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Stepping Stones: What US persons need to know about trusts

There are US tax and compliance issues for US citizens, residents and green card holders (referred to as US persons) who are the settlor or a beneficiary of a non-US trust. This Stepping Stone focuses on the tax issues that US beneficiaries face.

Last updated: 20 August 2020

The popularity of trusts with families has expanded globally over the years as a tool for asset protection and wealth preservation. However, with millions of people migrating into and out of the US there will be many situations where there are:

  • Non-US (foreign) trusts with US beneficiaries 
  • US trusts with foreign beneficiaries
  • Foreign trusts with US beneficiaries - US domestic trusts that have been exported out of the US due to the trustees moving outside of the US

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.

About the author

Martin Scullion

+44 (0)20 7556 1207
scullionm@buzzacott.co.uk
LinkedIn

Last updated: 20 August 2020

The popularity of trusts with families has expanded globally over the years as a tool for asset protection and wealth preservation. However, with millions of people migrating into and out of the US there will be many situations where there are:

  • Non-US (foreign) trusts with US beneficiaries 
  • US trusts with foreign beneficiaries
  • Foreign trusts with US beneficiaries - US domestic trusts that have been exported out of the US due to the trustees moving outside of the US

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.

Case study

Case studies 

Rohit, a British and Indian citizen, was resident and domiciled in India with his parents and siblings. He was accepted at a US university so moved to America to study, initially on a student F-1 visa. After university, Rohit continued to live and work in the US initially with a company sponsored visa, which then lead to him becoming a green card holder. 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 made up of collective investment funds. The trust has historically paid educational costs on behalf of Rohit and received advice at the time but the trustees are now looking for current advice should there be future distributions made to Rohit as a US person.  

Rohit's student F1 visa

Case study one: Rohit’s student F1 visa

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 SPT 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, the 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 nonresident 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 the current year DNI before the 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 many years, and now one of the grandchildren has moved to the US and received direct and indirect distributions. Therefore, there were many years worth of accumulated income and gains (UNI).

Passive Foreign Investment Company (PFIC) fund rules

Based on the collective investment funds held being non-US funds, Passive Foreign Investment Company (PFIC) fund 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 nonresident 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 did advise 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.

US tax filing

We finally concluded that Rohit would not have a US tax return filing requirement, as he is nonresident 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 15 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 and 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.

Rohit's company sponsored visa

Case study two: Rohit’s company sponsored visa and becoming a green card holder

Passive Foreign Investment Company (PFIC) fund rules

Thankfully due to previous advice given to the trustees in case study one, once Rohit (the US beneficiary) lost his exempt status under an F-1 visa, the trustees no longer held any PFICs therefore no attribution to the US beneficiary, and we are left with just throwback tax issues, and UNI/DNI calculations.

US tax filing

Rohit has had a US tax return filing requirement since giving up his F-1 visa and moving to a company sponsored visa, and he now has a permanent resident status with his green card. For any year that Rohit receives a distribution from the trust in the future, he will need to report this on Form 3520. 

If the trustees have prepared current DNI calculations and historic UNI calculations, they can provide Rohit with a Foreign Non-Grantor Trust beneficiary statement showing the current year income, prior year accumulated income and any trust corpus that is matched to the distribution. Without this, Rohit would be forced to prepare Form 3520 using the default method, which taxes the entire distribution as accumulated income, which normally leads to a larger tax liability due to the throwback tax rules.

By working with us, Rohit and the trustees were able to get a clear understanding of the US tax requirements before his move to the US and his time as a student. Once Rohit decided to remain in the US, we advised both Rohit and the trustees on their reporting requirements, the tax implications of holding certain investments, creating a strategy for future distributions, and making a decision on the feasibility to prepare current and historic UNI/DNI calculations as opposed to using the default method.

What should you do?

What should you 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, make sure that you are aware of your responsibilities as a trustee from a US tax perspective. 

Speak to an expert
Speak to an expert

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. For further guidance and advice tailored to your specific circumstances, please fill in the contact form below.

The full Stepping Stones series can be found here.

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