Non-residents who are considering setting up a foreign trust should know the rules governing the taxation of that trust, both as a non-residents and if they later decide to establish residency in the United States. There are some key taxable events that occur when you become a resident of the United States, depending on your answers to a specific set of questions. They are: 1) Is it a trust? 2) Is it a really foreign or domestic trust?, 3) Is it a grantor or non-grantor trust?, and 4) What changes occur when you become a resident of the United States?
Is it a Trust?
First, it is important to realize that the United States taxes foreign investment vehicles as trusts, even if they are not called “trusts” in their country of origin. Under Internal Revenue Service policy, a trust is where a person or person (“trustees”) takes responsibility for the guardianship and preservation of property for another group of people (“beneficiaries”), who do not share in the responsibilities of guardianship and preservation. This definition is important for those individuals who own foreign investments in some other type of structure because US tax law may attempt to reclassify those investments as trusts and tax them accordingly.
Is it Foreign or Domestic?
Second, non-residents should also be cognizant that just because a trust is located outside of the United States that the IRS will not necessarily consider that trust a foreign trust for US tax purposes. Under the Treasury Regulations, a trust is considered a United States entity if: 1) a U.S. court can exercise primary supervision over trust administration and (ii) a U.S. person(s) have the authority to substantially control all of the trust decisions.1 known informally as the “court test” and the “control test,” then it is considered a foreign trust for United States tax purposes. In the case of a non-resident within the United States, the “control test” is generally not applicable and the principal test that will determine whether or not a trust is foreign is the “court test.”
Is it a Grantor or Non-Grantor Trust?
Next, after confirming that your trust is indeed foreign, you will need to make the distinction on whether or not your trust is a grantor trust under United States tax law. What constitutes a grantor trust and the rules for grantor trusts are found in Internal Revenue Code Sections 671-679.2 trust where the grantor of the trust retains substantial dominion and control over See Treas. Reg. 301.7701, available at: http://www.gpo.gov/fdsys/pkg/CFR-2008-1title26-vol18/pdf/CFR-2008-title26-vol18-sec301-7701-7.pdf
Full text of the Internal Revenue Code is available at: http://www.gpo.gov/fdsys/granule/USCODE-2011-title26/USCODE-2011-title26-subtitleA-chap1-subchapJ-partI-subpartE-sec671/content-detail.html
If a trust does not meet one of these two tests,the assets of the trust. The distinction of whether or not a trust is a grantor trust or not is an important one because the income/expenses associated with a grantor trust will be associated with the grantor (and reported on their tax return) rather than being associated with the trust. The trust essentially becomes a flow through entity for the grantor. In the case where the trust is classified as a foreign non- grantor trust, then the trust will be separately responsible for the accounting and reporting of the trust’s income.
What changes occur when you become a resident of the United States?
Obtaining residency status has far reaching tax consequences for the owner of a foreign trust and it is important to be cognizant of what changes occur when you obtain residency status. The most important distinction to remember is this:US residents (as well as citizens) are taxed on all of their worldwide income whereas non-residents are only taxed on US sourced income or income that is “effectively connected” with a United States trade or business. This has critical tax consequences for grantor trusts (whether domestic or foreign), whose income is connected to the grantor, in that suddenly all of the income of the trust is subject to the tax laws of the United States. Non-grantor foreign trusts continue to remain foreign entities and will only be taxed on US sourced income, subject to the following caveat. Internal Revenue Code Section 679 contains an additional catchall provision for non-residents who set up foreign trusts and later become United States residents. In this case where a United States person(s) has established a foreign trust and that foreign trust also has United States beneficiaries, then it will also be considered a grantor trust under United States tax law regardless of whether or not the grantor retains control over the trust assets. Additionally, non-residents of the United States who become United States residents will be subject to a five-year look back period for transfers of assets into a foreign trust. If a new resident of the United States has transferred property into a foreign trust and that foreign trust has a United States beneficiary, then that trust will be treated as a grantor trust under the Internal Revenue code and all of the income from that trust will be tied to the grantor.3
The taxation of and rules surrounding the taxation of foreign trusts can be complex and may have far reaching consequences to non-resident aliens who establish them. Particularly, if you are seeking to become a permanent resident of the United States, it is important to be aware of the look back rules and the potential tax consequences associated with them. For more information or for further assistance, please contact the tax professionals at Capital Tax & See IRC Section 679, available at: http://www.gpo.gov/fdsys/pkg/USCODE-2011-3title26/html/USCODE-2011-title26-subtitleA-chap1-subchapJ-partI-subpartE-sec679.htm
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