Foreign Grantor Trusts: Non-US Trust Planning for US Family Members

Article 18 November 2021 Experience

Trusts are often used by successful families to provide for long term succession planning and centralized asset management. However, US tax rules can adversely impact US citizens, green card holders and income tax residents who do or even can benefit from income and capital gain in non-US trusts (and their underlying holding companies). Non-US patriarchs and matriarchs with US family members can though substantially improve the position for their US family members through the establishment of a so called ‘foreign grantor trust’ (hereinafter ‘FGT’).

Advantages of a FGT

A properly structured and administered FGT provides highly favorable US federal tax treatment for US family members including:

  • No annual tax or reporting with respect to trust income or gains (unless earned from US sources) during the settlor’s lifetime;
  • No annual tax or reporting with respect to investments classified as passive foreign investment companies (‘PFICs’) and/or entities that might otherwise be classified as controlled foreign company (‘CFC’) during the settlor’s lifetime;
  • Tax free distributions to US family members during the settlor’s lifetime (though an information reporting obligation applies to the recipient); and
  • Elimination of future US gift and estate taxes on trust assets (provided that US situs assets, if any, are held via a non-US holding company classified as a corporation for US tax purposes).

Disadvantages of outright gifts and foreign non-grantor trusts

These benefits are particularly attractive when compared either to transferring assets outright to US family members or currently placing assets into a trust not qualifying for FGT status. Assets currently transferred to:

  • US family members would be subject to tax on future income and gains generated by those assets and would become subject to the US gift and estate tax system currently imposing tax at the rate of 40% on the asset value of future gifts or bequests made by the US family members.
  • Any non-US trust other than one qualifying for ‘foreign grantor trust’ status would be classified as a ‘foreign non-grantor trust’ and generally would subject US family members to tax on current year income and gains distributed to them and adverse tax rates and compounding interest charges with respect to trust income and gains not distributed in the year realized and could result in current tax and/or reporting obligations for the US family members with respect to any PFIC or CFC assets held by the trust.

Trust structuring for further US considerations

While in many circumstances it should be relatively straight forward to structure a trust to qualify for FGT status, there are a number of related but additional trust drafting and structuring considerations needing to be addressed:

  • If US family members are given certain powers or rights under the trust, that could subject them to US income or gift or estate tax either during the settlor’s lifetime or following the settlor’s passing.
  • If the trust directly holds US situs assets then those assets generally would be subject to US estate tax exposure on the settlor’s passing (and gift tax exposure if transferred to family members during the settlor’s lifetime).
  • If the settlor directly owns US situs assets and transfers those assets to the trust then, upon the settlor’s passing, there generally would be US estate tax on the trust even if those assets had long ago been sold and the trust did not directly or indirectly own any US situs assets at the time of the settlor’s passing.
  • Such estate and gift tax exposure generally can be avoided through the use of a non-US holding company to own US situate assets.
  • In most cases, it will be desirable to structure the FGT such that assets directly held by the trust automatically receive a ‘basis step up’ to current market value upon the settlor’s passing. Upon a subsequent sale of these directly held assets, the amount of gain realized by the trust will be reduced, thus reducing the amount of tax liability with respect to distributions to US family members.

Following the settlor’s passing

Following the settlor’s passing, the FGT will automatically convert to ‘foreign non-grantor trust’ (hereinafter ‘FNGT’) status. At that point in time, leaving aside additional considerations with respect to trust assets classified as PFICs or CFCs, very generally speaking,

  • Income and gains distributed in the year realized to US family members generally would be taxed to them as if such amounts had arisen directly to such persons; and
  • Income and gains realized but not distributed until a later year to US family members generally then would be subject to tax under the so called ‘throwback’ rules as ‘undistributed net income’ (‘UNI’) with such amounts generally being taxable at ordinary income rates, even if originally capital gains in nature, and generally being subject to an additional interest charge compounding over the time period during which such amounts were accumulating in the trust.

Holding Companies

Rather than owning investment assets directly, non-US trusts will frequently choose to use a non-US holding company to own such assets. Further, as noted above, where it comes to US situs assets, it is generally the case that such assets should be held via a non-US holding company so as to eliminate US estate tax exposure that generally would otherwise apply to those US situs assets. The use of a holding company can though create income and gains tax complications for the US family member beneficiaries with respect to the settlor’s passing.

Depending on the overall facts and circumstances at the time of the settlor’s passing, if more than half of the holding company’s ownership is attributed through the trust to US family members, such holding company generally would be classified as a CFC thereby creating US tax and reporting considerations for the US family members with respect to income and gains arising within the holding company after the settlor’s passing.

Prior to 2018, it was generally the case that (following the settlor’s passing) ongoing CFC tax exposure to the US family members could be eliminated by filing a so called “check the box” election to treat the holding company as liquidated / disregarded for US tax purposes in a manner that did not create CFC tax exposure to the US family member beneficiaries while still protecting US situs assets held by the holding company from US estate tax exposure in connection with the settlor’s passing.

However, under current law, such “check the box” election could now itself generate CFC tax for the US family members (generally measured by reference to the amount of built-in gains in the holding company’s assets and the point in time during the year at which the settlor passed). Thus, if the holding company owns a mix of US and non-US situs assets, absent additional planning the tax cost of protecting the US situs assets from estate tax exposure generally will be a one off CFC tax exposure for the US family members following the settlor’s passing.

In instances where the holding company doesn’t own any US situs assets, it generally should be possible to make a check the box election in a manner that doesn’t cause CFC tax exposure for the US family members.

Assuming it’s not feasible to eliminate US situs assets, then consideration can be given to several strategies, all of which would improve the position in varying ways, including:

  • selling and repurchasing assets annually so as to ‘step up’ the holding company’s basis in those assets;
  • isolating US situs assets in a separate non-US holding (which holding company does not itself own any non-US situs assets); and
  • creating certain types of multi-tier holding structures so as to allow check the box elections to be implemented in a manner that should itself allow for most, but not necessarily all, asset appreciation to escape being taxable under the CFC rules.

Where the trust (directly or indirectly) holds substantial interests in ‘trading’ or ‘operating companies’, further CFC considerations may apply.

PFICs

Depending on the overall facts and circumstances following the settlor’s passing, if the trust holds PFICs (directly or via or with respect to holding companies) then the US family member beneficiaries might be subject to tax and compounding interest charges when such PFICs are disposed of or such PFICs themselves make distributions (potentially even if such amounts are not even currently distributed to the US family member beneficiaries). Generally speaking:

  • holding companies through which trusts indirectly own investments can themselves be classified as PFICs. For example, a holding company for investment assets which is not classified as a CFC may be classified as a PFIC.
  • most non-US collective investment schemes such as non-US mutual funds, non-US ETFs, non-US hedge funds and certain non-US private equity funds will be classified as PFICs.

How best to deal with PFICs will depend on a number of factors including the mix and needs of US and non-US family members, whether the trust was structured to qualify for a basis step up, how the PFICs were held (e.g. if through a holding company, did it also own US situs asses) and how check the box planning is implemented in connection with the settlor’s passing.

Planning Opportunities

We would be pleased to discuss how best to tailor a ‘foreign grantor trust’ structure to the particular facts and circumstances of individual families.