Tax 101: Taxation of Foreign Trusts

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INTRODUCTION: WHAT IS A FOREIGN TRUST?

In General

A trust is a relationship (generally a written agreement) created at the direction of an individual (the settlor), in which one or more persons (the trustees) hold the individual's property, subject to certain duties, to use and protect it for the benefit of others (the beneficiaries). In general, the term “trust” as used in the Internal Revenue Code (the “Code”) refers to an arrangement created either by a will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts.

Trusts can be characterized as grantor trusts or ordinary trusts. Ordinary trusts can be characterized as simple trusts or complex trusts; U.S. tax laws have special definitions for these concepts. A simple trust is a trust that is required to distribute all of its annual income to the beneficiaries. Beneficiaries cannot be charitable. A complex trust is an ordinary trust which is not a simple trust, i.e., a trust that may accumulate income, distribute corpus, or have charitable beneficiaries. Ordinary trusts are “hybrid” entities, serving as a conduit for distributions of distributable net income (“D.N.I.”), a concept defined in the Code,52 to beneficiaries and receiving a deduction for D.N.I. distributions, while being taxed on other income (e.g., accumulated income, income allocated to corpus).

A trust can be domestic or foreign. This article will focus on the U.S. tax consequences with respect to “foreign grantor trusts” (“F.G.T.”) and “foreign nongrantor trusts” (“F.N.G.T.”).

Cross-Border Estate Planning: Canadian Parents of U.S. Children

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U.S. transfer taxes (U.S. gift, estate and generation skipping taxes) should be a concern to any practitioner creating an estate plan with U.S. links. The following article addresses U.S. estate tax consequences of a family comprised of Canadian citizen/resident parents with American children.

IN GENERAL

Transfer tax is imposed on the fair market value of the property transferred, reduced by any consideration received.

U.S. citizens, and non-U.S. citizen individuals that are domiciled in the U.S., are subject to the U.S. transfer tax system on global assets.

A person acquires a domicile in a place by living there, for even a brief period of time, without the presence of a definite intention to leave.

A facts and circumstances test is used to determine domicile. Factors include, e.g.:

1. Statements of intent (as reflected, e.g., on tax returns filed, visa application, and similar evidence);
2. Time spent in U.S. versus time spent abroad;
3. Visa status (e.g., green card holder);
4. Ties to the U.S. versus abroad;
5. Country of citizenship;
6. Location of employment, business, and assets;
7. Other indicators such as voting, affiliations, membership, driver license, and similar items.

Residence without the intention to remain indefinitely will not constitute a domicile, and the intention to change domicile will not effect such a change unless accompanied by actual relocation.

Proposed Partnership Regulations Will Affect Partnership Deal Economics

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INTRODUCTION

In 2014-8 I.R.B., the I.R.S. proposed amendments to regulations issued under Code §707 relating to disguised sales of property to or by a partnership and under Code §752 regarding the treatment of partnership liabilities. The proposed regulations address certain deficiencies and technical ambiguities in the existing regulations and certain issues in determining partners’ shares of liabilities under Code §752. The proposals are designed to limit taxpayers’ ability to structure a sale of a partnership interest as a contribution of property by one partner and the receipt of a distribution by a second partner in a way that is not taxable in the year of the transaction. For a foreign investor, the proposed regulation regarding the interplay of partnership liabilities and investor basis in the partnership add another unwelcome level of complexity that must be accounted for in tax planning for an investment. The reason is that a partner’s ability to deduct losses of a partnership or L.L.C. is capped at the basis maintained in the partnership interest held. Partners have basis for liabilities of the partnership. The issue is the allocation of losses among the partners or members. The proposed regulations limit ways to increase basis through planning mechanisms that have been accepted for a long period of time.

PARTNERSHIP BASICS AND RELATED ISSUES

Background

A partnership is said to be created when persons join together their money, goods, labor, or skill for the purpose of carrying on a trade, profession, or business and when there is community of interest in the profits and losses.

New York State Makes Major Changes to Estate and Gift Tax Law

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New Exclusion Amount: Prior to April 1, 2014, an estate was required to file a New York State estate tax return if the total of the federal gross estate plus the federal adjusted taxable gifts and specific exemption exceeded $1 million (the “basic exclusion amount”) and the individual was either: (i) a resident of the state at the time of death or (ii) a resident or citizen of the U.S. at the time of death but not a resident of the state, whose estate includes real or tangible personal property located in the state. (Other rules apply to individuals who were not residents or citizens of the U.S., but who died owning real or tangible personal property located in the state.)

Recent N.Y.S. legislation has increased the basic exclusion amount as follows:

• For individuals dying on or after April 1, 2014 and before April 1, 2015 - $2,062,500
• For individuals dying on or after April 1, 2015 and before April 1, 2016 - $3,125,000
• For individuals dying on or after April 1, 2016 and before April 1, 2017 - $4,187,500
• For individuals dying on or after April 1, 2017 and before January 1, 2019 - $5,250,000

After January 1, 2019, the basic exclusion amount will be indexed for inflation from 2010, which should link the state exclusion amount to the federal amount.

U.S. Tax Treaty Update→

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At a business meeting on April 1, 2014, the Senate Foreign Relations committee approved two proposed treaties with Hungary and Chile, tax treaty amendments (“protocols”) with Switzerland and Luxembourg, and a protocol amending the Multilateral Convention on Mutual Administrative Assistance in Tax Matters.

As in recent years, improved information sharing and limitations on “treaty shopping” (the inappropriate use of a tax treaty by residents of a third country) continue to be important U.S. objectives.

Highlights of the approved measures include the following:

• The proposed treaty between Hungary and the U.S. encompasses a comprehensive “Limitation on Benefits” provision, unlike the current treaty with Hungary, of 1979, which contains no such limitation, and also provides for a full exchange of information. The new Limitation on Benefits provision includes a measure granting so-called “derivative benefits” similar to the provision included in all recent U.S. tax treaties with European Union members.

The I.R.S. Extends the Time for Estate Tax Portability Election for Small Estates

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On January 27, 2014, the I.R.S. released Rev. Proc. 2014-18. This revenue procedure provides an automatic extension of time to file a late portability election for estates of the first to die of a married couple provided that certain requirements are met. “Portability” refers to the option of the surviving spouse to make use of any gift and estate tax exemption that was not used by the deceased spouse. Thus, if the executor missed the opportunity to elect portability, now is the time to take advantage of this election, as this opportunity will end on December 31, 2014.

BACKGROUND

In 2010, Congress amended §2010(c) of the Code to allow the estate of a decedent who is survived by a spouse to make a portability election, which allows the surviving spouse to apply the decedent’s unused exclusion (“D.S.U.E.”) amount toward the surviving spouse’s own transfers during life and at death.

Notice 2011-82, issued on October 17, 2011, provided preliminary guidance regarding the requirements to elect portability of the decedent’s D.S.U.E. amount. Notice 2012-12, issued on March 3, 2012, provided temporary (and limited) relief by, in general, extending the deadline to file an estate tax return (Form 706, Unified States Estate (and Generation-Skipping Transfer) Tax Return) for portability election purposes by six months if certain requirements were met. In June 2012, temporary regulations were issued that provided more detailed guidance on portability.

F.A.T.C.A. and Trusts: A Primer

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The Foreign Account Tax Compliant Act (“F.A.T.C.A”) requires that “foreign financial institutions” (“F.F.I.’s”) and “non-financial foreign entities” (“N.F.F.E.’s”) identify and disclose their U.S. accounts and substantial U.S. holders or be subject to a 30% withholding on certain U.S. source payments (including gross proceeds) made to a foreign entity.

F.A.T.C.A. affects both:

• U.S. tax residents owning assets outside the U.S.; and
• Non-U.S. tax residents holding assets inside the U.S. provided they are tax residents of a country subject to a Model Intergovernmental Agreement (“I.G.A.”) that provides for reciprocity (i.e., U.S. financial institutions reporting information on non-U.S. tax residents to their non-U.S. home country).

More notably, F.A.T.C.A. withholding may apply to all foreign entities including foreign trusts. However, F.A.T.C.A. withholding will not apply if the entity qualifies for an exemption or complies with specified reporting requirements.

Year-End Review: Net Investment Income Tax

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The Net Investment Income Tax (“N.I.I.T.”) was added to the Code on March 30, 2010. It is imposed at a rate of 3.8% of certain net investment income (“Net Investment Income”) of individuals, estates and trusts having income above specified triggering amounts. For individuals who are calendar year taxpayers, the tax first became effective in 2013. Thus, the current tax return filing season will be the first time taxpayers feel the effect of the tax. In late 2013, the I.R.S. released final and proposed regulations for the N.I.I.T. These regulations clarify proposals that were issued on December 5, 2012. This article provides a summary of the N.I.I.T. and explains how the new regulations will affect taxpayers.

IN GENERAL

Applicable Thresholds

Individuals will owe the tax if they have Net Investment Income and also have modified adjusted gross income over the following thresholds:

Filing Status	Threshold Amount
Married Taxpayers (Joint Filing)	$250,000
Married Taxpayers (Separate Filing)	$125,000
Single	$200,000
Head of household (with qualifying person)	$200,000
Qualifying widow(er) with dependent child	$250,000

These amounts are not indexed for inflation.