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Foreign Trusts Pose Headaches for US Transferors, Beneficiaries

Dec. 2, 2022, 9:45 AM

Foreign trusts and foundations treated like trusts have long been marketed to US clients as the be-alls and end-alls of asset protection. And with good reason—foreign asset protection trusts often provide increased asset protection over domestic asset protection trusts. This is largely due to many foreign asset protection trust jurisdictions having firewall provisions, not recognizing foreign judgments, and being outside the jurisdiction of US courts.

While foreign trusts may provide superior asset protection, they can create a tax quagmire for US citizens, residents, or entities such as corporations or partnerships that transfer property to them (US transferors). This is because US transferors can be liable for three levels of tax: gift tax on completed gifts to the trust, income tax on the portion of the trust they are considered to own, and capital gains tax on appreciated transferred assets.

Gift Tax

Gift tax can arise when a US transferor transfers property to a foreign trust. Foreign and domestic asset protection trusts generally are set up as self-settled irrevocable discretionary trusts with independent trustees. As such, transfers of property to such trusts often are considered completed gifts and subject to gift tax. A completed gift arises under Internal Revenue Code Section 2036 when the US transferor no longer possesses or enjoys the property, retains a right to the income from the property, or retains a power of appointment.

Income Tax

US transferors can continue to be liable for income taxes on income from the transferred property under Section 679. This occurs when the foreign trust has or is permitted to have US beneficiaries. In such cases, the foreign trust will be considered a foreign grantor trust, and the US transferor (grantor) will continue to be treated as the owner of the transferred property for US income tax purposes.

Whether a foreign trust can have US beneficiaries is construed broadly. For example, a trust would be considered to have a US beneficiary even if their interest was contingent. A foreign trust that prohibits US beneficiaries but that could be amended to allow them would likely be considered to have US beneficiaries.

Capital Gains Tax

A US transferor can be liable for capital gains tax on the appreciation of the transferred assets under Section 684. Tax under Section 684 arises when a US transferor transfers property to a foreign non-grantor trust—a trust that doesn’t have, and cannot have, US beneficiaries—or upon the US transferor (grantor) ceasing to be treated as the owner of the transferred assets for income tax purposes, the most common example of which is the death of the US transferor (grantor).

Conclusion

As a result of the above tax provisions, US transferors can be subject to all three levels of tax. First, gift tax will be applicable if the transfer was a completed gift. Second, the US transferor will continue to liable for income tax on income from the transferred property if the foreign trust has or is permitted to have US beneficiaries. Third, capital gains tax will apply to any appreciation of transferred assets upon transfer to a foreign trust that prohibits US beneficiaries or upon the US transferor ceasing to be treated as the owner of the transferred property for US income tax purposes. As noted above, this would happen upon the death of the US transferor but could also happen, for example, upon their expatriation or cessation of US residency.

The gravity of the application of these tax provisions should not be underestimated because it is possible for more than one to apply at the same time. If a US transferor made a completed gift of appreciated property to a foreign trust that prohibited US beneficiaries, for example, they would be liable for both gift tax and capital gains tax.

It is also possible for all three taxes to apply to the same transfer. Let’s say a US transferor makes a completed gift to a foreign trust with US beneficiaries. The US transferor would be liable for gift tax and continue to be liable for income tax on income from the transferred property. And when the US transferor ceases to be treated as the owner of the transferred assets, capital gains tax would become due. US transferors also must file certain IRS international information returns, including Forms 3520 and Forms 3520-A.

As with most things tax, it is possible to achieve a better tax result with proper planning. That said, one must weigh the benefits of a foreign trust against their tax consequences to determine if the tradeoff is worth it or if a domestic trust may be better suited for the given situation.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Jimmy Sexton, LL.M., advises private clients on international tax and wealth planning. He is the is the founder and CEO of Esquire Group and the chairman of the International Business Structuring Association (Middle East Chapter).

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