Unlike almost all other nations, the U.S. taxes all worldwide income of its citizens and of those persons with permanent U.S. resident status. Internal Revenue Code (IRC), section 61 states: “Except as otherwise provided . . .gross income means all income from whatever source derived . . .” The IRS and courts interpret this to include income of every nature and place it may be earned in the world, including offshore trust income.
Under U.S. tax law, foreign asset protection trusts as such are “income tax neutral,” as are domestic trusts. That simply means all trust income is treated as the grantor’s personal income, reportable annually as gross income on IRS Form 1040 and taxed accordingly at applicable personal income tax rates. The fact that a grantor’s trust is located in a foreign nation does not negate the grantor’s personal obligation to report trust income.
It is virtually impossible for a U.S. person to avoid taxation on the income of a foreign trust that has any U.S. persons as beneficiaries. IRC section 679(a)(1) states: “A U.S. person who directly or indirectly transfers property to a foreign trust . . . shall be treated as the owner [of the property] if for such year there is a U.S. beneficiary of any portion of such trust during any taxable year.”
Estate Tax Savings
There is one method remaining to cut U.S. taxes using a foreign trust, but the trust grantor will not be around to enjoy this legal tax avoidance.
A deceased U.S. citizen’s estate can’t avoid the estate tax on assets remaining in an offshore grantor trust that were actually under his control at the grantor’s death. At death, estate taxes are imposed on the value of any part of trust assets which may be counted as part of the deceased grantor’s estate, but all exemptions, such as the $675,000 (the year 2000 authorized amount) lifetime estate tax exemption can be applied. However, the trust can be arranged so its assets will escape future estate taxes as those assets pass to succeeding generations.
In addition, future IRS offshore trust taxes will not apply to a foreign testamentary trust, meaning a trust created under the terms of a will. Neither the decedent’s estate nor any U.S. person named as beneficiary of a testamentary foreign trust can be taxed on that trust’s income and assets.
Simply put, assets placed in an offshore trust with a U.S. beneficiary will be included in the grantor’s estate for estate tax purposes. However, assets placed in a foreign trust under the terms of a last will and testament, or already included in a grantor trust at the grantor’s death, are counted once for estate tax purposes as part of the grantor’s estate, but afterwards the trust and its assets may be free of most U.S. taxes. Gaining advantage from this exception requires very careful planning and expert advice on structuring an estate.
This testamentary exception allows trust income to accumulate and be invested anywhere in the world, including the United States, with minimal immediate tax obligations. However, under IRC secs. 665-668; 679(b) certain “throwback” tax rules apply to accumulated income of a foreign trust that is distributed to a U.S. beneficiary before expiration of a period of one-year after the deaths of the grantor and spouse. If heirs do not need the trust income or assets currently, sound investment policies by the offshore trustee eventually can increase the inheritance many times over. Later distributions to U.S. beneficiaries will be subject to tax.
US Reporting Requirements
U.S. law imposes on a grantor or beneficiary of any trust, including a foreign APT, the legal duty to disclose the existence of the trust on federal income tax returns, documents supposedly kept “confidential” by the IRS. (In theory, creditors must obtain a court order to gain access to your tax returns. That takes time and is expensive).
The reporting requirements for foreign trusts under IRS sec. 6048 include reporting any “capitalized reportable event.” That means the creation of a foreign trust by a U.S. person, a transfer (even by death) of any money or property (directly or indirectly) to a foreign trust by a U.S. person or the death of a U.S. person who was taxed as the grantor of a foreign trust. Any U.S. person who, as a beneficiary, receives directly or indirectly a distribution from a foreign trust during the taxable year, is required to file a return including the trust name, amount of the distribution received and certain other data. The grantor’s reporting is done on IRS Form 3520. Similar reporting requirements are now in effect in Canada and the United Kingdom.
In addition, every foreign trust created by a U.S. grantor must appoint a limited U.S.-based agent to receive and respond to IRS notices and inquiries. Although compliance is the duty of the trustee, the tax law holds the grantor responsible for proper filing of the U.S. agent’s name and address. A foreign trust also must have a U.S. taxpayer I.D. number and submit IRS Form 3520-A each year. A professional trust service can handle all such matters on behalf of the trust.
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