Trust domestication tactics

Saturday, 01 February 2014
William H Newton, III explains how the right approach to domestication of a foreign situs trust can minimise US tax consequences

Trust domestication is the process whereby the situs of a trust is shifted from a foreign jurisdiction to the US in order to minimise US income tax. The rationale for domestication varies depending on the facts and circumstances; it may be that the trust transitions from a grantor to a non-grantor trust on the demise of the trust settlor, or that trust domestication is used as a pre-immigration tax-planning strategy for trust beneficiaries moving to the US.

Approaches to domestication

Two principal approaches to trust domestication exist: the decanting and identity retention approaches. An understanding of both is important, since resulting US tax consequences may differ depending on which is utilised.

The decanting approach is based on a transfer of all or part of underlying trust capital from an extant foreign trust (the distributing trust) to a newly created domestic trust (the receiving trust). By contrast, the identity retention approach avoids a transfer of trust capital from one trust to another. The pre-existing trust in the foreign jurisdiction retains its identity as part of the situs shift, with no new domestic trust being brought into existence. Thus, the trust as domesticated is the same trust as posited in the foreign jurisdiction. Accordingly, rather than a transfer of capital, a situs shift is deemed or treated as having occurred, through the refocusing of the criteria for determining trust situs from the foreign jurisdiction to the US.

Notice 2011-101

The importance of the distinction between the two approaches was highlighted by the US Internal Revenue Service (IRS) Notice 2011-101 (the Notice). On its face the Notice focuses only on the decanting approach and does not reference or even implicitly allude to the identity retention approach. In so doing the Notice requests comment and then effectively concludes that the IRS will refrain from issuing private letter rulings involving decanting transfers that result in a change in trust beneficial interests or in the applicable rule against perpetuities period. Section 5 of Rev. Proc. 2013-3, as issued on 2 January 2013, continues to express this same position.

The Notice also sets forth a series of broadly-based, non-inclusive criteria which the US Treasury Department and IRS ‘... identified as potentially affecting one or more tax consequences ...’ The criteria as enumerated in the Notice are as follows:

  • a beneficiary’s right to or interest in trust capital or income is changed;
  • trust capital and/or income may be used to benefit new (additional) beneficiaries;
  • a beneficial interest (including a power to appoint income or capital, whether general or limited, or other power) is added, deleted, or changed;
  • the transfer takes place from a trust treated as partially or wholly owned by a person under sections 671–678 of the US Internal Revenue Code (Code) to a trust that is not a grantor trust, or vice versa;
  • the situsor governing law of the receiving trust differs from that of the distributing trust, resulting in a termination date of the receiving trust subsequent to that of the distributing trust;
  • a court order and/or approval of a state attorney general is required for the transfer by the terms of the distributing trust and/or applicable law;
  • the beneficiaries are required to consent to the transfer by the terms of the distributing trust and/or applicable local law;
  • the beneficiaries are not required to consent to the transfer by the terms of the distributing trust and/or applicable local law;
  • consent of the beneficiaries and/or court order (or approval of a state attorney general) is not required but is obtained;
  • the effect of state law or the silence of state law on any of the above scenarios;
  • a change in the identity of a donor or transferor for gift and/or generation-skipping transfer (GST) tax purposes;
  • the distributing trust is exempt from the GST tax under Treas. Reg. s26.260 1-1, has an inclusion ratio of zero under Code, s2632, or is exempt from the GST tax under Code, s2663; and
  • none of the changes above are made, but a future power to make any such changes is created.

Due to their expansive scope, concern exists that one or more of the above criteria could be satisfied, even inadvertently, in connection with trust domestication. The result, if the decanting approach were utilised for this purpose, could be negative; use of the identity retention approach and avoiding on its face the scope of the Notice should enhance the likelihood of a seamless situs transition while correspondingly minimising undue tax consequences.

Where the criteria and a change in beneficial interests or the lengthening of the period of trust duration may potentially be at issue, an additional safeguard in connection with a situs shift is recommended. Specifically, the identity retention approach should be coupled with the requirement that the exercise of any decisions that may otherwise touch the criteria should be restricted to unrelated, non-subordinate parties, e.g. an independent trustee. The objective is to enhance the level of potential tax compliance by insulating the trust beneficiaries and other potential related parties through extension of the decision-making process to a detached and disinterested fiduciary.

This collective domestication strategy may be combined with trust provisions that create appropriate checks and balances on the potential acts of an errant fiduciary. To illustrate, a protector may be inserted which, through assiduously crafted protector provisions, may be extended a veto power over certain designated actions as otherwise exercisable by an independent trustee. Correspondingly, as an ultimate safeguard, the trust beneficiaries may also be extended the power to remove and replace an erstwhile trustee. The power as drafted should restrict at all times the appointment of a successor trustee to an unrelated, non-subordinate party. 

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William H Newton, III

William H Newton, III TEP is an Attorney-at-law based in Miami

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