Private Foundations to Protect Wealth Are the New Sheriff in Town

Private foundations have been gaining popularity as a simpler alternative to trusts. While there are technical differences between trusts and foundations, the main practical difference is that foundations are an all-in-one standalone wealth protection and estate planning vehicle that are managed by a board.

When most people think about estate planning, they consider setting up a trust. This is because trusts have been around for centuries, and people are more familiar with them than foundations. A settlor (the person setting up the trust) transfers property to a trustee pursuant to a trust agreement (a contract between the settlor and trustee) to hold and manage for the benefit of the beneficiaries.

And here is the complication—you need a third-party trustee. Typically, settlors have two options: hiring a professional trustee or setting up a private trust company. A professional trustee is a trust company that is in the business of managing trusts. A PTC is a special purpose company set up to manage the settlor’s trust.

As civil law entities, civil law jurisdictions’ legal and tax systems are well equipped to deal with them. The same can’t be said for common law jurisdictions. Because foundations aren’t common law entities, the legal and tax systems of common law countries such as the US are often ill-equipped to deal with them.

That said, many common law countries, as well as the states of Wyoming and New Hampshire, have foundation legislation. So how does the US treat foundations for tax purposes?

Under US tax law, a foundation can be treated as a trust or corporation, depending on the facts and circumstances. This determination is left to the tax professional, whose opinion could vary from the IRS’s.

The first step in determining how the US will tax a foundation is to determine whether it will be treated as a trust or corporation. Courts generally look to the founder’s intent when setting up a foundation, its governing documents, and its activities when determining whether it’s a corporation or a trust for tax purposes.

If a foundation’s main purpose is business, it would likely be classified as a corporation. If its main purpose is to protect and conserve wealth for its beneficiaries, it would likely be classified as a trust.

Once it’s determined if the foundation will be treated as a corporation or a trust, it must be determined whether it is domestic or foreign. If the foundation is to be treated to be treated as a corporations and is incorporated in the US, it’s a domestic corporation. If it’s incorporated in a foreign country, it is a foreign corporation.

Determining this with respect to a foundation treated as a trust is more complex. A domestic trust is one in which a court within the US can exercise primary supervision over the trust’s administration (court test), and one or more US persons have authority to control all of the trust’s substantial decisions (control test). All other trusts are foreign trusts.

Finally, it must be determined if it’s a grantor or nongrantor trust. A domestic trust generally will be treated as a grantor trust if the grantor has power of appointment, reserves the right to revoke the trust, continues to possess or enjoy property owned by the trust, or has a right to receive income from the trust. All other domestic trusts will be nongrantor trusts.

Several factors determine whether a foreign trust will be a grantor or nongrantor trust. If the grantor is a US person, and the trust either already has, or can have, US beneficiaries, it will be a grantor trust.

If the grantor isn’t a US person, the trust will be a grantor trust if the grantor if the grantor has the sole power to revoke the trust, exercisable without any other person’s approval or consent (or with the consent of a related or subordinate party that is subservient to the grantor), or the only trust amounts (income or corpus) distributable during the grantor’s lifetime are distributable to the grantor or the grantor’s spouse.

All other foreign trusts are nongrantor trusts.

To further complicate matters, it is possible to have a US foundation (incorporated in Wyoming or New Hampshire) that is classified as a trust treated as a foreign trust for US tax purposes. This would be the case if the foundation didn’t meet the court and control tests. In such a situation, the foundation wouldn’t be liable for US income taxes or be required to file a US income tax return absent US source income.

Tax professionals may assume that a US foundation treated as a foreign trust for US tax purposes means that it is treated as foreign for all purposes. One of the main mistakes I have seen tax professionals make is assuming that a US trust, or a US foundation classified as a trust, that is a foreign trust for US tax purposes doesn’t have to file a Report of Foreign Bank and Financial Accounts.

This isn’t the case because of how a US person is defined for FBAR purposes. A US foundation treated as a foreign trust for US tax purposes would be required to file an FBAR to report any foreign bank or financial accounts. This could happen if such a foundation owned more than 50% of a foreign corporation that had a foreign bank or financial account.

While foundations are powerful wealth protection and estate planning tools regardless of where they are formed, people must carefully plan the foundation and the drafting of its governing documents to achieve the desired results.

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 is founder and CEO of Esquire Group and chairman of the International Business Structuring Association (Middle East Chapter).

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