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May 21, 2010 - Phil Hodgen

New foreign trust tax rules, Part 4 – new presumption for discretionary trusts

Continuing on with the latest and greatest in U.S. tax law changes affecting foreign trusts, we come now to the Beginning of the End for discretionary trusts, at least when they touch the United States.

Previous episodes of this series: Part 1 – OverviewPart 2 – Using Trust Property For Free, Part 3 – expanding the grantor trust rules.

The situation

Almost every non-U.S. trust document I have ever read will be constructed roughly as follows.  The person creating the trust (call him/her the Settlor) will typically grant the trustee absolute discretion to distribute trust assets to beneficiaries.  Who are these beneficiaries?  There may be some specifically-identified people (names are actually put in the document!).  There might be a designation of beneficiaries by characteristic (“my spouse and my descendants”).  So far, this is unremarkable.

What is entirely remarkable from the U.S. tax authority’s point of view is that the trust document typically grants the trustee the power to add or remove beneficiaries in its sole discretion.

Forty years from now the trustee can decide to add a new beneficiary that is not my child, grandchild, etc.?

Yes.  Exactly.

The tax game

U.S. tax law says that if the Settlor (U.S. tax law calls this person the “grantor” but it is all the same) is a U.S. taxpayer and there is a U.S. taxpayer who is a beneficiary, then the trust is a grantor trust.  The person establishing the trust (a U.S. person, remember?) is forced to pay income tax on the foreign trust’s income.

Tax lawyers look to “adjust” reality in the form of not having a U.S. beneficiary, thereby defeating this rule which causes U.S. income taxation on the foreign trust’s income.  But at the same time, the person creating this foreign trust has children who are U.S. citizens and those are the real people who should get the money.  So “cake” (we don’t want U.S. beneficiaries because we don’t want a grantor trust) and “eat it too” (I want my U.S. citizen children to receive distributions from this trust) are in conflict.

Back door solution?  Create a foreign trust with all foreign beneficiaries.  None of the people named as beneficiaries are U.S. taxpayers.  None of the members of a class of beneficiaries are U.S. taxpayers.  Hey presto!  No grantor trust.

Then you stick one of these provisions in the trust document saying “the trustee has the discretion to name someone else as a beneficiary.”

And you wink at the trustee and say “Hey, look at the pictures of these kids of mine.”

That’s the game.

Wink, wink, nudge, nudge

And the game as it is played is actually a bit more formal than that.  You don’t wink at the trustee.  (The trustee might think you got something in your eye, or the trustee might have been looking the other way when you winked, or . . . . You get it.  You don’t trust the trustee to do what you want him/her/it to do).

So you put it on paper.  It’s called a Letter of Wishes.  It says “this is totally nonbinding on you, dear Trustee, but hey! look at these pictures of my kids!”

Today’s blog post talks about how U.S. tax law now makes those “the trustee can add or remove beneficiaries on a whim” provisions dangerous.  Tomorrow’s blog post will talk specifically about the Letter of Wishes.

Warning: New Reality

MEMO TO TRUSTEES OF FOREIGN TRUSTS – the new State of the Art for foreign trusts touching the United States is radically different from what you’ve been used to up to now.

  • Don’t use Letters of Wishes.  It is a waste of time.
  • Don’t let your lawyers pull out the Same Old Trust Document you’ve used 100 times before.

This.  Is.  Fail.

I assert that corporate trustees of foreign trust must go through their files and clean up all trusts where there is — or conceivably may be — a U.S. beneficiary.  The trust documents must be reviewed to understand how they will operate for U.S. tax purposes, and amended if necessary.

What the HIRE Act says

The HIRE Act changed a provision in the U.S. tax law.  We are looking at Section 531(b) of the HIRE Act.  I dealt with Section 531(a) in a previous blog post, and will deal with Section 531(c) — which affects Letters of Wishes — in a future post.

Here’s what the new law says:

(b) Clarification Regarding Discretion To Identify Beneficiaries – Subsection(c) of section 679 is amended by adding at the end the following new paragraph:

‘(4) SPECIAL RULE IN CASE OF DISCRETION TO IDENTIFY BENEFICIARIES – For purposes of paragraph (1)(A), if any person has the discretion (by authority given in the trust agreement, by power of appointment, or otherwise) of making a distribution from the trust to, or for the benefit of, any person, such trust shall be treated as having a beneficiary who is a United States person unless—

‘(A) the terms of the trust specifically identify the class of persons to whom such distributions may be made, and

‘(B) none of those persons are United States persons during the taxable year.’ .

What the HIRE Act means

This new law tells you to look at the trust documents (including the Letter of Wishes and all of the other wink, wink, nudge, nudge stuff that I will discuss in the blog post about Section 531(c) which will follow in the future).

If you find that someone has the discretion to add beneficiaries, the U.S. tax authorities will ASSUME that a U.S. resident/citizen will be added as a beneficiary, unless the trust documents are specifically written to exclude that possibility.

Don’t be lazy

“Heh!” I hear you snort with derision.  “I’ll just write the trust documents to specifically exclude U.S. persons as potential beneficiaries.  That will solve the problem!”

And yes, it will.  Until some point 20 years in the future where events change and suddenly your children immigrate to the United States.

I have seen too many trust documents which simple reflexive provisions like this.  These provisions have caused immense difficulties.  Difficulties like being unable to migrate the trust to the United States.  Difficulties like being unable to distribute money to people the Settlor clearly have wanted to benefit.

Tax and Trusts