The Foreign Grantor Trust: International Families with US Connected Family Members

Introduction

More and more families are becoming internationally mobile, with family members spread throughout the world. For educational, professional, and lifestyle reasons, the US has become an attractive location, with a significant increase in the number of families having a family member connected to the US through either citizenship, being a green card holder, or simply those who are tax residents in the US by virtue of spending sufficient time there. For these families, having a multi-purpose structure is crucial.

A trust can result in a favourable outcome for these families, not only because of the tax efficiencies that such a structure offers but also because of the non-tax benefits, including family governance and long-term succession planning, that can be introduced in advance of the grantor’s death. Where the head of the family is a non-US person, generally, to ensure optimisation for the US family members, a Foreign Grantor Trust is often established.

This article will provide an overview of what Foreign Grantor Trusts are, how they function when the grantor is a non-US person, and the key considerations for those involved.US Income Tax Considerations of Foreign Grantor Trusts

Where the grantor is a non-US person, it is imperative to seek advice on establishing a trust to ensure the Foreign Grantor Trust requirements are satisfied. A properly structured Foreign Grantor Trust provides for very effective tax treatment for US family members.

Two crucial tax incentives include:

1. The non-US grantor is considered the tax owner of the trust’s assets, with the trust’s income and gains being considered taxable to the non-US grantor if they were derived from taxable US sources. Provided the grantor does not become a US person, where the trust generates non-US source income and gains, such items will not be taxable in the US; and
2. Distributions made to a US beneficiary from a Foreign Grantor Trust are tax-free, although disclosure must be made to the Internal Revenue Service.

US Estate Tax Considerations of Foreign Grantor Trusts

Generally, for US gift and estate tax purposes, a Foreign Grantor Trust will be disregarded.

On the death of the non-US grantor, an exposure to US estate tax may arise on US situs assets held by the trust. US situs assets include, but are not limited to:

1. Tangible property in the US.
2. US real estate; and
3. Shares in US corporations.

If the non-US grantor can access an estate tax treaty with the US, it may be possible to claim relief, but absent a tax treaty, a US estate tax exposure will arise on US situs assets to the extent they exceed $60,000. Importantly, there is a deemed US situs rule that can impose US gift and estate tax on the non-US grantor where the non-US grantor owned US situs assets directly that were then transferred to the Foreign Grantor Trust. On the death of the non-US grantor, the deemed US situs rule can impose US estate tax on the assets of the trust, even if the US situs assets originally settled had been disposed of by the trustees and reinvested in foreign-situs property.

To mitigate the potential exposure to US gift and estate taxes, US situs assets can be held through a non-US holding company to provide a shield for US estate tax purposes. Whilst the non-US holding company can provide a shield for US estate tax purposes, such a vehicle can create tax issues following the death of the non-US grantor.

Issues on the Death of the Non-US Grantor

On the death of the grantor, generally, the Foreign Grantor Trust will convert to a Foreign Non-grantor Trust, at which point US beneficiaries will be subject to US tax on current year income and gains distributed to them and potentially adverse tax rates and interest charges with respect to historic trust income and gains distributed; furthermore, depending on the underlying assets held within the trust, the punitive Controlled Foreign Corporation and Passive Foreign Investment Company regimes may be applicable.

The Controlled Foreign Corporation (“CFC”) Issue

As above, given the exposure to US gift and estate tax, rather than the Foreign Grantor Trust owning the assets directly, a non-US holding company will be used instead to mitigate the US gift and estate tax exposure. Whilst this is beneficial for US gift and estate tax purposes for the non-US grantor, it can result in complications for the US beneficiaries following the death of the non-US grantor.

One such complication is with respect to the CFC regime. The non-US holding company would generally be considered a CFC after the non-US grantor’s death if more than half of the non-US holding company is attributed to US beneficiaries. In such circumstances, liquidating the underlying assets of the non-US holding company, if appreciated, will create Subpart F Income, which will be taxed to the US beneficiaries to the extent of their pro rata share. If, during the lifetime of the non-US grantor, the non-US holding company has made a practice of selling appreciating assets, the amount of Subpart F Income that may be taxed to the US beneficiaries after the death of the non-US grantor can be limited.

If the non-US holding company does not own any US situs assets, rather than selling appreciated assets periodically, an election can be made with respect to the non-US holding company to remove the CFC issues; however, generally, this is not feasible given the exposure to US gift and estate tax that such an election can create.

The Passive Foreign Investment Company (“PFIC”) Issue

Following the death of the non-US grantor, if PFICs are held by the trust, then US beneficiaries can be subject to tax when such PFICs are sold, or dividends are paid from the PFICs. Like the attribution of income under the CFC regime, this can create a dry-tax charge as the US beneficiaries may be taxed on the PFIC activity, irrespective of whether they physically receive funds from the trust. If a non-US holding company has been used to hold investments and the non-US holding company is not considered a CFC, it may be classified as a PFIC.

The extent of the PFIC tax exposure to the US beneficiaries will be heavily dependent on whether the trust assets will qualify for a step-up in basis on the death of the non-US grantor, which will generally be the case where:

1. The trust income will be paid to the decedent for life or on the order or direction of the decedent; and
2. The decedent reserves the right at all times before their death to revoke the trust.

Conclusion

A Foreign Grantor Trust with non-US grantor is a valuable tool for international estate planning, family governance, asset protection, and enhanced privacy. However, they come with complex requirements and potential risks. This article will form part of a wider series of articles with respect to the US tax considerations of foreign trusts, in our next article, we will delve deeper into the tax considerations following the death of the non-US grantor and mitigation strategies available.

Careful planning and professional guidance are crucial to maximize the benefits while ensuring compliance with all applicable laws.

If you would like to better understand the intricacies involved with non-US grantors of Foreign Grantor Trusts, or speak to us about the information discussed above, please do reach out via our contacts page.