How to Figure Out if a Foreign Person is the Owner of a Grantor Trust

It’s not easy to figure out whether a foreign person can be treated as the owner of a trust under the grantor trust rules.

Here’s a quick explanation for how you think through the problem of identifying whether you have someone as an “owner of the trust” (the key phrase for grantor trust status), and if that person is foreign, whether that status will be permitted to remain.

Explanation

When you’re trying to figure out whether your trust is a grantor trust—and your foreign grantor is the “owner of a portion of the trust” (to use the immortal phrase repeated throughout IRC §§671-679), there’s a process. And the process is more complicated than it needs to be. The process is all revolves around applying special rules found in IRC §672(f).

The problem paragraph

The problem in all of this analysis comes from IRC §672(f)(1). It basically says that if you do your grantor trust analysis and conclude that the owner of the trust is a foreign person, then you aren’t allowed to treat that person as the owner of the trust.

But it is not as simple as it seems.

Here’s the step-by-step analysis.

Step 1. Who is the grantor?

The first step is to identify the grantor(s). A grantor is someone who creates the trust or makes a gratuitous transfer to the trust. Reg. §1.671-2(e)(1).

You can eliminate from the list of grantors anyone who merely created the trust. Such a person will be a grantor but can never be an owner of a portion of the trust. Reg. §1.671-2(e)(1).

Usually, you are going to have one grantor as a candidate for “owner of a portion of the trust” because the funding usually comes from one person.

For the rest of this discussion, I will assume there is only one grantor.

Step 2. Is the grantor an “owner”?

Next, look at IRC §§673-679 to determine whether your grantor is the owner of a portion of the trust. This involves reading the trust document to find magic language that might cause one or more of those Code sections to cause the grantor to be an owner of the trust.

Note that IRC §678 allows someone who is NOT a grantor to be treated as the owner of the trust. I’m going to ignore IRC §678 because let’s not go chase rabbits across the prairie, OK? We’re busy here.

Important! You will want to leap ahead to the rules that generally prohibit foreign persons from being classified as owners of a portion of the trust—the IRC §672(f) rules. Ignore them for now as you do this analysis.

Good. You’ve identified the owner of a portion of the trust, and you have identified the Code section that causes the grantor to have that status.

Step 3. Is the would-be owner a U.S. person (or one type of foreign persons)?

Here’s where we bring in IRC §672(f)(1)—the rule that makes it hard for there to be a foreign owner of a portion of a trust. And we bring in a small swarm of exceptions to make it harder to apply the rule.

U.S. citizen, U.S. resident, domestic corporation

If the owner you found in Step 2 is a U.S. citizen, U.S. resident, or domestic corporation, then IRC §672(f)(1) does not apply (emphasis added):

A CFC is a domestic corporation

One of our usually “let’s pretend” rules in the Internal Revenue Code: let’s pretend that a controlled foreign corporation is a domestic corporation. IRC §672(f)(3)(A) says:

If the owner you identified in Step 2 is a CFC, then pretend it is really a domestic corporation (but just for the purposes of this grantor trust analysis). Take that piece of magic thinking to IRC §672(f)(1). If you have a domestic corporation, IRC §672(f)(1) says that you include trust income in computing the income of a domestic corporation if the grantor trust rules say so. And since we pretend that a CFC is a domestic corporation, we now have an approved owner of a portion of the trust according to IRC §672(f)(1), even though the taxpayer is a foreign person.

Read Reg. §1.672(f)-2(a) along with IRC §672(f)(3)(A) to understand that a CFC is a domestic corporation ONLY for the purposes of bypassing the IRC §672(f)(1) foreign filter.

Foreign owner got a back-door gift from a U.S. beneficiary

That person you identified in Step 2. Is that a foreign person who created a trust and received a gift from a U.S. beneficiary of that trust? If so, the U.S. person is the grantor-owner of the trust. IRC §672(f)(5).

If none of these apply . . .

If your “owner of a portion of the trust” is not a U.S. citizen, U.S. resident, domestic corporation, or CFC, then you are ready for the next step to decide whether your foreign owner (identified in Step 2) will indeed be classified as owner of the trust under the grantor trust rules.

Step 4. Do exceptions to IRC §672(f)(1) apply?

There are three exceptions to IRC §672(f)(1). If one of these applies, it means that the ban on foreign persons as owners of trusts will not apply, and if you can apply the generic grantor trust rules to make a person an owner of the trust, then you do it—whether the person is foreign or U.S.

Revocable trusts

Now it’s back to reading the trust document. You’re looking for ways in which your grantor-owner has the power to “revest” assets in his or her own name, unimpeded by needing to get permission from people.

IRC §672(f)(2)(A)(i) says that if the grantor has the power to take assets out of the trust and put them back in his/her own pocket, then IRC §672(f)(1) will not apply:

That means if a foreign grantor (who you have previously decided is an owner of a portion of the trust) has such a power, we do not bother with the question of whether the owner of the trust is a U.S. person or foreign person—and that person is treated as the owner of a portion of the trust under IRC §671.

Go back to Step 2. Did you identify IRC §676(a) as one of the ways in which the person you identified as an owner . . . became an owner? Good. Because that means you satisfied IRC §672(f)(2)(A)(i) as well, and your foreign person is the owner of a portion of the trust.

“Power to revest” is a subset of the power to revoke or amend the trust. If you can find a clause in the trust document allowing your owner to revoke or amend the trust, and if your owner is a “grantor,” then you win. The owner you identified in Step 2 is the owner for U.S. income tax purposes.

Irrevocable trusts

Irrevocable trusts can be grantor trusts. A foreign person can be the owner of a portion of a trust if he/she is the sole lifetime recipient of income and principal distributions—or, alternately, adding the grantor’s spouse as a permitted recipient of distributions. Remember—if it is theoretically possible for anyone else to get a penny out of the trust during the grantor’s lifetime, this exception fails.

IRC §672(f)(2)(A)(ii) says:

This is simple to find in a trust document. You’re looking for a paragraph that says exactly that. If you find it, then you have a grantor trust and your grantor (who you decided was an owner, in Step 2) is treated as the owner of the trust.

Go back and look at your work in Step 2. Did you identify IRC §677(a) as one of the reasons why your client is the owner of the trust? That’s the analogous grantor trust rule to the IRC §672(f)(2)(A)(ii) exception to IRC §672(f)(1).

Compensatory trusts

I’m just going to leave a bookmark here and won’t discuss it. If you’re dealing with deferred compensation trusts, they can be grantor trusts with the employee (a foreign person) as the owner of the trust—in spite of IRC §672(f)(1). See IRC §672(f)(2)(B) and Reg. § 1.672(f)-2(b).

Conclusion

In summary, it’s not as easy as looking at the exceptions of IRC §672(f)(2). While 95% of the time that will get you the right answer,

• Apply the grantor trust rules (IRC §§673-679) without regard to IRC §672(f). Identify the owners of the trust.
• For all owners, determine if they are U.S. persons. If so, the grantor trust rules stick, as-is, according to your analysis.
• If they are foreign persons, first apply the special rules at IRC §672(f)(3) for CFCs to see if they allow those foreign corporate entities to be owners of the trust, in spite of IRC §672(f)(1).
• Then, look for the “gifts from U.S. beneficiaries” rule of IRC §672(f)(5).
• Then, look for either the “power to revest” exception or the “lifetime beneficiary” exception. Both are in IRC §672(f)(2). If either exists in the trust document, then the person you identified as the owner of the trust—even if foreign—will be treated as the owner of the trust.
• If neither of the IRC §672(f)(2) exceptions apply, IRC §672(f)(1) blocks foreign ownership of the trust, and the trust therefore is a nongrantor trust as to that portion.