What to Expect When a Foreign Settlor Becomes a U.S. Tax Resident
By Nina Krauthamer, Ruchelman P.L.L.C
It is quite common for a foreign high net worth individual to establish a foreign trust, usually discretionary, for the benefit of members of her family. There are a host of reasons - asset protection, forced heirship provisions, privacy – for creating such a trust. It is not unusual for a beneficiary of such a trust to move to the United States for education, work or personal reasons. It is less common for the settlor of the trust to make such a move, or be present for a significant period of time in the United States, but with increasing political and economic instability in many regions of the world, such moves are happening more frequently.
In addition to becoming a U.S. tax resident by becoming a permanent resident alien (a “green card” holder), a foreign person can become a U.S. tax resident by meeting a “substantial presence” test. There are a number of exceptions, based on the status of the individual (Form 8843), a “closer connection” to another foreign country if present for in the U.S. for fewer than 183 days (Form 8840), or a residency tie-breaker provision under an income tax treaty with the U.S. (Forms 1040NR/8833). Generally, a person can be present for roughly 120 days or less each year without meeting the substantial presence test. A U.S. tax resident is taxed on worldwide income and is subject to many reporting requirements.
Trusts can be treated for U.S. tax purposes as either foreign or domestic (U.S.), grantor or non-grantor, each with different operative rules. A trust will be a “foreign” trust for U.S. income tax purposes unless (i) a U.S. court can exercise primary supervision over trust administration (the "court test"), and (ii) U.S. persons control all substantial trust decisions (the "control test"). Most trusts established by foreign settlors will be designed as “foreign” trusts. A domestic trust is taxed on worldwide income, a foreign trust only on certain types of U.S.-source income.
Where home country tax regimes are favorable, a settlor may choose to use a foreign grantor trust (FGT), particularly when the intended beneficiary is a U.S. person. The grantor of an FGT is treated as the owner of the trust assets and is therefore treated, for U.S. tax purposes, as the taxpayer. Distributions to the U.S. beneficiary, while reported to the U.S. taxing authorities on IRS Form 3520, are not subject to U.S. income tax. A trust settled by a foreign individual will treated as a grantor trust only if the trust is fully revocable or benefits the grantor or spouse exclusively.
N.B. The FGT should not own U.S. assets that could give rise to U.S. estate tax (e.g., stocks and securities of U.S. corporations), or should hold such assets through a wholly-owned foreign corporate subsidiary.
Most foreign discretionary trusts, however, are structured as foreign nongrantor trusts (FNGTs) with the settlor retaining limited rights to income and capital of the trust. In that case, the FNGT (not the settlor) is the taxpayer, taxed as a nonresident alien individual not present in the U.S.
So what can a foreign settlor of either an FGT or an FNGT expect when the foreign settlor becomes a U.S. tax resident?
In the case of an FGT, the answer is straightforward – the settlor will continue to be treated as the owner of the assets of the trust, and therefore will be taxed on the trust’s worldwide income and gains. Certain investments in foreign corporations, however, may become problematic for the settlor if the foreign corporation is characterized either as a “controlled foreign corporation” (“CFC”) or “passive foreign investment company” (“PFIC”). If the settlor subsequently leaves the United States (assuming she has not obtained a green card and becomes subject to the U.S. expatriation tax rules applicable to “long-term residents”), her trust will revert to FGT status with no untoward consequences.
The rules become significantly more complex in the case of an FNGT. A discretionary foreign trust where the grantor is one of many beneficiaries may not be an FGT when the grantor is a nonresident alien, but under U.S. tax rules can be treated as a grantor trust when the grantor becomes a U.S. tax resident. Even if a previously-established trust would not otherwise be treated as a grantor trust, the trust will be treated as a grantor trust as to property transferred by the foreign individual to the foreign trust within five years of becoming a U.S. tax resident. The application of this provision may be avoided where the terms of the trust prohibit any U.S. person from receiving any income (whether current or accumulated) or any corpus, either during the life of the trust or upon its termination.
N.B. Modification of the terms of the trust prior to becoming a U.S. tax resident, if feasible, may be desirable. For example, if a trust is intended to benefit primarily non-U.S. beneficiaries, excluding all U.S. persons as beneficiaries may prevent the trust from becoming a U.S. grantor trust. Alternatively, if an FNGT is intended to benefit primarily U.S. beneficiaries, consideration could be given to domesticating the trust (or transferring a portion of the trust to a new domestic trust).
Tax planning may be necessary if the foreign individual leaves the U.S. in the future and is no longer a U.S. tax resident. An FNGT trust that became a grantor trust when the individual became a U.S. tax resident may revert to FNGT status. In that case, the tax rules would treat this change as a deemed sale or exchange of the trust’s assets, taxable to the foreign individual under a special rule applicable to transfers of property by U.S. persons to a foreign trust or estate.
Published: January 2016 l Photo: colourbox.de