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Why Domesticate or Decant a Foreign Non-Grantor Trust

Why Domesticate or Decant a Foreign Non-Grantor Trust

Under U.S. law, a foreign trust is an entity which does not meet either the “Court Test” or the “Control Test” described below.

Court Test

The Court Test is satisfied if any federal, state, or local court within the United States is able to exercise primary authority over substantially all of the administration of the trust (the authority under local law to render orders or judgments). There are four so-called “bright-line rules” for meeting the U.S. court test.

1. A trust will automatically meet the court test if the trust is registered with a U.S. court.

2. In the case of a testamentary trust created pursuant to a will probated within the U.S. (other than ancillary probate), the trust will meet the court test if all fiduciaries of the trust have been qualified as trustees of the trust by a court within the U.S.

3. If the fiduciaries and/or beneficiaries take steps with a court within the U.S. that causes the administration of the trust to be subject to the primary supervision of such U.S. court, the trust will meet the court test.

4. If the trust specifies that a court within the U.S. has the authority to exercise primary supervision over enforcing the governing law of the trust, the court test will be met. Please note that if a trust document specifies that a foreign country’s law will govern the trust, this does not necessarily mean that the trust will fail the court test.

The income tax regulations also provide that the Court Test would not be met if the trust instrument provides that a U.S. court’s attempt to assert jurisdiction or otherwise supervise the administration of the trust would cause the trust to migrate from the U.S.. 

Control Test

The Control Test is satisfied if one or more U.S. persons have the authority, by vote or otherwise, to make all “substantial decisions” of the trust with no other person having veto power. Substantial decisions mean all decisions other than ministerial decisions, that any person is authorized to make under the terms of the trust instrument or applicable law, including but not limited to:

1. Whether and when to distribute income or corpus;

2. The amount of any distributions;

3. The selection of a beneficiary;

4. Whether to allocate receipts to income or principal;

5. Whether to terminate the trust;

6. Whether to compromise, arbitrate or abandon claims of the trust;

7. Whether to sue on behalf of the trust or to defend suits against the trust;

8. Whether to remove, add or replace a trustee; and

9. Investment decisions.

Types of Foreign Trusts

For U.S. federal income tax purposes, trusts are further classified as either grantor or non-grantor trusts. The grantor-owner of a grantor trust would generally file a federal tax return to report and pay tax on the trust’s income during the grantor-owner lifetime, if otherwise required to do so.  In contrast, to the extent a trust was classified as a non-grantor trust, it would generally be treated as a separate entity for federal tax purposes and subject to federal income taxation on its U.S. source income unless such income is distributed to a trust beneficiary as current trust income. 

If a trust is considered a grantor trust, then all of the trust’s income, deductions, credits, and other U.S. tax effects (if any) will flow through to the owner of the trust for U.S. income tax purposes. If the owner of a grantor trust is a non-resident alien, then the non-resident alien will only be subject to U.S. income tax on the following types of income: (1) non-exempt “passive” (“FDAP”) income from U.S. sources (e.g., dividends from U.S. corporations, interest payments received from U.S. persons, rents from U.S. real estate, etc.), which is generally subject to tax at a flat thirty percent (30%) rate, without the benefit of deductions; and (2) income effectively connected with the conduct of a U.S. trade or business, including U.S. real estate gains, which is generally subject to tax at graduated rates and entitled to deductions. Thus, during the owner’s lifetime, he or she will be the only person subject to U.S. income tax with respect to the income and gains realized by the grantor trust and, assuming said income and gains are not considered U.S. source FDAP income or income effectively connected with a U.S. trade or business, said income or gains will not be subject to U.S. income tax. 

The grantor trust rules generally only apply to a “grantor” who is treated as the “owner” of the assets of a trust. For purposes of the application of the grantor trust rules, a “grantor” includes any person to the extent such person either creates a trust, or directly or indirectly makes a gratuitous transfer of property to a trust. However, a person who creates a trust but makes no gratuitous transfers to the trust will not be treated as the “owner” of the assets of the trust. Currently, the grantor trust rules, in combination with Rev. Rul. 69-70, 1969 1 C.B. 182, would cause a grantor trust’s income to be taxed in its owner’s hands and be converted to principal “as if” such income had been previously taxed to the grantor. Where the grantor is a foreign person and a trust’s income is, for example, dividends from a foreign corporation, the conversion of income to principal would be accomplished with no adverse U.S. income tax consequences. Any ultimate U.S. person beneficiary could later receive such “once” accumulated income as “principal” free from U.S. income tax.

However, amendments were made in 1996 to the grantor trust rules that severely restricted the ability of foreign persons to take advantage of this income conversion afforded to grantor trusts. Specifically, the 1996 amendments made it harder for a foreign trust created by a foreign person to be classified as a grantor trust, allowing such classification in only two narrow exceptions. The first exception requires the foreign person who creates the foreign trust to retain the absolute power to revest the trust’s assets in himself. This revesting power must be exercisable by the foreign person  without the need for consent from any party or, if consent is required, such consent is only from a related or subordinate party subservient to the foreign person. See IRC Section 672(f)(2)(A)(i). The second exception requires the foreign person (or his spouse) to be the only permissible recipient(s) of any and all income or principal distributions made by the foreign trust during the foreign person’s lifetime.  

A foreign non-grantor trust is subject to U.S. income tax in a manner similar to a non-resident individual that is not present in the U.S. at any time. That is, a foreign non-grantor trust will only be subject to U.S. income tax on its: (1) FDAP income from U.S. sources (e.g., dividends from U.S. corporations, interest payments received from certain U.S. persons, rents from U.S. real estate, etc.), which is generally subject to tax at a flat thirty percent (30%) rate, without the benefit of deductions; and (2) income effectively connected with the conduct of a U.S. trade or business (including U.S. real estate gains), which is generally subject to tax at graduated rates and entitled to deductions.

On the other hand, a U.S. beneficiary of a foreign non-grantor trust would generally be subject to U.S. income tax on the income of the trust to the extent such beneficiary receives distributions of such trust’s current income or gains, or has an unconditional right to receive a distribution of such income or gains, but only to the extent of such trust’s worldwide distributable net income. This would apply even if such income or gains are not subject to U.S. income tax in the hands of the trust. Distributions from a foreign non-grantor trust to U.S. beneficiaries are subject to a complex set of rules. In calculating its taxable income for U.S. beneficiaries, a foreign non-grantor trust will receive a deduction for distributions to its beneficiaries to the extent that these distributions carry out the trust’s “distributable net income” or “DNI” for the taxable year. Generally, the DNI of a non-grantor trust for a particular year is equal to its taxable income for that year adjusted (1) by adding to taxable income the amount deducted as a personal exemption, the amount of its tax exempt income, and the amount of the trust’s deduction for distributions to beneficiaries and (2) by subtracting from taxable income the trust’s capital gains except to the extent such capital gains are “paid, credited or required to be distributed to any beneficiary during the taxable year.” See IRC Section 643(a)(6)  Any DNI so distributed will retain its character in the hands of the recipient beneficiaries and will be taxed to them. 

Capital gains of a domestic non-grantor trust generally do not enter into the DNI calculation and are usually taxed to the trust. Any distributions by the trust to U.S. beneficiaries in excess of DNI will be a non-taxable distribution of capital. The DNI of a foreign non-grantor trust includes its capital gains. In addition, a foreign non-grantor trust’s DNI includes the amount of its income from non-U.S. sources subject to certain reductions. Distributions to beneficiaries are considered first to carry out the DNI of the current year (pro rata as to each item of income or gain) and will be taxed to the recipient beneficiaries. If a foreign trust does not distribute all of its DNI in the current year, the after tax portion of the undistributed DNI will become “undistributed net income” or “UNI.” 

Distributions of the UNI of a foreign non-grantor trust received by a U.S. beneficiary are taxed under the “throwback rule,” which generally seeks to treat a beneficiary as having received the income in the year in which it was earned by the trust. A foreign non-grantor to UNI for for any particular year is equal to the amount by which its DNI for such year exceeds the sum of:

1. The amount of trust accounting required to be distributed in such year;

2. The amount of any other amount properly paid or credited or required to be distributed for such year; and

3. The amount of any taxes imposed on the trust that are attributable to its DNI for the year. 

The throwback rule effectively results in federal tax being levied at the recipient’s highest marginal income tax rate for the year in which the income or gain was earned by the trust. This means that any capital gains accumulated by a foreign trust for distribution in a later taxable year will lose its favorable rate and instead be taxed at ordinary income rates. In addition, the throwback rule adds an interest charge to the taxes on a throwback distribution in order to offset the benefits of tax deferral. The interest charge accrues for the period beginning with the year in which the income or gain is recognized and ending with the year that the UNI amount is distributed, and is assessed at the rate applicable to underpayments of tax, as adjusted compounded daily. A beneficiary of a foreign non-grantor trust may be liable for U.S. tax on distributions of income (current and accumulated) from the trust. Foreign non-grantor trust corpus distributions are not taxable to a beneficiary. The U.S. income tax consequences of an income distribution to the beneficiaries of a foreign non-grantor trust depend upon whether the distribution represents current income, distributable net income (“DNI”) or accumulated income, undistributed net income (“UNI”). When a U.S. beneficiary receives a distribution of income from a foreign non-grantor trust, the U.S. beneficiary will generally be taxed on his or her share of DNI of the trust.

To the extent that DNI is not distributed, the amount is accumulated, and constitutes UNI. When the UNI is ultimately distributed, it is an “accumulation distribution,” and is subject to a “throwback tax.” See IRC Section 665(b).

Below, please find an example of how the throwback tax is calculated on a non-grantor trust.

Trust X has UNI of $100,000 in Year One and $200,000 in Year Two. It paid income tax in Years One and Two of $33,000 and $90,000. It makes a distribution of $150,000 of UNI in Year Three. Beneficiary’s taxable income for the past five years is $300,000, $200,000, $100,000, $200,000, and $200,000. The throwback tax is computed as follows:

Step one. The accumulation distribution is deemed made from each year’s UNI beginning with the earliest year.

Step two. The income taxes paid by the trust attribution is added to the accumulation distribution. The sum is then deemed distributed. In this case, the amount of UNI for Year One is $100,000 plus $33,000 tax, or $133,000. The amount of UNI for Year Two is $50,000 distribution plus $22,500 tax. This amount equals $72,500. The deemed distribution totals of UNI for Years One and Two is $205,500.

Step three. For step three, it is necessary to ascertain the beneficiaries’s taxable income for the beneficiary’s five taxable years preceding the distribution. It is also necessary to disregard the two years with the highest and lowest taxable income. The remaining three years are called the “Base Years.”

Step four. For step four, it is necessary to divide the deemed distribution by the number of UNI years. Expressed formulaically: $205,500 deemed distribution divided by 2 UNI years = $102,750. It is then necessary to add this number to each of the Base Years’ taxable incomes. In this case, each Base Year will have $302,750 taxable income (i.e., $200,000 deemed base year income + $102,750).

Step five. For step five, it is necessary to determine the average increase in the beneficiary’s tax for the Base Years. Using the facts discussed above, the average increase in tax for the Base Years is $40,689.

Step six. For step six, it is necessary to multiply the average increase in tax by the number of UNI years. As per the facts discussed above, this would be determined as follows: $40,689 X 2 = $81,378. It is then necessary to subtract the taxes deemed distributed to the beneficiary. In this case, $81,378 – $55,500 taxes deemed distributed = $25,878.

Step seven. The final step is to determine the throwback tax. The number determined at the end of step six to be the throwback tax was $25,878.

As demonstrated above, the computation of the throwback tax is not only complicated, the throwback tax can be significant.

As a result of the complicated and harsh throwback tax, some U.S. beneficiaries of foreign non-grantor trust have considered domesticating foreign trusts to the U.S. In some cases, domesticating a foreign non-grantor trust can be an effective tool for the beneficiaries of such a trust to avoid the throwback tax. The most frequent situation in which a non-grantor foreign trust is when foreign beneficiaries of such a trust become U.S. persons.

There are two possible ways to domesticate a foreign non-grantor trust. The first option is known as a migration of a foreign trust. Under this option, the foreign non-grantor trust can name one or more U.S. persons as trustee of such a trust. The appointment of one or more U.S. trustees that have responsibilities for making all substantial decisions involving the trust could result in the foreign trust satisfying the above discussed Court and Control tests. Once the Court and Control tests are satisfied, the foreign non-grantor trust could be considered a U.S. rather than a foreign trust. The problem domesticating a foreign non-grantor trust with appointing future U.S. trustees is the trust must ultimately become a trust that is enforceable under U.S. law. This often requires a revision of the foreign trust to comply with laws of a U.S. state. These revisions may create a conflict with U.S. and foreign laws.

In the alternative, U.S. beneficiaries of a foreign non-grantor trust can elect to utilize a process known as decanting to domesticate the foreign trust. Under this process, the foreign non-grantor trust’s assets are transferred into newly created U.S. domestic trusts upon a specific period of time such as the death or incapacity of settlor of the foreign trust. The right to decant was first discussed by the Florida Supreme Court in Philipps v. Palm Beach Trust Co, 142 Fla 782 (1940). The Florida Supreme Court ruled that it was within a trustee’s discretion to invade a trust’s principle and pay it to another trust established for the benefit of the original trust beneficiary. While the details vary greatly among the states with decanting statutes, the premise is the same. A trustee’s discretion to make distributions include the lesser power to move the trust assets to a second trust. Most statutes expressly prohibit the modification or elimination of an income interest. Though most statutes preclude a trustee from using decanting to add new beneficiaries, many statutes indirectly permit the addition of beneficiaries by allowing the second trust to include a limited power of appointment that theoretically could be used by the power holder to expand the class of beneficiaries. The benefit of decanting a foreign non-grantor trust is it can provide the U.S. beneficiary or potential U.S. beneficiary of a foreign trust with predictability of future trust administration. 

Whether a foreign non-grantor trust becomes a U.S. trust as a result of migration or decanting, throwback tax consideration will remain. For example, if the foreign non-grantor trust contained significant cash or assets that were not distributed, these undistributed amounts could be reclassified into DNI and be subject to the throwback tax upon the reclassification of the trust.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.