose between two primary strategies to address the “UNI problem”: Cleanse FNGTs of UNI or leave the UNI untouched.

We will review both approaches and suggest that, over time, leaving the UNI in the FNGT can significantly enhance family wealth when compared with cleansing strategies—despite the latter’s popularity among many trustees and advisors.

IN GENERAL: U.S. TAXATION OF U.S. BENEFICIARIES OF FNGTs

Before delving into the murky realms of UNI taxation, the discussion warrants a brief overview of the mechanics of U.S. taxation of FNGTs in general.

FNGTs are subject to U.S. taxation vis-a‘-vis their U.S. beneficiaries who are taxed on income distributions received from such trusts. (See tax code Sections 652(a), 662(a).) To determine the U.S. tax treatment of a distribution, an advisor requires three crucial pieces of information: (1) whether the FNGT contains UNI; (2) whether the FNGT has distributable net income (DNI)—which essentially consists of the FNGT’s current net income (See tax code Section 643(a)); and, (3) whether the distribution to the U.S. beneficiary exceeds the trust’s DNI.

If a U.S. beneficiary receives a distribution equal to or lower than the FNGT’s DNI, the tax treatment of the income in the beneficiary’s hands will mirror the tax character of the income in the FNGT. To the extent that the distribution includes realized long-term capital gains or qualified dividends, the distribution will be taxed at the lower long-term capital gains rate afforded in the U.S. If the FNGT has no UNI, the distribution will be treated as a nontaxable distribution of principal to the extent that the distribution exceeds the FNGT’s DNI. (See tax code Section 662(a).)

If, on the other hand, the FNGT contains UNI and the U.S. beneficiary receives a distribution that exceeds the FNGT’s DNI, then amounts exceeding DNI and consisting of previously accumulated income will be treated as an accumulation distribution. (See tax code Section 665(b).) In this case, the distribution will be subject to the “throwback tax” and to interest charges on the UNI included. (See tax code Section 668.)

The throwback tax and interest charge are designed to impose on the beneficiary approximately the same income taxes that would have been levied had the trust distributed its income currently (assuming all income would have been taxed at the highest rate). (See tax code Sections 666, 667.) The longer the income was accumulated in the FNGT, the more corrosive the effect of the throwback tax and interest charge—so much so that after a certain point, tax and interest can consume an entire UNI distribution.

Therein lies the challenge for U.S. beneficiaries of FNGTs with UNI amassed over extended periods. If such beneficiaries need to access trust funds in excess of DNI, distributions will first tap tax-inefficient UNI before tax-free principal distributions can be made. For this reason, trustees and advisors need to consider the overall economic impact of all available methods before deciding on the most effective distribution strategy.

CLEANSING STRATEGIES

Solving the UNI problem may prove more challenging than it seems. For example, less experienced advisors might think that simply domesticating an FNGT renders the issue moot. Aren’t distributions from domestic trusts, for the most part, exempt from throwback taxes? Not so. Distributions from domesticated trusts that consist of UNI formerly accumulated in foreign trusts are treated as having been made directly from a foreign trust and therefore, will be subject to the throwback regime. (Revenue Ruling 91-6.) “What about a distribution to charity?” one might ask. Unfortunately, charitable distributions do not reduce UNI. (Treasury Regulation Section 1.665(b)-1A(c)(2).)

There is only one effective way to cleanse an FNGT: distribute the UNI to the beneficiaries. But how? Advisors must weigh several approaches to distribution, each with its own tax consequences and time horizon. Below we will compare the duration and cumulative financial consequences of the following cleansing strategies: distributing UNI in one fell swoop, using the default method, and using what we refer to in this article as an “enhanced default” method.

Ripping off the Band-Aid: A One-Time Cleanse

Distributing all UNI in one fell swoop represents the quickest way for beneficiaries to gain access to trust principal tax-free. However, depending on the size of the UNI relative to the principal—and how long the UNI has accrued—the economic impact of this strategy can differ greatly. In general, the longer the UNI has accumulated, the greater the cost of this approach due to the compounding of the interest charge.

For example, if the interest charge averages 6%, then for every dollar of UNI accumulated for 15 years or more, the combined interest charge and throwback tax would consume the entire dollar once distributed. (Combined tax and interest equals 98%.) On average, the higher the interest rate, the lower the requisite accumulation period before interest and taxes completely engulf the distribution, and vice versa. Yet, in certain cases, this strategy may still make sense. For instance, if the UNI comprises just one-fifth of the FNGT’s value, the US beneficiaries might consent to a one-time distribution sacrificing 20% of the trust in exchange for gaining tax-free access to the remaining 80%.

However, in most cases where an FNGT has existed for decades, there is often little or no information available to help determine how much of the trust consists of UNI and how long it has been accruing. Without such records, the Internal Revenue Service will assume that the entire distribution consists of UNI, which will be allocated to the earliest year that the trust was in existence. (See tax code Section 666(d).) In such cases, making a UNI distribution is not economically viable, and advisors should opt for the default method instead.

The Default Method

The default method allows U.S. beneficiaries of FNGTs who are unable to determine whether a distribution consists of UNI to instead apply a formula to determine the character of the distributions. (Notice 97-34.) The technique is available to any U.S. beneficiary who makes a proper, irrevocable election. Once an election is made, it is irrevocable as to subsequent tax years, except with respect to the final year in which the FNGT terminates. Given its broad applicability, beneficiaries of FNGTs that have amassed significant amounts of UNI over an extended period may wish to avail themselves of this method as well.

The default method’s formula requires U.S. beneficiaries to average the distributions made from the FNGT in the prior three years. This average is then multiplied by 1.25 to arrive at the “Current Distribution Amount”—the amount that will be treated in the fourth year as a distribution of current income for U.S. tax purposes. Distributions exceeding the Current Distribution Amount will be treated as UNI distributions and taxed accordingly—though they will raise the Current Distribution Amount for subsequent years. Under the default method, interest will be calculated based on one-half of the number of years the trust has been an FNGT.

While almost all default method distributions are converted to ordinary income and subject to the highest income tax rates, at least the interest charge no longer applies. In the FNGT’s final year, the default method election can be revoked. The longer the accumulation period, the more meaningful the savings. Because an FNGT’s actual income is unlikely to exceed the annual growth built into the default formula, distributions of income will eventually deplete the foreign trust, cleansing it of all UNI.

Given the higher income tax rate applied to default method distributions, once elected, the FNGT’s investments should be selected based on their pre-tax return potential. That includes tax-inefficient investments generating ordinary income, which advisors typically avoid with U.S. beneficiaries in the mix.

Default Method in Practice

The following example illustrates how the default method works. An FNGT in existence for 30 years has $100 million in assets. The advisors have opted to employ the default method either because:

• the beneficiaries lack sufficient information to determine how much and how long UNI has been accruing; or
• UNI comprises a sizable portion of the trust and has been accumulating for too long (rendering its withdrawal economically unfeasible).

The trustee of the FNGT plans to distribute all DNI to its U.S. beneficiaries over the next three years. For purposes of this illustration, let us assume that $5 million will be distributed from the FNGT each year.

In year four, a default method election is made, and $6.25 million ($5 million x 1.25) will be distributed and treated as DNI (even if the FNGT only contains $5 million in actual DNI that year). In year five, $6.8 million will be distributed and treated as DNI. The pattern continues until—in year 18—the FNGT has been entirely depleted and the beneficiaries have received cumulative after-tax distributions totaling $132 million over the 18-year period. (Cumulative after-tax distributions received over 18 years—median outcome, in nominal dollars). Note, to neutralize the impact of state income taxes, we assume in this example that distributions are made to a Delaware Trust for the benefit of the beneficiaries.

The default method completely cleanses UNI while avoiding the interest charge, but it carries a steep price. It subjects nearly all the trust’s value to ordinary income taxes and takes some time to unfold. This may work for some, but what if the beneficiaries need to access trust funds sooner? Fortunately, the default method can be adjusted to accommodate a shorter time horizon.

Enhanced Default Method

The cleansing period under the default method can be shortened by intentionally realizing all the FNGT’s built-in capital gains in the year prior to the default method election. This enhances the trust’s DNI which, in turn, increases the size of the distributions and speeds up the FNGT’s windup. However, if the FNGT does not have a meaningful amount of unrealized capital gains to harvest, the intentional distribution of UNI in the year prior to the default method election should be considered. Granted, the entire UNI distribution will likely be consumed by the tax and interest charges, but it will serve to augment future distributions even further.

Take the trust from our prior illustration. Instead of simply using the trust’s $5 million DNI distributions, let’s assume the trustee distributes an additional $10 million of UNI in year three, bringing the year four distribution to $10.4 million. The distribution in year five will total $12.7 million, and so on, until the FNGT is depleted by year 11—seven years sooner than the standard default method. (In year four, the average of the three prior year’s distributions is $8.3 million [($5 mill. + $5 mill. + $15 mill.)/3. That figure is then multiplied by 1.25 to arrive at ~$10.4 million. In year five, the average of the prior three-years’ distributions is $10.1 million [($5 mill. + 15 mill. + 10.4 mill.)/3]. That figure is then multiplied by 1.25 to arrive at ~$12.7 million.)

This speed, however, comes at a cost.

As Display 1 illustrates, after 10 years of distributions, the enhanced default method transfers $75 million onshore—$27 million more than the straight default method. However, the economic impact of sacrificing $10 million UNI to accelerate the distributions results in $7 million less family wealth overall in 20 years compared to the straight default approach. Some families may be willing to surrender 5% of total family wealth in order to gain unfettered access to the funds sooner. As with the first two strategies, the specific facts of the case will dictate whether this solution proves ideal.

What about U.S. beneficiaries who remain unwilling to pay the price of cleansing UNI? How should advisors counsel those who may not have a pressing need for funds or who enjoy a longer time horizon? In those instances, cleansing UNI may not be the appropriate answer and strategies that leave UNI in the FNGT should be explored instead.

KEEPING UNI OFFSHORE

Beneficiaries with a longer time horizon and less urgent need for large distributions are likely better off leaving the UNI in the FNGT, rather than cleansing it. Below we will examine the financial impact of two strategies that do not cleanse UNI.

If the beneficiaries’ spending needs are met by the FNGT’s DNI, with no immediate need to access UNI and trust principal, over the same 18-year period that it took to cleanse the trust of UNI using the default method, total DNI distributions would amount to $102 million. (Cumulative after-tax distributions received over 18 years (median outcome, in nominal dollars).) However, the untouched UNI will continue to generate DNI, so that after 20 years, total family after-tax wealth would reach $201 million—$69 million more than if the FNGT had been domesticated via the default method.

Display 2 illustrates the growth and allocation between onshore and offshore of family wealth over time when DNI is distributed annually from the same FNGT as our prior two examples. Note, for simplicity, we assumed all distributions are made to, and remain in, a Delaware trust that pays no state income tax.

While the enhanced default method moves more money onshore faster, total family wealth suffers because of the sacrificed UNI distribution. In contrast, by leaving the UNI untouched, the beneficiaries receive the same amount ($48 million) after 10 years of annual DNI distributions as they would have under the straight default method. However, because none of the UNI is accessed, more money remains offshore to generate future DNI.

Notably, after 20 years of annual DNI distributions, the amount of funds transferred to a domestic trust sits only somewhat higher using the default method compared to leaving the UNI untouched. Yet, total family wealth is significantly greater using the latter method. That is because the family has a $77 million pot of funds offshore that will continue to generate DNI in perpetuity.

The untouched UNI method should start producing more onshore wealth by year 21 compared with the straight default method. The approach can transfer the bulk of family wealth to the U.S. over time: 62% by year 20 and 95% by year 50 can be moved onshore.

It should be noted that if UNI remains untouched in the FNGT and if all DNI is distributed annually, the FNGT’s income will be taxed in the U.S. Therefore, advisors should pay careful attention to the tax efficiency of the FNGT’s allocation—it should be invested as a U.S. taxpayer would be, giving preference to tax efficient investments.

DON’T OVERLOOK THE ACCUMULATION ALTERNATIVE

Family wealth can be even further enhanced if the FNGT’s beneficiaries do not need access to the trust’s entire DNI. This is because increasing UNI will allow for additional tax-free growth and larger DNI distributions down the road. For instance, if the trustee continues to accumulate the FNGT’s income for a 20-year period before distributing DNI annually to the beneficiaries, the family’s total wealth at the end of the 50th year will reach $734 million—a 25% increase over the annual DNI distribution strategy.

Upon determining that all DNI will be accumulated for a given number of years, the FNGT’s investments should be selected based on their pre-tax return potential (as with the default method). Before DNI distributions begin, the asset allocation of an FNGT should be shifted back to a tax-aware allocation.

CONCLUSION

U.S. advisors have long dreaded the complexity of FNGTs with UNI. While there are several approaches to tackling the UNI challenge, one size does not fit all. Advisors may naturally gravitate towards cleansing strategies that eliminate UNI. However, given the right circumstances and time horizon, UNI can be harnessed to produce outcomes that far exceed those generated by cleansing techniques.

Diligent advisors should carefully consider all the relevant factors—including the amount of UNI, the number of years it has accrued, family needs, time horizons, and likely DNI distributions—before recommending one course of action over another. Thoughtful advice and complementary investment strategies can result in meaningfully improved economic outcomes for beneficiaries.

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

Shelly Meerovitch is a Director and Senior Vice President in the Wealth Strategies Group in Bernstein’s New York office. She focuses on international planning, and works with high-net-worth clients and their professional advisors to optimize structures for tax-efficient investment in the U.S., wealth transfer to U.S. beneficiaries, and the creation and administration of global trusts.

John F. McLaughlin is a Director and Senior Vice President in Bernstein’s Wealth Strategies Group. He serves as senior research analyst for initiatives on investment planning and asset allocation issues facing high-net-worth families, family offices, and endowments and foundations.

Bernstein does not provide tax, legal, or accounting advice. In considering this material, you should discuss your individual circumstances with professionals in those areas before making any decisions.