Sorry. I jumped on a plane and didn’t send a Jell-O Shot. I am in Washington DC as you read this with my daughter. She is thinking of attending Georgetown in the fall. We are staying with my brother-in-law and sister-in-law while we are here in DC.
My email last week (“Hey, who is interested in Fight Club?”) triggered a lot of responses. Apparently a lot of you are interested in foreign trusts, and not just from the asset protection point of view.
This week, then, I will answer one of the questions I received. This is from a U.S. citizen living abroad, married to a non-U.S. citizen. He has U.S. assets. When he dies these assets will go into a trust for the benefit of his non-U.S. spouse.
His question (lightly edited to remove identifying information):
US citizen living in a jurisdiction that taxes foreign trusts as ordinary income.
US assets will on death go into a trust FBO non-citizen spouse (who, even if a resident of the US does not quality for spousal exemption on inheritance tax).
If trust remains in the US, income will be taxed in the US and in home country, and [home country] taxes will be at ordinary income rates, even for capital gains.
US attorney says trust can be re-titled as a foreign trust (which has its own local tax implications, some good in the short term, some not so much longer term).
All that is preamble to question (which is the one that might be of general interest):
What are the US tax implications of making the inherited trust a foreign trust? (Assume for the moment that all assets in the trust are US)
The short answer is that when a trust migrates out of the United States, you pretend that all of the trust’s assets are sold and the trust pays income tax on the pretend sale.
When the trust is established and funded at the time of someone’s death, the income tax consequences of that “pretend” sale will probably be small. You can ignore this “pretend” sale problem.
Migrating a trust from one country to another can be a pain in the neck. Here’s what you need to do:
We can talk about the practical details some other day. It is not easy and it can take a long time. Why? Trustees are by nature risk averse and this process will be heavily documented and you will sign endless documents assuring the Trustees that It Isn’t the Trustee’s Fault, no matter what “it” is.
There is a second way to accomplish the same thing. Old wine, new bottle. This is called trust decanting.
Someone creates a new trust in the desired location, and the trustee of the old trust transfers all of the trust assets into the new trust. The old trust is left behind as an empty shell.
Again, we can talk about this decanting process some other day.
By the way: I’m taking my cues from you guys. If you are interested in a topic, I’m going to write about it.
Going from domestic trust to foreign trust status (as “foreign trust” is defined for income tax purposes, not
necessarily trust law purposes) has income tax consequences: this is treated as a sale of all of the trust assets.
You can find the rules in Internal
Revenue Code Section 684(a). Here is the magic:
Except as provided in regulations, in the case of any transfer of property by a United States person to a foreign estate or trust, for purposes of this subtitle, such transfer shall be treated as a sale or exchange for an amount equal to the fair market value of the property transferred, and the transferor shall recognize as gain the excess of–
(1) the fair market value of the property so transferred, over
(2) the adjusted basis (for purposes of determining gain) of such property in the hands of the transferor.
A domestic trust is a “United States person” but just in case we, the laity, are obtuse, the Internal Revenue Code makes it
abundantly clear that this rule applies to a domestic trust that converts to a foreign trust. Internal Revenue Code Section 684© says:
If a trust which is not a foreign trust becomes a foreign trust, such trust shall be treated for purposes of this section as having transferred, immediately before becoming a foreign trust, all of its assets to a foreign trust.
In the situation posed by my correspondent, Section 684 does not matter. The difference between fair market value – Section 684(a)(1) – and adjusted basis –Section 684(a)(2) – is close enough to zero that it can be safely ignored.
When this individual dies, the property passing into the trust for the benefit of his non-U.S. spouse will have an adjusted basis of fair market value. See Internal Revenue Code Section 1014(a).
If the trust then immediately migrates across the border and becomes a foreign trust, it is treated as selling all of its assets at fair market value.
The difference between the sale price (fair market value at date of the migration) and basis (fair market value at the date of death) will probably be small. The assets will not have much time to appreciate in value.
And the faster the estate and trust lawyers can do the job, the better off everyone is because there will be less time for the asset values to change from the date-of-death values.
In fact, maybe the best thing to do is to not create a domestic trust that is later migrated across the border. Maybe the best thing to do is have the property transfer at death directly into a foreign trust.
In other words, finesse the whole trust migration problem by starting with a foreign trust. This is the third way to migrate a foreign trust – by avoiding migration entirely.
Just have the will say “when I die transfer these assets into a foreign trust … .” Then the transfer occurs at the date of death, which guarantees that there will be zero capital gain under Section 684.
Insert the usual disclaimer here. This is not legal advice to you and it is not legal advice to the person who sent me the email. (I saw your website, by the way. Picturesque and worth a visit!)
Until next week, happy travels.