Part I of this blog post set out the tax problems that arise when one has created a foreign trust with US beneficiaries. This Part II will probe the factors used to determine whether a trust is a US trust or a “foreign” trust. It will also point out a possible pitfall for many families who have members living overseas, a phenomenon that is becoming more and more prevalent in today’s global economy.
Determining Trust’s Residence – US or Foreign?
The relevant Treasury Regulations to determine the US or “foreign” residence of a trust are found in Treasury Regulation Section 301.7701-7. This blog post breaks down the analysis contained in the Regulations.
A trust is defined as a “United States person” (therefore, not foreign) if (1) a court within the United States is able to exercise primary supervision over the administration of the trust (the “court test”), and (2) one or more United States persons have the authority to control all substantial decisions of the trust (the “control test”). Thus, a trust must satisfy both the “court test” and the “control test” in order to be treated as a US person for US income tax and reporting purposes. Any trust that is not a US person will be treated as a “foreign” trust.
- Court Test
The Court Test seeks to ensure that a US court can exercise primary supervision over the administration of the trust. Administration of the trust means the carrying out of the duties imposed by the terms of the trust instrument and applicable law, including maintaining the books and records of the trust, filing tax returns, managing and investing the assets of the trust, defending the trust from suits by creditors, and determining the amount and timing of distributions.
In determining whether a trust satisfies the “court test,” due consideration is given to all of the terms of the trust instrument as well as applicable local law. Just because a trust may be governed by the laws of a particular US state does not mean the trust will be treated as a domestic, rather than a “foreign”, one. There’s much more to the inquiry.
If the trust instrument states that the trust is to be administered outside of the US then the trust will fail the “court test” and will be considered a “foreign” trust. Sometimes, a trust instrument does not state where the trust is to be administered. In such a case, the trust may be considered administered in the US, unless the trust is subject to an automatic migration provision. Commonly called a “flee clause”, this is a provision which states that if a US court attempts to take primary control over the administration of the trust, then the trust will immediately and automatically “migrate” to a foreign jurisdiction.
The Regulations are replete with guidance, safe harbors and examples. Some are particularly worthy of note: If both a US court and a foreign court are able to exercise primary supervision over the administration of the trust, the trust can still meet the court test. For example, a US court could still be considered to have primary supervision over the trust even if a foreign court had primary supervision over the trustee or the trust protector.
Certain trusts can qualify as domestic trusts under safe harbor provisions contained in the Regulations. A trust will satisfy the “court test” and, accordingly will be treated as a domestic trust under this prong of the tests, if it meets any one of the following: (1) the trust is registered with a State court under provisions similar to Article VII of the Uniform Probate Code; (2) the trust is created pursuant to a will that is probated in the US and all fiduciaries have been qualified as trustees of the trust by a court within the US; or (3) with respect to an inter vivos trust (i.e., one that is not created by a will, but is created during the lifetime of the grantor), the trustees or beneficiaries of the trust take steps with a US court to cause the administration of the trust to be subject to the primary supervision of the US court.
- Control Test
In order to be treated as a US “domestic” trust, in addition to the court test outlined above, the trust must meet the “control test”. Similar to the “court test,” the criteria for satisfying the “control test” are set forth in the Treasury Regulations. Under the control test, one or more United States persons must have the authority to control all substantial decisions of the trust. A “United States person” is defined in Internal Revenue Code Section 7701(a)(30) (the term includes a US citizen or resident, or a US corporation or partnership).
The Regulations define a “substantial decision” as follows:
[a] decision that persons are authorized or required to make under the terms of the trust instrument and applicable law and that are not ministerial. Decisions that are ministerial include decisions regarding details such as the bookkeeping, the collection of rents, and the execution of investment decisions.
Substantial decisions include, but are not limited to, decisions concerning—
(A) Whether and when to distribute income or corpus;
(B) The amount of any distributions;
(C) The selection of a beneficiary;
(D) Whether a receipt is allocable to income or principal;
(E) Whether to terminate the trust;
(F) Whether to compromise, arbitrate, or abandon claims of the trust;
(G) Whether to sue on behalf of the trust or to defend suits against the trust;
(H) Whether to remove, add, or replace a trustee;
(I) Whether to appoint a successor trustee to succeed a trustee who has died, resigned, or otherwise ceased to act as a trustee, even if the power to make such a decision is not accompanied by an unrestricted power to remove a trustee, unless the power to make such a decision is limited such that it cannot be exercised in a manner that would change the trust’s residency from foreign to domestic, or vice versa; and
(J) Investment decisions; however, if a US person under section 7701(a)(30) hires an investment advisor for the trust, investment decisions made by the investment advisor will be considered substantial decisions controlled by the US person if the US person can terminate the investment advisor’s power to make investment decisions at will.
Definition of the term “control” is very important under the Regulations and is defined as:
[h]aving the power, by vote or otherwise, to make all of the substantial decisions of the trust, with no other person having the power to veto any of the substantial decisions. To determine whether United States persons have control, it is necessary to consider all persons who have authority to make a substantial decision of the trust, not only the trust fiduciaries.
This language is important. Here’s an example. Assume the trust instrument states that the US trustee has the power to make all of the decisions listed in (A) through (J) above. However, assume it also states that a foreign individual (non-US citizen/non US resident) can veto the decision of the trustee to terminate the trust. In that example, the trustee does not have the authority to control all substantial decisions of the trust. Voila! The trust will be “foreign” because it will have failed the Control Test.
So, Your Trustee Has Since Expatriated….
In today’s global economy individuals with US tax status (US citizenship or a green card) can be living anywhere on the globe. If a decision is made to create a trust, the temptation will be to have a trustee who is familiar to the creator of the trust feels and with whom the creator is familiar and feels confident.
It is becoming more and more common for family members to be of different nationalities, and I can see how it would be easy to choose a family member who is not a US person to occupy this position of trust. We are also seeing more and more individuals change their citizenship status. It is no secret that many persons with US status are divorcing themselves from America.
Care must be taken to examine any roles such persons may have as a trustee or other person who can make all of the trust’s substantial decisions when the trust has the possibility of having any US beneficiaries. In the case of an expatriation, once an individual expatriates and ceases to be a US person, the trust will become a “foreign” trust since it will no longer satisfy both the Court Test and the Control Test. Utmost care must be taken in appointing a trustee or other person with power to make substantial trust decisions, including veto powers. If you mistakenly appoint a foreigner, including an expatriate, you’ve set yourself up for a big US tax problem.
This communication is for general informational purposes only which may or may not reflect the most current developments. It is not intended to constitute tax advice or a recommended course of action. Professional tax advice should be sought as the information here is not intended to be, and should not be, relied upon by the recipient in making a decision.
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