The U.S. Taxpayer and the Foreign Trust
Can the Ultimate Asset Protection Tool Backfire?
What consequences might a U.S. taxpayer encounter as a result of establishing a foreign trust, and what considerations should the taxpayer address before establishing such a trust?
Advantages of a Foreign Trust
For many people, a “foreign trust” is a vague legal tool that lies steeped in notions of secrecy and is designed only for sophisticated and wealthy individuals who desire tax avoidance and absolute protection from creditors. Such trusts are commonly believed to be invulnerable from attack and absolutely undetectable to the IRS. This, however, is far from the truth.
Foreign trusts are simply trusts that are governed by the laws of another country and are, generally speaking, affordable to almost anyone who has assets and a desire to protect them.
Whether, and to what extent, the trust offers confidentiality and protection from creditors depends upon the laws of the jurisdiction in which the trust is established. [Regardless of the jurisdiction in which the trust is established, the trust may be subject to the jurisdiction of U.S. courts if the assets held by the trust are located in the U.S. or if the trustee is located in the U.S.]
Some of the most common foreign jurisdictions are the Cayman Islands, the Cook Islands, Bermuda and the Isle of Man because of their stable governments, their low- or non-tax policies and their lack of currency restrictions.
Although there are several reasons to establish a foreign trust, one of the best is that often the foreign law governing the trust offers special asset protection advantages over U.S. law.
This advantage cuts against any future creditor because the creditor will be faced with extensive and expensive litigation which will probably not result in an enforceable judgment. Thus, the creditor, because he or she is faced with protracted and expensive litigation, will generally discount any claim they have in an effort to settle.
In this respect, the benefits of a foreign trust are straightforward; simply by establishing a foreign trust and placing his or her assets into it, the grantor will have acquired a very large “club” with which to force a favorable negotiation in the event any claims are brought against him or her.
The asset protection advantages of a foreign trust will insulate assets not just from the usual commercial and civil tort claims, but also from matrimonial claims, forced inheritance and even civil government actions (e.g., non-payment of taxes) . [Almost all offshore jurisdictions honor treaties requiring reciprocal enforcement of criminal convictions.]
Considerations In Establishing a Foreign Trust
First and foremost, the grantor of a foreign trust must address the economic, social and political stability of the jurisdiction in which he or she is considering establishing the trust.
Most people consider this the most important factor as, without such stability, the assets remain at risk. Closely related to this, the financial credentials of the foreign trustee and custodian of the assets must be carefully examined.
It is important for the grantor or his/her counsel to perform careful and complete due diligence on the jurisdiction and its trustee/banking institutions.
Second, the grantor should consider the amount of legal precedent or the “maturity” of the laws of the jurisdiction. Although the country may be very stable, without a long legal history with respect to the administration and taxation of foreign owned trusts, the grantor is left with uncertainty regarding any future claims relating to the trust assets.
As a general rule, when considering what jurisdiction in which to establish your trust, you should choose a country which provides explicit statutory protection of trusts and trust assets, rather than merely relying on judicial precedent and common law.
In addition, you should carefully consider such issues as: the choice of laws provisions available, the jurisdiction’s treaties and policies with respect to foreign judgments, and the tax structure of the foreign jurisdiction.
Third, the grantor should evaluate the technological quality of banking and communications facilities and the efficiency of trustee and banking institutions.
Fourth, the presence or absence of corruption in government and/or judicial activities must be considered.
Finally, U.S. concerns should be considered, including the risk that a transfer of property to a foreign trust can be an “indicium of fraud” which could result in a denial of discharge in a U.S. bankruptcy and, most importantly, the U.S. tax consequences of such a transfer.
Specifically, the taxpayer should be aware of the onerous reporting requirements imposed under the Small Business Job Protection Act of 1996 and the substantial effort the Internal Revenue Service is prepared to make (and the substantial penalties the Service is prepared to impose) to insure that these types of trusts are not used for tax evasion purposes. These factors, once understood, can diminish the appeal of a foreign trust considerably.
U.S. Tax Consequences of Establishing a Foreign Trust
In recent years Congress has attempted to curb “abusive trust arrangements” by imposing specific penalties against such trusts, clarifying foreign trust rules, and expanding disclosure requirements. [An “abusive trust arrangement” is any trust scheme which purports to reduce or eliminate federal income taxes in ways that are not permitted by federal tax law. Abusive trust arrangements are typically promoted by the promise of tax benefits with no meaningful change in the taxpayer’s control over, or benefit from, the taxpayer’s income or assets. See, IRS Notice 97-24.]
Concurrently, the Internal Revenue Service enacted the National Compliance Strategy, Fiduciary and Special Projects Task Force to closely scrutinize both domestic and foreign trusts for abusive schemes. [The National Compliance Strategy, Fiduciary and Special Projects Task Force is a joint effort between the Assistant Commissioner of Examination, the Assistant Commissioner of Criminal Investigation and the Office of the Chief Counsel, created by the IRS for the express purpose of combating abusive trusts.]
At the same time, the U.S. government succeeded in pressuring most “tax haven” jurisdictions into signing new “exchange of tax information” treaties, thereby eliminating the “tax confidentiality” upon which most abusive trust arrangements relied.
Thus, taxpayers should be aware that any trust arrangement is subject to close scrutiny and extensive reporting requirements and that taxpayers and/or promoters of “abusive trust arrangements” may be subject to severe civil and/or criminal penalties.
Small Business Job Protection Act of 1996
The Small Business Job Protection Act of 1996 (hereinafter the “1996 Act”) contained sweeping new provisions which affected the manner in which U.S. taxpayers are required to report to the IRS with respect to Foreign or Offshore Trusts.
Under this new legislation, the definition of a “Grantor Trust” was modified and expanded to include many foreign trusts which, prior to its enactment, would not have been subject to the Grantor Trust rules. [Under Internal Revenue Code Section 671 (hereinafter references to sections of the Internal Revenue Code will be cited as “IRC § __”), where the grantor is treated as the owner of any portion of a trust, “there shall then be included in computing the taxable income and credits of the grantor those items of income, deductions, and credits against tax of the trust which are attributable to that portion of the trust to the extent that such items would be taken into account under this chapter in computing taxable income or credits against the tax of an individual. See also, IRC §§ 672-679.]
The 1996 Act imposed broad new reporting requirements and significant penalties for noncompliance.
What is a Foreign Trust?
As a threshold matter, the taxpayer must determine whether, under the new provisions of the 1996 Act, the trust in question is foreign or domestic. In making this determination, the taxpayer must apply the newly enacted tests provided in IRC §§ 7701 (a) (30) and (31).
The Service has issued a bulletin (1996-52 I.R.B. 1) which offers the taxpayer some assistance in applying the rules set forth under Section 7701.
IRC § 7701 (a) (30) provides that, for years beginning after December 31, 1996, a trust will be treated as a domestic trust if:
- a court within the United States is able to exercise primary supervision over the administration of the trust, and
- one or more U.S. fiduciaries have the authority to control all substantial decisions of the trust.
IRC § 7701(a)(31) provides that a foreign trust is any trust that is not a domestic trust.
Grantor Trust Rules
Prior to the 1996 Act, a trust established by a foreign person (grantor) for the benefit of a United States beneficiary was treated as a “Grantor Trust” and all of the income generated by the trust was attributed to the foreign person.
Any distributions made to the U.S. beneficiary, whether directly from the trust or from the foreign person, were deemed gifts from the foreign person. Thus, the U.S. beneficiary did not realize or recognize any income as a result of the distribution.
This arrangement made it possible, through the use of foreign entities, for a taxpayer to avoid U.S. income tax by establishing a foreign entity (trust, partnership or corporation) which, in turn, funded a foreign trust (usually in a country with minimal or no tax), which, in turn, distributed funds back to the U.S. taxpayer or his/her beneficiaries.
The income from the foreign trust would be attributed to the foreign entity (also usually domiciled in a country with minimal income taxes) and any distribution to a U.S. taxpayer would be deemed a non-taxable “gift” from the foreign person to the U.S. donee.
The 1996 Act included a new provision with respect to Grantor trusts which was designed to stop such schemes. IRC § 672 (f) was amended to provide that U.S. Grantor Trust rules generally will not apply to any portion of a trust that would otherwise be deemed to be owned by a foreign person.
In addition, IRC §’ 672 (f) (4) now provides that, “[I]n the case of any transfer directly or indirectly from a partnership or foreign corporation which the transferee treats as a gift or bequest, the Secretary may recharacterize such transfer in such circumstances as the Secretary determines to be appropriate to prevent the avoidance of the purpose of this subsection.”
[“Grantor” treatment may be maintained despite the new provisions in the following circumstances:
- The trust is revocable by the grantor without approval or consent of another party.
- The trust is irrevocable and the only permissible distributions are to the grantor or the grantor’s spouse.
- Distributions from the trust are taxable as payment for services, and
- The trust was in existence on September 19, 1995 and was treated as owned by the grantor under IRC §§ 676 and 677.]
As a result, any transfers from the foreign trust to U.S. beneficiaries are recharacterized as taxable distributions rather than non-taxable “gifts” from the foreign grantor.
In addition, if a U.S. taxpayer receives any distributions made from a foreign trust out of the trust’s accumulated income from prior years, the taxpayer must pay income tax plus interest as if the taxpayer were late in filing his or her return for the year in which the income was actually earned.
Finally, to prevent non-U.S. intermediaries from disguising distributions from a trust to a U.S. beneficiary, any transfer from the trust to a non-U.S. intermediary followed by a transfer to a U.S. beneficiary will be treated as a transfer directly from the trust to the U.S. beneficiary. [However, one exception to this rule does exist with respect to withdrawals from the foreign trust by the grantor followed by a transfer to the U.S. Beneficiary. In such a case, the transfer of the property from the grantor to the U.S. beneficiary will be deemed a gift. The 1996 Act requires that any U.S. citizen or resident receiving a gift in excess of $10,000 shall report the gift for tax purposes.]
In addition to altering the rules with respect to Grantor trusts, the 1996 Act imposed onerous new reporting requirements on grantors, owners and beneficiaries of foreign trusts.
The Basic Rule – IRC § 6048
With respect to foreign trusts, IRC ‘ 6048(a) imposes a duty upon the “responsible party” to provide written notice of any “reportable event” on or before the 90th day (or such later day as the Secretary may prescribe) to the Secretary.
[I.R.C. § 6048 (a) (2) provides that, at a minimum, the required notice shall contain:
- The amount of money or other property transferred to the trust in connection with the reportable event; and
- The identity of the trust and of each trustee and beneficiary (or class of beneficiaries) of the trust.]
[The term “Secretary” means the Secretary of the Treasury or his delegate. IRC § 7701(a)(11)(B). The term “Delegate” means any officer, employee, or agency of the Treasury Department duly authorized by the Secretary of the Treasury. IRC § 7701 (a) (12) (A) (i).]
In IRS Notice 97-34, the Secretary prescribed that form 3520 shall be used to report all transactions with foreign trusts and receipts of foreign gifts and that Form 3520 should be filed with the taxpayer’s annual income tax return. [A copy of Form 3520 must also be sent to the Philadelphia Service Center by the same date.]
In order to apply this rule, the taxpayer must first determine what is, and what is not, a “reportable event” and who is, and who is not, a “responsible party” within the meaning of the statute.
A “reportable event” is defined under IRC § 6048 (a) (3) as:
- The creation, by a United States person, of any foreign trust;
- The transfer of any money or property (directly or indirectly) to a foreign trust by a U.S. person, including transfer by reason of death; and
- The death of a citizen or resident of the U.S. if:
(a) The decedent was treated as the owner of any portion of a foreign trust; [See IRC §§ 670 – 680 for rules pertaining to ownership of foreign trusts.] or
(b) Any portion of a foreign trust was included in the gross estate of the decedent.
NOTE: Under IRC § 7701, the term “United States person” means:
- A citizen or resident of the United States,
- A domestic partnership,
- A domestic corporation,
- Any estate (other than a foreign estate, within the meaning of paragraph (31), and
- Any trust if:
(i) a court within the United States is able to exercise primary supervision over the administration of the trust, and
(ii) one or more United States persons have the authority to control all substantial decisions of the trust.
NOTE: Fair market value sales and transfers to deferred compensation and charitable trusts are not considered “reportable events” in most circumstances. [See IRC § 6048 (a) (3) (b) (I) & (ii).]
A “responsible party,” is defined under IRC § 6048 (a) (4), as either:
- The grantor, in the case of the creation of an inter vivos trust;
- The transferor, in the case of a transfer of money or property to a foreign trust, including a transfer by reason of death; or
- The executor of a decedent’s estate, in any other case.
Failure to Comply
Under Section 6677 (a), a person who fails to comply with the reporting requirements outlined above with respect to a transfer occurring after August 20, 1996, will be subject to a 35 percent penalty assessed against the gross value of the property transferred.
In addition, if the taxpayer fails to file a return within 90 days after the Secretary mails notice of such failure to file, the taxpayer shall pay a penalty (in addition to the 35% penalty already imposed) of $10,000 for each 30 day period (or fraction thereof), beginning on the 91st day, during which such failure continues.
In no event, however, shall the aggregate penalty exceed the value of the gross reportable amount.
Additional Reporting Requirements – Owners
In addition to the reporting requirements imposed on “responsible parties”, IRC § 6048(b) imposes upon an “owner” of any portion of a foreign trust the responsibility of insuring that:
- The trust files a return for each year which sets forth a full and complete accounting of all trust activities and operations for the year, the name of the U.S. agent for the trust, and such other information as the Secretary prescribes; and
- The trust furnishes such information as the Secretary requires to each U.S. person who is treated as an owner of any portion of the trust or who receives (directly or indirectly) any distribution from the trust.
A Trustee may use form 3520-A to satisfy the trust’s reporting requirements. If the trustee fails to file this form, the responsibility will rest with the U.S. owner.
The owner can avoid many of these reporting requirements by insuring that there is a U.S. agent appointed and authorized to act pursuant to IRC § 6048 (b). Once appointed and authorized to act, the agent can insure that all reporting requirements are met and any IRS inquiries can be made directly to him or her.
In the case of a return required under IRC § 6048 (b), the taxpayer/owner will be liable for penalties upon a failure to report just as if the person were a “responsible party” except that the penalty will be limited to 5 percent of the gross reportable amount rather than 35 percent. [IRC § 6677 (b).]
The penalties imposed under IRC § 6677, however, will not be assessed if the failure to file was due to “reasonable cause” and not negligence. The owner should know that he or she can be held liable if the trust, citing the bank secrecy laws of the country where the trust’s bank accounts are located, fails to produce records requested by the agent or the IRS.
The IRS has stated that the imposition of foreign criminal or civil penalties upon a trustee for disclosing financial information does not qualify as “reasonable cause” for failure to report and, if the trustee refuses to provide the information requested, the owner will be subject to penalties. [IRC § 6677(d).]
Whether this rule will stand up to constitutional review is a matter of debate as the issue has not been addressed yet.
Additional Reporting Requirements – Beneficiaries
Finally, with respect to a person who is neither a “responsible party” nor an “owner” of a portion of a foreign trust, IRC § 6948 (c) may still require reporting. IRC § 6048 (c) imposes a duty upon a beneficiary of a foreign trust who receives (directly or indirectly) any distribution from the foreign trust during the taxable year to file a return, which must include:
- The name of such trust,
- The aggregate amount of the distributions so received from such trust during the taxable year,
- Such other information as the Secretary may prescribe.
NOTE: The Service defines a beneficiary as “any person that could possibly benefit (directly or indirectly) from the trust at any time (including any person who could benefit if the trust were amended), whether or not the person is named in the trust instrument as a beneficiary and whether or not the person can receive a distribution from the trust in the current year. [If] the trustee is given complete discretion to distribute trust income to anyone, friends and business associates of the family would be considered beneficiaries of such a trust because it could be reasonably anticipated that the trust could possibly benefit such persons.” Notice 97-34. 1997-25 I.R.B.I.
- Cash payments.
- Payments in excess of fair market value of goods or services provided to the trust.
- Constructive distributions (loan or debt forgiveness, credit guarantee, etc.).
This filing requirement is the result of the above mentioned changes in the grantor trust rules and it is the first time a beneficiary of a foreign trust has been saddled with such a reporting requirement. Failure to report as required will subject the taxpayer to a penalty, under IRC §§ 6677(a) and 6039F, of 35 percent of the gross reportable amount and an additional $10,000 per thirty-day period (or portion thereof) for each period beginning on the 91st day after the mailing of a notice of failure to report by the Secretary.
Thus, under the provisions of IRC § 6048, any U.S. citizen or resident could be saddled with the duty to file a return every year in which there is a reportable event if that citizen or resident is deemed a “responsible party,” an “owner” or a “beneficiary” of a foreign trust.
To compound the problem, a separate filing must be made for each foreign trust in which the taxpayer is deemed a responsible party, owner or beneficiary.
Although transferring assets to a foreign trust can, in many cases, provide valuable asset protection advantages to an individual, that person should be aware of the onerous reporting requirements imposed by the Small Business Job Protection Act of 1996 and the substantial effort the Internal Revenue Service is prepared to make (and the substantial penalties the IRS is prepared to impose) to insure that these types of trusts are not used for tax evasion purposes.
The U.S. taxpayer must therefore confine his/her offshore trust strategy exclusively to asset protection and be prepared to accept and comply with IRS reporting and taxation requirements.
If the taxpayer adopts a policy of U.S. tax compliancy, the foreign trust can continue to provide that person with absolute asset protection.