Auditing U.S. Involved Foreign Trusts: A Must for Foreign Trustees

Cayman Financial Review
July 19, 2011

Many financial institutions and trust companies in the Cayman Islands serve as the trustee of trusts in which at least one settlor or a current or future beneficiary is a United States person. It is now more important than ever that these trustees fully understand all past, current and future United States federal and state tax payment and reporting obligations related in any way whatsoever to such trusts.

Recent Internal Revenue Service regulatory and Congressional legislative efforts to better enforce compliance with the tax and reporting requirements of United States taxpayers with interests in foreign
trusts and other entities, such as the Foreign Account Tax Compliance Act1 and The Offshore Voluntary Disclosure Initiative2 have highlighted the difficult position in which a foreign trust company can be placed without proper professional guidance from a qualified United States tax attorney.  

For any trust that has a United States person, who is the settlor or current or future beneficiary, and also for any trust that directly or indirectly owns assets located within the United States, the trustees should take the steps necessary to determine the following:  

  • The current and past places of residence, domicile and citizenship for each settlor and beneficiary, and whether any changes to the current status are anticipated. 
  • Whether any settlor or beneficiary ever renounced their United States citizenship or relinquished their United States green card. 
  • Whether the trust is considered to be a foreign trust for federal tax purposes and under what circumstances that may change. 
  • The extent to which the trust is (and has been) a grantor trust and/or a non-grantor trust for United States federal income tax purposes. 
  • Who (if anyone) is current or in the past has been treated as a grantor of the trust and who (if anyone) is currently or in the past has been treated as the owner of the assets of the trust and under what circumstances that may change. 
  • The United States federal income, estate and gift tax consequences to the settlor and each beneficiary who is a United States person, whether due to (a) direct or indirect transfers of property to the trust, (b) powers or rights in connection with the trust or the entities owned by the trust and/or (c) the right to potentially benefit from the trust or the direct or indirect actual or deemed receipt of distributions or loans from the trust. 
  • The United States federal and state reporting requirements, if any, of the trustees, the settlor(s) and the beneficiaries of the trust (ie, Internal Revenue Service Forms 3520, 3520-A, 8621, 5471, 1040, 1041, 8858, 926, 706 and 709, Treasury Department Form TD F 90-22.1 and compliance under FATCA). 
  • Whether and to what extent the trustee could be held liable for United States federal withholding tax or federal and state transfer tax (such as estate tax and gift tax). 
  • What important changes should be made to the trust deed, letter of wishes and/or the entities owned by the trust to ensure the trust is structured in a tax-efficient manner (ie, to ensure there is a “step-up in basis” upon the death of the settlor, to prevent a United States person from having a “general power of appointment” for United States federal tax purposes, etc). 
  • How to administer the entities owned by the trust in a tax efficient manner (ie, whether and when to make a “check-the-box election” and how to deal with appreciated assets and retained earnings). 
  • What type and situs of investment structures should not be held directly by the trust or indirectly through an entity. 
  • What procedures should be followed for making any additions to the trust so as to avoid adverse tax and reporting requirements. 

Trustees are well advised to conduct proper advance planning and employ institutional procedures for a systematic review of their trust inventory on a regular basis.
By doing so, the trust company can avoid serious problems before they present themselves and minimise reputational risks. The benefits of maintaining an ongoing trust audit policy within the trust company far outweigh the costs involved. 

Merely relying upon a representation by a settlor or beneficiary as to his or her compliance with United States federal and state tax payments and reporting obligations should not be viewed as sufficient for the comfort of the trustee. Similarly, the failure of the settlor or beneficiary to comply with United States law should not be tolerated by the trustee.

Our experience has been that financial institutions and trust companies have found a systematic trust audit to be a very useful tool to assure themselves and their clients that their trust inventory has been properly reviewed and that important United States tax and reporting issues have been properly addressed. 

Hal J. Webb
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