Importance of Estate and Tax Planning

Transcription

1 Washington, DC New York, NY New Haven, CT Chicago, IL FOREIGN TRUSTS: EVERYTHING YOU WANTED TO KNOW Doc. # Donald Kozusko Kozusko Harris Duncan Stanley A. Barg 575 Madison Avenue March 10, 2016 New York, NY Importance of Estate and Tax Planning Persons subject to U.S. taxation can realize substantial savings through estate and asset planning. U.S. recognizes broad range of trusts and trusts play an important role in many structures. Particularly effective for non-u.s. persons who take professional advice before coming to or investing in the U.S. Also important for U.S. persons who acquire assets outside the U.S. or who have family members who reside outside the U.S. and may not be U.S. persons. 1

2 Use of Trusts 3 Important part of estate plan for virtually every person of means Control Privacy Asset protection Tax efficiency Hybrid Trusts Business Trusts Purpose Trusts Foundations Comment Other Types of Trusts 4 Business Trusts Sometimes called statutory trusts since now authorized and regulated by State statutes in the US Most often used as a multi-party investment vehicle and thus treated as a (1) partnership for US federal income tax purposes, or (2) if trustee s investment powers are very restricted, as a fixed investment trust taxed as a grantor trust as to each investor (to avoid double taxation as an association taxable as a corporation ); Reg (c); Rev. Rul (authority to reinvest sale proceeds causes disqualification as a trust); Rev. Rul , (permitting staggered formation and funding of trust over a 90-day period with substantially the same assets)). Check the box rules do not control whether it s taxed as a trust. (Reg (a). Historically business trusts were governed by trust law principles but modern statutes as in Delaware have elaborate default rules on matters not addressed by agreement. Purpose trusts Authorized by statute in the US; relatively new vehicle, typically used in commercial and lending structures and limited in duration, but have been used to hold ownership of private family trust cos in states that allow longer duration. US federal income tax treatment is not well established but should be taxed as a trust without beneficiaries by analogy to pet trusts (see Rev. Rul , CB 192) or taxed as a fixed investment trust, which may be a non-grantor or a grantor trust. Nominee trusts: a trust in which the trustee merely holds title subject to direction of the beneficiaries would usually be treated as a mere agent or nominee relationship (typical fidei comiso ruled as agency in Rev. Rul , IRB 1267) 2

3 5 Classification of Foundations Memorandum AM Entity Classification of Liechtenstein Anstalts and Stiftungs. Issued by Internal Revenue Service Office of Chief Counsel 16 October In most cases Anstalts are properly classified as business entities. Stiftungs will be classified as trusts, unless under the facts and circumstances, the entity was created primarily for commercial purposes. 6 Foreign Trusts for U.S. Tax Purposes Objective Rule A trust is considered domestic for U.S. tax purposes only if: a U.S. court can exercise primary supervision over its administration (the court test); and the U.S. fiduciaries have the authority to control all substantial decisions relating to the trust (the control test). A trust that does not satisfy both tests is a foreign trust for U.S. tax purposes. Trusts can become foreign because of appointment of new trustee 3

4 7 Court Test Treas. Regs (c) A court is able to exercise primary supervision over the trust if a U.S. court has authority to render orders or judgments resolving substantially all issues concerning administration of the entire trust. A trust that is registered with a U.S. court under the registration provisions of a statute similar to Article VII of the Uniform Probate Code meets the court test. If the parties take steps with a U.S. court that cause the administration of the trust to be subject to the primary supervision of the court, the trust meets the court test even if both a U.S. court and a foreign court have jurisdiction over the trust. A trust fails the court test if the trust instrument includes a migration clause but a clause triggering migration of the trust only in the case of foreign invasion or widespread confiscation or nationalization of property is not regarded as a migration clause. Safe Harbor: The trust instrument does not direct that the trust be administered outside of the U.S. The trust is actually administered exclusively in the U.S. The trust is not subject to an automatic migration provision. Comment Auto Migration Provision 8 Automatic migration provision precludes treatment as a US trust for federal income tax purposes But a typical flight clause might not be literally automatic (if conditions or trustee discretion is involved) and would not be treated as a flight clause if triggered only by foreign invasion of or widespread expropriation in the US. Can be used if foreign status is desired if it is does not disrupt the design of trust governance and is not expected to actually be triggered. However, these clauses might not in fact be innocuous, i.e., unlikely to ever apply, as shown by Example 2 from safe harbor control test in Reg (c)(5): The trust instrument further provides that in the event that a creditor sues the trustee in a United States court, the trust will automatically migrate from State Y to Country Z, a foreign country, so that no United States court will have jurisdiction over the trust. See also Reg (d)(3). Thus designing such a clause goes beyond an exercise in pasting in boilerplate language from a form book, and depends on the desired tax situs (US or foreign) and the triggering events. The Treasury has not taken up the suggestion that the U.S. situs choice be made elective. 4

5 9 Control Test Treas. Regs (d) One or more U.S. persons must have the authority to control all substantial decisions of the trust. Substantial decisions include: Whether and when to distribute income or corpus The amount of any distributions The selection of a beneficiary Whether a receipt is allocable to income or principal Whether to terminate the trust Whether to compromise, arbitrate or abandon claims Whether to sue on behalf of the trust or to defend suits against the trust Whether to remove, add or replace a trustee Investment decisions Comment Control Test Planning 10 Note that, subject to a grace period under the Regulations to correct for inadvertent changes, a U.S. trust can become foreign due to a trustee change, or a change in the tax residence of a non-u.s. citizen individual holding a power, since US persons does not include individuals who are nonresident aliens as to the US. Reg (c). The rule applies to non-fiduciary powers, not only trustee powers e.g., a power to add a beneficiary such as in a typical power of appointment, or a power to direct investments if not terminable at the will of U.S. persons. But non-fiduciary powers could be held, for example, by a corporation incorporated under U.S. law (which typically would qualify as a U.S. person). Examples of powers under the control test: Power to allocate receipts between income/principal is not substantial if the distinction is meaningless under the trust. Power to deal with claims may be a convenient means to create foreign status. See Reg (d)(3). Power to remove and replace a trustee can lead to surprising result if trustees have mixed US tax status but a trustee targeted for removal cannot in effect cast a vote due to a conflict of interest. 5

6 Grantor Trusts 11 Trust assets treated as owned by the foreign grantor and not subject to U.S. tax unless U.S. source. The Internal Revenue Service Office of Chief Counsel in a chief counsel advice memorandum said that grantor trusts are disregarded as entities separate from their owners for all federal income tax purposes. CCA released November 1, 2013 The Service position of treating the owner of an entire trust as the owner of the trust s assets is consistent with and supported by the rationale for attributing items of income, deduction, and credit to the owner. Accordingly, we conclude that a trust that is treated as a grantor trust is ignored as a separate entity apart from the owner for all federal income tax purposes Need to identify the Grantor Contributor in substance, not necessarily the Settlor. Under 672 (f)(5) and Reg (f)-5 a U.S. beneficiary is treated as the grantor to the extent he/she has made direct or indirect gifts to the foreign grantor, whether or not pre-arranged or tax-motivated, unless wholly unrelated. Multiple contributors to the trust result in multiple grantors PLR (6/30/2015) (foreign grantors, community property). Trusts that fund other trusts grantor of 2nd trust is ordinarily that of 1st trust, unless funded by using general power of appointment. Reg (e)(5). 12 Grantor Trusts with Foreign Grantors General rule: A trust (foreign or domestic) is treated as a grantor trust only if the person deemed to own the trust is a US citizen or resident or a domestic corporation. Designed to preclude the use of the grantor trust rules to eliminate all US income taxation on foreign-source income of a foreign grantor trust distributed to U.S. beneficiaries Exceptions: Revocable Trusts (solely by grantor or with consent of related and subordinate subservient party) Problems for trusts which were once non-grantor trusts. See last sentence of Reg 1.672(f)-3(a)(1). Irrevocable trusts benefiting only the Grantor and/or the Grantor s Spouse Grandfather rule for revocable trusts and certain 677 trusts in place as of Sept 15,

7 13 Grantor Trusts with U.S. Grantors Section 674 grantor or non-adverse party has power over beneficial enjoyment Section 675 grantor retains power to deal with or borrow from trust without adequate and full consideration Section 676 power to revoke Section 677 grantor or non-adverse party has power to distribute income to grantor or spouse Section 679 distribution from a foreign trust may be made to or accumulated for a U.S. beneficiary during taxable year Only practical protection against grantor trust treatment is for the trust to preclude irrevocably a distribution ever being made to a U.S. person; the Code and Regulations deal at length with changes in beneficiaries and their tax status, indirect beneficiaries, indirect transfers, powers of appointment, etc. Section 678 person other than grantor treated as owner 14 Tax Implications of Foreign Non-grantor Trusts Taxed as if non-us person: trust treated as owner of trust assets and not subject to US tax unless U.S. source. Deemed Sale: Under Code 684 any transfer of property by a U.S. person to a foreign trust or estate is treated as a sale or exchange for an amount equal to the fair market value of the property transferred and gain is recognized to the extent of the excess of the fair market value of the transferred property over the transferor's adjusted basis. Losses may not be recognized on the transfer of depreciated assets to a foreign trust and such losses also cannot offset gains otherwise recognized on the simultaneous transfer of depreciated and appreciated assets to a foreign trust. Applies to indirect and constructive transfers, as under 679, and to a transfer by a grantor trust as transferor or a transfer by reason of a foreign grantor trust ceasing to be a grantor trust. A domestic trust that becomes a foreign trust is deemed to have transferred all of its assets to a foreign trust, and, to the extent that the assets are attributable to transfers by U.S. persons, the domestic trust recognizes gain under Code 684 unless one of the exceptions otherwise applies. Reg Exceptions apply to transfers to foreign grantor trusts, certain charitable trusts, transfers at death with stepped up basis, and transfers for fair market value. 7

8 Comment Section 684 Deemed Sale 15 Example: deemed sale possible if grantor leaves the U.S. and ceases to be U.S. resident after funding a trust while a U.S. person (or even within 5 years of becoming a U.S. person, per 679) Trust becomes non-grantor trust because no longer has a U.S. grantor (e.g., grantor ceases to be U.S. person under substantial presence test) and the more restrictive rules preclude grantor trust status (e.g., trust is not qualified as revocable and is not exclusively for grantor and spouse during life) Trust becomes foreign because now flunks control test (e.g., grantor has investment power or changes trustee to a non-u.s. trustee) or trust was set up under non-u.s. court jurisdiction Grantor is not entitled to a step up, unlike an expatriating long-term resident Example: deemed sale is possible if grantor dies having established a foreign grantor trust while a U.S. person since trust necessarily becomes non-grantor upon grantor s death Transfer at death exception does not apply if trust doesn t qualify for 1014(a) basis step up 16 Distributions from Foreign Non-Grantor Trusts Distributions to U.S. beneficiaries carry out income: Distributions are attributed first to current year income (DNI). Up to that amount, they retain the character of income (e.g., capital gains) and are taxed accordingly to the beneficiary To the extent distributions in any year exceed DNI and FAI, the excess is first attributed to any undistributed net income (UNI) for prior years, which is then specially taxed as an accumulation distribution under the throwback rules. UNI is income from prior years that has not been distributed FAI is fiduciary accounting income If a foreign trust makes such an accumulation distribution to a U.S. beneficiary The amount of UNI deemed distributed must be calculated and attributed to the preceding taxable years of the trust on a FIFO basis, i.e., starting from earliest years with UNI. The resulting income is taxed at ordinary rates. The beneficiaries can credit any foreign taxes paid by the trust on that income. An interest charge is added to the tax (now at variable compound rates), calculated from the length of time the US tax was deferred by the income accumulation by the trust. Distributions are not attributed to principal until UNI has been exhausted. Interest charge does not apply for years when beneficiary was not a U.S. person. Same result should apply to the underlying tax none if no U.S. source income. 667(a)(last part of first sentence); e.g., Zaritsky et al, Federal Income taxation of Estates and Trusts, 6.06[6][b]. 8

9 17 Non-Grantor Foreign Trusts - Reporting Any distribution from a foreign trust, whether from income or principal, to a U.S. beneficiary will be treated as an accumulation distribution if adequate records are not provided to justify some other treatment. If a U.S. beneficiary receives a Foreign Grantor Trust Beneficiary Statement, the beneficiary must treat the distribution as a nontaxable gift from the owner of the trust. If a U.S. beneficiary receives a Foreign Non-grantor Trust Beneficiary Statement that provides adequate information to determine the U.S. tax consequences of the distribution from the foreign trust, the beneficiary may determine the tax consequences of the distribution on an actual basis and avoid the default treatment available under Form If neither statement is obtained, Form 3520, Schedule A, allows the U.S. beneficiary to limit the amount treated as an accumulation distribution by using actual distributions from the trust for the prior 3 years to calculate an average annual baseline. Under this default treatment, the total 3-year amount is multiplied by 125% and divided by 3. Any distribution in the current year up to this baseline is taxed as a distribution of current ordinary income, and only the excess amount, if any, of the current distribution is treated as an accumulation distribution. Thus the simple math allows distributions to increase each year without triggering an accumulation distribution, although this method obviously requires a prolonged period of management of distribution levels. Reporting can be switched to exact method in final year of the trust. 18 Intermediary Rules A transfer to a U.S. person will be treated as made by a foreign trust rather than by the transferor ( intermediary ) if the intermediary (who is not the trust grantor) receives the property or certain related property from the foreign trust principally to avoid U.S. tax. Code 643(h) and related regulations. The principal tax avoidance purpose will be found if the following facts are present: The U.S. person is related to a grantor of the foreign trust or has another relationship with the grantor that establishes a reasonable basis for concluding that the grantor would make a gratuitous transfer to the U.S. person; The U.S. person receives from the intermediary, within 24 months before or after the intermediary's receipt of property from the foreign trust, either the actual property the intermediary received from the trust or proceeds from that property or property received in substitution for that property; and The U.S. person cannot sufficiently demonstrate that (a) the intermediary has a relationship with the U.S. person that establishes a reasonable basis for concluding that the intermediary would make a gratuitous transfer to the U.S. person; (b) the intermediary acted independently of the grantor and the trustee; (c) the intermediary is not an agent of the U.S. person; and (d) the U.S. person timely complied with the reporting requirement of Section 6039F, if applicable and if the intermediary is a foreign person. Note that the 24 month rule is a sword for the IRS, not a shield for the U.S. person. Transfers outside of the 24 months are not in a safe harbor. 9

10 Mitigation of Throwback Tax 19 Isolate Tainted Income with Cleansing Distribution A wholly discretionary trust that makes a distribution to a foreign person carries out income of the distributing trust. The distribution could be to a foreign trust. A distribution to a U.S. beneficiary in a subsequent year will not carry out income of the trust if all income has been stripped by the distributions to foreign persons in prior years. Distribution of no more than current income in any year Use of Default Method Life Insurance Products Sale of a beneficial interest in the trust Domestication Fiduciary Accounting Income Limitations: No accumulation distribution is deemed to have occurred if the total trust distributions do not exceed the year s fiduciary accounting income. Code 665(b) Resettlement to a new (grantor) trust using a general power of appointment Distinguish from use of a distribution or pour-over. The powerholder is the grantor of a trust funded by using general power of appointment. Reg (e)(5). Comment Mitigation of Throwback Tax 20 Default Method from Form 3520: Practical and predictable Does not avoid ordinary income treatment on entire distribution, just the interest charge; can switch to exact method in final year to report original basis/principal free of tax Building up an initial 3-year base period ordinarily requires taxable distributions, unless distributions can be made to a trust with exempt or low tax beneficiaries Despite the similarity to the excess distribution rules for PFICs, Form 3520 does not coordinate with that tax regime Examples of Fiduciary Account Income Limitation: Corporate dividends from check the box entity are generally FAI unless extraordinary or liquidating Exact treatment depends on local trust law to define FAI Example of troublesome deemed distribution: IRC 643(i)(1) treats personal rent-free use of a residence (or tangible property) by a U.S. beneficiary (or grantor, or related person) as a deemed distribution (unless fair market rent). Troublesome because a trust that also holds funds to pay property expenses is likely to have UNI due to lack of offsetting deductions. 10

11 Comment Domestication Process 21 Ordinarily domesticate by simply naming U.S. trustee, to avoid an accumulation distribution. Accumulation history is then preserved and the trust becomes a hybrid: no throwback rules apply to the domestic-status accumulation years but would to the foreign status accumulations according to Rev. Rul However, trusts coming to the U.S. usually need revision. Often easier to remodel an irrevocable trust under local U.S. trust law than under law of originating jurisdiction (unless, of course, an effective decanting power is provided by the trust document). Bright line rules for preserving foreign trust status (relying on the control test) afford the opportunity to access U.S. trust law while maintaining foreign income tax status to avoid an accumulation distribution during that process. Comment Tax Treatment of a Decanting 22 IRS requested comments regarding when transfers from one irrevocable trust to another ( decanting ) that result in a change of beneficial interest are not subject to income, gift, and estate taxes. Notice But the issue has disappeared from the Priority Guidance List. Comments by ACTEC of April 2, 2012 (posted on actec.org under Resources/Government Submissions ) explain that a decanting power ought to be treated like a trustee s distribution power: If a decanting is partial, the receiving trust ( Receiving ) should be treated for income tax purposes as if receiving a distribution as a beneficiary of the distributing trust ( Distributing ), but Receiving should be treated as a continuation of Distributing if the decanting passes out all the assets. The grantor should not change, because the decanting power is not comparable to a general power of appointment. If the trustee who decants the trust is not a beneficiary, the transfer should not ordinarily be attributed to the beneficiary for estate/gift tax purposes, even if the beneficiary s trust interest is thereby diminished, unless the beneficiary could block the decanting under trust law or would be attributed the trustee s distribution powers under Rev. Rul due to a power to remove and replace the trustee. Similarly the decanting should ordinarily not change the identify of the transferor under the generation-skipping transfer tax ( GST ), and thus a decanting should not cause a clean NRA trust (not subject to GST because funded by a non-domiciliary with non-u.s. situs property) to lose its protection from these wealth transfer taxes 11

12 Check The Box Entities The use of companies under trusts and the problems with PFICs Election out of default classification Made on Form 8832, Entity Classification Election Generally effective on date filed 75-day retroactive election 12-month prospective election Timing Issues 60-month moratorium on change after election Comment PFICs Owned by Trusts 24 U.S. Treasury has failed to propose regulations on how to attribute ownership of foreign investment companies owned by foreign non-grantor trusts to the trust beneficiaries for allocating any taxable income at the trust level from excess PFIC distributions or from dispositions of PFIC interests. Fundamentally the PFIC regime was designed to offset offshore deferral in mutual funds by imposing an interest charge upon an excess distribution or disposition. Thus it calls for Regulations to allocate income from PFICs held by trusts in order to prevent foreign trusts from walling off taxable income and undermining the PFIC anti-deferral regime. But the PFIC regime generally does not tax phantom income, or gain prior to a disposition, because PFICs are not controlled by U.S. persons. Also, the PFIC regime was enacted 10 years before the trust throwback rules were reformed and made much more robust. The modern throwback rules now provide a strong anti-deferral regime at the trust level. Indeed the default method for trusts mirrors the PFIC system for determining excess distributions, so the two regimes are essentially duplicative if applied literally. Treating trusts as fully transparent would also ignore the reality that the economic enjoyment of a trust asset by an individual U.S. beneficiary is not predictable prior to an actual distribution. Thus ACTEC has called for PFIC regulations that rely on the throwback rules of Subchapter J rather than treating trusts as transparent in allocating PFIC income earned by foreign trusts. S. Vetter ACTEC Proposals Integrate Subchapter J, PFIC Regime for Foreign Trusts, Tax Notes (October 11,2010). 12

13 Washington, DC New York, NY New Haven, CT Chicago, IL FOREIGN TRUSTS: EVERYTHING YOU WANTED TO KNOW Donald Kozusko Kozusko Harris Duncan Stanley A. Barg 575 Madison Avenue March 10, 2016 New York, NY