RICHARD M. COLOMBIK, JD, CPA
LINDA GODFREY, JD
An offshore trust is a primary legal tool involved in offshore planning. The offshore trust is generally a ?self-settled trust.? This is a trust where the settlor and the beneficiary are both one and the same. The trustee is a person who is nominated by the settlor and is either an individual who is not a U.S. citizen or a business having no U.S. offices or affiliation. An offshore trust has additional people who serve as trust advisors or trust protectors. These individuals are not under the settlor?s control, but they have certain powers in the administration and protection of the trust and its assets. Offshore trusts provide a method of transferring assets between generations, probate free. The trust will usually provide that assets will automatically pass to named successor beneficiaries upon the settlor?s death.
Offshore trust planning is the establishment of legal entities in favorable foreign jurisdictions that are under the control of trustees who are neither citizens of the U.S. or persons having a business presence in the U.S. The purpose of offshore planning is the removal of legal battles with creditors to jurisdictions that are beyond the reach of U.S. courts. Offshore planning works because there are offshore jurisdictions that do not recognize judgments rendered by U.S. courts.
There are four key elements for proper protection from creditors when assets are transferred to a trust.
- The assets cannot be fraudulently transferred,
- The trust must be established as irrevocable,
- Distributions from the trust must be discretionary in the judgment of an independent trustee; and
- The trust instrument must include “spendthrift” provisions that provide that creditors of the beneficiaries of the trust cannot reach the trust assets.
Conflicts of law and choice of law issues are definitively settled in many foreign jurisdictions. Only the foreign law will apply since offshore jurisdictions are not subject to the control of U.S. courts.
II. Ethical considerations-guarding against fraudulent transfer
A. Ethical Considerations
In order for the attorney to avoid ethical violations and the possibility of civil and criminal liability, he must be careful in accepting new clients and in advising and servicing them. The basic concept that should be employed is the performance of due diligence.
The due diligence procedures should generally include the following:
1. A retainer letter, signed by the client, which includes,
- definition of a fraudulent conveyance under local law,
- potential consequences of the making of a fraudulent conveyance,
- the attorney will not assist the client in any transfer which he believes may constitute a fraudulent conveyance,
- the attorney is relying on full and continuing disclosure by the client in the attorney’s assessment of whether the transfers at issue are, in fact, permissible, and
- a breach of the client’s required full and continuing disclosure will constitute grounds for the attorney to resign as counsel; BNA 810 2d
2. Investigate the client?s financial condition,
- obtain client?s financial statement,
- determine whether the client, or any company the client has been closely connected to, has ever filed for relief in bankruptcy,
- determine if the client’s federal, state and local tax reporting is current, and
- determine if the client is currently being audited by any tax authority.
3. Examine all client debts, liabilities, and obligations
- determine whether the client has any direct or indirect liability for any loan,
- determine if there are any contingent liabilities;
- gather information about client?s historical method of doing business; and
- investigate the client?s general reputation among business;
4. Perform a solvency analysis;
5. The client should provide the following documentation for review,
- copies of the client’s most recent personal income tax returns, as well as a current personal financial statement, and
- if the client is closely connected with any company, copies of that company’s most recent income tax returns, as well as a current financial statement of the company;
6. The client should provide personal references from one or more of the following:
- primary banker,
- the client’s personal attorney,
- personal accountant and,
- personal tax return preparer;
The attorney must be knowledgeable about all aspects of a client?s wealth and objectives. This knowledge will aid in determining the benefits of an offshore trust and influence the way the plan is structured.
The reasons for creating an offshore trust should be discussed with the client. The motivations for the creation of an offshore trust generally fall into one of four classes: (1) asset protection; (2) economic or investment issues; (3) tax or estate planning issues; and (4) personal or family issues.
1. Asset Protection
2.Economic or investment issues may be as follows:
- economic diversification;
- participation in investments not otherwise available to U.S. investors, and
- liability protection, tax planning, or strategic advantage in the context of an active trade or business abroad.
3.Tax or estate planning issues including:
- transfer tax planning;
- perpetual trusts;
- income tax planning;
- accessing the offshore life insurance market; and using a foreign qualified personal residence trust.
4.Personal or family issues including:
- planning for the contingency of changing one?s domicile or citizenship;
- the achievement of a ?low profile? or anonymity with respect to wealth;
- the avoidance of forced dispositions;
- premarital planning; and
- marital property planning.
Possible Attorney Liability
A “civil conspiracy” is defined as a combination by two or more persons to commit an unlawful act that causes damage to a person or property. Black’s Law Dictionary 305 (7th ed. 1999).
The separate of civil conspiracy include:
(1) an agreement between two or more persons;
(2) to participate in an unlawful act, or a lawful act in an unlawful manner;
(3) an injury caused by an unlawful overt act performed by one of the parties to the agreement;
(4) which overt act was done pursuant to and in furtherance of the common scheme. Ryan v. Eli Lilly & Co., 514 F. Supp. 1004, 1012 (D. S.C. 1981).
The agreement in a civil conspiracy is neither wrongful nor actionable. The action is for damages occurring from the acts committed pursuant to the conspiracy. Onderdonk v. Lamb, 79 Wis.2d 241, 255 N.W.2d 507 (1977).
Generally, if the attorney’s only connection to the fraudulent transfer is as the recipient of a portion of the client’s transferred assets as a legal fee, he will not be held liable. If the attorney receives more than payment of a past due fee, that additional consideration carries the possibility of the him being found liable in civil conspiracy.
Aiding and Abetting
Aiding and abetting is when a defendant knowingly gives substantial assistance to someone who performed wrongful conduct. Halberstam v. Welch, 705 F. 2d 472 (D.C. Cir. 1983). It is not whether or not the defendant agreed to join the wrongful conduct.
The aiding and abetting liability elements are: (1) the party whom a defendant aids and abets must perform a wrongful act that causes injury; (2) the defendant must be generally aware of his or her role as part of an overall tortious activity at the time that he provides the assistance; and (3) the defendant must knowingly and substantially assist the principal violation. Id.
The attorney must have failed to exercise the care, skill, and diligence that are commonly exercised by other attorneys practicing in similar situations in order to be found liable for malpractice. The attorney who asserts specialization in an area of law will normally be held to the higher standard of care that other legal specialists practicing in the same area. Legal malpractice looks to the potential of the attorney being held liable to his own client.
The Federal Bankruptcy Code states it is a crime when a person, “in a personal capacity or as an agent or officer of any person or corporation, in contemplation of a case under title 11 by or against the person or any other person or corporation, or with intent to defeat the provisions of title 11, knowingly and fraudulently transfers or conceals any of his property or the property of such other person or corporation.” 18 USC §152. The defendant may be fined up to $5,000 or sentenced up to five years in jail or both if found guilty. Id. The use of the term “knowingly” appears to require specified knowledge or intent before criminal liability may be imposed. The knowledge requirement may be met by showing “willful blindness.” The defendant may be subject to being charged with obstruction of justice.
B. Fraudulent Transfers
The Uniform Fraudulent Transfer Act (UFTA) is patterned after Section 548 of the Bankruptcy Code. Illinois adopted the UFTA on January 1, 1990 and is codified at 740 ILCS 160/1 et. seq.
The most common occurrence of a fraudulent conveyance is a transfer made with the intent to hinder, delay or defraud a creditor. 740 ILCS 160/5(a)(1). A transfer made without fair consideration by a person who is insolvent, or who will become insolvent because of the transfer, is considered a fraudulent conveyance. 740 ILCS 160/5(a)(2). The UFTA states a “debtor is insolvent if the sum of the debtor’s debts is greater than all of the debtor’s assets at a fair valuation.” 740 ILCS 160/3(a). Also, a person is considered insolvent if he is not paying his debts timely. 740 ILCS 160/5(b).
The term “transfer” is defined as including “every mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with an asset or an interest in an asset, and includes payment of money, release, lease, and creation of a lien or other encumbrance.” 740 ILCS 160/2(l).
A current creditor does not need to establish the debtor intended a transfer to be fraudulent. The creditor only needs to prove the assets were transferred without receiving an equivalent value in exchange and the debtor was insolvent at the time of the transfer or became insolvent because of the transfer. 740 ILCS 160/6(a).
Badges of Fraud
The courts have allowed various badges of fraud to be considered as proof of intent because of the difficulty in proving intent of a fraudulent transfer or conveyance. one of the following factors, individually, may be considered proof of intent. However, an aggregation of a number of the following badges may serve as a determination of the debtor’s intent. These factors are as follows:
- Whether the transfer or obligation was to an insider;
- Whether the debtor retained possession or control of the property transferred after the transfer;
- Whether the transfer or obligation was disclosed or concealed;
- Whether before the transfer was made or the obligation was incurred, the debtor had been sued or threatened with suit;
- Whether the transfer was of substantially all of the debtor’s assets;
- Whether the debtor absconded;
- Whether the debtor removed or concealed assets;
- Whether the value of the consideration received by the debtor was reasonably equivalent to the value of the asset transferred or the amount of the obligation incurred;
- Whether the debtor was insolvent or became insolvent shortly after the transfer was made or the obligation was incurred;
- Whether the transfer occurred shortly before or shortly after a substantial debt was incurred; and
- Whether the debtor transferred the essential assets of the business to a lienor who transferred the assets to an insider of the debtor. 740 ILCS 160/5(b).
The UFTA offers several remedies when a fraudulent transfer is alleged to have been made. Some of the remedies include:
- avoidance of the transfer or obligation to the extent necessary to satisfy the creditor’s claim;
- an attachment or other provisional remedy against the asset transferred or other property of the transferee; and
- an injunction against further disposition by the debtor or a transferee, or both, of the asset transferred or of other property of the transferee or any other relief the circumstances may require. 740 ILCS 160/8.
The creditor with a judgment on a claim may levy execution on the asset that was transferred or the proceeds from that asset. 740 ILCS 160/8 (b).
- Bankruptcy Issues
According to Section 548 the bankruptcy estate trustee is authorized to avoid certain prior fraudulent transfers of the debtor which were made or incurred on or within one year before the date of the filing of the bankruptcy petition. This one-year period was increased to two years by The 2005 Bankruptcy Abuse Prevention and Consumer Protection Act increased the one-year period to two years for cases initiating more than one year after April 20, 2005. 11 USC §548(a)(1),(b).
The Bankruptcy Court may use the finding that the debtor has effected a fraudulent conveyance use to deny the debtor a discharge in Bankruptcy. 11 USC §727(a)(2)(A). The problem of fraudulent transfers is they, generally, are based on a debtor’s inadvertent overly aggressive pre-bankruptcy “exemption planning”.
The trustee is able to avoid the debtor?s prepetition transfers of property as a fraudulent conveyance through use of the following:
1. Transfers Avoidable. A transfer of an interest of the debtor in property within one year before the filing of the petition, or an obligation incurred by the debtor within one year before the filing of the petition, may be avoided as a fraudulent conveyance if one of the following tests is met:
- Actual Fraud: A transfer made or obligation incurred with actual intent to hinder, delay, or defraud creditors. 11 U.S.C. §548(a)(1)(a).
- Constructive Fraud: The debtor received less than reasonably equivalent value in exchange for such transfer or obligation, and
- The debtor was insolvent or became insolvent as a result of the transfer or obligation;
- The debtor was engaged in business for which any remaining property was unreasonably small capital, or;
- The debtor intended to incur debts that would be beyond the debtor?s ability to pay as they mature. 11 U.S.C. § 548(a)(1)(B).
- Self-Settled Trusts (Section 548(e). A transfer made within 10 years before the filing of the petition may be avoided, if ?
- Such transfer was made to a self-settled trust or similar devise;
- Such transfer was by the debtor;
- The debtor is the beneficiary of such trust or similar device; and
- The debtor made such transfer with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made, indebted. 11.U.S.C.§548(e).
3. Insolvency: For purposes of constructive fraud, insolvency is measured using a balance sheet test, i.e. whether the sum of the debtor?s debts is greater that all of the debtor?s property at a fair valuation. 11 U.S.C.§101(32).
4. Party: The only party who may bring this action is the trustee or debtor in possession. If a debtor-in-possession refuses to file a fraudulent transfer claim, the Court may authorize the Creditor?s Committee to bring the claim. An individual creditor has no standing to bring a fraudulent transfer claim.
- Trustee may recover the property transferred or its value from the transferee or party for whose benefit it was made.
- A transferee that takes for value and in good faith has a lien to the extent the transferee gave value. 11 U.S.C.§ 550.
- Potential Criminal Issues
4. Bankruptcy Crimes
The United States Code provides the possibility of fines, imprisonment of not more than five years, or both, for any person who in connection with a bankruptcy case who;
knowingly and fraudulently conceals any property belonging to the estate of a debtor; 18 USC §152(1).
knowingly and fraudulently receives any material amount of property from a debtor after the filing of a bankruptcy case, with intent to defeat the provisions of the Bankruptcy Code; 18 USC §152(5). or
in a personal capacity or as an agent or officer of any person or corporation, in contemplation of a bankruptcy case by or against the person or any other person or corporation, or with intent to defeat the provisions of the Bankruptcy Code, knowingly and fraudulently transfers or conceals any of his property or the property of such other person or corporation. 18 USC §152(7).
III. Selecting the Proper Jurisdiction and Foreign Service Professionals.
Selecting the Jurisdiction
The first step begin the process of implementing an offshore trust is to select the jurisdiction. Following are factors that should be considered in selecting the jurisdiction.
A jurisdiction whose legal system is English common law-based will have a trust concept and legal foundation upon which the offshore trust plan can be structured. The jurisdiction should also have legislation establishing rules specifically relating to international trusts and the related issues.
These rules should also address the how the Statute of Elizabeth applies. The Statute of Elizabeth was enacted in England in 1571 and is the basis for the fraudulent transfer law. A negative aspect of this statute is that it contains no limitation period. In selecting a jurisdiction, the attorney should look for a jurisdiction that has legislation that has repealed the Statute of Elizabeth.
Statutes that require the complaining creditor to prove the fraudulent transfer “beyond a reasonable doubt” are found in the Cook Islands International Trusts Act 1984 and the Nevis International Exempt Trust Ordinance 1994. Under these statutes, the entire transfer is not set aside if the creditor is successful. Instead, the trust is liable to satisfy the creditor’s claim out of trust property that would have been available to satisfy the claim excepting for the settlor’s transfer. Rosen and Rothschild, 810-2nd T.M., Asset Protection Planning.
This type of fraudulent transfer provision is very important because each creditor must endure the time and expense of proving beyond a reasonable doubt the settlor’s transfer was fraudulent. Each of these cases must be brought in the situs jurisdiction court utilizing counsel admitted to practice in the trust situs jurisdiction. Ibid.
The comity concept is an important factor in an offshore trust. A creditor may obtain a domestic court order directing the trustee to distribute assets to the settlor. This order would not be effective where the foreign trustee of the offshore trust is a resident in a jurisdiction which does not grant comity to foreign judgments.
Retained Interests, Powers, and Self-Settled Spendthrift Provisions
The offshore trust jurisdiction laws should override the common law rules that prevent effective asset protection for the settlor-beneficiary of a spendthrift, wholly discretionary, and other retained-interest trusts.
Tax Laws and Exchange Controls
The selected jurisdiction should exempt the offshore trust, assets, and income from any type of taxation, and from any exchange controls.
(3) Other Factors
Other factors to be considered in selecting the offshore trust jurisdiction include:
- compatible language,
- availability and quality of professional services,
- economic and political stability,
- transportation and communications,
- banks and investment advisors,
- criminal activities, and
- influences of other countries.
After the location of the offshore trust has been determined, local professionals must be chosen. Locally located legal counsel and a bank or trust company are required for the offshore location. A portfolio manager will also be necessary if one is not provided by the bank or trust company. It is recommended that the attorney and/or the client interview these professionals.
The interviewer should question the trustee regarding the number of offshore trusts and the asset values under its administration. The trust company should be provide local certificates of good standing and financial statements. Confirm that the trust company does not have any U.S. branch operations. This requirement will preclude a U.S. court from exerting pressure on the offshore trustee through the issuance of an order on the U.S. branch.
The attorney and client may be examined by the local professionals they are interviewing. They may be asked for references.
IV. Tax Considerations in the Offshore World
The attorney must be knowledgeable of any tax implications when assisting a client in establishing an offshore trust. The offshore trust is generally designed to be U.S. income tax-neutral during the settlor’s lifetime.
The Internal Revenue Code uses the term ?trust? to refer to an arrangement created either by a will or by an inter vivos declaration where the trustee takes title to property for the purpose of protecting or conserving it for the beneficiaries. If the beneficiaries of the trust are the persons who created the trust, it will be recognized as a trust under the Internal Revenue Code as long as the trust was created to protect or conserve trust property. Regs. §301.7701-4(a).
Foreign or Domestic Determination
The Small Business Job Protection Act of 1996 established a bright-line, two-pronged test to determine whether a trust is domestic or foreign. Section 7701(a)(31)(B) defines a “foreign trust” as a trust that does not qualify as a “United States person” under §7701(a)(30)(E).
A trust is considered a “United States person” if it meets both of the following requirements:
- a court within the United States is able to exercise primary supervision over the administration of the trust (“court test”), Regs.§301.7701-7(1)(a)(i) and
- one or more U.S. persons have the authority to control all substantial decisions of the trust (“control test”). Regs. §301.7701-7(1)(a)(ii).
A trust that fails either of these tests is regarded as a foreign trust. Whether a trust meets these two tests is determined according to the terms of the trust instrument and the applicable local law. Regs. §301.7701-7(b).
A trust will meet the court test by being under the “primary supervision” of a U.S. court. Regs. §301.7701-7(a)(1)(i). “Primary supervision” means that a court has or would have the authority to determine substantially all issues regarding the administration of the entire trust. Regs. §301.7701-7(c)(3)(iv).
However, the regulations point out that a court may have “primary supervision” even though another court has jurisdiction over a trustee, a beneficiary, or trust property. Regs. §301.7701-7(c)(3)(iv). The trust will meet the court test even if a U.S. court and a foreign court are both able to exercise primary supervision. Regs. §301.7701-7(c)(4)(i)(D). A court within the United States” means only the fifty states and the District of Columbia. Regs §301.7701-7(c)(3)(ii). Therefore, a court within a territory or possession of the United States, or within a foreign country, is not considered to be a court within the United States. Id.
A domestic trust must also meet a control test. This test requires one or more U.S. persons must have the authority to control all substantial decisions of the trust. Regs. §301.7701-7(a)(1)(ii). The term “United States person” is defined as a citizen or resident of the United States, a domestic partnership or a domestic corporation. Regs. §3301.7701(a)(30) and Regs. §301.7701-7(d)(1)(i).
“Control” is defined as having the power, by vote or otherwise, to make all of the substantial decisions of the trust, with no other person having the power to veto any of the substantial decisions. Regs. §301.7701-7(d)(1)(iii). To determine whether U.S. persons have control, therefore, It is necessary to consider all persons who have authority to make a substantial decision of the trust in order to determine whether U.S. persons have control. Id. “Substantial decisions” are defined as decisions that persons are authorized or required to make under the terms of the trust instrument and applicable law, and that are not only ministerial. Regs. §301.7701-7(d)(1)(ii). The regulations provide the following list of “substantial decisions” made with respect to:
- whether and when to distribute income or corpus;
- the amount of any distribution;
- the selection of a beneficiary;
- whether a receipt is allocable to income or principal;
- whether to terminate the trust;
- whether to compromise, arbitrate or abandon claims of the trust;
- whether to sue on behalf of the trust or to defend suits against the trust;
- whether to remove, add or replace a trustee;
- whether to appoint a successor trustee to succeed a trustee who has died, resigned, or otherwise ceased to act as a trustee, even if the power to make such a decision is not accompanied by an unrestricted power to remove a trustee, unless the power to make such a decision is limited such that it cannot be exercised in a manner that would change the trust’s residency from foreign to domestic or vice versa; and
- investment decisions. Regs. §301.7701-7(d)(1)(ii)(A) through (J).
Investment decisions made by the investment advisor will be considered substantial decisions controlled by the U.S. person if the U.S. person can terminate the investment advisor’s power to make investment decisions at the will of the U.S. person. Regs. §301.7701-7(d)(1)(ii)(J).
Consequences of Changing from Domestic to Foreign Trust
Changing status from a domestic trust to a foreign trust may create dramatic tax consequences. The most significant is Section 684 that provides any transfer of property by a U.S. person to a foreign trust will be treated as a sale or exchange for an amount equal to the fair market value of the property transferred. §684(a). Capital gain is realized upon the transfer of these appreciated assets by a U.S. person to a foreign trust. Section 684(c) states that when a domestic trust converts to a foreign trust, the domestic trust is considered to have transferred all of its assets to the foreign trust immediately before becoming a foreign trust. Section 684 does not apply to a transfer to a grantor trust. §684(b).
Gift and Estate Tax Consequences
The trust may be structured so transfers to the trust will be considered incomplete gifts. The value of the trust will then be included in the settlor’s gross estate when the settlor dies. The assets in the trust will then receive a “step-up” in basis under Section 1014. General estate planning considerations utilizing the unified credit against estate tax, §2010; the marital deduction, §2056; and the GST exemption §2631 may be addressed in the settlement of trust by including the appropriate provisions. When a trust is structured so transfers to the trust will be considered completed gifts; gift tax may be due because of the transfer. Generally, these transferred assets will be excluded from the settlor’s gross estate.
U.S. Tax Rules Applicable to Foreign Trusts and Foreign Grantors
Taxation Of Transfers To Foreign Trusts.
A U.S. person who transfers property to a foreign trust is treated as if he had sold the assets at their fair market value. The transfer of assets upon the death of a U.S. grantor of a foreign trust will not be subject to Section 684 if the foreign trust takes a stepped-up basis in the assets under §1014(a). Treas. Reg. §1.684-3(c).
Outbound Foreign Trusts.
IRC §679 states if a U.S. person transfers property, directly or indirectly, to a foreign trust that has a U.S. beneficiary, that transferor will be treated as the owner of the portion of the trust attributable to such property. There are four questions to ask to determine whether §679 applies to the situation. The questions are: (1) whether there is a U.S. transferor; (2) whether there has been a transfer of property within the meaning of §679; (3) whether the transferee trust is domestic or foreign; and (4) whether the trust has any U.S. beneficiaries.
U.S. Transferor. A foreign person who transfers property to a foreign trust and becomes a U.S. citizen or resident within five years of such transfer will be treated as a U.S. transferor with respect to the portion of the trust that, as of the date of immigration, is attributable to such prior transfer. §679(a)(4).
Debt owed by the trust, any grantor, owner, or beneficiary of the trust, or by certain persons related to a grantor, owner, or beneficiary will be disregarded in the determination of the receipt of the fair market value. §679(a)(3). If the U.S. transferor transfers property to a foreign trust with U.S. beneficiaries in exchange for the trust’s fair market value debt instrument, the transferor will still be treated as the owner of the portion of the trust attributable to such property under §679.147.
U.S. Beneficiary. Section 679(c)(1) provides that a trust will be treated as having a U.S. beneficiary for any given taxable year of the transferor unless (1) under the terms of the trust, no part of the income or corpus of the trust may be paid or accumulated during such taxable year to or for the benefit of a U.S. person, and (2) if the trust were terminated at any time during such taxable year, no part of the income or corpus of the trust could be paid to or for the benefit of a U.S. person. The 1996 Act added §679(c)(3), which provides that if a foreign beneficiary of a foreign trust subsequently becomes a U.S. citizen or resident, §679 will apply to prior transfers by a U.S. person to the trust only to the extent they were made within five years of such immigration.
The legislative history of §679 indicates Congress? intention to treat a foreign trust as having United States beneficiaries if the trust instrument, taken together with any related written or oral agreements between the trustee and the grantor, gives to any person the authority to distribute income or corpus to unnamed persons generally or to any class of persons which includes United States persons. The legislative history further provides that such authority would be deemed to exist if any person has the power to amend the trust instrument in such a way as to include United States beneficiaries.153 The final regulations follow this approach and provide numerous examples of prohibited arrangements.154
Taxation Of Accumulation Distributions From Foreign Nongrantor Trusts.
The U.S. tax law applicable to foreign nongrantor trusts contains complicated rules for the taxation of trust distributions which represent accumulations of trust income. These “throwback rules” are designed to approximate and capture the incremental amount of U.S. tax that would have been collected if amounts accumulated by the trust and later distributed to a U.S. beneficiary had instead been distributed when earned.
TRA `76 introduced the nondeductible §668 interest charge that accrues over a statutorily prescribed deferral period on the throwback tax attributable to an accumulation distribution from a foreign nongrantor trust. The interest charge is now equal to the rate charged on tax underpayments, compounded daily.
The period for which interest accrues is now determined under a weighted method that takes into account the amount of the accumulation distribution allocated to each prior year.
For purposes of determining the interest accrual period only, an accumulation distribution is now allocated to prior years in proportion to the undistributed net income from such years (rather than being allocated first to the earliest years).
Capital gains are included in the “distributable net income” of any foreign trust, even if such gains are allocated to corpus under local law or under the terms of the trust instrument. Because accumulation distributions do not retain their character in the hands of the recipient beneficiary, beneficiaries of foreign nongrantor trusts are taxed at ordinary income rates on distributions of accumulated capital gains.
Reporting and Disclosure
Form 3520?Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts. A U.S. person who creates a foreign trust or transfers money or property to a foreign trust must report those events on Form 3520. This is an annual return that is due on the date the reporting party?s income tax return is due. The failure to file penalty is 35% of the amount transferred plus an additional $10,000 penalty every 30 days after.
Form 3520-A?Annual Information Return of Foreign Trust With a U.S. Owner. A U.S. person who is taxable as the owner of a foreign trust under any of the grantor trust rules must make certain the trustee files an annual return on Form 3520-A. The filing requirement is imposed on the trustee but the penalty for failure to file is imposed on the U.S. grantor. The penalty is equal to 5% of the trust assets treated as owned by the U.S. grantor plus an additional $10,000 penalties every 30 days for continuing failure to file.
Form 709?U.S. Gift (and Generation-Skipping Transfer) Tax Return. If a transfer to a trust is incomplete for gift tax purposes, the transferor must still file Form 709 to inform the IRS of an incomplete gift. The IRS requires a copy of the trust document to be included as well as disclosure of all the relevant facts. IRC §6048(b). This form is due April 15 following the year of the transfer. The penalty for not filing is calculated on the amount of tax shown on the return.
Treasury Department Form 90-22.1?Report of Foreign Bank and Financial Accounts. A U.S. person who has a financial interest, signatory, or other authority over one or more financial accounts worth more than $10,000 in a foreign country must report those on their individual federal income tax return and file Form 90-22.1. This form must be filed on or before June 30th of the year following the close of the taxable year of the U.S. person. A failure to comply will cause the taxpayer to be subject to a penalty. The maximum penalty is $10,000 unless the violation is ?willful,? in which case the maximum penalty is increased to the greater of $100,000 or 50% of the transaction or balance in the account at the time of the transaction. The failure to comply may also result in criminal penalties, including imprisonment. 31 UCS§5322
Trustee Or Executor.
Form 3520-A?Annual Information Return of Foreign Trust With a U.S. Owner. The trustee of a foreign grantor trust with a U.S. grantor must file Form 3520-A annually by March 15.
Foreign Grantor Trust Owner Statement.160. The trustee must furnish a Foreign Grantor Trust Owner Statement to the U.S. grantor of the trust when he files Form 3520-A.
Foreign Trust Beneficiary Statement. The trustee of a foreign trust must furnish a Foreign Grantor Trust Beneficiary Statement or a Foreign Nongrantor Trust Beneficiary Statement to any U.S. beneficiary who received a distribution from the trust during the year. The statements must be furnished at the same time that the trustee files Form 3520-A.
Form 3520?Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts. The transfer to a foreign trust by reason of the death of a U.S. person must be reported on Form 3520. The executor of the estate of the U.S. person must report that death if the decedent was treated as the owner of any portion of a foreign trust under the grantor trust rules or if any portion of a foreign trust was included in the decedent’s gross estate. The penalty for noncompliance is equal to 35% of the reportable amount, with additional $10,000 penalties every 30 days for continuing failure after notice from the IRS.
Form 1041?U.S. Income Tax Return for Estates and Trusts. Regulations state the trustee of a foreign trust that is a grantor trust for U.S. income tax purpose must file a statement attached to Form 1041 to report the income of the trust. Treas. Reg. §§1.671-4(a)(6)(ii). The form and letter must be filed by April 15 each year.
Form 1040NR?U.S. Nonresident Alien Income Tax Return. The trustee of a foreign trust that is not a grantor trust for U.S. income tax purposes but which has U.S. source income must file a Form 1040NR if the U.S. tax on that income was not withheld at its source by the payor. Form 1040NR must be filed by June 15 each year. The penalty for failure to file is 5% of the amount of tax on the return and an additional 5% penalty for each month or partial month thereafter up to a maximum penalty of 25%.
Form 3520?Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts. A U.S. beneficiary of a foreign trust is required to provide information to the IRS regarding distributions from the foreign trust. This is accomplished using Form 3520. The penalty for failure to file is equal to 35% of the amount of the distribution plus an additional $10,000 penalty every 30 days for continuing failure to file.
Investment by Foreign Trusts in Foreign Entities
Since the U.S. tax law will generally treat an investment by a foreign grantor trust with a U.S. grantor as an investment by the U.S. grantor, the investments in foreign entities will be subject to U.S. tax rules relating to investments in foreign entities.
Controlled Foreign Corporations
A foreign corporation is a controlled foreign corporation if the U.S. shareholders own, directly or indirectly, 50% or more in the value or the voting power of its stock at any time during the corporation’s taxable year. IRC §957. A U.S. shareholder is any U.S. citizen or resident who owns, directly or indirectly, 10% or more of the voting power of the stock. IRC §§951(b), 957(c).
The effect of have a controlled foreign corporation classification is that certain types of corporate income are taxable to the U.S. shareholders owning 10% or more of the controlled foreign corporation. This taxation is regardless of whether the income is actually distributed. IRC §956.
Foreign personal holding company income includes dividends and equivalents, interest and equivalents, royalties, rents, annuities, gains from the sale of assets that produce the foregoing types of income, gains on certain commodity transactions, foreign currency gains, and certain amounts attributable to notional principal contracts and securities lending transactions. Income that is not controlled foreign corporation income may still be taxable currently. IRC §956.
Foreign Personal Holding Companies
The American Jobs Creation Act of 2004, Pub. L. No. 108-357, 118 Stat. 1418, repealed the foreign personal holding company rules.
Passive Foreign Investment Companies
A foreign corporation is a passive foreign investment company if (i) at least 50% of its assets produce passive income or are expected to produce passive income, or (ii) at least 75% of its gross income for the year in question is passive. IRC §§1297(a), (b).
There is no minimum U.S. shareholder requirement for passive foreign investment company classification. A U.S. citizen or resident directly or indirectly holding any interest in a passive foreign investment company will be subject to the passive foreign investment company rules.
A shareholder may elect to treat the passive foreign investment company as a qualified electing fund. The shareholder will then be taxed currently on his proportionate share of ordinary earnings and net capital gains of the qualified electing fund.even if they are not distributed. IRC §1293.
- Completed Gifts.
A transfer to a foreign trust that constitutes a completed gift for U.S. gift tax purposes could incur a U.S. gift tax liability. The transfer could be considered a completed gift for gift tax purposes if (1) the transferor no longer controls or has the beneficial enjoyment of the property, and (2) the property is not subject to the claims of the transferor’s creditors. Treas. Reg. §25.2511-2(b).
- Incomplete Gifts.
The settlor will often retain a right or power over the trust assets that will render transfers to the trust incomplete for U.S. gift tax purposes. The gift will become complete when those rights and powers expire or are released
Even though the settlor intends that an initial transfer of assets be incomplete, the regulations require that a gift tax return must be filed for the year of transfer and must disclose the transaction and all relevant facts. IRC §6019. It must be accompanied by a copy of the trust settlement. Treas. Reg §25.6019-3(a).