Question: My family consists solely of U.S. citizens. I formed a foreign trust and transferred assets into it, years ago, to plan for my family's future. The trust hasn't distributed anything yet. The grantor trust rules don't apply at this point. Do they?
First, as a preliminary matter, I'd verify the accuracy of your question, as phrased. That is, if you were to engage the firm, I'd initially confirm the assertions, both legal and factual, on which your question depends. For instance, you refer to a “foreign trust.” Among other tasks, I would need to substantiate, upon reviewing the instrument, that your terminology comports with relevant sections of the Internal Revenue Code and Treasury Regulations, etc. See, e.g., I.R.C. § 7701(a)(31) and Treas. Reg. § 301.7701-7. I'd review the nature of your “transfer,” in the context of Treas. Reg. § 1.679-3.And so forth.
Next, consider Code section 679(a), which ropes many, if not most, foreign trusts created by U.S. persons for personal planning, including asset protection, into the grantor trust rules. This effect is by design, being founded on long-standing concerns about the use of foreign trusts for tax deferral, avoidance (or worse).(1) Subject to narrow exceptions, paragraph (1) provides that a “United States person who directly or indirectly transfers property to a [non-excepted] foreign trust . . . shall be treated as the owner for his taxable year of the portion of such trust attributable to such property if for such year there is a United States beneficiary of any portion of such trust” (boldface added). Thus, as reaffirmed by Treas. Reg. § 1.679-1(b), this “ownership” rule applies here, absent an exception, “without regard to whether the U.S. transferor retains any power or interest described in sections 673 through 677.”
Thus, the critical issue is whether the trust has a “United States beneficiary” for the relevant taxable years. The question does not elaborate on trust provisions governing distribution or accumulation. However, because the trust was formed to protect your “family,” which comprises U.S. citizens, it is difficult to imagine many (realistic) circumstances in which the trust would escape the grantor trust rules. In addressing the “United States beneficiary” question, Code section 679(c) and Treas. Reg. § 1.679-2 cast a wide net over potential benefits, whether held in trust, accumulated, or distributed.
For example, ask yourself the following regarding the years in question, even if the interest of the U.S. family member is contingent:(2)
- Do the trust terms allow even the possibility that any income may be distributed to, or accumulated for the benefit of, a family member? E.g., income that could possibly be accumulated during the year(s) for potential future distribution to the family member?
- May any corpus be distributed to, or even just held for the future benefit of, a family member? E.g., corpus held for potential distribution in the distant future, perhaps even after your death?
- If you said no, would either answer change if indirect distributions and other payments for the benefit of potential recipient(s) were counted as well? Assume George Smith, a hypothetical U.S. citizen, takes out a loan to build a moat around his mansion. The trust does not permit payments directly to Mr. Smith. However, it provides that corpus may be paid to satisfy Mr. Smith's liabilities, by paying creditors directly, to the extent they relate to “[Mr. Smith's] reasonably necessary home-safety measures, which shall include a custom moat and any land improvement abutting such moat.”
- What about if the trust is terminated during the taxable year: could any of the income or corpus be paid, under the trust terms, to or for the benefit of such a family member?
- If distributions are discretionary, do the trust terms fail to “specifically identify the class” of potential recipients or, alternatively, does the recipient class, if identified, include a United States person?
If you answered yes to any of these questions, which were inspired by Treas. Reg. § 1.679-2, the trust likely has a “United States beneficiary” for the year(s) at issue, at least in this hypothetical. Furthermore, these questions don't address the full breadth of the rules.(3) Granted, the determination is performed annually. Also, certain narrow exceptions are available in Code section 679. Realistically, though, these will seldom, if ever, apply when a U.S. person, such as the questioner, transfers assets during her lifetime into a foreign trust that she formed for asset protection and planning purposes under the above circumstances. See also part II.
(1) See, e.g., H.R. Rep. 94-658, 207, 1976 U.S.C.C.A.N. 2897, 3101-3102; see also PL 94–455 (HR 10612), PL 94–455, October 4, 1976, 90 Stat 1520 (among other measures, reorganizing statutory sequence; creating code Section 679; introducing rules for interest on accumulation distributions from foreign trusts, under section 668; and directly linking new reporting requirement, under section 6048, to foreign grantor trust rules).
(2) In certain circumstances, under Treas. Reg § 1.679-2(a)(2)(ii), a person's contingent interest can be shown to be “so remote as to be negligible,” thereby permitting exclusion of the person as a potential U.S. beneficiary. But given the questioner's family planning, this condition seems unlikely.
(3) In 2010, for instance, Congress sought to quell workarounds that taxpayers might employ to avoid the effects of Code section 679. Several of the measures are reflected in current subsection (c). See Hiring Incentives to Restore Employment Act, PL 111-147, March 18, 2010, 124 Stat 71. The point being: if you believe you've identified a crafty loophole or sidestep to the “U.S. beneficiary” determination, while also preserving benefits for U.S. persons, there's a good chance you're mistaken. The HIRE Act was flawed and insufficient in many respects, but it gave subsection (c) much-needed teeth, particularly when coupled with the $10,000 civil-penalty floor added to Code section 6677(a).
Content posted June 17, 2023.
