The use of trusts has long been a part of tax and succession planning. Here's why it's important for trustees and beneficiaries to consider how and when their personal and corporate tax residency can impact the reporting requirements and residency of trusts.
Trust residency
For US tax purposes, a trust is considered resident in the United States if it satisfies both the Court and the Control tests:
A Court within the United States is able to exercise primary supervision over the administration of the trust; and
one or more US persons have the authority to control all substantial decisions of the trust.
In order to satisfy the Court test, the trust needs to be written and administered under the law of a US State. For the Control test to be met, substantial power over the trust must be held by US people only.
For these purposes, substantial power includes, but is not limited to, any of the following:
Decisions regarding distributions – which beneficiary/ies will receive distributions, the timing and/or the amount of the distributions.
Investment making decisions for 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 receipts are allocable to income or principal of the trust.
Whether to remove, add, or replace a trustee.
The ability to appoint a successor trustee/(s).
The ability to terminate the trust.
In practice, this means that if the trustees are US persons, whether that is because they are US citizens, Green Card Holders or Resident Aliens living in the US, or US corporations, then the Control test will be satisfied. It’s worth noting that if there is a foreign trustee that has control over a substantial decision, this could be enough to make the trust foreign. This could include a trust protector who has been given a substantial power, resulting in them having control.
In a situation where there are multiple trustees that are a combination of both US and non-US people, then the determining factor will be whether the trustees have equal power. On the basis that a majority vote is required to make any substantial decisions for the trust, the Control test will only be satisfied if the majority of the trustees are US persons. For example, if there are three trustees and two of them are US people, the trust will meet the control test. In the case where the power is not split equally and one trustee is able to override the vote of the other trustees, if that trustee is a US person, then the control test will be satisfied.
Regardless, both of the Court and Control tests need to be satisfied in order for the trust to be resident in the United States. Therefore, any trust that is not written and administered under the law of a US state will be a foreign trust for US tax purposes.
Changing the residency of a trust
It is possible to change the residency of a trust for US tax purposes. This can be part of a tax-planning strategy, looking to domesticate a foreign trust to improve the US tax-efficiency for US beneficiaries or it can happen unintentionally.
Most commonly, an unplanned change of residency occurs when a sole trustee of a trust administered under the law of a US state, becomes a US person, making the trust US resident, or ceases to be a US person, making the trust a foreign trust.
However, care should also be taken when a trust has a protector with the power to overrule trustee decisions. Protectors are often family members or close friends of the settlor and may be unaware that their personal tax residence can impact the residence of the trust.
US tax filing requirements – for trustees
Foreign trust
Trustees of a foreign trust will only have a US tax filing requirement if the trust has US source income that is Effectively Connected Income (ECI) or Fixed, Determinable, Annual, Periodical (FDAP) income. Usually, this would be in rental income from US real estate or US business profits (ECI) or US dividend income (FDAP).
The trust would then be required to file a Form 1040NR. The filing and payment deadline for this form is 15 April, with the ability to request an extension to 15 October. The extension is for filing purposes only and does not extend the date to pay any tax liability.
For most trustees, as the trust will not be in receipt of US earned income subject to withholding reported on a Form W-2, they have until 15 June to file Form 1040NR or request a further extension, without facing late filing or payment penalties.
The trustees will also need to consider any FATCA reporting requirements to ensure that they have the correct rate of withholding applied to their US income.
US trust
Trustees of a US trust will need to report all the trust income, gains, deductions, and distributions made in the calendar year on a Form 1041. The filing and payment deadline for this Form is 15 April, with the ability to request an extension until 30 September. The extension is for filing purposes only and does not extend the date to pay any tax liability.
US tax filing requirements – for US beneficiaries
Foreign trust
In any year that the US beneficiary receives a distribution from a foreign trust, they will be required to file a Form 3520 – Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts. The deadline for submission of this follows their individual US Federal tax return, including any applicable extensions up to 15 October. This is an information-only reporting form. It provides basic information to the IRS about the foreign trust as well as detailing the US tax treatment of the distributions received by the beneficiary for the year.
For the beneficiary to report the distribution correctly, they will either need to receive a Foreign Grantor Trust Beneficiary Statement or a Foreign Non-Grantor Trust Beneficiary statement from the trustees, otherwise there can be punitive tax issues for them.
US trust
In any year that there has been a distribution, the trustees must ensure that they provide the beneficiaries with the relevant Form K-1 for them to complete their personal US tax filings.
Case study – US trust accidentally becoming a Foreign trust
Imagine the situation where a close family friend was acting as a sole trustee of a US resident trust. They decide to expatriate from the US, having failed to consider the impact this would have on the trust.
Once the trustee ceased to be a US person, the trust would fail to meet the Control test, therefore becoming a foreign trust from this point onwards for US tax purposes. This would have a huge impact on the US taxation of the distributions to US beneficiaries going forward, opening the trust up to the punitive Undistributed Net Income (UNI) and Throwback Tax rules.
Fortunately, IRS regulations provide a 12-month grace period from the date the trust ceases to be a US trust to make the necessary changes to give control back to US persons when the change occurred unintentionally.
This would provide sufficient time to appoint two new trustees, who were US citizens.
Combined with an amendment to the deed to allow decisions to be made based upon a majority vote, this would be sufficient to restore the US residency of the trust, whilst still allowing the existing trustee to maintain their role within the trust, even though they were no longer a US person.
In a situation where a trustee plans to moves elsewhere or a successor trustee is appointed who is tax resident outside of the US, then it would be necessary to review the trust residence rules in the other jurisdiction to understand how this could impact the residency of the trust. This review should be undertaken prior to their move or appointment to ensure that any necessary planning can be implemented by the trust.
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Establishing the residence of a trust for US tax purposes can be a complicated matter.
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