There are also examples of US domestic trusts that have been exported out of the US due to the trustees moving outside of the US. These could be considered foreign trusts with US beneficiaries.
It is important to understand the implications for the US beneficiaries, as there are some adverse rules that can result in high or unexpected taxation.
Rohit was a British and Indian citizen but resident and domiciled in India with his parents and siblings. He was accepted at a US university so moved to the US to study on a student F-1 visa. Rohit is the beneficiary of a trust established in the Cayman Islands by a great-grandparent who has since deceased.
There are substantial funds within the trust consisting mainly of cash and a portfolio of non-US financial assets, consisting of collective investment funds. The trust has paid educational costs on behalf of Rohit and includes enrolment fees, tuition fees, room and board, and a stipend to cover books, and subsistence.
Matters of residency
We advised Rohit on his US residency status under the substantial presence test (SPT). You are a resident under this test if you have been present in the US on at least 183 days during the three-year period that includes the current year. For the purpose of this test, each day of presence in the current year counts as a full day. Each day of presence in the preceding year is counted as one-third of a day and each day of the second preceding year is counted as one-sixth of a day. However, under the Internal Revenue Code and Treasury regulations, there is an exception to the substantial presence test for students who are admitted temporarily to the US as a non-immigrant under an F-1 visa who substantially complies with the requirements of being admitted.
We advised Rohit that he would substantially comply with the visa requirements relevant to residence for tax purposes if he was not engaged in activities that are prohibited by the Immigration & Nationality Act, for example if he is found to have accepted unauthorised employment or to have maintained a course of study that is not considered by the IRS to be full time. On the basis that Rohit was not engaged in such activities, then days of US presence during the period he was in the US on an F-1 visa were excluded from the substantial presence test, therefore Rohit was a non-resident for income tax purposes.
However, we did advise that capital gains could still be taxable to exempt students resident in the US. In addition, State tax rules may also want to be considered where the State tax does not follow the Federal income tax return (in this case it was not an issue).
'Throwback' tax rules
As the trust was considered a foreign non-grantor trust, normally we would be concerned about the “throwback” tax rules, which can apply to distributions of accumulated income/gains within the trust. The trustees would normally be advised to calculate annual distributable net income (DNI), which if not distributed becomes undistributable net income (UNI). Distributions are matched first to current year DNI before prior year UNI. Distributions of DNI keep their character when distributed to beneficiaries, so you can take advantage of the lower tax rates for qualified dividends and long-term capital gains. Distributions from UNI are taxed at the marginal income tax rate, with an interest charge depending on how long the UNI is deemed to have accumulated.
The concepts of UNI and DNI apply to foreign non-grantor trusts even when there are no US beneficiaries. For example, in this case, there were no US beneficiaries for years, and now one of the grandchildren has moved to the US and received direct and indirect distributions. Therefore, there was many years worth of accumulated income and gains (UNI).
So that's SPT, UNI, DNI...what else?
In addition, based on the collective investment funds held being non-US funds, passive foreign investment fund (PFIC) rules would also need to be considered. US rules stipulate that a US taxpayer will be treated as an indirect shareholder of a PFIC to the extent of a beneficiary’s proportional interest in a trust. Quantifying the level of a US person’s proportional interest in the trust is based on facts and circumstances of each individual case. If attribution applies in respect of a PFIC, US tax may be due on the US owner regardless of whether any actual distribution is made to them.
Therefore, our advice to Rohit was that if the trustees were to prepare such calculations then there was the likelihood that there would be distributions that would match to current year capital gains. However, all of these capital gains from the sale of collective investment funds represented PFIC “excess distribution” which are taxed as ordinary income and therefore not taxable to Rohit being a non-resident under the F-1 visa exemption. This was a surprising outcome that holding PFICs was better from a US tax perspective than holding directly held equities. Although we advised that if the client lost their exempt status, they would want to make sure they are out of their PFIC positions before becoming US resident under the SPT.
We finally concluded that Rohit would not have a US tax return filing requirement, as he is non-resident alien with no US sourced income or gains. However, we advised him that he would need to file Form 8843 each year that he is exempting himself from being resident as a student resident in the US under an F-1 visa. Form 8843 is due to be filed by 15th April following the end of the US tax year
By working with us, Rohit was able to get a clear understanding of his US tax position before his move to the US. Rohit was able to implement a plan to avoid unnecessary reporting requirements, and an unnecessary US tax bill. Rohit was also advised on the risks of US taxation in the future.
What should I do?
If you are a beneficiary of a trust and are considering a move to the US you should seek pre-immigration advice to ensure you avoid unnecessary reporting requirements, and a potentially higher tax bill. If you are a trustee with a beneficiary who has moved or is considering moving to the US, ensure you know what responsibilities you have as a trustee from a US tax perspective. We work with trustees, settlors, beneficiaries, and their advisors on a global basis on the US tax issues where there is a US connection with the trust structure. Our dual qualified team of advisors have specialist knowledge in a number of areas and we provide prompt, effective advice where there is a US beneficiary of a foreign trust. Get in touch via the form below if you feel we can work together.
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