Trust Uncle Sam: US tax planning and the Foreign Grantor Trust regime

Chris Mourant, Associate Director, discusses US tax planning and in particular, the Foreign Grantor Trust regime, outlining the US classification of Trusts and how foreign settlors can establish Trusts to benefit US based beneficiaries.

Global families and the US – what you need to know

Increasing numbers of families are relocating to the United States to access world leading education establishments for their children. Others are seeing their children leave the family home, whether that be in Europe, the Far East or Middle East, and moving State side for one of the prestigious Ivy League Universities - in some cases, these young people decide to stay in the US to work, eventually gaining US citizenship. Whatever the reason and whether it be the whole family or just one member a move across the Atlantic need not interfere with family wealth planning – the concept of being a globally mobile family is certainly not a new one. 
We explore what the options are to ensure that loved ones in the US are still able to benefit from the family’s wealth whether they have US citizenship or not.

So how do we report to the IRS about the tax affairs of US tax payers and entities part or fully owned by US taxpayers?

The Foreign Account Tax Compliance Act or “FATCA” as its more commonly known, is often associated with burdensome classification and reporting requirements where structures have some connection to US persons. FATCA requires foreign financial institutions (FFIs) to report to the IRS information about financial accounts held by U.S. taxpayers, or by foreign entities in which U.S. taxpayers hold a substantial ownership interest.
Over the last decade, many offshore service providers have tackled the large volume of classification and reporting work required under FATCA legislation which inevitably comes with an added cost to the client. But what was really interesting as part of the exercise was identifying a trend in the type of structures that had US connections.

What are these structures and how does the US tax individuals who are beneficiaries of Jersey law Trusts?

Predominantly, the structures that were required to report to the IRS were Jersey law Trusts that had been established by a non-US resident. So why does the Trustee have to report? Well, put quite simply, the beneficiaries of the Trust are US residents. This begs the question – in what scenario should a Jersey Trust be established when there are family members with US connections? To answer the question, we must first understand how the US taxes individuals and consider how Trusts are treated. 
Broadly speaking, US citizens and US residents are subject to US income tax on worldwide income. Non-US citizens are treated as US resident for income tax purposes if:

• they are a “lawful permanent resident” of the US (i.e. a “green card” holder);
• they meet the “substantial presence test”; or
• they elect to be treated as a US income tax resident. 

Non-US citizens and non-US residents (“non-resident aliens”) are subject to US income tax on certain US source income and income connected with a US trade or business.
The US classes a Trust as a foreign Trust unless it satisfies both the court and the control test:
— the "court test" (i.e. that a court within the US is able to exercise primary supervision over the administration of the Trust); and 
— the "control test" (i.e. that one or more US persons have the authority to control all substantial decisions of the Trust).

Grantor and non-Grantor Trusts

When children choose to stay in the US on completing their education for work, there is an opportunity for the parents to establish a Foreign Grantor Trust as any distributions made to a US beneficiary will not be subject to US tax provided the Trust meets certain conditions and is classified as a Foreign Grantor Trust. 
Although there are many types of Trust defined under US legislation, perhaps the most common in the offshore finance centres are “Grantor” and “non-Grantor” Trusts.  Grantor Trusts are generally considered transparent for US income tax purposes whereas non-Grantor Trusts are considered a separate taxpayer for US income tax purposes. It is worth noting that Grantor Trusts become non-Grantor on the death of the settlor.

Having understood the differences between Grantor and non-Grantor Trusts, one has to determine whether the Trust is foreign or domestic to assess the tax treatment. A Grantor Trust with a US settlor is subject to US tax on the Trust’s worldwide net income and gains. If the Grantor Trust has a non-US settlor the settlor is only subject to US taxation on certain US source income. It is worth noting that distributions made to beneficiaries are not subject to US tax although there is still a US reporting requirement if the distribution is over US$100,000 and made to a US person. On the other hand a non-Grantor Trust that is classed as a US Trust is subject to US tax on the Trust’s worldwide net income and gains. In this situation, distributions to both US and non-US resident beneficiaries are taxable in their hands. Nevertheless, if the non-Grantor Trust is classed as a foreign Trust, the Trust is only subject to US tax on certain US sources of income. There are however quite penal “throwback rules” on distributions to US beneficiaries.
We Trustees in the offshore jurisdictions are always careful to ensure that any Trust settled by a non-US person is considered to be a Grantor Trust for US purposes. The Trust instrument should be properly drafted to ensure that certain conditions are met. 

The advantages of Foreign Grantor Trusts include:

• no US reporting while the Trust has no US source income/directly held US assets;
• no “throwback rules”;
• Trust assets receive a free step-up in basis on the settlor’s death therefore minimising the capital gains tax exposure;
• a free step-up in basis of assets held in underlying companies can also be achieved on the settlor’s death; and
• distributions to US beneficiaries are not subject to US taxation (although there is a US reporting requirement for the beneficiary if the assets are over US$100,000);
• No annual tax or reporting with respect to investments classified as passive foreign investment companies (‘PFICs’) and/or entities that might otherwise be classified as controlled foreign company (‘CFC’) during the settlor’s lifetime;
• Elimination of future US gift and estate taxes on trust assets (provided that US situs assets, if any, are held via a non-US holding company classified as a corporation for US tax purposes).

One question often posed by clients/settlors is – What happens when I pass away?

Where the Grantor of a Foreign Grantor Trust dies there is a US tax requirement to either manage throwback rules by paying out income and capital gains to beneficiaries every US tax year which is often not terribly desirable! Another option is to set up a US domestic Trust and pay the income and capital gains to it every year. Perhaps the most beneficial option is to actually domesticate the Trust into the US i.e. convert the Trust into a US domestic Trust that satisfies the Court and the Control tests. 
A further option exists whereby If the trusteeship is transferred to a suitably organised US incorporated Private Trust Company the Control test is satisfied. A court order is obtained to confirm that the Court test is satisfied. The day-to-day Trust administration can be undertaken from Jersey (or other offshore centre) meaning that the existing relation is retained that would otherwise have been lost. 

In conclusion…

For any global family, it is incredibly important that you work with a financial services firm and an advisor, that you trust. You need an experienced administrator that can ensure your structuring needs are met and that the correct vehicles for your family are in place. The US tax rules are incredibly complex and in many cases families will not be able to completely avoid US tax, however, Foreign Grantor Trusts can go a long way to substantially improving the US tax position.