Mindful advisors around the globe seek to create sophisticated structures for their clients that allow them to transfer family wealth efficiently. Given the increased mobility of wealth creators and their family members, advisors must pay close attention to any changes in tax status over time. For example, a family member’s move to the US could inadvertently subject the assets in these structures to US income tax and reporting requirements that could undermine decades of careful planning. The potential severity of the consequences makes it essential that advisors are able to recognise ways in which clients can inadvertently trigger US tax and reporting requirements, and are familiar with techniques to avoid the problem or mitigate the downsides when the issue is discovered after the fact.
Rather than reciting a series of technical rules that may prove difficult for readers to contextualise and remember, we will present a pair of hypothetical scenarios designed to illustrate some of the potential hazards of wandering unaware into the US tax minefield.
Hilda, a wealthy business owner from Germany, formed an irrevocable trust in Jersey many years ago to own her various business interests and family investments. The trust benefits Hilda and her husband during their lifetimes; thereafter, assets will continue to be held in trust for their children and grandchildren, who are also non-US citizens living outside the US. Although Hilda is typically tax-resident in Germany, she fell ill in 2014 and decided to seek medical treatment in the US. Even though she was not medically required to stay in the US for such treatment, she ended up spending the majority of the year in New York, where the hospital is located.
Character of structure
As Hilda’s trust benefits only her and her husband during her lifetime, the trust is transparent, and Hilda is treated as owning everything within the structure for US income tax purposes (the same would also be true if Hilda had the right to revoke the trust). Accordingly, Hilda’s movements are essential to determining the tax and reporting issues associated with the underlying assets.
Prior to 2014, when she was not income-tax-resident in the US, Hilda was required to pay US income tax only with respect to certain investment income generated from US sources and income effectively connected with a US business (‘US investment income’). However, as discussed further below, Hilda’s extensive presence in the US during 2014 causes her to be treated as a ‘US person’, meaning that the income generated from all of her assets (both within and outside the trust), whether situated in the US or not, becomes subject to US income taxes.
US income tax residency
Individuals are considered income-tax-resident in the US if they are US citizens or permanent residents (i.e. green-card holders), or if they spend sufficient time to be deemed substantially present in the US (each being a ‘US person’). Generally, if a non-US citizen spends 183 days or more in any year in the US, they will be US income-tax-resident for that year. Even if the individual spends fewer than 183 days in the US in the current year, they may still be US income-tax resident if the sum of (i) all of the days in the current year, (ii) one-third of the days in the year prior, and (iii) one-sixth of the days of the year before that is equal to or greater than 183 days.
Because Hilda chose to remain in New York for more than 183 days in 2014 while pursuing her medical care, she is considered a US person for that year. While there is an exception to the day-counting rules for days on which an individual is prevented from leaving the US due to a medical condition that arose there, Hilda does not qualify for that exception, both because her condition arose prior to her arrival in the US and because the condition did not medically preclude her from leaving.
As a result of Hilda’s status as a US person, all of the income generated from assets she owns in her own name, as well as the income from assets in the transparent trust structure would be subject to US income tax for the year 2014. In addition to this potentially significant tax liability, any non-US corporations, partnerships or other investment vehicles either in Hilda’s name or in the structure would be subject to US income tax and would create additional reporting issues that must be considered as well. Even if assets are not held in offshore entities, Hilda will need to ensure she is filing annually FinCEN Report 114 (Report of Foreign Bank and Financial Accounts) to report her beneficial ownership.
What should Hilda or her advisors do under these circumstances? There are three key ways to address the issue. First, assuming we have some foresight regarding Hilda’s plans, we can attempt to reduce the length of time Hilda stays in the US, or attempt to structure her stay in a way that reduces the number of days that count toward her being ‘substantially present’ in the US.
Second, we might suggest restructuring her assets so that they are held in an opaque structure, which does not permit distributions to any US person, prior to entering the US. This would allow for the income to accumulate while she is in the US, but would shield the assets from the US tax net.
Finally, we might recommend restructuring investments with an eye toward reducing taxable income for the period in which she is a US person. This could mean something as simple as investing predominantly in non-dividend-paying stocks and/or other investments that produce little to no taxable income. At the more complex end of the spectrum, income-producing assets might be shifted into a new structure, such as a deferred variable annuity, a life insurance policy or a passive foreign investment company.
Edward, a beneficiary of an irrevocable Cayman Islands trust established by his non-US father, moved to the US from Italy to attend graduate school. After completing his degree, he was offered a competitive position at a great company and married his US-citizen girlfriend. His wife is pregnant with their first child, who will be born in the US and will be a US citizen. Edward plans to live in the US for the foreseeable future with his growing family.
Character of structure
In contrast to Hilda’s trust, this trust will be opaque for US income tax purposes – that is, treated as an independent taxpayer – because Edward’s father cannot revoke the trust and its current beneficial class includes his extended family. Prior to moving to the US, and during the period in which Edward was attending university, the trust (and Edward to the extent that he received distributions) was only required to pay US income tax on its US investment income. Because of the potential to accumulate income outside of the US tax net in opaque structures, however, the US Internal Revenue Service (IRS) has imposed a set of anti-abuse provisions, first, to ensure that beneficiaries like Edward who become income-tax-resident in the US report the assets of the structure currently, and, second, to prevent the long-term accumulation of trust income for US beneficiaries.
US beneficiaries of opaque structures
In general, if the trustees distribute trust income currently, Edward will pay tax at the same rates as other US taxpayers. This means taxes of up to 39.6 per cent for distributions attributed to income earned in the structure and up to 20 per cent for distributions attributed to long-term capital gains, plus any relevant state income tax (rates vary by state, from a low of zero in some states to a high of 13.3 per cent in California). However, if trust capital gains are accumulated and paid out in a later year, those gains will be taxed to Edward as ordinary income, rather than at the preferential capital gains tax rate. Furthermore, any distribution of accumulated income will be subject to an interest charge, compounded daily, on the tax attributable to that accumulated income from prior years (the ‘throwback tax’). As a result of this daily compounding, Edward’s receipt of an accumulation distribution could result in a substantial amount of tax and interest (possibly as high as 100 per cent of the amount of accumulated income). Effectively, this could prevent distributions to Edward because a large amount of tax would need to be paid first.
In addition, if Edward used property (e.g. lived in a home) owned by the non-US opaque structure without paying fair market rent for that use, the IRS will treat Edward as having received a distribution equal to the fair market value of use of the property to the extent the non-US opaque structure has undistributed income or gain from the current year or any prior year.
What should the trustee or manager of the opaque structure do under these circumstances? If the terms of the trust allow it, one of the most straightforward solutions would be to cease making distributions or at least limit distributions to Edward to current-year income so long as he is subject to US income tax. Nevertheless, when structures have been in place for decades, and beneficiaries have come to rely on distributions, it is often impossible to distribute completely clean capital.
To complicate matters further, even if Edward leaves the US, his US citizen child will continue to benefit from the trust and would be subject to the same throwback tax considerations as long as she remains a US citizen, regardless of her residency. In these cases, where there are both US and non-US person beneficiaries, it often makes sense to establish a parallel US trust to receive all of the foreign trust income each year. US person beneficiaries would then receive their share of distributions from the parallel US trust. If all else fails, and US person beneficiaries are expected to need distributions which would otherwise draw from accumulated income, with some time and foresight, it may be possible to minimise the throwback tax by structuring trust investments and distributions so as to qualify for relief under a regulatory safe harbour.
In general, non-US trusts can be extremely effective planning tools for non-US families. However, when one or more related parties become US income-tax-resident, these trusts – even if they were established years prior – may suddenly become subject to a burdensome array of US income tax and reporting rules, many of which can be mitigated or avoided entirely with careful planning. It is, therefore, imperative that advisors be conscious of changes in their clients’ jurisdictions of residence and understand when to suggest further review of relevant structures.
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