Understanding Foreign Trusts and Their Tax Treatment in the U.S. by Pedro L. Porras, CPA
Posted on January 25, 2023
by
Pedro Porras
In a global society where business and family affairs are conducted regularly across international borders, it is very easy for individuals’ activities to fall unintentionally under the taxing authority of another country. This is especially true when it comes to foreign persons making gifts and passing inheritances to heirs located in the U.S. With a properly structured foreign trust, however, foreign persons and their U.S. beneficiaries may avoid significant U.S. tax liabilities.
Trusts are legal structures individuals create during life to hold, preserve and protect assets for the benefit of third parties, also referred to as beneficiaries. A trust is considered a domestic trust that is required to pay U.S. taxes on its worldwide income when it meets the following tests 1) a U.S. citizen, resident alien or domestic entity has the authority to control all substantial decisions regarding the trust assets, and 2) a U.S. court has jurisdiction to resolve any matters regarding the administration of the trust.
If the trust does not satisfy the control and court criteria, it will be considered a foreign trust responsible for paying U.S. taxes only on income sourced in the U.S. It is important to note, however, that the term “foreign trust” is a misnomer since it can be created in the U.S., by a U.S. person or even for the benefit of U.S. beneficiaries. Moreover, a foreign trust, like a domestic trust, may be further categorized as either 1) a grantor trust that is owned by the person establishing the trust (also referred to as the grantor or settlor) or 2) a nongrantor trust, which the U.S. treats as a separate taxpayer from the grantor with its own tax reporting and payment requirement.
Grantors generally retain certain powers over assets held in a grantor trust, including the responsibilities to report and pay taxes on trust income. Because grantors generally pay those liabilities with non-trust assets, they have opportunities to further reduce the size of their taxable estates and allow the assets inside the trust to appreciate unfettered by income taxes. Grantors may be U.S. persons with the power to distribute trust income to themselves and their spouses, or they may be foreign persons with the authority to replace a named trustee, reclaim trust assets or revoke the trust entirely before distributions are made to named beneficiaries.
Commonly, foreign trusts are set up by family patriarchs or matriarchs who are not U.S. persons but develop connections with the U.S. in some way. For example, they may have married U.S. citizens, have children attending college in the U.S. or grandchildren who were born here. Foreign grantors may gift assets to the trust throughout their lives free of U.S. income tax and create an opportunity for those assets to escape U.S. estate taxes when the beneficiary passes away. There is however an exception to this rule when U.S. beneficiaries receive distributions of net income from foreign trusts. Under those circumstances, the U.S. beneficiary is responsible for paying U.S. income tax on those amounts as if they personally earned that money stateside. Currently, the U.S. has seven income tax brackets with a top rate of 37 percent. By contrast, qualified dividend income and long-term capital gains are taxed at a preferential 20 percent rate. Additionally, both income categories would generally be subject to the 3.8 percent net investment income tax (NIIT) when earned inside a trust or as income distributed from a trust.
About the Author: Pedro L. Porras, CPA, is an associate director of Tax Services with Berkowitz Pollack Brant Advisors + CPAs, where he provides income and estate tax planning and consulting services to domestic and foreign high-net-worth families and closely held businesses with international operations. He can be reached at the CPA firm’s Miami office at (305) 379-7000 or info@bpbcpa.com.
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