An individual is a U.S. person if he or she is either:

A  U.S. citizen, regardless of residence (including a dual citizen of the U.S. with one or more other countries of citizenship); or

A U.S. resident, regardless of citizenship.

Because a “bright line” test applies for income tax purposes and a “fact and circumstances” test applies for estate tax purposes, it is possible for an individual to be a U.S. resident for purposes of one tax and not for the other.

This area was significantly changed in 1996 and in 1999.  A trust is a foreign trust unless both of the following are true:

·         A U.S. court can exercise primary supervision over the administration of the trust; and

·         One or more U.S. persons have the power to control all substantial decisions of the trust.

A U.S. court is a court located in one of the 50 states and the District of Columbia.  To ensure that a trust is a domestic trust, the trust should be administered exclusively in the U.S, has no provision directing administration outside the U.S., and has no automatic change of situs clause (except in case of foreign invasion or widespread confiscation of assets in the U.S.).  If a person other than a trust (such as a Protector) has the power to control substantial decisions, that person will be treated as a fiduciary for purposes of the control test.  Powers exercisable by a grantor or a beneficiary, such as a power to revoke or a power to appointment will also be considered in determining “substantial control.”

Substantial decisions are viewed as the following:

·         Whether and when to distribute income or corpus

·         The amount of any distribution

·         The selection of a beneficiary

·         The power to make investment decisions[3]

·         Whether a receipt is allocable to income or principal

·         Whether to terminate the trust

·         Whether to compromise, arbitrate, or abandon claims of the trust

·         Whether to sue on behalf of the trust or to defend suits against the trust

·         Whether to remove, add, or name a successor to a trustee

When there is a vacancy of trustee, the trust has 12 months to reassert U.S. control by either a change of fiduciaries or a change of residence of a fiduciary.

A foreign trust is generally not subject to U.S. income tax, except for withholding tax on any U.S. source income.  However, distributions from the foreign trust to a U.S. person will carry out distributable net income to that person, with adverse tax treatment of accumulated income, unless the trust qualified as a “grantor trust” under U.S. law. 

Under the new law, as of August 20, 1996, non-U.S. persons generally cannot be grantors of trusts.  If a non-U.S. person sets up a trust for the benefit of a U.S. person, the U.S. person will be taxed on the income received.  There are three relevant exceptions to this law, which permit the non-U.S. resident to be the income tax grantor:

1.      The grantor has the full power to revoke the trust without the consent of any person, or with the consent of a subservient third party. 

2.      The grantor (and if desired, the grantor’s spouse) are the sole beneficiaries of the trust during the life of the grantor.  In this case, the grantor and the grantor’s wife could receive distributions from the trust and could then make gifts to the U.S. relative.  The U.S. person would then have to report the receipt of the gifts if they meet the applicable threshold, but they would not be taxable.

3.      The trust was created on or before September 19, 1995, but only as to funds already in the trust as of that date and only if the trust was a grantor trust under certain rules.

The greatest disadvantage to a foreign non-grantor trust is the treatment for income that is accumulated in the trust and then distributed to a U.S. person in a subsequent year.  Realized capital gains are included in distributable net income.

If the foreign trust accumulates income, the trust pays no U.S. income on that income.  However, the trust is building up accumulated income which will have tax consequences if it is distributed to a U.S. beneficiary in a future year.  When income is distributed to the beneficiary, it includes realized capital gains, and the accumulated income is carried out to the beneficiary.  This has the following negative consequences:

1.      All capital gains realized by the trust in prior years constitute part of the trust’s distributable net income and are carried out to the beneficiary, but at ordinary income rates (not capital gains rate).

2.      An interest charge is imposed on the tax due by the beneficiary on the accumulated income per annum form the date the income was originally earned by the trust.  The interest charged is the rate applicable to underpayment of tax and is compounded daily. 

3.      The “throwback” rules apply, so that the income may be taxed at the beneficiary’s tax bracket for the years in which income was accumulated. 

Some of the tax disadvantages can be reduced by creating a sub-U.S. trust that received capital gains, or to distribute the accumulated income to a foreign intermediary who can then later pay it to the U.S. beneficiary.  Another solution is to loan to the U.S. beneficiary trust’s assets, however, the loan needs to be a “qualified obligation.”

Finally, any U.S. person who receives any distribution from a foreign trust must report that distribution to the IRS on Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts.  The failure to report is subject to a penalty of 35% of the gross amount of the distribution.