Choosing a Trustee for Your Children – Should Foreign Family Members Apply?
Often the most difficult decision parents need to make when writing a Will is whom to appoint as the trustee for their children. The choice becomes particularly tricky for clients whose families live outside the U.S. since choosing a foreign trustee will cause the children's trusts to be classified under U.S. income tax laws as “foreign trusts” – with lots of ensuing complications.
Under the Internal Revenue Code, trusts are by default "foreign trusts" for U.S. income tax reporting purposes unless a U.S. court exercises both primary supervision over the administration of the trust (the "court test"), and one or more U.S. persons have authority to control all substantial decisions of the trust (the "control test"). The choice of a foreign trustee causes the trust to flunk the control test because a non-U.S. person controls substantial decisions of the trust. Being classified as a foreign trust results in some problematic U.S. income tax consequences. For example:
U.S. beneficiaries who receive distributions from the trust will be taxed to the extent that any trust income, including foreign-source income and capital gains, is included in the distribution. Normally, non-U.S. source income and realized capital gains are not deemed to constitute any part of a distribution to a beneficiary unless specifically allocated to a beneficiary. The foreign trust rules change this tax treatment such that non-U.S. source income, as well as capital gains, are deemed to be part of any taxable income distributed to a U.S. beneficiary.
Trust income not distributed in the year it is earned becomes undistributed net income (UNI). If, in a later year, a trust distribution to a U.S. beneficiary exceeds that year's trust income, the distribution carries out UNI and is deemed to include the accumulated income and capital gains realized by the foreign trust in prior years. These gains do not retain their character but rather are taxable to the U.S. beneficiary at ordinary income tax rates.
Also, to the extent that a distribution to a U.S. beneficiary exceeds the current year's trust income, a non-deductible interest charge will be assessed on the tax that is due with respect to the accumulated income and capital gains that are now deemed distributed. This charge is based upon the interest rate imposed upon underpayments of federal income tax and is compounded daily.
Finally, accumulated income and capital gains are taxable to the U.S. beneficiary at the beneficiary's ordinary income tax rate for the years during which it was earned under a complex formula designed to capture the U.S. tax that would have been payable if the accumulations had been distributed in the years earned – called the “throwback tax”.
Foreign trusts also trigger additional reporting obligations that carry heavy penalties for failure to comply. A U.S. beneficiary who receives a distribution from a foreign trust must file Form 3520 ("Annual Return to Report Transactions with Foreign Trusts") reporting the distribution and the character of the distribution. The failure-to-file penalty is equal to 35 percent of the gross distribution.
Recognizing, however, that a domestic trust can inadvertently become a foreign trust through changes in the identity of the trustee – such as a trustee’s resignation, disability, or death (but not removal) or the trustee ceasing to be a U.S. person (i.e. change of residency or expatriation) – U.S. Treasury Regulations provide for a 12-month period within which to cure the unintentional conversion. The trust can replace the foreign trustee with a U.S. person trustee, or the foreign person can become a U.S. person during these 12 months. The foreign person can effectuate the cure simply by making the United States his place of residence; he need not become a U.S. citizen.
Rather than rely upon the 12-month cure period, however, a trust agreement should provide for a means to remove a non-U.S. person trustee to assure that the trust qualifies as a domestic trust. Trustee removal and appointment provisions are critical but should be reserved to individuals or entities in the United States. These powers can also create inadvertent gift and estate tax issues, so consulting a qualified trusts and estates lawyer to draft them is critical.
To avoid these problems, it might seem to make sense to allow the foreign trustee to appoint a U.S. co-trustee or to grant certain reserved powers over the trust to a foreign family member in lieu of naming them as trustee (for example, reserving to them the power to remove and replace the U.S. trustee.) But this will not solve the problem. A trust is defined as foreign unless it satisfies both the court test and the control test.
The safe harbor provisions of the court test require that the trust must “in fact” be administered exclusively within the United States, meaning that the U.S. trustee must maintain the books and records of the trust, file the trust tax returns, manage and invest the trust assets, and determine the amount and timing of trust distributions.
The safe harbor provisions of the control test provide that, in addition to making decisions related to distributions, the U.S. trustee must be entirely responsible for a laundry list of decisions including selecting beneficiaries, making investment decisions, deciding whether to allocate receipts to income or principal, deciding to terminate the trust, pursue claims of the trust, sue on behalf of or defend suits against the trust, and deciding to remove, add or replace a trustee or name a successor trustee.
And just to be sure, a well-written document should include a backstop provision that requires the trust to always qualify as a U.S. trust for income tax purposes and to have a majority of U.S. trustees. The inclusion of such a provision, at the very least, alerts those administering the trust to consider these issues before making any changes to the trustee or after an inadvertent change in trustees has occurred.
The increase in cross-border families and multinational asset portfolios have added complexities to the financial planning of families. Familiarity with the impact that these rules may have to existing or proposed estate plans is critical when designing a comprehensive plan for clients.