In a previous post, we discussed the tax implications for U.S. beneficiaries who receive a distribution from a foreign trust. That discussion assumed that the trust in question was, in fact, a foreign trust for U.S. federal tax purposes. What, then, makes a trust a "foreign" trust?
The Internal Revenue Code unhelpfully provides that a foreign trust is any trust that is not a domestic trust.1 Accordingly, whether a trust is a foreign trust is determined by analyzing whether the trust does or does not qualify as a domestic trust for U.S. federal tax purposes. The tests for analyzing domestic trust status are found in the Treasury regulations.
In order for a trust to be classified as a domestic trust for U.S. federal tax purposes, the trust must satisfy both of the following two tests:
- Court Test: A court within the U.S. is able to exercise primary supervision over the administration of the trust; and
- Control Test: One or more U.S. persons have the authority to control all substantial decisions of the trust.
The Court Test is exactly what it sounds like and does not leave much to the imagination. If a trust is governed by U.S. law (i.e., the laws of a state of the U.S.) and is, in fact, administered exclusively in the U.S., it will generally satisfy the Court Test.2 The Control Test, however, is more nuanced and is where planning can be done and where, perhaps more importantly, mistakes can be made.
A "substantial decision" for purposes of the control test means a decision that a person is authorized or required to make under the terms of the trust instrument and applicable law and that is not ministerial in nature.3 Some examples of substantial decisions include decisions concerning the following:
- whether and when to distribute income or principal from the trust;
- the amount of any distributions;
- whether to terminate the trust; and
- whether to remove, add, or replace a trustee.
The foregoing merely describes some of the more common decisions that might come to mind when thinking of decisions that would be substantial decisions relating to a trust.4 Practitioners might be surprised to learn that less obvious decisions can also constitute substantial decisions, such as the decision of whether to compromise, arbitrate, or abandon claims of the trust.
The definitional requirements of domestic and foreign trust status afford planning opportunities for practitioners and clients, and, with proper drafting, it should be possible to achieve the desired classification. For example, it is possible that a trust with seemingly U.S. connections only can be still be considered a foreign trust for U.S. federal tax purposes. For example, consider an irrevocable trust established in Florida with a professional Florida trust company acting as trustee. The trust was created by a U.S. person for U.S. beneficiaries and owns only assets located in the U.S., but has a foreign protector who has the power to remove and replace the trustee. Such a trust would be classified as a foreign trust for U.S. federal tax purposes. On the other hand, appropriately structured, there could be a situation where a foreign person could have authority over investment decisions. While investment decisions are considered substantial decisions for purposes of the Control Test, if a U.S. person has the power to hire and fire such foreign person, the trust could still be considered a domestic trust.
The decision of whether a trust should be foreign or domestic is a case-by-case analysis, likely with pros and cons attaching to each decision. In certain cases, foreign trust status may be preferable (e.g., during the lifetime of a foreign grantor). In other cases – even those cases involving a foreign grantor – domestic trust status may be preferable (e.g., in the preimmigration planning context).
Clients should also be mindful of potential traps for the unwary. For example, the determination of whether a trust is foreign or domestic can change during the year if a person having a substantial decision was initially a U.S. person and later changed residency status. Another example is if the trustee is a U.S. person but lives outside of the United States, resulting in the administration of the trust happening outside of the United States such that the trust could fail the Court Test and be a foreign trust. In other words, converting from a foreign trust to a domestic trust (and vice versa) is very easy, whether or not such conversion was intentional.
Practitioners should bear in mind any related U.S. federal income tax consequences of such conversion, particularly in the case of a domestic trust that converts to a foreign trust.5 Additionally, information reporting implications should be observed. A distribution from a foreign trust to a U.S. beneficiary would require the U.S. beneficiary to report that distribution on IRS Form 3520 even if such distribution is not otherwise taxable income to the beneficiary. Thus, if a trust that was a domestic trust converted to a foreign trust, even if accidental, it could become an unexpected reporting surprise for any U.S. beneficiaries.
Another trap relates to the fact that a trust could be treated as a foreign trust for U.S. federal tax purposes even though established using the governing law of a U.S. state, but could still be treated as a U.S. based trust for other purposes. For example, if such U.S. governed law trust has an underlying non-U.S. bank account (either directly or indirectly), there could be an FBAR (FinCen Form 114) reporting obligation for the trust itself and any U.S. based trustee of the trust. The failure to report such non-U.S. accounts could lead to potentially significant penalty exposures. Another inconspicuous area relates to the treatment of the trust for SEC Regulation S purposes, which could limit what types of investments can be offered and sold to the trust or its underlying companies.
Practitioners and clients should keep these rules in mind when implementing a trust structure to ensure that the desired classification is achieved, not just at the time the trust is established, but also during the term of the trust. Additionally, thought should be given to long-term planning implications, as the most tax-efficient structure could change over time depending on the tax status of the grantor and the composition of the beneficiary class.
1 "Domestic" in this context means that the trust is viewed as a U.S. person for U.S. federal tax purposes.
2 Exceptions do exist, however, such as if the trust is subject to an automatic migration clause (sometimes commonly referred to as a "flee clause").
3 Examples of decisions that would be ministerial in nature include decisions regarding details such as the collection of rents and bookkeeping.
4 A full list of examples can be found in the Treasury regulations at § 301.7701-7(d).
5 Such conversion could be viewed as a taxable sale of the underlying trust assets.