The Impact of U.S. Tax Reform on International Private Clients and Their Foreign Trusts

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1 The Impact of U.S. Tax Reform on International Private Clients and Their Trusts Hal J. Webb: Partner Head of International Private Client Services STEP Cayman April 19,

2 Gift and Estate Tax Exemption Amounts The U.S. federal gift and estate tax exemption amount has been increased to $11,180,000 per U.S. citizen or domiciliary $22,360,000 for a married couple if both U.S. citizen or domiciliary Still $60,000 exemption for federal estate tax for transfers of US situs assets by non-us citizen/domiciliary, and still no exemption for federal gift tax (for gifts of tangible property in the U.S.) Exemption amount will automatically revert to approximately $6 million beginning January 1, 2026 Annual exclusion of $15,000 for U.S. federal gift tax for all donors Amount is unlimited (tax-free) if donee is the U.S. citizen spouse of donor ($152,000 if donee is the non-u.s. citizen spouse of donor) Most gifts made by a non-us citizen/domiciliary can be structured to be tax-free in the U.S. U.S. situs assets subject to estate tax, possibly gift tax 2

3 Grantor Trusts The grantor of the trust is treated as the owner of the trust's assets for US federal income tax purposes Transparent entity and income is treated as earned by the grantor/owner Trusts with non-u.s. grantor only can qualify as grantor trust if: Grantor has power to revest the trust assets in himself during grantor's life Distributions may be made only to the grantor and/or grantor's spouse during grantor's life There are some exceptions Incapacity of grantor 3

4 Nongrantor Trusts A separate taxable entity where the trust's taxable income is taxed at the trust level unless distributed out and taxed at the beneficiary level All trusts initially classified as grantor trusts will become nongrantor trusts upon death of grantor or possibly earlier (except if someone other than the grantor then starts being treated as the owner of the assets of the trust for U.S. federal income tax purposes) Domestic nongrantor trust subject to income tax on worldwide income nongrantor trust subject to income tax on certain US source income 4

5 Overview of CFC Rules A controlled foreign corporation ("CFC") is a non-u.s. company treated as a corporation of which more than 50% (by vote or value) of its stock is owned (or deemed to be owned via attribution rules) by U.S. persons If a U.S. person owns at least 10% (by vote or value) of a CFC, certain types of income (known as Subpart F income) are treated as being earned by such shareholder via a dividend even if such shareholder doesn't receive anything from the company that year e.g., passive income such as interest, dividends and gain from the sale of publicly-traded stock Attribution rules treat beneficiaries of a foreign nongrantor trust as owning stock owned by the trust; CFC issue is triggered if more than 50% of shares are owned or deemed to be owned by U.S. persons "30-Day Rule" (now repealed) provided that if a foreign corporation was not a "controlled foreign corporation" for more than 30 days during the tax year, no "Subpart F" income would pass through the foreign corporation to its U.S. shareholders 5

6 Overview of PFIC Rules A passive foreign investment company ( PFIC") is a non-u.s. company treated as a corporation of which either 75% or more of the corporation's gross income for its taxable year is passive income (income test) or at least 50% of the average percentage of assets held by the foreign corporation during the taxable year are assets that produce passive income or that are held for the production of passive income (asset test). No minimum U.S. ownership required U.S. shareholder taxed on dividend/distribution or gain from sale or exchange, subject to special tax rates and an interest charge; certain elections can be made to change tax treatment Attribution rules treat beneficiaries of a foreign nongrantor trust as owning stock owned by the trust; PFIC issue is typically triggered if the trust owns a holding company which in turn owns financial assets, of if the trust directly or indirectly owns funds incorporated in a jurisdiction outside the U.S. 6

7 Overview of Check-The-Box Election Default classification of entity as corporation, partnership or disregarded entity Check-the-box election to make initial classification or to change default or initial classification (IRS Form 8832) Change in classification of a corporation is treated as a liquidation of the company at the end of the day on the day before the effective date Eligible entities can make election; per se corporations cannot Election can be made retroactively up to 75 days (or up to 3 years and 75 days with IRS approval for relief pursuant to Revenue Procedure; or even longer with private letter ruling) Relevance Commonly used to prevent foreign companies from being a CFC or PFIC 7

8 Step-Up In Basis for Assets in Trust: Relevant Law Step-up in basis applies to all trust assets which are included in the gross estate of the decedent and all other assets held in a trust described in the following sections: Sec. 1014(b)(2): Property transferred by the decedent during his lifetime in trust to pay the income for life to or on the order or direction of the decedent, with the right reserved to the decedent at all times before death to revoke the trust Sec. 1014(b)(3): Property transferred by the decedent during his lifetime in trust to pay the income for life to or on the order or direction of the decedent, with the right reserved to the decedent at all times before death to make any change in the enjoyment thereof through the exercise of a power to alter, amend, or terminate the trust 8

9 Step-Up in Basis for Assets in Trust: Provisions in Trust Documents In addition to power to revoke or amend (or other similar powers), provide power of appointment over income or right to income for life Make sure power is not limited by local law; and Make sure power does not have to be exercised by the settlor in a fiduciary manner Consider whether the settlor continues to have the appropriate powers during incapacity 9

10 Typical (Pre-Repeal) Structure #1 Settlor Revocable Grantor Trust Corporation Investment Portfolio Upon death of Settlor, trust automatically receives step-up in basis in shares of FC (if trust structured properly) No automatic step-up of FC's basis in IP FC can elect to change its classification if eligible entity (treated as liquidation of FC) Check-the-box election made by FC effective prior to death, except if IP includes U.S. situs assets If IP includes U.S. situs assets, check-the-box election made effective post-death Typically effective between 2 days and 29 days after death to avoid CFC rules; otherwise potential Subpart F inclusion if gain is realized If IP includes PFICs, indirect disposition of PFICs Usually nominal amount of gain or loss in shares of FC Potential tax position risk 10

11 Typical (Pre-Repeal) Structure #2 Settlor Corporation 1 Revocable Grantor Trust Corporation 2 Same as previous slide, except: Check-the-box election made by FC1 effective prior to death Check-the-box election made by FC2 effective post-death Separates foreign situs assets from U.S. situs assets so foreign situs assets are not subject to some federal tax issues applicable to U.S. situs assets Investment Portfolio: Only Situs Investment Portfolio: Only U.S. Situs 11

12 Planning Option #1: No U.S. Situs Assets Settlor Revocable Grantor Trust Upon death of Settlor, trust automatically receives step-up in basis in shares of FC (if trust structured properly) No automatic step-up of FC's basis in IP Check-the-box election made by FC effective prior to death FC can invest in U.S. equity markets via foreign funds Corporation Investment Portfolio: Only Situs 12

13 Planning Option # 2: Churn/Cleanse Contribution Settlor Revocable Grantor Trust Corporation Investment Portfolio Dividend Use typical pre-repeal structure, but churn and cleanse in case IP includes U.S. situs assets at the time of settlor's death "Churn" refers to increasing basis of assets periodically so there is the least amount of built-in gain as possible existing at settlor's death; can be achieved by sale of assets or in-kind dividend "Cleanse" refers to reducing retained earnings by paying a dividend Periodically sell assets of FC and pay dividend of earnings and profits to trust; trust recontributes to FC assets it doesn't need to pay expenses or make distributions FC makes check-the-box election effective prior to the death of settlor, except that if IP includes U.S. situs assets, then effective date would be at least 2 days after death of settlor 13

14 Planning Option # 2A: Churn/Cleanse; Separate Corporations for U.S. Situs and Situs Corporation 1 Settlor Revocable Grantor Trust Corporation 2 Same as previous slide, except FC1 holds only foreign situs assets and FC2 holds only U.S. situs assets Churn and cleanse FC2, not FC1 Check-the-box election made by FC1 effective prior to death of settlor Check-the-box election made by FC2 effective at least 2 days after death of settlor Investment Portfolio: Only Situs Investment Portfolio: Only U.S. Situs 14

15 Planning Option #3: Two-Tiered Partnership Revocable Grantor Trust 99% Partnership 99% U.S. Partnership 1% 100% Corporation 1% Flow-through entities for U.S. federal income tax purposes; attempt to block U.S. estate tax in same manner as a foreign corporation U.S. estate tax law does not state the situs of a partnership; estate tax risk involved "Section 754 election" is required to achieve step-up in basis upon death of settlor FP may need to make check-the-box election to be treated as a partnership No need to make check-the-box election for FP post-death for income tax planning (no CFC or retained earnings issues, except for FC) FC can be replaced with an individual or trust but need to consider tax issues Investment Portfolio 15

16 Planning Option #3A: Two-Tiered Partnership for U.S. Situs & Corporation for Situs 100% Revocable Grantor Trust 99% 100% 1% Corporation Same as previous slide, except there are separate holding structures for U.S. situs assets and foreign situs assets Corporation Partnership 1% 99% Investment Portfolio: Only Situs U.S. Partnership Investment Portfolio: Only U.S. Situs 16

17 Planning Option #4: Irrevocable Trust Settlor Irrevocable Trust Holding Company [Optional] Investment Portfolio Irrevocable trust can be an estate tax blocker (if trust is structured properly) Upon death of settlor, no U.S. estate tax (risk of estate tax if settlor is a beneficiary) No automatic step-up in basis on death of settlor if no estate tax If trust is a grantor trust, can use holding company to manufacture step-up in basis by HC making checkthe-box election effective prior to death of settlor (may need other planning if IP includes U.S. situs assets) Grantor trust only if distributions can be made only to settlor and/or spouse of settlor during lifetime of settlor Consider for U.S. situs assets Can consider other planning ideas for step-up in basis Churn/Cleanse (if grantor trust) General Power of Appointment for NRA Etc. 17

18 Planning Option #5: Three Corporations for U.S. Situs Assets 100% Corporation 1 Investment Portfolio: Only Situs Revocable Grantor Trust 100% Corporation 2 50% 100% Corporation 4 Corporation 3 50% Check-the-box election made by FC1 and FC4 effective prior to death of settlor (ideal special timing for FC4's election) Need FC2 and FC3 so FC4's change in classification is treated as a taxable liquidation FC1, FC2 and FC3 serve as estate tax blockers Check-the-box election made by FC2 and FC3 effective at least 2 days after death of settlor (may trigger Subpart F income for U.S. beneficiaries) May not need to segregate U.S. situs assets and foreign situs assets Investment Portfolio: Only U.S. Situs 18

19 Other Planning Ideas Which structure is best? Depends on facts and circumstances Consider combination of planning strategies Check-the-box election for companies that own only foreign situs assets can be made effective when company is formed or at any time prior to the death of settlor (need to make sure company will never own U.S. situs assets) Importance of determining whether any company is or can become a CFC or PFIC due to attribution of ownership by beneficiaries Use of life insurance products Need to consider tax consequences and reporting requirements in relevant jurisdictions other than the U.S. 19

20 Change in Corporate Income Tax Rate Tax rate is now 21%, instead of previous brackets of 15% to 35% Will affect choice of entity planning for investment in U.S. assets 20

21 Form 5472 New requirement for 2017 tax year Required for foreign-owned single-member LLCs Reporting requirement created in part for the US to obtain information to potentially exchange with other countries Indirect ownership rules look-through grantor trusts to NRA Form is required only if there is a "reportable transaction" Reportable Transactions primarily include flow of funds between entities (e.g., contributions, loans, purchase, sale, etc.) 21

22 Repatriation Tax Deemed repatriation of deferred earnings and profits of: o CFCs; and o Other foreign corporations that have at least one shareholder that is a domestic corporation which owns at least 10% of the foreign corporation's shares Note: does not include a PFIC that is not also a CFC Measuring date for E&P inclusion is the greater of: November 2, 2017, or December 31, 2017 Tax rate for U.S. corporate shareholders: 15.5% for cash; 8% for non-cash Tax rate for U.S. individual shareholders: 17.5% for cash; 9.05% for non-cash Cash and cash equivalents include: (i) cash, (ii) net accounts receivable, (iii) personal property traded on a financial market, (iv) commercial paper, (v) certificates of deposit, (vi) state, federal, and foreign government securities, (vii) foreign currency, (viii) short-term obligations, and (ix) other assets that the IRS may identify 22

23 Global Intangible Low-Taxed Income ("GILTI") Applies to CFCs Essentially new category of Subpart F income Tax is based on the excess of 10% return on the tangible assets of the CFC Deduction of 37.5% for foreign-derived intangible income (FDII) plus 50% of the GILTI, and the amount treated as a dividend under Section 78. Deductions are reduced for tax years beginning after Dec. 31, Tax may be reduced by certain credits, such as foreign tax credit 23

24 CFC Downward Attribution NRA Corporation 1 Corporation 2 U.S. Corporation Section 958(b)(4) was repealed effective in 2017 Stock held by a foreign person will be attributed to a domestic corporation, partnership, trust, or estate This attribution can make a U.S. corporation treated as the shareholder of a brother-sister foreign corporation due to their common ownership by a foreign parent corporation Corporation 2 considered to be a CFC 24

25 2% Floor for Miscellaneous Itemized Deductions New law suspended miscellaneous itemized deductions for individuals for tax years beginning after 2017 and before 2026 Unclear if suspended for trusts too, and if so, for all deductions or only those not unique to trust (that would have otherwise been subject to 2% floor) Expenses unique to trust vs. miscellaneous itemized deductions (e.g., trustee fees vs. investment advisory fees and other related professional fees) 25

26 Expansion of Qualifying Beneficiaries of an ESBT An S corporation is a qualifying small business corporation that makes an election to be treated as a flow-through entity so there is a single-tax on corporate earnings at the shareholder level. An electing small business trust can be a shareholder of an S corporation. Effective January 1, 2018, a nonresident alien individual can be a qualifying beneficiary of an electing small business trust (ESBT). 26

27 Tax on Gain on the Sale of a Partnership Interest Effective for sales, exchanges, or other dispositions. Gain or loss from the sale of a domestic partnership interest is treated as effectively connected with a U.S. trade or business to the extent the transferor would have had effectively connected gain or loss had the partnership sold all of its assets at FMV as of the date of the sale/exchange Any gain or loss from the hypothetical asset sale by the partnership is allocated to interests in the partnership in the same manner as nonseparately stated income and loss Transferee is required to deduct and withhold 10% of the amount realized on the sale or exchange unless the transferor certifies it is not a NRA or foreign corporation 27

28 Technical Termination of a Partnership Partnership is treated as continuing upon a sale or exchange of 50% or more of the total interest in a partnership's capital and profits within a 12-month period Under prior law there was a "technical" termination of the partnership 28

29 Questions? Hal J. Webb Bilzin Sumberg Baena Price & Axelrod LLP 1450 Brickell Avenue, 23rd Floor Miami, Florida Bilzin.com 2018 Bilzin Sumberg Baena Price & Axelrod LLP. The materials contained within this presentation do not constitute legal advice and are intended for informational purposes only. These materials are not intended to be an advertisement and any unauthorized use of the materials is at the user's risk. Reproduction, distribution, republication and retransmission of any materials contained within are prohibited without the express written consent of Bilzin Sumberg Baena Price & Axelrod LLP. 29