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Estate Tax: Planning for Cross-border Families

California CPA magazine: November 2008

By Philip D. W. Hodgen

Multi-national families, unaccustomed to paying estate tax in their home country, create special challenges for tax advisers. In many cases, these families are not happy with the prospect of the U.S. government claiming a portion of their family’s wealth, so they decide to keep the majority of their wealth outside of U.S. borders. In cases like this, opportunities and pitfalls exist when considering the transfer of wealth from parents to U.S.-resident children.

Typical Situation

The parents are not U.S. citizens and live outside the United States. Their two adult children, both living in the United States, may be U.S. citizens or hold green cards. The parents have significant wealth, which is all outside of the United States. If the parents simply gave or transferred the family wealth on death to their U.S-resident children, there would be estate tax payable when the children die. So, while the parents are not at risk for U.S. estate tax, their children and future descendents would be.

The goal is to pass the assets efficiently to the children when the surviving parent dies, and ensure that successive wealth transfers to future generations are made without U.S. estate tax, or generation-skipping transfer tax. All the while, we want to minimize U.S. income tax on investment income.

Typical Solution: Start With a Foreign Grantor Trust

Start by having the nonresident parents create a revocable trust, to which they would be the sole beneficiaries during their lifetimes. The trust is fully revocable until the surviving parent dies.

Think of this like a generic revocable trust used in routine domestic estate planning—without all the U.S. estate tax stuff like bypass trusts and qualified terminable interest property trust provisions.

The trust is a “grantor trust” so the parents are treated as the owners of the trust assets. We achieve that status by satisfying the requirements of IRC Sec. 672(f); the simplest way is to make the trust fully revocable.

By design, this is a foreign trust since no U.S. residents control the substantial decisions for trust administration, and a U.S. court cannot exercise primary supervision over the trust [IRC Sec. 7701(a)(30)(E)].

As nonresidents, the parents’ only potential exposure to U.S. income tax will exist if they hold U.S. assets in the trust. With investment in only non-U.S. assets (or inoculation against U.S. income tax on U.S. assets in the trust) the parents will be outside the reach of U.S. income taxation. Careful investment decisions will solve most problems here: Avoid using this structure to hold U.S. stocks and bonds, U.S. real estate or U.S. partnerships, for example, which would be within reach of the IRS.

Now it is a Foreign Nongrantor Trust

By design, the trust will continue as irrevocable after both parents die. The beneficiaries are the U.S-resident children, grandchildren and so on. It’s a classic multi-generational trust, with special U.S. tax status as a “foreign nongrantor trust.”

It is a foreign trust because it is wholly managed outside the U.S. and is outside the reach of the U.S. courts, [IRC Sec. 7710(a)(30)(E)].

It is a nongrantor trust because grantor-trust rules (IRC secs. 671–679) no longer apply. Now the trust income-tax burden falls on the trust itself, or on the beneficiaries in the event of a distribution of income to the beneficiaries.

For U.S. income tax, we treat a foreign nongrantor trust just like a nonresident alien individual: income earned outside the United States is beyond the reach of the IRS. So, no income tax is imposed on the foreign nongrantor trust. Income tax is only applied when the U.S. beneficiary receives a distribution of trust income. From an estate tax perspective, the trust assets will receive a step-up in basis to fair market value calculated at the time of the surviving parent’s death.

At first impression, this is appealing: It allows us to accumulate income and enjoy tax-free, compounded investment returns, just like an IRA. Distribute later and pay tax then.

The Throwback Rule

This tax-free accumulation of income inside a foreign nongrantor trust, however, comes at a high price. The “throwback tax” (IRC Sec. 667) rules treat trust accumulations of income like this:

  • Accumulated capital gains are taxed when distributed at ordinary income tax rates, rather than the 15 percent long-term capital gains tax rate.
  • The income tax imposed on the distribution of accumulated income carries with it an interest charge based on the deferred tax liability that might potentially accumulate for many years (IRC Sec. 668).

Further, the accounting work required to track undistributed trust income is fiercely complex. Many times the accounting data will not exist because non-U.S. trustees don’t see the need to track income the same way that U.S. trustees do, or because the trust investment vehicles (mutual funds or unit trusts) do not report the necessary information.

The throwback rules were designed to make U.S. taxation of accumulated income in a foreign nongrantor trust equal to the tax that would have been imposed on an equivalent domestic trust, where income would have been taxed in the year earned, whether it was accumulated or not. In fact, the throwback rules act as an incentive to either have the U.S. beneficiary leave the United States, or to have the trust itself migrate to the United States to eliminate the throwback-rule problem.

If income is accumulated over time, the impact of the interest charge may be to essentially cause a tax of 100 percent of the distribution to the eventual beneficiary—an accumulation period of 20 years may be sufficient, depending on some assumptions. But if the trustee distributes income to the current beneficiaries in the year the income is earned, there is no accumulation and, therefore, the throwback rules do not apply.

The trustee owes a duty to all beneficiaries. If the trustee accumulates income for future generations of beneficiaries, the tax load imposed by the throwback rules may approach 100 percent. To avoid the punitive throwback rules, the trustee must distribute income to current beneficiaries every year—avoiding accumulation entirely.

There is no way to efficiently accumulate assets for future generations of U.S. resident beneficiaries inside a foreign grantor trust.

Solutions to the Throwback Rule

The usual solution is to get rid of the foreign nongrantor trust as soon as possible by domesticating it, since the throwback rules only apply to foreign trusts. This is achieved in one of two ways:

  • Transfer all of the administrative powers to a U.S.‑resident trustee and bring the trust within the reach of U.S. courts, which satisfies the requirements of IRC Sec. 7701(a)(30)(E) and the throwback rules no longer apply.
  • Alternatively, with some foresight or flexibility in the existing trust document, the assets contained inside the foreign nongrantor trust can be distributed to a new domestic trust with equivalent distribution provisions. This is called “decanting” the trust assets.

The decanting strategy is often preferable.

A foreign trust document’s provisions may not be workable for a U.S. trustee. Foreign trusts are frequently drafted with an administrative power granted to the trustee allowing them to distribute trust assets into a new trust with substantially the same beneficial interests to substantially the same beneficial class. Alternatively, a domestic trust can be created and funded with a nominal sum, and just sit there waiting for eventual distribution of assets into that trust.

No matter which way you domesticate the foreign trust, be sure that it keeps its generation-skipping transfer tax exemption.

The End State

You now have a domestic irrevocable trust, also known as a dynasty trust, that is funded with assets carrying step-up basis as of the date of death of the surviving parent. The trust’s assets are held for successive generations of beneficiaries with no estate or generation-skipping transfer tax, and the trust is now taxed in the normal fashion, free of the throwback rules.

Variations on this theme are endless, of course, depending upon the family situation, the desires of the parents and the assets involved. You can treat this model as a simple starting point for testing different estate-planning ideas.

Philip D. W. Hodgen is a Pasadena-based tax lawyer focusing on international matters. You can reach him via e-mail.