Anyone who has seen the current Broadway hit Hamilton knows that we are a nation of immigrants. Moreover, many U.S. persons who moved here from elsewhere have parents back in their home country.
When those “foreign” parents pass away and leave assets to their U.S. children, those assets become subject to the U.S. estate tax system in the children’s estates, where ultimately they can be taxed at a 40 percent federal tax rate (plus state estate taxes) when a child dies.
The adverse tax result that follows from foreign parents leaving their assets outright to U.S. children can be avoided with advance planning. Often, foreign parents can incorporate trust planning into their own estate planning documents. If assets pass to a properly structured trust for the benefit of a child rather than outright to the child, the assets in the trust may not be subject to estate tax in the child’s estate.
New York estate tax practitioners often consult with foreign advisors to effectuate this kind of planning, and it is becoming more important given the amount of immigration and investment in the New York area in recent years.
A parent can incorporate this type of trust planning—often called “dynasty trust” planning—in a Will that is valid in his or her home jurisdiction. The Will would include provisions to create the dynasty trust upon the parent’s death. To accomplish this, the U.S. trusts and estates lawyer can work with foreign counsel to (1) confirm that the “home country” law allows such a structure and (2) provide the dynasty trust language that will reflect the client’s goals and satisfy U.S. tax law requirements. For example, the trust can allow the child to be sole trustee of the trust created for his or her benefit, and permit distributions to the child and his or her descendants subject to ascertainable standards (i.e., health, education, maintenance and support) so that the trust assets are not included in the child’s estate. The trust can include powers of appointment and several other tools that allow for greater flexibility in the trust.
As an alternative to including the dynasty trust plan in a foreign parent’s Will, the parent could establish and fund a trust during lifetime to carry out his or her objectives. The U.S. tax practitioner can assist with the U.S. tax advice relating to such a trust.
If established outside the United States, such a trust usually will be structured to be a “foreign grantor trust.” This is a trust that, under the U.S. grantor trust rules (Internal Revenue Code §§671-679), is not treated as a separate taxpayer from the grantor. The trust is disregarded for U.S. income tax purposes, and the foreign grantor reports all items of income, deduction, gain, loss, credit, etc. on his or her own tax return, if any.
It is often simpler to structure this type of trust as a foreign grantor trust, rather than a foreign non-grantor trust that is treated as a separate taxpayer. A foreign non-grantor trust with U.S. beneficiaries has a number of tax reporting requirements, and also can be subject to punitive income tax rules (known as the throwback rules) when funds are distributed to U.S. beneficiaries. Thus, the parent’s trust is often best structured as a foreign grantor trust while the parent is alive. When the parent dies, the trust becomes a non-grantor trust, and the U.S. children generally will move the trust to the United States at that time (pursuant to a “change of situs” provision in the trust) so that it becomes a domestic, U.S.-situs trust.
In order to qualify as a foreign grantor trust, the trust must be fully revocable by the grantor. Internal Revenue Code §§672(f)(1) and (2). (Note that foreign trusts do not qualify as grantor trusts under the same rules as domestic trusts). This is often a desirable structure for U.S. children and their foreign parents. The foreign parent is committing to a structure that he or she can revoke or change at any time, while the U.S. child has the benefit of the parent’s proactive tax planning.
The foreign trust generally will have a bank or trust company acting as trustee in the jurisdiction of choice (e.g., BVI or Cayman Islands). The trust may have a family member named as a “trust protector” who has the right to remove and replace the trustee and make other changes to the trust. The trust may own the stock of an investment company that holds the assets transferred into this structure, and a family member can act as director of the company to manage the investments.
The substantive provisions of the trust permit distributions to children and grandchildren in the discretion of the trustee (which provides an asset protection benefit to the beneficiaries). The trust can continue in this fashion for many generations, and should not be subject to U.S. estate or generation-skipping tax.
As the parent/grantor of the trust is also included as a trust beneficiary, distributions from the trust can be made to the parent during his or her lifetime. In practice, if the parent wants funds in the trust to be distributed to a child, it is often best for the parent to withdraw funds from the trust and distribute them directly to the child. Among other things, this makes the U.S. tax reporting of the gift on a Form 3520 simpler.
Under certain circumstances, the foreign parent may wish to establish a U.S.-situs grantor trust rather than a foreign trust. This may make sense, for example, if the foreign parent has U.S. assets that will be transferred to the trust.
This article provides just a brief treatment of this issue and of course there are many additional complexities. The trusts and estates practitioner must consider, among other things, (1) whether home country law allows foreign parents to leave assets in this manner, (2) various reporting requirements for foreign trusts with U.S. beneficiaries, (3) trustee selection and fees, (4) numerous drafting issues to build maximum flexibility into long-term trusts, and (5) compliance with U.S. income and estate tax laws. Yet the tax saving opportunity for clients in this situation is substantial, and should be considered by all foreign parents leaving significant assets to U.S. children.
Reprinted with permission from the January 17, 2017 edition of The New York Law Journal© 2017 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. ALMReprints.com – 877-257-3382 – firstname.lastname@example.org