US Taxation of Foreign trusts: Foreign grantor trust

What is a foreign grantor trust (“FGT”). A FGT is typically used when a non-U.S. Person individual (i.e., an individual who is a non-U.S. citizen, not a “green card” holder, or otherwise not considered a U.S. income tax resident) wishes to benefit U.S. Persons through a trust. For example, a Singaporean resident wishes to create a trust to benefit her grandchildren who are U.S. Persons.

This primer explains the characteristics of FGT planning, the tax advantages of the FGT during the settlor’s lifetime, and the pitfalls of the FGT after the settlor’s demise.

What is a “Foreign Grantor Trust”?

The term “foreign grantor trust” is a U.S. term meaning that a trust satisfies a particular tax status under the U.S. tax rules. “Foreign” (i.e., non-U.S.) means that the trust is not considered a U.S. domestic trust, so neither the trust nor its trustees are not liable to U.S. taxation. “Grantor” (the U.S. term for “settlor”) means the non-U.S. Person individual who for U.S. tax purposes funded the trust.

What are the advantages of a FGT?

The ideal scenario to take advantage of FGT planning is when a non-U.S. Person establishes a trust with U.S. Person beneficiaries in mind. The advantages typically are as follows:

Settlor/FGT: The settlor will only suffer U.S. taxation on certain defined categories of U.S.-source income, such as U.S.-source dividends. Without any U.S.-source assets held in trust, the FGT/settlor will not be liable to any U.S. taxation.

There are 2 Options for U.S. Person Beneficiaries:

  • Option 1 (Revocable Trust): The U.S. Person Beneficiary may benefit tax free from the FGT during the lifetime of the settlor. The U.S. Person Beneficiary need only report the distribution from the FGT to the Internal Revenue Service (the “IRS”).
  • Option 2 (Irrevocable Trust): The U.S. Person beneficiary may not directly benefit from the FGT during the lifetime of the settlor however they may receive unlimited gifts from the settlor or settlor’s spouse without any U.S. tax. Unlike Option 1, the U.S. Person Beneficiary need only report to the IRS a gift of over 100,000 USD per calendar year though the gift usually is not subject to U.S. taxation (this is an area that needs to be carefully reviewed, several tax traps abound here).

Revocable Versus Irrevocable Trust?

Any trust that is properly drafted can qualify as a FGT. A person wishing to establish a FGT must choose either:

  • Option 1 (Revocable Trust): very flexible because anyone in the class of beneficiaries may benefit. The settlor has the power to revoke the funds, which provides a higher level of comfort to the settlor in some cases.
  • Option 2 (Irrevocable Trust): To qualify as a FGT under this option the trust must be irrevocable and only the settlor or the settlor’s spouse may benefit from the FGT during the settlor’s lifetime. Option 2 is often confusing to families because of this restriction, however, it is allowable from the U.S. tax side to have the FGT make a distribution to the settlor, and then have the settlor make a gift to the U.S. Person beneficiary.

What are the disadvantages of a FGT?

Unfortunately, the advantages of the FGT do not last forever: when the settlor of the FGT dies the ideal U.S. tax treatment also ends. Upon death, the FGT became a foreign non grantor trust (the “FNGT”). It is important to also to plan for the FNGT phase of the trust. Families often only consider the FGT period (i.e., the tax advantageous period), but fail to consider the complex U.S. tax consequences to the U.S. Person beneficiaries of a FNGT.

What are the solutions for U.S. Person Beneficiaries of a FNGT?

After the settlor’s demise, careful planning is required to ensure the U.S. Person beneficiaries do not suffer substantial U.S. taxation when benefiting from the FNGT.

There are 4 common strategies to mitigate U.S. taxation and onerous foreign trust reporting:

  • Scenario A: The FNGT makes distributions to a U.S. Person beneficiary of income and realized capital gains arising annually. Under this Scenario, the FNGT will ensure that the trust’s income and realized capital gains (trust distributable net income or DNI) are distributed to the U.S. Person beneficiary annually and thereby avoid a U.S. tax problem of accumulating income and gains (undistributed net income (UNI) is subject to a high throwback tax with an interest charge).
  • Scenario B: As a variation of Scenario A, the FNGT could establish a U.S. resident trust (which would be treated as a U.S. Person for U.S. tax purposes) and make annual distributions of income and realized capital gains to the newly created U.S. resident trust.
  • Scenario C: The FNGT may wish to redomesticate the trust so that it is no longer a “foreign” trust, and becomes a U.S. resident trust. No annual distributions are then necessary.
  • Scenario D: In some cases, it may be easier to simply terminate the FNGT soon after the death of the settlor, and make distributions to the U.S. Person beneficiaries.Further scenarios may be possible depending on the situation.

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