Understanding Trusts in the USA- Part 2

Understanding Trusts in the USA- Part 2

April 12, 2023

Introduction

US beneficiaries of foreign trusts are subject to a throwback tax regime and an interest charge when they receive distributions of accumulated income from the trust.

To avoid these punitive payments, families often choose to convert or decant the trust to a US domestic trust.

Much depends on a close look at the tax residence and financial needs of each of the beneficiaries, alongside a careful examination of the trust's current investments, investment policy and duration.

Background

During the late 1990s, US tax law became increasingly hostile to trusts that were foreign usually because the trusts were created in no-tax jurisdictions outside the United States (hereinafter referred to as 'offshore trusts') and benefited US persons.

Tax compliance and planning became increasingly difficult and new rules were enacted to put more offshore trusts into the category of 'non-grantor trusts' if they were established by a non-US grantor. 

As a result, many offshore trusts established by multinational families for the benefit of their US family members have since migrated to the United States.

After major US tax cuts were passed in 2003 and 2017, the reasons for foreign non-grantor trusts to become US domestic trusts seemed even more compelling when family members in the United States were the intended beneficiaries. The lower tax rate of 15% on qualified dividends and long-term capital gains seemed too good to pass up when compared with the punitive tax burden imposed on any future distributions of accumulated income to the US beneficiaries if the trust stays offshore.

US tax rules attempt to recoup lost tax plus interest on distributions from offshore trusts

Since offshore trusts are outside the US tax net, a US beneficiary who receives a distribution from a foreign non-grantor trust will owe tax on the income.

No tax is owed if no distributions are made to US beneficiaries.

This basic principle is implemented by the same complex system of tax rules that apply to domestic trusts, but with two important differences that address the loss of annual tax revenue from a foreign trust:a special 'throwback rule' and an interest charge apply to any distribution from a foreign trust that is treated as passing out income accumulated in a prior year (including realized capital gains).

An interest charge  will apply when the accumulated income (including realized capital gains) is later distributed to a US beneficiary. An accumulation distribution occurs when distributions exceed income for the current year, as measured for both income tax purposes and accounting purposes, and there is undistributed net income (UNI) in the trust from prior years, including undistributed realized capital gains.

  • Throwback rule

The two rules work in concert to magnify the tax liability. The throwback rule artificially raises the applicable tax rate on the accumulation distribution by taxing the income passed out to the US beneficiary at the ordinary income tax rates that would have applied had the distribution been made in the year earned. The beneficiary cannot use the substantially lower maximum US income tax rate on qualified dividends and long-term capital gains (15% compared with ordinary income at a top rate of 37%).

  • Interest charge

An annual interest charge is then imposed to eliminate the benefit of paying the tax later. The interest charge applies to the amount of tax that was effectively deferred during the time the recipient beneficiary was a US person (regardless of the beneficiary's age). However, notably, the interest is being charged against the artificially high tax liability created by the throwback rule, as if this was the tax previously deferred. In addition, the interest charge is compounded and is not deductible in computing net taxable income.(1)

Taken together, the high tax rate generated by the throwback rule and the added interest charge on accumulation distributions create a tax drag that is virtually impossible to overcome through successfully reinvesting the deferred tax funds. The growing liability can consume the entire amount distributed to the US beneficiary when the tax bill comes due at that time.

Even the final terminating distribution can disappear. What seemed like a benign or even beneficial deferral can turn into a mounting liability that eats away at the original trust capital.

Tax advisers have tried with some success to develop a cure for the tax drag resulting from the combination of a high tax rate generated by the throwback rule and the added interest charge on accumulation distributions from an offshore trust to a US beneficiary.

Generally speaking, these cures are designed to quarantine the tainted income – that is, to isolate and seal off the accumulated income so that it cannot be pulled out of the trust by future distributions to US beneficiaries.

Sources:

  1. "US Beneficiaries of Foreign Trusts: The Throwback Tax Regime." Baker McKenzie. https://www.bakermckenzie.com/en/insight/publications/2021/03/us-beneficiaries-of-foreign-trusts-the-throwback-tax-regime
  2. "Foreign Trusts with US Beneficiaries: Navigating the Throwback Tax Rules." The National Law Review. https://www.natlawreview.com/article/foreign-trusts-us-beneficiaries-navigating-throwback-tax-rules
  3. "Foreign Non-Grantor Trusts." Internal Revenue Service. https://www.irs.gov/businesses/international-businesses/foreign-non-grantor-trusts
  4. "Tax Consequences of Trusts." Thomson Reuters Practical Law. https://uk.practicallaw.thomsonreuters.com/6-107-7084?transitionType=Default&contextData=(sc.Default)&firstPage=true&bhcp=1
  5. "Offshore Trusts: US Tax and Compliance Issues." Withers Worldwide. https://www.withersworldwide.com/en-gb/offshore-trusts-us-tax-and-compliance-issues


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