UPDATED: June 2021
Roderick Balfour, President of Equiom’s US trust company and 25 years’ experience of US issues, outlines how advisors can help families with US complications to achieve satisfactory tax outcomes on the generational transition of wealth.
As many readers will know, wealth professionals in certain locations were, until recently, completely ignoring whether their clients have US connections such as citizenship, dual passports or a Green Card.
Following sanctions, fines and sometimes imprisonment of those who conspired to defraud the IRS (Internal Revenue Service), the USA imposed the FATCA (Foreign Account Tax Compliance Act) regime involving reporting on foreign assets to the USA. This was fairly draconian at the time but, as with CRS (Common Reporting Standard), practitioners globally have learned to live with it.
The introduction of FATCA, coupled with the USA having its own very particular tax regime which covers all citizens, wherever resident, means advisors involved in tax and succession planning really do need to know if anybody ‘US’ will be involved. It is estimated that there are circa seven million US taxpayers scattered around the globe, including many ‘accidental’ Americans e.g. those born in the US while a parent had a short-term job-assignment in the country.
It is not a disaster fiscally to have US members of an otherwise ‘foreign’ family, but it can be if their status is ignored in the wealth planning process.
The Foreign Grantor Trust
The clients at issue are usually advised to hold their assets through 'Foreign Grantor Trusts' (FGTs) which is a term used in the US Tax Code (S.672) to describe a trust which has US beneficiaries but which, while the non-US settlor/grantor is alive, is deemed to belong to that settlor. It is therefore not normally subject to US taxes on non-US assets, nor on income and gains on US assets, provided such US assets are held though a non-US holding entity, sometimes referred to as a 'blocker'. Such trusts are characterised by being revocable, or with the settlor having the sole right to income and gains in his or her lifetime. A foreign trust with US beneficiaries without either of these features will be a ‘Non Grantor’ trust with potential long-term penal tax consequences for the US heirs.
It follows that a FGT’s status changes to irrevocable, however, on the passing of the settlor which means that trustees really do need to know of such events and that is not always the case. Worse still, if the trustees have not been active in ensuring that the family is appraised of the US-compliant actions which need to be taken in advance of and on the passing of the settlor, they could be accused of negligence.
The reason for this is, from the date of this trigger event, the IRS considers that the trust now ‘belongs’ to the US heirs and, as such, it wants to tax them on the income and gains as they arise in the offshore trust. Where these are not distributed, they will become Undistributed Net Income (UNI) comprising income and gains, which will be subject to the ‘throwback rules’ by which these accumulations will be taxed with interest and penalties if remitted to US beneficiaries. The IRS compounds interest and penalties so income from prior years is taxed more heavily than that from recent years. UNI attributable to US beneficiaries which arose 18 years ago may incur a 100% tax charge when distributed. It follows that if a trust is non-grantor currently, and even if the settlor is living, it is very likely accumulating UNI which the IRS chooses to consider is attributable to the US heirs. Bearing all of this in mind, advance planning is vital.
The antidote to the UNI problem on the passing of the settlor is to ‘domesticate’ the trust, i.e. appoint US trustees instead, or create a US domestic ‘pour-over’ trust to receive the income and gains arising offshore after the passing of the settlor. There are situations where US beneficiaries were born after an irrevocable trust was formed and all of the accumulated income and gains are therefore UNI stretching back many years.
The US tax reform measures of 2017 incorporated a major change to controlled foreign corporation (CFC) rules whereby trustees or corporate administrators no longer have the 30-day option to re-characterise a holding company to be US-friendly. This means advice needs to be taken on how to hold different classes of assets going forward, especially US assets, under an FGT. All current structures need an urgent review with US tax counsel if one has not been done post the 2017 changes.
How taxation on US beneficiaries is a greatly exaggerated threat
The two major taxes which concern the wealthy are on capital gains, and on death or gifts. At time of writing a new Presidency is threatening to overhaul taxes on the wealthy, largely to pay for the Covid pandemic, which almost certainly means potentially swinging increases, or in the case of estate/gift tax, a substantial reduction in the $11m+ exemption per person.
It is in relation to the gift and capital gains taxes that the (currently) foreign trust comes into its own for the US heirs via the following mechanisms;
1. By making a ‘Check the Box’ or Entity Classification Election whereby the company is disregarded for US tax purposes. The assets in the company will be deemed to have current market value as of the effective date of the election for future US Capital Gains purposes – and not the settlor’s original cost. The difference between the two can be very significant, particularly in relation to closely-held company shares. This action is known as ‘getting a step-up in basis’ for future capital gains tax calculations. Awareness of the issue is the key. It also needs to be noted that certain non-US holding entities such as Panamanian or Luxembourg S.A.s (‘per se corporations’) cannot ‘Check the Box’ so where US heirs appear on the scene, a review and possible restructuring are required.
2. It is not always appreciated that what started as a FGT and not subject to US Estate Tax (but caveat re US assets) will, if properly structured, remain free of that tax even after domestication. As matters currently stand, no US transfer tax will be imposed on future generations of beneficiaries, a factor which makes such planning invaluable for keeping close company shares ‘in the family’ (as well as other assets) and not needing to sell them to raise tax money. Such trusts are known in the US as ‘dynasty trusts’. It should be noted that the trust will still have its original tenor or duration unless the FGT was created in a jurisdiction such as Guernsey with no law against perpetuities. Where FGTs are revocable, a simple way to address this point is for the settlor to revoke and re-form the trust with no end date provided this does not trigger tax complications in his or her own tax domicile.
It is also possible, in some jurisdictions, to extend the trust period via application to the courts. Increasingly, FGTs are being set up under the laws of a US state such as South Dakota but which are regarded as foreign for US tax purposes. This makes domestication relatively seamless when it is needed (see below).
The imperative to plan ahead
From the above it can be seen that having heirs and beneficiaries who are subject to US taxation is not the wealth-destroying situation often perceived or feared and a correctly organised FGT can confer considerable long-term benefits to rival those in most jurisdictions from both fiscal and asset protection standpoints. It is vital, therefore, to ensure that;
- the client family with US heirs and/or assets receives early expert advice on structuring
- they know at all times whether there are US beneficiaries or are likely to be, e.g. via marriage, migration or a birth
- they are kept informed of the foreign grantor’s health and are notified immediately of their passing
- if advice suggests that domestication or the creation of a ‘pour-over’ trust to receive the trust’s Distributable Net Income (DNI) will be likely, then the US trustees should have been selected in advance, since trying to accomplish a rapid US trustee appointment with all associated due diligence on the grantor’s passing may prove hard to achieve in this age
- in fact, when choosing a trustee for a FGT it is becoming even more important and practical to choose a trustee who can offer trusteeship both inside and outside the US. This is because of the increasing compliance and administrative burdens involved in domesticating a FGT. A US trustee from a different group will need to conduct full due diligence (or likely refresh for a pour-over trust) on the family and the assets to be transferred, with associated indemnities, accounting and possible restatement of the trust to be US-friendly. This is costly and all at a time when the family may be coming to terms with the passing of the settlor
This article is designed to be a guide to general principles in a highly technical area and should in no way be construed as tax or legal advice. Timely advice is essential regarding the appropriate actions needed in respect of each client situation – including the non-US grantor’s domestic fiscal rules which have not been addressed here, and nor indeed have some of the implications of the HIRE Act (incorporating FATCA), such as investing money for trusts with US ‘owners’ or regarding trust property enjoyed by US persons. In conclusion, if the reader finds his or her client has any US tax exposure or US assets, then working with specialist US counsel is essential.