US Trusts with UK Resident Beneficiaries: A Complex Dilemma

The Dilemma

US family trusts continue to be a popular and powerful estate planning tool in the US, providing various tax benefits as well as non-tax benefits in the form of asset protection and wealth preservation. For education, employment, or family reasons, it is not uncommon for a dynasty family trust settled in the US to, at some point in time, have a beneficiary who is a UK tax resident. This can result in increased tax burdens, which can go on unnoticed given that you may have two different taxpayers, the trustees in the US and the beneficiary in the UK.

Without careful planning, a beneficiary of a US trust who is both a UK tax resident and a US citizen can be subject to taxation in both jurisdictions and face difficulties in obtaining tax credits between the two tax authorities. Diligent planning and advice can mitigate the risk of double taxation.

Taxation of US Trusts

Typically, a US trust will either be a grantor trust or a non-grantor trust.

A grantor trust is transparent for US income tax purposes, with the grantor of the trust being subject to US income tax on the underlying income and capital gains as if they owned the assets of the trust directly.

A non-grantor trust is not transparent for US income tax purposes, with the trust being a separate taxpayer and the trustees being subject to US income tax on the income and capital gains of the trust. However, where distributions have been made to beneficiaries, the trustees are entitled to a deduction, with the distributable net income of the trust being allocated to the beneficiary instead.

Unless permitted under the terms of the governing instrument of the US trust, generally, capital gains arising within a non-grantor trust are subject to US income tax at the trust level, irrespective of distributions made to beneficiaries. This article focuses primarily on non-grantor trusts.

Taxation of UK Tax Resident Beneficiaries of US Trusts

For UK tax purposes, generally, the triggering tax event arises on the receipt of distributions or other benefits from the US trust by the UK tax resident beneficiary. Importantly, the UK tax exposure is the responsibility of the UK tax resident beneficiary.

Whether the UK tax resident beneficiary is a discretionary beneficiary of the US trust or if they are entitled to a portion of the income of the US trust will have an impact on their exposure to double taxation.

For a UK tax resident beneficiary who is also a US citizen, the availability of foreign tax credits between the two jurisdictions depends on the nature of the income and the interaction under the terms of the US/UK tax treaty.

Tax Implications of Trustee Discretion

Where a UK tax resident receives an income distribution from a discretionary US trust, i.e., a trust where the trust instrument permits the trustees to accumulate income, typically, the trust is considered to be the source of income, with the payment received being categorised as non-savings trust income. The income received by the UK tax resident beneficiary, irrespective of the taxes the trustees have suffered, is regarded as gross income for the UK tax resident beneficiary.

From a US perspective, the beneficiary receiving an income distribution from the US trust will be subject to US income tax on their share of the US trust’s income. Importantly, the character of the underlying income will be retained by the beneficiary; for example, dividends arising within the trust will be taxable as dividends in the hands of the beneficiary.

A common mistake UK tax advisors make is that the figures declared on the beneficiaries Schedule K-1, issued to them by the trustees, is declared on the beneficiaries UK income tax return, this is not necessarily the correct treatment and can lead to incorrect submissions with HMRC. This scenario gives rise to difficulties in offsetting tax credits between the two jurisdictions as there is a mismatch in the character of income, potentially resulting in double taxation.

On the other hand, when a UK tax resident receives an income distribution from an interest in possession US trust, i.e., a trust where the trust instrument enforces the income to be distributed, for example, on a quarterly basis, provided the US trust is governed by certain state-specific law, the source of the income for the beneficiary should be the income-producing assets, as opposed to the trust in the case of a discretionary trust. The beneficiary will be subject to tax at their respective tax rates, and in accordance with the type of income within the trust, for example, an additional rate taxpayer will be subject to tax at 39.35% on dividends, subject to foreign tax credit relief.

Providing tax payments are made timely by the beneficiary, this scenario should allow for tax credits to be utilised between the two jurisdictions, avoiding the risk of double taxation, as alignment between the US and the UK on the character of income and timing of taxation will be achieved.Capital Distributions

Tax discrepancies can also arise when a UK tax resident receives a capital distribution from a US trust. Such capital distributions can be matched to the capital gains of the trust that have arisen in the current year, previous years, or future years, which will be subject to UK capital gains tax on the UK tax resident beneficiary.

Where historical capital gains are matched to the capital distribution made to a UK tax resident beneficiary, a tax surcharge could also be imposed that could result in a marginal rate of UK capital gains tax of 32%. Furthermore, personal capital losses a UK tax resident beneficiary has accumulated cannot offset capital gains matched to them from the capital distribution received from the US trust.

A significant issue that can arise with respect to capital distributions from US trusts is the fact that a UK tax resident beneficiary could be liable to UK tax on capital gains realised by the US trust, which the US trust has already paid US income taxes on.

The double tax exposure on the underlying capital gains could be mitigated by introducing fiduciary changes such that capital gains can be distributed to the beneficiaries rather than the trustees being subject to US tax on the capital gains. A strategy of making capital distributions to the UK tax resident beneficiary in the same calendar year as the capital gains of the trust arose would result in consistency between the timing of taxation in both the US and the UK, thereby reducing the ongoing risk of the underlying capital gains of the trust being subject to double taxation.

Summary

Navigating the US and UK tax landscapes with respect to US family trusts that have UK tax resident beneficiaries is complex. Proactive tax advice should be sought to ensure the exposure to double taxation is mitigated. There are various methods and planning tools that can be implemented to ensure tax optimization; any such planning is driven by the facts and circumstances of the family and their ambitions.

The domicile status of the beneficiary and whether the trust is a grantor trust are also of significant importance when considering any optimization strategies. If you would like to understand the intricacies involved with UK resident beneficiaries of US trusts more, or speak to us about the information discussed above, please do reach out via our contacts page.