When Does a Trust Become a Foreign Trust for Tax Purposes?
At what stage is a trust is treated as a foreign trust? If the trust has a non U.S person trustee, would it be deemed to be a foreign trust. But at what stage does it become a foreign trust? Is it as soon as a settlor appoints a successor trustee who is a non-U.S. person or is it when that non-U.S. person assumes the role of trustee? Also, is it true that even if the trustee is a U.S. citizen, but residing outside of the United States, the trust would be deemed to be a foreign trust?
That’s a very interesting question and an important one because the tax treatment of of “foreign” trusts can be super punitive. If the trust is foreign, there are information reporting forms (Form 3520/3520A) that are required and if income is not fully distributed each year there is potential for a throwback tax which basically says we’re going to tax the beneficiary at the highest rate of tax in the year the income was earned regardless of character (so capital gains lose the favorable rate), rather than the year it was distributed. In addition, they add in an interest charge.
As if that’s not enough, if the forms aren’t filed, they impose a $10,000 per form penalty to start OR the 35% of the gross value of the distribution received, whichever is higher. As is said, the rules are super punitive.
Fortunately, you can avoid the trust being deemed as “foreign.” There is much said in the Treasury Regulations on this point. IRC Section 7701 and Treas. Reg. 301.7701 indicate that a trust is considered to be a foreign trust unless it meets both the following two tests:
– The Court Test, and
– The Control Test
A trust meets the Court Test if: “A court within the United States is able to exercise primary supervision over the administration of the trust.”
A trust meets the Control Test if: One or more United States persons have the authority to control all substantial decisions of the trust with no other person having the power to veto any of the substantial decisions.
A U.S. Person is defined in section IRC §7701(a)(30) as “a citizen or resident of the United States”; “substantial decisions” are fiduciary decisions authorized or required under the terms of the trust agreement and applicable law, such as those dealing with distributions, selection of beneficiaries, investment decisions and changes of trustee; and “control” means 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 those “substantial decisions.”
To determine whether a “United States Person” has the authority to control all substantial decisions you must consider all persons who have authority to make a substantial decision of the trust, not only the trustees. Further, the Internal Revenue Service has indicated that a review of the trust document itself must be conducted to determine whether a “flee clause” exists which allows for automatic migration and a transfer of jurisdiction for control under prescribed circumstances. If such clause does exist, the trust is not considered to have met the Court Test.
In your specific scenario, it is when the successor trustee comes into power as trustee as they would have the ability to make substantial decisions and render the trust a foreign trust for tax purposes. However, since a “U.S. person” includes U.S. citizens no matter their actual residence, as long as they have control, the trust remains a domestic trust even if they live outside the United States.