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Chartered Wealth ManagerCourse Presentation

STRUCTURING NON-GRANTOR TRUSTS

January 27-29, 2006Ashford Suites, High Point, NC

by

J. Richard Duke, Esq.Attorney and Professor of Law

Duke Law Firm, P.C.400 Vestavia Parkway, Suite 100

Birmingham, AL 35216-3750Telephone: (205) 823-3900

Fax: (205) 823-2630E-mail: [email protected]

Web site: http://www.assetlaw.comSt. Thomas University School of Law: http://www.llmprogram.org/faculty.htm

http://www.llmprogram.org/faculty.htm

http://www.assetlaw.com/

mailto:[email protected]

TABLE OF CONTENTS

I. Foreign Trusts—In General.............................................................................................1A. Tax Classification...................................................................................................1B. Tax Classification of a Foreign Non-Grantor Trust...........................................1

1. Foreign Non-Grantor Trust at Death of U.S. Settlor.............................12. Can a U.S. Settlor Form a Foreign Non-Grantor Trust?......................1

a. Position Apparently Contrary to IRS..........................................1b. Definition of U.S. Beneficiary During Settlor's Lifetime...........1c. Trust Becomes a Foreign Non-Grantor Trust at Settlor's

Death...............................................................................................2d. Apparent Meaning of I.R.C. § 679(b)..........................................2e. Grantor Trust Provisions..............................................................2f. Planning for the Accumulation of Income Problem...................2g. IRS Omission..................................................................................2

3. Foreign Non-Grantor Trust Created by a Non-U.S. Person.................34. Foreign Irrevocable Trust Created by a Non-U.S. Person....................3

C. Foreign vs. Domestic Trusts..................................................................................31. In General...................................................................................................32. Classification of a Trust as Domestic or Foreign....................................3

a. Court Test.......................................................................................3b. Control Test....................................................................................4

(i) Substantial Decisions.............................................................4(ii) Ministerial Decisions.............................................................4(iii) Definition of Control............................................................4

II. Taxation of the Grantor of a Domestic or Foreign Trust..............................................4A. Treating the Grantor as Owner............................................................................4

1. Reversionary Interests...............................................................................52. Power to Control Beneficial Enjoyment..................................................53. Administrative Powers..............................................................................54. Power to Revoke........................................................................................55. Income for Benefit of a Grantor...............................................................56. Foreign Trust Having a U.S. Beneficiary................................................57. U.S. Transferor..........................................................................................58. U.S. Person.................................................................................................69. Property......................................................................................................610. Person Other Than Grantor Treated as Substantial Owner.................6

B. Grantor Defined.....................................................................................................61. Gratuitous Transfer...................................................................................62. Nongratuitous Transfer.............................................................................6

C. An Accommodation Party is not the Grantor Subject to Taxation..................6D. Person with Power to Withdraw From Trust Settled by Another Person

is Not a Grantor.....................................................................................................7E. Foreign Trust Having One or More U.S. Beneficiaries......................................7

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1. The Foreign "Grantor" Trust..................................................................72. Direct or Indirect Transfer.......................................................................73. Guarantee on a Loan for the Trust..........................................................84. Satisfaction of an Obligation of a Foreign Trust....................................85. Transfer to an Entity Owned by the Trustee of the Foreign Trust.......86. Domestic Trust Becoming a Foreign Trust.............................................87. Definition of U.S. Beneficiary...................................................................88. Beneficiary Further Defined by Treas. Regs...........................................89. Attribution of Ownership from Controlled Foreign

Corporations, Foreign Partnerships........................................................9III. Taxation of Foreign and Domestic Trusts.......................................................................9

A. Simple Trust...........................................................................................................9B. Complex Trust.......................................................................................................9C. Income.....................................................................................................................9D. Accounting Income................................................................................................9

IV. Taxation of Foreign Non-Grantor Trusts.....................................................................10A. Distribution Deduction........................................................................................10B. The Concept of Distributable Net Income.........................................................10C. Distributable Net Income of a Foreign Non-Grantor Trust............................10D. Treatment of Capital Gains................................................................................10E. Treatment of Beneficiaries With Respect to Distributable Net Income.........11F. Distributable Net Income of Complex Trust Exceeding Income Required

to Be Distributed..................................................................................................11V. Tax Return Compliance With Respect to a Foreign "Non-Grantor" Trust..............11

A. Events Requiring Filing......................................................................................11B. Form 3520–Creating or Funding a Foreign Non-Grantor Trust....................11

1. Reportable Events....................................................................................11a. Creating Foreign Trust...............................................................11b. Gratuitous Transfer.....................................................................11

2. Responsible Party....................................................................................123. Reporting Gain on Transfer of Appreciated Assets.............................124. Form 56–Notice Concerning Fiduciary Relationship...........................125. Form 709, U.S. Gift (and Generation-Skipping Transfer) Tax

Return.......................................................................................................126. Form 1040–Schedule B, Part III.............................................................127. TD F 90-22.1–Report of Foreign Bank and Financial Accounts.........12

VI. Reporting Requirements for U.S. Beneficiaries............................................................13A. Attached Statements............................................................................................13B. Distributions from a Foreign Non-Grantor Trust............................................13C. Distribution Defined............................................................................................13

1. Loans.........................................................................................................142. Exception to Treatment of Loan as a Distribution...............................143. Distributions by Certain Foreign Trusts through Nominees...............14

D. General Rule–Foreign Person Not Treated as Owner.....................................14E. Special Rules for Treating a Foreign Person as Owner...................................15

1. Certain Revocable Trusts........................................................................15

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2. Certain Trusts That May Distribute Only to Grantor or Grantor's Spouse.....................................................................................15

3. Compensatory Trusts..............................................................................164. Trusts Settled by Certain Foreign Corporations..................................165. An Accommodation Party is Not a Grantor..........................................166. Foreign Person with Right to Withdraw–Not a Grantor.....................167. Special Rule Where Grantor is Foreign Person....................................168. Recharacterization of Purported Gifts..................................................17

F. Consequences of Not Filing Foreign Non-Grantor Trust Beneficiary Statement.........................................................................................17

G. Foreign Trust Treated as Having a U.S. Beneficiary.......................................18H. Foreign Trust Acquiring a U.S. Beneficiary.....................................................18

VII. Planning for a Foreign Non-Grantor Trust at the Death of the Grantor of a Foreign Trust...................................................................................................................18A. Asset Protection Trust.........................................................................................19B. Gratuitous Transfer.............................................................................................19C. Nongratuitous Transfer.......................................................................................19D. Tax Treatment of a Foreign Grantor Trust......................................................19E. Transfers of Property to a Foreign Grantor Trust...........................................19F. Tax Treatment at Death of the Grantor of a Foreign Grantor Trust.............20G. Foreign Non-Grantor Trust–Tax Treatment....................................................20H. Taxation of Distributions to U.S. Beneficiaries of a Foreign Non-

Grantor Trust.......................................................................................................20I. Taxation of Accumulation Distributions—Prior Law......................................20J. Taxation of Accumulation Distributions—Current Law.................................20K. Undistributed Net Income...................................................................................21L. Reporting Distributions from a Foreign Non-Grantor Trust..........................21M. Accumulation Distribution.................................................................................22N. Calculating an Accumulation Distribution under the Default Method..........22O. Throwback Tax on an Accumulation Distribution...........................................23P. The Throwback Rule...........................................................................................23

1. Computation of a Partial Tax on an Accumulation Distribution........232. Where Accumulation Distribution Exceeds Undistributed Net

Income.......................................................................................................24Q. Specific Gifts.........................................................................................................24

1. Instrument is Required to Provide for a Transfer of a Specific Sum of Money or Specific Property................................................................24

2. Examples of Specific Sums of Money or Specific Property.................253. Examples That Are Not Specific Sums of Money or Specific

Property....................................................................................................25R. Three Installment Rule........................................................................................25

1. Income Earned by Specific Bequest Not Qualified...............................252. Difficult for Trust Distributions to Qualify...........................................253. Distributions from Trusts That Qualify................................................26

S. Avoiding the Throwback Rule and Interest Charge........................................261. A Number of Planning Possibilities........................................................26

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2. Distribution of Yearly Net Income.........................................................263. Distribution of Specific Sum of Money or Property.............................264. Trustee May Acquire Growth Assets that Pay Little Income

or Dividends.............................................................................................275. Acquire Foreign Variable Life Insurance on Lives of Beneficiaries...276. Dynasty Trust and Generation-Skipping Transfer Tax Planning......27

a. Choosing Jurisdiction that Abolished the Rule Against Perpetuities.....................................................................27

b. GST Exemption............................................................................277. Implementing the Planning Concepts....................................................27

a. GST Planning...............................................................................27b. Acquiring Life Insurance from the GST Exempt Trust..........28c. Remainder Distributed Under the Three Installment Rule.....28d. Nonexempt Trust Planning.........................................................28

8. Proper Drafting to Implement the Foregoing Planning.......................29a. Designate Specific Property to be Distributed Under the

Three Installment Rule................................................................29b. Establishing a Testamentary GST Exempt Trust.....................29c. Interests Regarding GST Tax.....................................................29

(i) Elections Regarding GSTs..................................................29(ii) Division of Trust For Allocation of GSTs.........................29(iii) Holding Property in Separate Trust................................30(iv) Segregation of Property.....................................................30(v) Avoiding Distributions Subject to GST Tax.....................30

d. Providing Flexibility for Trustee to Create or Eliminate General Power of Appointment................................30

e. Creation by Trustee of, and Elimination of, General Power...31f. Provide Flexibility of Trustee to Acquire Life Insurance on

the Life of the Settlor or Beneficiaries.......................................31T. Obtaining Offshore Life Insurance....................................................................31

1. Life Insurance..........................................................................................312. Provide Flexibility of Trustee to Create Trusts, Partnerships or

LLCs for Beneficiaries............................................................................31a. Settle a Trust for a Beneficiary...................................................32b. To Form a Partnership or Limited Liability Company for

a Beneficiary.................................................................................32c. Change Situs of Trust so That the GST Exempt Trust May

be a Dynasty Trust.......................................................................32d. Change of Governing Law..........................................................32

(i) By Trustee.............................................................................32(ii) Changes to Settlement........................................................32(iii) Resulting Changes.............................................................32

VIII. Inbound Foreign Non-Grantor Trusts..........................................................................33A. Tax Rules Regarding Foreign Non-Grantor Trusts Formed by Non-

U.S. Persons..........................................................................................................331. Foreign Source Income............................................................................33

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2. Passive Income.........................................................................................333. Trade or Business Income.......................................................................334. Capital Gains Tax....................................................................................335. Sale of Real Estate or Personal Property..............................................336. FADPI and Trade or Business Income..................................................347. Deductions Attributable to Effectively Connected Income.................34

B. Planning for Non-U.S. Persons with Foreign Non-Grantor Trusts................341. Non-U.S. Persons Moving to the U.S......................................................342. Avoiding Branch Income........................................................................343. Avoiding Capital Gains Tax...................................................................344. Foreign Non-Grantor Trust with a U.S. Beneficiary............................34

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STRUCTURING NON-GRANTOR TRUSTS

I. Foreign Trusts—In General.

A. Tax Classification. U.S. persons who establish or are beneficiaries of foreign trusts are taxed according to the tax classification of the particular foreign trust.i The legal classification and tax classification may not be the same. For example, a Liechtenstein or Panamanian foundation whose founder is a U.S. person will be recognized in accordance with the laws of Liechtenstein or Panama for legal pur-poses; however, the foreign foundation must be classified for U.S. tax purposes as either a for-eign trust or a foreign corporation based on the language in the foundation documents.ii

B. Tax Classification of a Foreign Non-Grantor Trust. A foreign non-grantor trust is a trust in which the income of the trust is not taxed to the grantor, or to any other U.S. person such as a U.S. beneficiary.iii A foreign non-grantor trust is taxed as a nonresident alien individual and is subject to income tax as an individual. The Internal Revenue Service (hereinafter "IRS") defines a non-grantor trust as "any trust to the extent that the assets of the trust are not treated as owned by a person other than the trust."iv

1. Foreign Non-Grantor Trust at Death of U.S. Settlor. Upon the death of a grantor of a foreign trust, the foreign trust ceases to be a grantor trust (since the grantor is deceased) and becomes a foreign non-grantor trust. However, if, after the settlor's death, the trust instrument grants powers, stated under the provisions of Internal Revenue Code (hereinafter "I.R.C.") §§ 672-678, to U.S. beneficiaries, such beneficiaries shall be treated as grantors of the foreign trust, for income tax purposes. The typical asset protection trust does not give such powers to U.S. beneficiaries. In addition, even if powers are not included in the trust causing any one or more U.S. beneficiaries to be treated as a grantor under I.R.C. § 672-678 and if one or more of the beneficiaries in fact control the trustee, such beneficiary or beneficiaries may be treated as grantors under one or more of the provisions of I.R.C. § 672-678.i See J. Richard Duke, U.S. Tax Treatment of Low-Tax Jurisdictions, in INTERNATIONAL TAXATION OF LOW-TAX TRANSACTIONS (Bureau of Nat’l Affairs 1996); Alan R. Eber, Creative Use of Foreign Entities for Asset Protection and Tax Planning, 1, 1, ASSET PROTECTION J., 12 (1999).

ii See J. Richard Duke, The Use of the Panamanian Foundation in Asset Protection Planning and Related Tax Issues , ASSET PROTECTION JOURNAL, vol. 1 no. 4, A Panel Publication, Aspen Publishers, Inc., (1999).

iii I.R.C. §§ 673-678. If the trust instrument provides certain powers to a beneficiary, or the beneficiary in fact exercises certain powers stated in one or more of the foregoing I.R.C. provisions, the beneficiary may be treated as the "grantor" of the trust and may be taxed on all income, gains and losses of that trust.

iv Instructions for Forms 3520 and 3520-A, Definitions, at 3 (2004) and 2 (2004), respectively. Legally, a trust con-sists of pieces of paper that cannot own anything. The legal owner of the trust assets of a trust is the trustee. When a trust is created or settled, a relationship is created consisting of the settlor, the trustee who as the legal owner holds the trust assets in a fiduciary capacity for the benefit of the beneficiaries, and the beneficiaries who are the beneficial owners.

©J. Richard Duke 2006 All rights reserved

2. Can a U.S. Settlor Form a Foreign Non-Grantor Trust? The issue is whether a foreign trust that specifically states that it can have no U.S. beneficiary in accordance with the provisions of I.R.C. § 679(b) until one taxable year after the deaths of the grantor and the grantor's spouse may be classified for tax purposes as a foreign non-grantor trust.v

a. Position Apparently Contrary to IRS. The grantor trust provisions relate to taxation of a "grantor" for income tax purposes. The sett-lor of a trust, domestic or foreign, is taxed as the "grantor" under the provisions of I.R.C. §§ 671-678 and 679 (foreign trust with a U.S. beneficiary).

b. Definition of U.S. Beneficiary During Settlor's Lifetime. The definition of a U.S. beneficiary with respect to a foreign trust, including the cited legisla -tive history, relates to a living "grantor." The focus here in this chapter is on a settlor who dies and the trust instrument specifically excludes U.S. persons as beneficiaries until one taxable year after the deaths of the settlor and the settlor's spouse.

c. Trust Becomes a Foreign Non-Grantor Trust at Settlor's Death. At the settlor's death, the trust becomes a foreign non-grantor trust (settlor is deceased). The trust has no grantor, both for legal purposes and tax purposes. Now the question is whether the trust has a U.S. beneficiary at the settlor's death. I.R.C. § 679(b) is entitled "Trusts Acquiring United States Beneficiaries" and provides:

If–(1) subsection (a) [I.R.C. § 679(a)] applies to a trust for the transferor's taxable year, and (2) subsection (a) would have applied to the trust for his immediately preceding taxable year but for the fact that for such preceding taxable year there was no United States beneficiary for any portion of the trust, then … the transferor shall be treated as having income for the tax-able year … equal to the undistributed net income (at the close of such im-mediately preceding taxable year) attributable to the portion of the trust re-ferred to in subsection (a).

d. Apparent Meaning of I.R.C. § 679(b). This provision appears to state that if the foreign trust specifically provides that no U.S. person can become a beneficiary for one taxable year following the deceased transferor's death, income taxation under I.R.C. § 679(a) is not applicable. I.R.C. §§ 679(b) and 672(e)(1), for a married settlor, appear to provide the solution to avoiding classification of that trust as a grantor trust (to the grantor's estate) at the grantor's death.

e. Grantor Trust Provisions

v I.R.C. §§ 679(b) and 672(e)(1).

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. I.R.C. §§ 671-679 are the "grantor" trust provisions and tax the grantor of (or transferor to) a trust. A settlor who sets up a foreign trust is subject to these provisions (primarily I.R.C. § 679) and is treated as the grantor. At the death of this settlor, however, the foreign trust becomes a for-eign non-grantor trust. Although the provisionsvi that determine whether a foreign trust has a U.S. beneficiary apply both before and after the death of the settlor, the foreign trust becomes a non-grantor trust at the death of the settlor. The window provided by I.R.C. §§ 679(b) and 672(e)(1) appears to foreclose the foreign trust from being treated as a "grantor" trust at the settlor's (and spouse's) death.

f. Planning for the Accumulation of Income Problem. If this contrary position is correct, one problem remains. Under I.R.C. § 679(c)(1)(A), no in-come can be "accumulated during the taxable year for the benefit of a United States person." To deal with this concern while both or either the settlor and the settlor's spouse are living, the trust assets can be invested in capital appreciation assets with low income and all of the income can be distributed to the non-U.S. beneficiary each year in which earned. Thus, no income is accumu-lated for later distribution to a U.S. beneficiary. The Instructions to Form 3520 address this plan-ning.

g. IRS Omission. The IRS, in writing the Treas. Regs. under I.R.C. § 679, failed to refer to I.R.C. § 679(b). Based on conversation of this author with the IRS, it appears to be dangerous to rely upon the reasoning of the foregoing paragraphs (see "Position Apparently Contrary to IRS," supra).vii

3. Foreign Non-Grantor Trust Created by a Non-U.S. Person. A foreign trust created by a non-U.S. person that includes no U.S. beneficiary is a foreign non-grantor trust and the U.S. has no tax authority or jurisdiction over such trust or beneficiaries un-less the trustee of the trust invests in the U.S., which may subject certain types of passive income on those investments to withholdings and some trade or business income to withholdings. viii A foreign non-U.S. person may also create a foreign non-grantor trust that includes a U.S. benefi-ciary.

4. Foreign Irrevocable Trust Created by a Non-U.S. Person. An irrevocable trust, as opposed to a revocable trust, created by a non-U.S. person that includes one or more U.S. beneficiaries is classified for tax purposes as a foreign non-grantor trust.ix

C. Foreign vs. Domestic Trusts.

1. In General. A trust formed by a U.S. person outside the U.S. is commonly referred to as an offshore trust, international trust, foreign grantor trust, or a foreign non-grantor trust.x The I.R.C. uses the words, "foreign trust."xi The I.R.C., as amended by the Small Business Job Protection Act of 1996,xii provides two tests, as discussed below, to determine whether a trust is a domestic trust. If either of these tests is failed, the trust is a foreign trust. Unlike earlier law, the focus now is on


the legal and fiduciary control over a trust, not on the source of trust income or the residency of the parties.xiii

2. Classification of a Trust as Domestic or Foreign. Effective for tax years beginning after December 31, 1996, I.R.C. § 7701(a)(30) classifies a trust for tax purposes as domestic if two tests are met.xiv A trust is treated as a domestic trust if: (i) a court within the U.S. can exercise primary supervision over the administration of the trust, and (ii) one or more U.S. persons have the authority to control all substantial decisions of the trust.xv As stated, if either of the foregoing conditions is not satisfied, the trust is treated as a for-eign trust.xvi The House of Representatives indicates that the first test generally is satisfied if the trust instrument is governed by the laws of a state in the U.S.xvii The second test is satisfied only if U.S. persons make all substantial decisions with no other person having the power to veto any substantial decisions.xviii These two tests are referred to as the "court test" and the "control test."

a. Court Test. The court test is satisfied for a trust if (i) the trust instrument does not direct that the trust is to be administered outside the U.S.; (ii) the trust is in fact administered exclusively in the U.S.; and (iii) the trust is not subject to an automatic migration provision.xix A court within the U.S. does not have primary supervision over the administration of a trust if the trust instrument provides that an attempt by a U.S. court to assert jurisdiction or otherwise supervise the administration of the trust, directly or indirectly, causes the trust to migrate from the U.S. to a foreign jurisdiction (a "flee" clause).xx However, an automatic migration provision does not fail the court test if the trust instrument provides that the trust migrates from the U.S. only upon a foreign invasion of the U.S. or upon widespread confiscation or nationalization of property in the U.S.xxi

b. Control Test. The control test is met if U.S. persons have the authority to "control all substantial decisions" of the trust.

(i) Substantial Decisions. Those decisions that persons are authorized or required to make under the terms of the trust in-strument and applicable law that are not ministerial are deemed substantial decisions.xxii Substan-tial decisions include, but are not limited to, the following:xxiii (i) whether and when to distribute income or corpus; (ii) the amount of any distributions; (iii) the selection of a beneficiary; (iv) whether a receipt is allocable to income or principal; (v) whether to terminate the trust; (vi) whether to compromise, arbitrate, or abandon claims of the trust; (vii) whether to sue on behalf of the trust or to defend suits against the trust; (viii) whether to remove, add, or replace a trustee; (ix) whether to appoint a successor trustee to succeed a trustee who had died, resigned, or other-wise 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 (x) investment decisions. However, if a U.S. person under I.R.C. § 7701(a)(30) hires an investment advisor for the trust, investment decisions made by the invest-


ment advisor will be considered substantial decisions controlled by the U.S. person if the U.S. person can terminate the investment advisor's power to make investment decisions at will.

(ii) Ministerial Decisions. Ministerial decisions include details such as bookkeeping, collection of rents and the execution of investment decisions.xxiv

(iii) Definition of Control. Control means having the power, by vote or otherwise, to make all substantial decisions of the trust with no other person having the power to veto any of the substantial decisions. Control is determined by looking at U.S. persons, not just U.S. fiduciaries, who have authority to make all substantial decisions of the trust.xxv U.S. persons are not deemed to be in control of all substan-tial decisions if an attempt by any governmental agency or creditor to collect information from or assert a claim against the trust causes one or more substantial decisions of the trust to be no longer controlled by such U.S. persons.xxvi

II. Taxation of the Grantor of a Domestic or Foreign Trust.

A. Treating the Grantor as Owner. Where the settlor or another person, such as a beneficiary, is classified as the "grantor" of a trust, that grantor is treated as the owner of the assets of the trust and the income from the trust assets is taxed to the grantor or another person who is treated as the owner of the trust assets.xxvii

The grantor or another person is treated as the owner for income tax purposes if certain interests, controls or powers are retained over the trust.xxviii Treating the settlor as the owner of a trust, for tax purposes, causes confusion and misunderstanding because a trust is a relationship, not an en-tity. Upon formation of an entity, the owner or owners transfer assets in exchange for ownership interests, such as stock certificates, partnership interests or membership interests. When a trust is created (or settled), the result is a relationship between the settlor of the trust, the trustee and the beneficiaries. Upon creation of the trust, the settlor receives no evidence of ownership because the trustee is the legal owner of the trust assets and holds the trust assets as a fiduciary, in a fidu-ciary capacity, for the benefit of the beneficiaries, pursuant to the trust relationship. The follow-ing is a brief discussion of the powers that may be retained by the settlor or another person that causes the tax classification of that trust as a grantor trust, causing the grantor to be treated as the owner of the trust assets and taxed on all income, gains and losses.

1. Reversionary Interests. The grantor is treated as the owner of any portion of a trust in which he has a reversionary inter-est in either the corpus or income thereof if, at the inception, that portion of the trust exceeds five percent in value.xxix

2. Power to Control Beneficial Enjoyment. The grantor is treated as the owner of any portion of a trust in which the beneficial enjoyment of the corpus or the income is subject to a power of disposition, exercisable by the grantor or a


non-adverse party, or both, without the approval or consent of an adverse party.xxx The defini-tions of non-adverse party and adverse party are provided under I.R.C. § 672.

3. Administrative Powers. The grantor is treated as the owner of any portion of a trust in which he has the power to deal for less than adequate and full consideration, the right to borrow without interest or security and certain other powers retained over the trust.xxxi

4. Power to Revoke. The grantor is treated as the owner of any portion of a trust for any time that the power to revest title to the grantor in such portion is retained by the grantor, and is exercisable by the grantor or a non-adverse party, or both.xxxii Such a trust is generally referred to as a revocable trust.

5. Income for Benefit of a Grantor. The grantor is treated as the owner of any portion of a trust whose income, without the approval or consent of any adverse party or in the discretion of the grantor or adverse party, may be dis-tributed to the grantor or the grantor's spouse, held or accumulated for future distribution to the grantor or grantor's spouse, or applied to the payment of premiums on policies of insurance on the life of the grantor or the grantor's spouse.xxxiii

6. Foreign Trust Having a U.S. Beneficiary. Special rules apply to foreign trusts established or funded by a U.S. person with a U.S. benefi-ciary. See "Foreign Trust Having One or More U.S. Beneficiaries," supra.

7. U.S. Transferor. A U.S. transferor means any U.S. person who directly, indirectly or constructively transfers property to a foreign trust.xxxiv For purposes of I.R.C. § 679, "transferor" and "grantor" are the same.xxxv

8. U.S. Person. The definition of a U.S. person is determined under I.R.C. § 7701(a)(30) and includes individu-als and entities, as well as individuals who elect, under I.R.C. § 6013(g) to be treated as a U.S. resident and an individual who is a dual resident taxpayer within the meaning of Treasury Regu-lation (hereinafter "Treas. Reg.") § 301.7701(b)-7(a).xxxvi

9. Property. The term "property" means any asset or assets, including cash.xxxvii

10. Person Other Than Grantor Treated as Substantial Owner. A person, other than the grantor, shall be treated as the owner of any portion of a trust in which such person has a power exercisable solely by himself to vest the corpus or income in himself, or such person has previously partially released or otherwise modified such a power, and after such release or modification, retained such control that subjects him to grantor trust treatment under I.R.C. §§ 671-677.xxxviii


B. Grantor Defined. A grantor is a person to the extent such person either creates a trust, or directly or indirectly makes a gratuitous transfer of property to a trust.xxxix In the event a person creates or funds a trust on behalf of another person, both persons are treated as grantors of the trust.xl

1. Gratuitous Transfer. A gratuitous transfer is any transfer other than a transfer for fair market value.xli A transfer of property to a trust may be considered a gratuitous transfer whether or not the transfer is a gift for gift tax purposes.xlii A transfer is for fair market value only to the extent of the value of the prop-erty received, services rendered, or the right to use property of the trust.xliii

2. Nongratuitous Transfer. A person who makes a nongratuitous transfer to a trust he settled is not treated as the owner of any portion of the trust under I.R.C. §§ 671-677 or 679.xliv A nongratuitous transfer to a foreign trust by a U.S. person must be reported on form 3520.xlv A gratuitous transfer to a trust does not include a distribution to a trust with respect to an interest held by such trust in certain described trustsxlvi or an entity (such as a distribution to a trust by a corporation with respect to stock in a transaction described under I.R.C. § 301).xlvii If a trust makes a gratuitous transfer to another trust, the grantor of the transferor trust is treated as the grantor of the transferee trust.xlviii How-ever, if the transferor trust grants a general power of appointment to another person, who in fact exercises the power in favor of another trust, the power holder is treated as the grantor of the transferee trust.xlix

C. An Accommodation Party is not the Grantor Subject to Taxation. If one person creates or funds a trust for another person, both persons are treated as grantors of the trust and are subject to the reporting requirements of I.R.C. § 6048. However, a person who creates a trust but makes no gratuitous transfer to the trust is not treated as the owner of any por-tion of the trust under I.R.C. §§ 671-677 or 679. l In addition, a person who funds a trust with an amount that is directly repaid to such person within a reasonable period of time, and who makes no other transfers to the trust that constitute gratuitous transfers, is not treated as owner of any portion of a trust for income tax purposes under I.R.C. §§ 671-677 or 679. li For example, if an attorney creates a trust and nominally funds the trust for the benefit of his client and client's chil-dren with the trust naming the attorney as grantor, followed by the client reimbursing the attor-ney, the client is treated as the owner; however, both the client and the attorney are subject to the tax reporting requirements of I.R.C. § 6048.lii In this example, the attorney is a grantor, but he is not treated as an owner because he makes no gratuitous transfer to the trust.liii

D. Person with Power to Withdraw From Trust Settled by Another Person is Not a Grantor. If a person creates a trust and retains no powers causing income taxation to him, and the trust grants an unrestricted power to withdraw to another person, that other person is not treated as owner of the portion of the trust that is subject to the withdrawal power because that other person neither settled the trust nor made a gratuitous transfer to the trust.liv


E. Foreign Trust Having One or More U.S. Beneficiaries. A U.S. person who directly or indirectly transfers property to a foreign trust is treated as the owner of the portion of such trust attributable to such property if, during the taxable year, there is a U.S. beneficiary of any portion of such trust. lv Under the general grantor trust rules of I.R.C. §§ 671-678, the word "grantor" is used. However, under I.R.C. § 679, the word "transferor" is used.

1. The Foreign "Grantor" Trust.lvi Special rules render a foreign trust a "grantor trust" for U.S. tax purposes. Under these rules, a U.S. person is treated as the owner of a trust or the portion thereof, if (1) the U.S. person trans-fers, directly or indirectly, property to a foreign trust and (2) there is a U.S. beneficiary for such year for any portion of the trust.lvii U.S. person is treated as owner of the trust to the extent prop-erty is transferred by him to the trust. If the trust has a U.S. beneficiary, the transferor is taxed not only on income of the trust during the year, but income for all previous years since the trust was created.lviii Under regulations, the grantor trust rules of § 679 supersede other rules, so that if another person is treated as being the owner of the trust under § 678, the U.S. transferor will nonetheless be treated as the owner under § 679.lix

2. Direct or Indirect Transfer. Any direct or indirect transfer is taken into account in determining whether there is a transfer to a foreign trust, as illustrated by the following rules:

Transfers from a grantor trust are treated as a transfer from the U.S. grantor.lx

A transfer by an intermediary to whom a U.S. person transferred property is treated as an indirect transfer by the U.S. person if one of the principal purposes of the transfer (or the plan of which the transfer is part) is the avoidance of U.S. tax. In most circumstances, the principal purpose will be deemed to be the avoidance of U.S. tax. lxi Where applicable, the inter-mediary will be treated as the agent of the U.S. transferor, who will in-stead be treated as having made the transfer to the trust.lxii

3. Guarantee on a Loan for the Trust. If a U.S. person (that is, a related person to the trust)lxiii guarantees a loan made to a foreign trust by a third party, the U.S. guarantor is treated as having made a transfer to the trust in the amount of the loan.lxiv

4. Satisfaction of an Obligation of a Foreign Trust. Any assumption or satisfaction of an obligation of a foreign trust (to a third party) by a U.S. person is treated as a constructive transfer by the U.S. person to the foreign trust in the amount of that obligation.lxv


5. Transfer to an Entity Owned by the Trustee of the Foreign Trust. A transfer by a U.S. person (that is, a related person to the trust) lxvi to an entity owned by the foreign trust is treated as a transfer to the foreign trust followed by a transfer to the entity by the foreign trust.lxvii

6. Domestic Trust Becoming a Foreign Trust. A domestic trust that becomes a foreign trust can also be subject to the rules of I.R.C. § 679 at the date the trust becomes a foreign trust. The amount deemed transferred includes undistributed net income.lxviii

7. Definition of U.S. Beneficiary. A U.S. beneficiary includes a "U.S. per-son," defined as a U.S. citizen or U.S. resident, a domestic partnership, a domestic corporation, or any estate or trust other than a foreign estate or foreign trust. lxix The definition of a U.S. bene-ficiary is extremely broad and includes a U.S. person who has a future economic interest. lxx Fur-ther, the trust will have a U.S. beneficiary even if there is merely the possibility that the trust in-strument may be amended to include a U.S. beneficiary in the future. lxxi Thus, the law governing the trust must not allow the trust to be amended to add a U.S. beneficiary in contravention of the trust instrument.lxxii These rules, which are reflected in the legislative history, are consistent with the statute, which provides that a trust will be treated as having a U.S. beneficiary unless both of the following conditions are met:

1. No part of "the income or corpus of the trust may be paid or accumu-lated during the taxable year to or for the benefit of a U.S. person"; and

2. If the trust were terminated at any time during the tax year, no part of the income or principal of the trust could be paid to or for the benefit of a U.S. person.lxxiii

8. Beneficiary Further Defined by Treas. Regs.lxxiv The regulations take the same position. Further, the conduct of the parties related to the trust is also taken into account in determining whether the trust has a U.S. beneficiary.lxxv However, a person who is not named and is not within a defined class of beneficiaries is not taken into con-sideration in determining whether a trust has a U.S. beneficiary, if it is proved to the Service that that person's interest is so remote as to be negligible.lxxvi The regulations provide some guidance for what constitutes a remote interest for this purpose. lxxvii A trust will also be treated as having a U.S. beneficiary if the trustee has the discretion to select a U.S. person as beneficiary. The regu-lations give as an example discretion of a trustee to benefit any person who studies ancient Greece. Since "any person" includes a U.S. person, a U.S. person could benefit under this stan-dard. Consequently, the trust is treated as having a U.S. beneficiary.lxxviii This example also states that the remote interest exception does not apply to the trustee's discretion. Another example concludes that the power to change the beneficiary to a U.S. person will result in the trust being treated as having a U.S. beneficiary.lxxix A non–U.S. person can become a U.S. person, and thereby cause the trust to be treated as having a U.S. beneficiary, but this rule applies only in the tax year in which the person actually becomes a U.S. person. This rule does not apply, however,


if the beneficiary becomes a U.S person more than five years after the date of transfer to the for-eign trust by the U.S. transferor.lxxx If the trust gains a U.S. beneficiary, the U.S. transferor will have additional income equal to the trust's undistributed net income from the preceding year. lxxxi

Conversely, if the trust no longer has a U.S. beneficiary, the U.S. transferor ceases to be treated as the owner, unless he is so treated pursuant to the other grantor trust rules. lxxxii If the trust is no longer treated as a grantor trust, a deemed taxable sale or exchange can occur pursuant to I.R.C. § 684.lxxxiii

9. Attribution of Ownership from Controlled Foreign Corporations, Foreign Partnerships. To determine whether the trust has a U.S. beneficiary, there is attribution of ownership from controlled foreign corporations, foreign partnerships that have U.S. partners, and foreign trusts or foreign estates that have a U.S. beneficiary.lxxxiv Further, the beneficiary is not treated as a U.S. beneficiary if he becomes a U.S. person more that five years after the date of the transfer of prop-erty.lxxxv

III. Taxation of Foreign and Domestic Trusts. Taxation of Trusts. Foreign and domestic trusts are classified, for income tax purposes, either as simple or com-plex.lxxxvi

A. Simple Trust. A simple trust is a trust that is required to distribute all income currently, does not provide for charitable contributions, and makes no distributions other than current income (makes no distri-bution of principal in the year of characterization).lxxxvii All income of a foreign non-grantor trust that is classified as a simple trust is taxed to the beneficiaries and the trust receives a deduction from its current income that must be distributed, whether or not the income is actually distrib-uted.lxxxviii The amount included in the beneficiaries' gross income and the amount of the deduc-tion by the trust are each limited by the distributable net income of the trust.lxxxix

B. Complex Trust. A complex trust is a trust that is not classified as a simple trust.xc

C. Income. Income, as it relates to simple and complex trusts, generally refers to accounting income, not taxable income.xci

D. Accounting Income. Trust accounting income is generally the amount required or permitted to be distributed to cur-rent trust beneficiaries where the trust instrument requires or permits trust income, but not princi-pal, to be distributed to such beneficiaries.xcii Accounting income is income that is defined under the terms of the trust instrument or the applicable local law.xciii A simple trust may have accumu-lated taxable income, even though required to distribute all accounting income currently.


IV. Taxation of Foreign Non-Grantor Trusts. A foreign non-grantor trust has no grantor for income tax purposes.xciv Distributions of accumu-lated income from foreign non-grantor trusts to U.S. beneficiaries are subject to the complicated throwback rules. U.S. beneficiaries of a foreign non-grantor trust are subject to complex rules and reporting requirements, along with high taxation, if all net income of the trust is not distrib-uted each year to the beneficiaries.

A. Distribution Deduction. The deduction for a simple trust is allowed only for accounting income required to be distrib-uted currently.xcv The deduction for a complex trust is allowed for currently distributable ac-counting income in addition to other amounts properly paid, credited or required to be distrib-uted.xcvi A distribution deduction reduces the taxable income of the trust.xcvii The distribution de-duction for both simple and complex trusts is limited by the distributable net income of the trust.xcviii The computation of distributable net income relates to foreign and domestic trusts.

B. The Concept of Distributable Net Income. Distributable net income places a ceiling on the distribution deduction in determining the taxa-tion of trusts.xcix In addition, distributable net income limits the amount of tax to beneficiaries.c

In limiting the distribution deduction, distributable net income for a domestic trust is the taxable income of the trust without the: (i) distribution deduction;ci (ii) personal exemption;cii and (iii) undistributed capital gains and losses allocated to corpus.ciii

C. Distributable Net Income of a Foreign Non-Grantor Trust. The distributable net income of a foreign non-grantor trust begins with the worldwide taxable income of the trust, including both U.S. source and foreign source income.civ The distributable net income of a foreign trust (foreign grantor or foreign non-grantor) is computed the same as for a domestic trust, except that undistributed capital gains and losses are allocated to corpus for a foreign trust. This is because distributable net income of a foreign trust includes capital gains,cv

foreign source income,cvi income that is exempted by treaty,cvii and extraordinary dividends or taxable stock dividends allocated to corpus in good faith for trusts distributing current income only.cviii Capital gains are included in the distributable net income of a foreign non-grantor trust, irrespective of whether capital gains are allocated to income or to corpus under the trust instru-ment or the governing law and irrespective of whether currently distributed.cix The inclusion of capital gains, for example, in distributable net income of a foreign trust preserves the taxation to the beneficiaries of the trust. Thus, U.S. beneficiaries of a foreign trust (foreign grantor or for-eign non-grantor) are taxed at such time as distributions are made.cx The U.S. beneficiaries are taxed, upon distribution, on those foreign trust gains from the sale or exchange of capital assets, foreign source income and income exempted from treaty, notwithstanding that the foreign non-grantor trust is generally not subject to income taxation.

D. Treatment of Capital Gains. A domestic trust generally allocates capital gains to its corpus. Thus, the domestic trust pays the tax on the gains and later distributes those gains without taxation to the beneficiaries. Because the foreign trust allocates its capital gains to distributable net income, if the capital gains of the


trust are not currently distributed, these gains become a part of the undistributed net income of the trust. Upon distribution, the gains lose their capital character and are taxed as ordinary in-come to the beneficiaries.cxi

E. Treatment of Beneficiaries With Respect to Distributable Net Income. If the amount of income distributions that must be made exceeds the distributable net income of a simple trust or complex trust, each beneficiary shares in the distributable net income of the simple trust or complex trust in the proportion that amount of income required to be distributed to each beneficiary bears to the amount of income required to be distributed to all beneficia-ries.cxii

F. Distributable Net Income of Complex Trust Exceeding Income Required to Be Distributed. The distributable net income of a complex trust may exceed the amount of income required to be distributed to the beneficiaries. In such case, if other amounts of income are either required to be distributed or are properly distributed to a beneficiary, such beneficiary shares in the remain-ing distributable net income of the complex trust in the proportion that the amount of the distri-bution (or required distribution) of the complex trust to that particular beneficiary bears to the amount of all distributions (or required distributions) to all beneficiaries.cxiii

V. Tax Return Compliance With Respect to a Foreign "Non-Grantor" Trust.

A. Events Requiring Filing. I.R.C. § 6048 includes reporting requirements for two events relating to a foreign non-grantor trust: (i) creating or funding the foreign non-grantor trust by a U.S. person; and (ii) distributions to U.S. beneficiaries from a foreign non-grantor trust.

B. Form 3520–Creating or Funding a Foreign Non-Grantor Trust. A "responsible party" is required to provide written notice of a "reportable event."cxiv The "re-sponsible party" is required to file Form 3520 with his or her federal income tax return. In addi-tion, a copy must be sent to the Philadelphia Service Center, Philadelphia, PA 19255.cxv

1. Reportable Events. A "reportable event" includes any one of the following:

a. Creating Foreign Trust. The creation of any foreign trust by a U.S. person;cxvi or

b. Gratuitous Transfer. A "gratuitous transfer" of money or property, directly or indirectly, to a foreign trust (including by reason of death).cxvii The transfer of assets by a U.S. person to a foreign grantor trust may or may not be a completed gift for gift tax purposes, as discussed below.cxviii The transfer of assets by a U.S. person to a foreign non-grantor trust is a completed gift for gift tax purposes. Form


3520, Part I, Line 7a, requires the foreign non-grantor trust or foreign person to be acknowledged as the owner of the transferred assets after the transfer.cxix

2. Responsible Party. A "responsible party" includes the settlor of a foreign non-grantor trustcxx and a transferor (ex-cept by reason of death) to a foreign non-grantor trust.cxxi

3. Reporting Gain on Transfer of Appreciated Assets. The transfer of appreciated assets by a U.S. person to a foreign non-grantor trust results in the recognition of gain for tax purposes.cxxii Instructions to Form 3520 make the following note: "With respect to any transfer by a U.S. person to a foreign non-grantor trust after August 4, 1997, the transfer is treated as a sale or exchange and the transferor must recognize as a gain the excess of the FMV [fair market value] of the transferred property over its adjusted basis. Although the

cxix Form 3520, Part I, Transfers by U.S. Persons to a Foreign Trust During the Current Tax Year, Line 7a, asks "Will any person (other than the U.S. transferor or the foreign trust) be treated as the owner of the transferred assets after the transfer?" If the answer is "yes," the following information must be provided: (i) name of other foreign trust owners, if any; (ii) address; (iii) country of residence; (iv) identification number, if any; and (v) relevant I.R.C. Sec-tion.

cxx I.R.C. § 6048(a)(4)(A).

cxxi I.R.C. § 6048(a)(4)(B).

vi I.R.C. §§ 679(b) and (c).

vii See "Foreign Trusts Having One or More U.S. Beneficiaries," supra.

viii See Tax Rules Regarding Foreign Non-Grantor Trusts Formed by Non-U.S. Persons, supra.

ix I.R.C. § 672(f)(2)(A). See also "Special Rules for Treating a Foreign Person as Owner," "Certain Revocable Trusts," supra.

x See General Classifications of Offshore Trusts, supra.

xi I.R.C. §§ 7701(a)(30)(E) and 7701(a)(31)(B).xii

? The Small Business Job Protection Act of 1996, Pub. L. No. 104-188, H.R. Rep. No. 3348, 104th Cong., 2nd Sess. (1996), amending I.R.C. §§ 7701(a)(30) and 7701(a)(31).

xiii Treas. Reg. § 301.7701-7(a). xiv The Small Business Job Protection Act of 1996, Pub. L. No. 104-188, H.R. Rep. No. 3348, 104th Cong., 2nd Sess. (1996), amending I.R.C. §§ 7701(a)(30) and 7701(a)(31). xv I.R.C. § 7701(a)(30)(E).xvi

? I.R.C. § 7701 (a)(31)(B).xvii

? The Small Business Job Protection Act of 1996, Pub. L. No. 104-188, Rep. No. 3348, 104th Cong., 2nd Sess. ©J. Richard Duke 2006 All rights reserved

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gain is not reported on Form 3520, it is to be reported on the appropriate form or schedule of the transferor's income tax return. See Section 684." Presumably, this instruction also applies to the migration of a domestic trust to a foreign trust, unless the domestic trust is a grantor trust.cxxiii

4. Form 56–Notice Concerning Fiduciary Relationship. This form is filed when a fiduciary relationship is created. This form serves to place the IRS on notice of the correct address and identity of the foreign trust.

5. Form 709, U.S. Gift (and Generation-Skipping Transfer) Tax Return

(1996), amending I.R.C. §§ 7701(a)(30) and 7701(a)(31).xviii

? Treas. Reg. § 301.7701-7(d)(1)(iii).

xix Treas. Reg. § 301.7701-7(c)(1).

xx Treas. Reg. § 301.7701-7(c)(4)(ii).

xxi Treas. Reg. § 301.7701-7(c)(4)(ii).

xxii Treas. Reg. § 301.7701-7(d)(1)(ii).

xxiii Treas. Reg. § 301.7701-7(d)(1)(iii).

xxiv Treas. Reg. § 301.7701-7(d)(1)(iii).

xxv Treas. Reg. § 301.7701-7(d)(1)(iii).

xxvi Treas. Reg. § 301.7701-7(d)(3).

xxvii I.R.C. § 671.

xxviii I.R.C. §§ 673-678. Such powers cause the grantor to be treated as the owner of the assets of a trust for income tax purposes, whether the trust is domestic or foreign.

xxix I.R.C. § 673(a).

xxx I.R.C. § 674(a).

xxxi I.R.C. § 675.

xxxii I.R.C. § 676(a).

xxxiii I.R.C. § 677(a).

xxxiv Treas. Reg. § 1.679-1(c)(1).

xxxv Treas. Reg. § 1.671-2(e)(1). In defining a grantor who makes a gratuitous transfer, the definition includes a grantor making transfers to a foreign trust under I.R.C. § 679, which uses the word "transferor."


. When a U.S. person transfers assets to a foreign non-grantor trust, he retains no rights or pow-ers that cause him to be classified as a grantor,cxxiv and generally parts with dominion and control so there is a completed gift and the assets are generally excluded from his estate for estate tax purposes. The transfer of property to a foreign non-grantor trust requires a Form 709 to be filed with the IRS Center where the federal income tax return is filed and is due on April 15 following the year of any transfer.

6. Form 1040–Schedule B, Part III. The U.S. person who creates and funds a foreign non-grantor trust has no interest in, or signa-ture or other authority over, the trust so the answer to Line 7a of this Schedule is in the negative. xxxvi Treas. Reg. § 1.679-1(c)(2).

xxxvii Treas. Reg. § 1.679-1(c)(4).

xxxviii I.R.C. § 678(a).

xxxix Treas. Reg. § 1.671-2(e)(1).

xl Treas. Reg. § 1.671-2(e)(1).

xlii Treas. Reg. § 1.671-2(e)(2)(i).

xli Treas. Reg. § 1.671-2(e)(2)(i).

xliii Treas. Reg. § 1.671-2(e)(2)(ii).

xliv Treas. Reg. § 1.671-2(e)(1).

xlv I.R.C. § 6048(a)(3)(A)(ii).

xlvi These certain trusts include investment trusts, liquidating trusts or environmental remediation trusts described in Treas. Reg. §§ 301.7701-4(c), 301.7701-4(d), and 301.7701-4(e).

xlvii Treas. Reg. § 1.671-2(e)(2)(iii).

xlviii Treas. Reg. § 1.671-2(e)(5).

xlix Treas. Reg. § 1.671-2(e)(5).

l Treas. Reg. § 1.671-2(e)(1).

li Treas. Reg. § 1.671-2(e)(1).

lii Treas. Reg. § 1.671-2(e)(6), Example 3.

liii Treas. Reg. § 1.671-2(e)(6), Example 3; see also Treas. Reg. § 1.671-2(e)(1).

liv Treas. Reg. § 1.671-2(e)(6), Example 4. In addition, Treas. Reg. § 1.671-2(e)(1) requires a person to either create a trust or directly or indirectly make a gratuitous transfer of property to the trust in order to be treated as a grantor for income tax purposes.


However, Line 8 asks "Were you the grantor of, or transferor to, a foreign trust … whether or not you have any beneficiary interest in it?" A U.S. person who creates a foreign non-grantor trust and makes transfers to it is a transferor and Line 8 of this Schedule must be answered in the affir-mative. It is recommended that an explanation be written below Line 8 of this Schedule, or at-tached to this Schedule, stating "No U.S. person has any financial interest in the foreign trust or any foreign account established by the foreign trust. The person filing this Form 1040 settled a foreign non-grantor trust, made a transfer or transfers, as transferor, to the trust. The person fil-ing this Form 1040 retained no beneficial interest in this trust, and the trust includes no U.S. ben-eficiaries who will receive any distributions (directly, indirectly or constructively)."

lv I.R.C. § 679(a)(1).

lvi See Peter Spero, ASSET PROTECTION: LEGAL PLANNING, STRATEGIES AND FORMS, Vol. 1, ¶ 7.04[10][a] (Warren Gorham & Lamont, 2005).

lvii I.R.C. § 679(a)(1).

lviii I.R.C. § 679(b).

lix Treas. Reg. § 1.679-1(b).

lx Treas. Reg. § 1.679-3(b)(1).

lxi Treas. Reg. § 1.679-3(c).

(2) Principal purpose of tax avoidance deemed to exist. For purposes of paragraph (c)(1) of this section , a transfer is deemed to have been made pursuant to a plan one of the principal purposes of which was the avoidance of United States tax if— (i) The U.S. person is related (within the meaning of paragraph (c)(4) of this section) to a beneficiary of the foreign trust, or has another relationship with a beneficiary of the foreign trust that establishes a reasonable basis for concluding that the U.S. transferor would make a transfer to the foreign trust; and (ii) The U.S. person cannot demonstrate to the satisfaction of the Commissioner that— (A) The intermediary has a relationship with a beneficiary of the foreign trust that establishes a reasonable basis for concluding that the intermediary would make a transfer to the foreign trust; (B) The intermediary acted independently of the U.S. person; (C) The intermediary is not an agent of the U.S. person under generally applicable United States agency principles; and (D) The intermediary timely complied with the reporting requirements of section 6048 , if applicable.

lxii Treas. Reg. § 1.679-3(c)(3). Generally, the transfer is deemed to occur when the property is made available or transferred to the trust. The transfer can occur when the transfer is made to the intermediary, if the taxpayer can demonstrate to the IRS that the intermediary is the agent of the U.S. transferor under the applicable rules of the U.S. agency.

lxiii The applicable attribution rules are broad. See Treas. Reg. § 1.679-1(c)(5).

lxiv Treas. Reg. § 1.679-3(e).

lxv Treas. Reg. § 1.679-3(d).©J. Richard Duke 2006 All rights reserved

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http://checkpoint.riag.com/getDoc?DocID=T0TCODE:28904.1&pinpnt=

7. TD F 90-22.1–Report of Foreign Bank and Financial Accounts. A foreign non-grantor trust is treated as the owner of assets, for income tax purposes, not the grantor, due to the grantor retaining no rights or powers that cause the grantor to be treated as the owner for income tax purposes.cxxv This Form apparently is not due since no "financial interest" or "signature authority" is retained by a U.S. person over any account established by the trustee of a foreign non-grantor trust.cxxvi However, signature authority includes the ability to control the disposition of money or property in the foreign account by oral or written instructions to the sig-natory or titleholder in the account.cxxvii It is recommended that a U.S. person who discusses as-set management issues or investment management issues, including allocations of investments,

lxvi The applicable attribution rules are broad. See Treas. Reg. § 1.679-1(c)(5).

lxvii Treas. Reg. § 1.679-3(f) (this result is avoided if the U.S. person demonstrates to the satisfaction of the Commis-sioner that the transfer to the entity is properly attributable to the U.S. person's ownership interest in the entity).

lxviii Treas. Reg. § 1.679-6.

lxix I.R.C. § 7701(a)(30).

lxx See Note Staff of the Joint Comm. on Tax'n, 94th Cong., 2d Sess., "General Explanation of the Tax Reform Act of 1976," at 222 (a settlor who entered into a collateral agreement with a friendly trustee to assure that a specific U.S. person is added by the trustee to the list of beneficiaries would be treated as constituting the creation of a trust with a U.S. beneficiary).

lxxi See Note Staff of the Joint Comm. on Tax'n, 94th Cong., 2d Sess., "General Explanation of the Tax Reform Act of 1976," at 222.

lxxii See Note Staff of the Joint Comm. on Tax'n, 94th Cong., 2d Sess., "General Explanation of the Tax Reform Act of 1976," n.8.

lxxiii I.R.C. § 679(c)(1) (emphasis added).

lxxiv Id.

lxxv Treas. Reg. 1.679-2(a)(4)(i). The Section 679 regulations are generally effective as of August, 2000. Treas. Reg. § 1.679-7.

lxxvi Treas. Reg. § 1.679-2(a)(2)(ii).

lxxvii Compare Treas. Reg. § 1.679-2(a)(2)(iii), Example 7 (where one of two first cousins is a U.S. person, the fact that the U.S. person could be a beneficiary of the trust under the rules of intestate succession is so remote as to be negligible, where several non–U.S. persons would take before the remote U.S. beneficiary) with Treas. Reg. § 1.679-2(a)(2)(iii), Example 8 (contingent U.S. beneficiary interest is not negligible where he takes upon the death of the grantor provided that one non–U.S. person does not survive the grantor).

lxxviii I.R.C. § 679(a)(4)(A); Treas. Reg. § 1.679-2(a)(2)(iii), Example 10.

lxxix Treas. Reg. § 1.679-2(a)(2)(iii), Example 11.©J. Richard Duke 2006 All rights reserved

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with the asset manager or the trustee file a Form TD F 90-22.1 to avoid an argument with the IRS that the report is due and to avoid potential severe penalties.

VI. Reporting Requirements for U.S. Beneficiaries. A U.S. person receiving any distribution, directly or indirectly, from a foreign trust is required to disclose the following information: (i) the name of the trust; cxxviii (ii) the aggregate amount of the distributions received during the tax year;cxxix and (iii) other information that the IRS pre-scribes (Form 3520).cxxx

A. Attached Statements

lxxx Treas. Reg. § 1.679-2(a)(3)(i).

lxxxi Treas. Reg. § 1.679-2(c)(1). The net income is determined under I.R.C. § 665(a) and is subject to the interest charge of I.R.C. § 668.

lxxxii Treas. Reg. § 1.679-2(c)(2).

lxxxiii Treas. Reg. § 1.679-2(c)(2). ("The U.S. transferor is treated as making a transfer of property to the foreign trust on the first day of the first taxable year following the last taxable year of the U.S. transferor during which the trust was treated as having a U.S. beneficiary. The amount of the property deemed to be transferred to the trust is the portion of the trust attributable to the prior transfer to which paragraph (a)(1) of this section applied.")

lxxxiv I.R.C. § 679(c)(2).

lxxxv I.R.C. § 679(c)(3).

lxxxvi I.R.C. §§ 651 and 661.lxxxvii

? I.R.C. § 651; Treas. Reg. § 1.651(a)-1.lxxxviii

? I.R.C. §§ 651(a) and 652.lxxxix

? I.R.C. §§ 651(b) and 652(a).xc

? I.R.C. § 661.xci

? See I.R.C. § 643(b); Treas. Reg. § 1.643(b)-1. xcii

? Provisions in trusts that include definitions of income departing fundamentally from local law are not recognized for purposes of defining accounting income. Treas. Reg. § 1.643(b)-1.

xciii Treas. Reg. § 1.651(a)-2.

xciv A trust that is treated as having no grantor under I.R.C. §§ 673-679.

xcv I.R.C. §§ 651 and 661.xcvi

? Id.©J. Richard Duke 2006 All rights reserved

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. Form 3520-A requires one or more statements to be attached.cxxxi

B. Distributions from a Foreign Non-Grantor Trust. A U.S. beneficiary who receives a distribution from a foreign non-grantor trust is also required to complete Form 3520, Part III–Distributions to a U.S. Person From a Foreign Trust During the Current Tax Year. In addition, a Foreign Non-grantor Trust Beneficiary Statement (no pre-scribed form) must include six items:cxxxii (i) the first and last day of the taxable year of the for-eign trust to which the statement applies; (ii) an explanation of the appropriate U.S. tax treatment of any distribution or deemed distribution for U.S. tax purposes, or sufficient information to en-able the U.S. beneficiary to establish the appropriate treatment of any distribution or deemed dis-xcvii

? Id.xcviii

? I.R.C. §§ 651(b) and 661(a).xcix

? Id.c

? I.R.C. §§ 652(b) and 662(b).ci

? I.R.C. § 643(a)(1).cii

? I.R.C. § 643(a)(2).ciii

? I.R.C. § 643(a)(3).civ

? I.R.C. § 643(a)(6).cv

? I.R.C. § 643(a)(6)(C).cvi

? I.R.C. § 643(a)(6)(A).cvii

? I.R.C. § 643(a)(6)(B).cviii

? I.R.C. § 643(a)(4).cix

? I.R.C. § 643(a)(6)(C); Treas. Reg. § 1.643(a)-6(a)(3)(iii).cx

? If a foreign non-grantor trust recognizes both ordinary income and capital gains in the same taxable year and makes distributions to U.S. beneficiaries, those beneficiaries include a proportionate share of both the ordinary income and capital gains, based on the relative inclusion of each type of income in distributable net income. The beneficiaries include the distributed capital gains and their own computations of net long-term and short-term capital gains and losses to determine each of their respective tax liabilities. Treas. Reg. § 1.643(a)-5(b), Example 1.

cxi I.R.C. §§ 652(b), 662(b) and 667(a).cxii

? I.R.C. §§ 651(a) and 662(a)(1).cxiii

? I.R.C. § 662(a)(2).

cxiv I.R.C. § 6048(a)(1). Instructions for Form 3520, Who Must File, 1 (2004).©J. Richard Duke 2006 All rights reserved

- 19 -

tribution for U.S. tax purposes; (iii) a statement identifying whether the owner of the trust is a partnership or a foreign corporation; (iv) a statement that the trust will permit either the IRS or the U.S. beneficiary to inspect and copy the trust's permanent books of account, records, and such other documents that are necessary to establish that the trust should be treated for U.S. tax purposes as owned by another person (the statement is not necessary if the trust has appointed a U.S. agent); (v) a description of property (including cash) distributed or deemed distributed to the U.S. person during the taxable year, and the fair market value of the property distributed; and (vi) a statement as to whether the foreign trust has appointed a U.S. agent. If the trust has a U.S. agent, the name, address, and taxpayer identification number of the agent must be included.

cxv Instructions for Form 3520, When and Where To File, 1 (2004).

cxvi I.R.C. § 6048(a)(3)(A)(i).

cxvii I.R.C. § 6048(a)(3)(A)(ii).

cxviii See Treas. Reg. §§ 25.2511-2(b) and (j).

cxxii I.R.C. § 684(a).

cxxiii I.R.C. § 684(b).

cxxiv I.R.C. §§ 673-678. Also, the trust includes no U.S. beneficiary until one taxable year after the deaths of the grantor and his spouse under I.R.C. §§ 679(b) and 672(e)(1).

cxxv I.R.C. §§ 673-678. In addition, a foreign non-grantor trust includes no U.S. beneficiaries under I.R.C. § 679.

cxxvi However, question 26 of this Form asks: "Does the filer have a financial interest in this account?" It then states that if the answer is No, that boxes 27-35 are to be completed. Instructions for the TD F 90-22.1, Item 26, states "United States Persons with Authority over but No Financial Interest In an Account–Except as provided in the fol-lowing paragraph, you must state the name, address, and identifying number of each owner of an account over which you had authority but if you complete items 27-35 for more than one account of the same owner, you need identify the owner only once. If you complete items 27-35 for one or more accounts in which no United States per-son had a financial interest, you may state on the first line of this item, in lieu of supplying Information about the owner, 'No U.S. person had any financial interest in the foreign accounts.' This statement must be based upon the actual belief of the person filling this form after he or she had taken reasonable-measures to ensure its correctness."

cxxvii Instructions for TD F 90-22.1, General Definitions, 3.cxxviii

? I.R.C. § 6048(c)(1)(A).

cxxix I.R.C. § 6048(c)(1)(B).

cxxx I.R.C. § 6048(c)(1)(C).

cxxxi Instructions for Form 3520-A, Part III, Foreign Trust Balance Sheet, 4 (2004).

cxxxii Unlike the "Foreign Grantor Trust Beneficiary Statement" which is an attachment to Form 3520-A (see previous two endnotes), because the trust here is a foreign non-grantor trust, no reference is made to this form under Form


C. Distribution Defined. Except as provided by Treas. Regs., a distribution from a foreign trust includes any gratuitous transfer of money or other property, whether or not the trust is owned by another person and whether or not that person is U.S. or foreign.cxxxiii Distributions include: (i) loans; (ii) gifts; (iii) bequests; and (iv) distributions of income or corpus.cxxxiv A distribution is reportable by a benefi-ciary whether actually or constructively received. For example, credit card charges paid by the foreign trust that are guaranteed or secured by the assets of the foreign trust are treated as distri-butions.cxxxv Furthermore, if payment is received by a U.S. person from a foreign trust in ex-change for property transferred to the trust or services rendered to the trust, and the fair market value of the payment received exceeds the fair market value of the property transferred or ser-vices rendered, the excess is treated as a distribution.cxxxvi

1. Loans. Loans of cash or marketable securities from a related foreign trust to a U.S. person, whether di-rect or indirect, are treated as a distribution.cxxxvii The amount of a loan is its issue price.cxxxviii Re-lated parties are determined under the provisions of I.R.C. §§ 267 or 707(b).cxxxix I.R.C. § 267 broadly defines related parties, and for purposes of application here, I.R.C. § 267(c)(4) is applied as if the family of an individual includes his or her spouse.

2. Exception to Treatment of Loan as a Distribution. If a loan meets the requirements for a "qualified obligation,"cxl such a loan is not treated as a distribution. The requirements are: (i) it is reduced in writing; (ii) the term does not exceed five years; (iii) all payments are denominated in U.S. dollars; (iv) the yield is between 100 percent of the applicable Federal rate under I.R.C. § 1274(d) and 130 percent of the applicable Federal rate

3520-A. However, Form 3520, Part III—Distributions to a U.S. person From a Foreign Trust During the Current Tax Year, Line 30, asks: "Did you receive a Foreign Non-grantor Trust Beneficiary Statement from the foreign trust with respect to a distribution? This question at Line 30 is confusing since the Foreign Non-grantor Trust Beneficiary Statement is not required to be prepared and attached to Form 3520-A. Apparently, this form, prepared in accor-dance with the Instructions for Form 3520, Part II, U.S. Owner of a Foreign Trust, for Line 30, is to be attached to Form 3520 and furnished to each U.S. beneficiary; otherwise, Form 3520, Part III, Schedule A–Default Calculation of Trust Distributions (Lines 31-38) or Schedule B–Actual Calculation of Trust Distributions (Lines 39-47) must be completed by each U.S. beneficiary.

cxxxiii I.R.C. § 6048(c)(1).

cxxxiv Instructions for Forms 3520 and 3520-A, Definitions, 2 and 1 respectively (2004).

cxxxv Instructions for Forms 3520 and 3520-A, Definitions, 2 and 1 respectively (1999).

cxxxvi Instructions for Forms 3520 and 3520-A, Definitions, 2 and 1 respectively (1999).

cxxxvii I.R.C. § 643(i).

cxxxviii Treas. Reg. §§ 1.446-2(d)(1), 1.1273-2, or 1.1274-2, whichever is applicable, defines the issue price.

cxxxix I.R.C. § 643(i)(2)(B)(i); Instructions for Form 3520, Definitions, 3 (2004).


for the day in which the obligation is issued; (v) the U.S. obligor extends the period for assess-ment of any income or transfer tax attributable to the loan and any consequential income tax changes for each year that the obligation is outstanding, to a date not earlier than three years after the maturity date of the obligation, unless the maturity date does not extend beyond the end of the U.S. person's taxable year and is paid within such period;cxli and (vi) the U.S. obligor reports the status of the obligation, including principal and interest payments, on Form 3520 for each year that the obligation is outstanding.cxlii Thus, even though the obligation is treated as a loan instead of a distribution, the reporting requirements are not avoided. Form 3520 requires report-ing for the creation of the obligation as well as the status of the obligation for each year that the obligation is outstanding.cxliii

3. Distributions by Certain Foreign Trusts through Nominees. Any amount paid to a U.S. person, whether the amount is derived directly or indirectly from a foreign trust, of which the payor (person or entity) is not the grantor, is treated as if paid by the foreign trust directly to the U.S. person.cxliv Thus, a payor, who is not the grantor of the foreign trust, is ignored for tax purposes if the payor distributes income, derived directly or indirectly from a foreign trust, to a U.S. person.cxlv The Treas. Regs. under I.R.C. § 643(h) treat any prop-erty (including cash)cxlvi that is transferred to a U.S. person by an intermediary as transferred di-rectly by the foreign trust to the U.S. person if the intermediary received the property from the foreign trust pursuant to a plan, one of the principal purposes of which is the avoidance of U.S. income tax.cxlvii The Treas. Regs. under I.R.C. § 679 follow the regulations under I.R.C. § 643(h).cxlviii

cxli This extension is reported on Form 3520, Part I, Transfers by U.S. Persons to a Foreign Trust During the Current Tax Year, Schedule A—Obligations of a Related Trust, and Part III—Distributions to a U.S. Person From a Foreign Trust During the Current Tax Year, as applicable.

cxlii Notice 97-34; Instructions for Form 3520, Definitions, 3 (2004).

cxliii Form 3520, Part I, Schedule A–Obligations of a Related Trust, Lines 11a and 11b-12 and Schedule C–Qualified Obligations Outstanding in the Current Tax Year, Line 19.

cxl Instructions for Form 3520, Definitions, 3 (2004).

cxliv I.R.C. § 643(h).

cxlv See Grantor Defined, for a discussion of the definition of grantor, supra.

cxlvi Treas. Reg. § 1.643(h)-1(f).

cxlvii Treas. Reg. § 1.643(h)-1(a)(1).

cxlviii Treas. Reg. § 1.679-3(c). Treas. Reg. § 1.679-3(c)(3) provides that where a transfer is treated as an indirect transfer, the intermediary generally is treated as an agent of the U.S. transferor and the property is treated as trans -ferred to the foreign trust by the U.S. transferor in the year the property is transferred, or made available, by the in-termediary to the foreign trust.


The provisions of I.R.C. § 643(h) do not apply in three situations: (i) nongratu-itous transfers from the foreign trust to the intermediary or the transfer from the intermediary to a U.S. person;cxlix (ii) the intermediary is the grantor of the portion of the trust from which the property that is transferred is derived;cl and (iii) if, during the taxable year of the U.S. person, the aggregate fair market value of all property transferred to such person from all foreign trusts, di-rectly or indirectly, through one or more intermediaries, does not exceed $10,000.cli These provi-sions primarily apply to a grantor trust where the grantor is treated as the owner under I.R.C. § 679(a).

D. General Rule–Foreign Person Not Treated as Owner. I.R.C. § 672(f), entitled "Subpart not to Result in Foreign Ownership," provides that the grantor trust rules under I.R.C. §§ 671-679 apply only to the extent that income, if any, that is currently taken into account (directly or through one or more entities) is reported by a citizen or resident of the U.S. or a domestic corporation.clii

E. Special Rules for Treating a Foreign Person as Owner. A foreign person is not treated as the owner of a foreign trust for tax purposes,cliii subject to three exceptions:cliv (i) the foreign trust includes an absolute power to the foreign grantor to revest title of the trust assets in himself. This power may be exercised solely by the grantor with-out the approval or consent of any other person or with the consent of a related or subordinate party, subservient to the grantor (such a trust is revocable to the foreign grantor meaning that the foreign grantor may terminate the trust or leave the assets at his death to his desired beneficia-ries); (ii) the foreign trust specifically states that distributions can only be made to the grantor or the grantor's spouse; or (iii) a trust making distributions that are taxable and reported by a U.S. person as compensation for services rendered. If the requirements of one of the three exceptions are not met, the I.R.C. finds some U.S. person or persons to tax or treats the trust as a foreign non-grantor trust subject to the accumulation distribution rules,clv and subjects distributions to an interest charge.clvi These three exceptions to the general rule of not treating a foreign person as owner of a trust,clvii are clarified by Treas. Regs. as follows:

1. Certain Revocable Trusts. To the extent that a foreign grantor has the power to revest, absolutely in himself, title to any portion of a trust, which power is exercisable solely by the foreign grantor (or, in the event of the grantor's incapacity, by a guardian or other person with unrestricted power to exercise such power on the grantor's behalf) without the approval or consent of any other person, the foreign person is treated as owner for income tax purposes of such foreign trust.clviii However, the for-cxlix Treas. Reg. § 1.643(h)-1(b)(1). A gratuitous transfer is defined as any transfer other than a transfer for fair mar -ket value under Treas. Reg. § 1.671-2(e)(2).

cl Treas. Reg. § 1.643(h)-1(b)(2).

cli Treas. Reg. § 1.643(h)-1(d).

clii Treas. Reg. § 1.672(f)-1(a)(1).


eign grantor is treated as having the power to revest for a taxable year only if such power exists for a total of one hundred eighty-three or more days during the taxable year of the trust. If the first or last taxable year of the trust (including the year of the foreign grantor's death) is less than one hundred eighty-three days, the grantor is treated as having a power to revest, causing him to be treated as the owner for income tax purposes, only if the grantor has such power for each day of the first or last taxable year.clix Certain revocable trusts in existence on September 1995 are grandfathered.clx

2. Certain Trusts That May Distribute Only to Grantor or Grantor's Spouse. A foreign grantor may be treated as owner of a trust for income tax purposes if, at all times dur-ing the lifetime of the grantor, the income or principal of the trust are distributable only to the grantor or the grantor's spouse.clxi Payment of amounts that are nongratuitous transfersclxii are not amounts that are deemed to be distributable. In other words, if the foreign person did not fund the trust, he cannot be treated as a grantor. In addition, an accommodation party cannot be a grantor.clxiii A trust (or portion of a trust) that distributes amounts in discharge of the legal obliga-tion of the grantor or the grantor's spouse does not cause the foreign grantor to fail to be treated as the owner for income tax purposes.clxiv A legal obligation is defined as one that is enforceable under the local law of the jurisdiction in which the grantor (or the spouse of the grantor) re-sides.clxv An obligation to a person who is a related personclxvi (other than an individual who is legally separated from the grantor under a decree of divorce or of separate maintenance) is not a legal obligation, unless it is contracted bona fide and for adequate and full consideration in money and money's worth.clxvii However, amounts that are distributable from the trust (or a por-tion thereof) to support the following are considered a legal obligation: (i) an individual is treated as a dependent of the grantor or the grantor's spouse under I.R.C. §§ 152(a)(1)-(9), without re-gard to the requirement that over half of the individual's support be received from the grantor or the grantor's spouse, and the person is permanently and totally disabled within the meaning of I.R.C. § 22(e)(3) or is less than nineteen years old;clxviii and (ii) the fact that amounts may become distributable from a trust (or a portion of the trust) in discharge of a potential obligation under lo-cal law to support an individual (other than an individual who is a dependent or permanently and totally disabled under Treas. Reg. § 1.672(f)-3(b)(2)(ii)(B)(1)) is disregarded if such potential obligation is not reasonably expected to arise under the facts and circumstances.clxix Certain I.R.C. § 677 trusts in existence on September 1995 are grandfathered.clxx

3. Compensatory Trusts. A foreign person can be treated as owner of certain compensatory trusts for income tax pur-poses.clxxi

4. Trusts Settled by Certain Foreign Corporations. I.R.C. § 672(f)(3) provides that the rules of I.R.C. § 672(f)(1) do not apply to a controlled for-eign corporation or a passive foreign investment company. The Treas. Regs. expand these rules to include foreign personal holding companies. These provisions prevent such corporations from forming foreign trusts in order to avoid U.S. tax, and provide that such entities are treated as a domestic corporation for purposes of applying the general rule of Treas. Reg. § 1.672(f)-1.clxxii


5. An Accommodation Party is Not a Grantor. If a person creates or funds a trust for another, both persons are treated as grantors for income tax purposes.clxxiii However, a person who creates a trust but makes no gratuitous transfer to the trust is not treated as the owner of any portion of the trust under I.R.C. §§ 671-677 or 679.clxxiv In addition, a person who funds a trust with an amount that is directly repaid to such person within a reasonable period of time, and makes no other transfers to the trust that constitute gratuitous transfers, is not treated as owner of any portion of the trust for income tax purposes under I.R.C. §§ 671-677 or 679.clxxv

6. Foreign Person with Right to Withdraw–Not a Grantor. A foreign person who is given an unrestricted power to withdraw any amount contributed to a foreign trust established and funded by a U.S. person is treated as an owner of the trust under I.R.C. § 678 due to the withdrawal power. However, the foreign person is not a grantor clxxvi of the foreign trust since the foreign person neither settled the foreign trust nor made a gratuitous transfer to the trust.clxxvii

7. Special Rule Where Grantor is Foreign Person. If a foreign person would be treated as the owner of any portion of a trust under one of the three exceptionsclxxviii and such a trust has a U.S. beneficiary, such beneficiary is treated as the grantor of such portion to the extent the beneficiary makes transfers of property, directly or indirectly, (other than sales for full and adequate consideration) to such foreign person, to the extent the yearly value of the transfer is a taxable gift under I.R.C. § 2503(b).clxxix

8. Recharacterization of Purported Gifts. A purported gift or bequest is defined as any transfer of property by a partnership or foreign corporation other than a transfer for fair market value (within the meaning of Treas. Reg. § 1.671-2(e)(2)(ii)) to a person who is not a partner in the partnership or a shareholder of the for-eign corporation (or to a person who is a partner in the partnership or a shareholder of the foreign corporation, if the amount transferred is inconsistent with the partner's interest in the partnership or the shareholder's interest in the corporation).clxxx In the case of any transfer, directly or indi-rectly, from a partnership or foreign corporation that the transferor treats as a gift, the Secretary may recharacterize such transfer as the Secretary determines to be appropriate to prevent the avoidance of taxation to a U.S. person.clxxxi Prior to this provision, the transfer of funds from a foreign corporation or foreign partnership to a U.S. donee was treated as a gift. Now, this receipt of corporate or partnership funds is treated as income to a U.S. doneeclxxxii unless it comes within one of the exceptions set forth under Treas. Reg. § 1.672(f)-4(b): (i) the U.S. donee establishes that a U.S. citizen or resident alien treated the purported gift for U.S. tax purposes as a distribu-tion from the partnership or corporation and as a subsequent gift or bequest to the U.S. donee; or (ii) the nonresident alien who directly or indirectly holds an interest in the partnership or foreign corporation treats and reports the purported gift or bequest under the tax laws of the nonresident alien individual's country of residence as a distribution to such individual and a subsequent gift or bequest to a U.S. donee, and the U.S. donee complies with the reporting requirements of I.R.C. § 6039F, if applicable.clxxxiii In addition, the purported gift or bequest from a domestic


partnership is not recharacterized as income if the U.S. donee can establish that all beneficial owners (within the meaning of Treas. Reg. § 1.1441-1(c)(6)) of the partnership are U.S. citizens, residents or domestic corporations.clxxxiv Also, a purported gift or bequest is not recharacterized to the extent that a U.S. corporate donee can establish that the purported gift or bequest is treated, for U.S. tax purposes, as a contribution to the capital under I.R.C. § 118.clxxxv Also, certain chari-table transfers and certain transfers from trusts to which a partnership or foreign corporation has made a gratuitous transfer will not be recharacterized as purported gifts.clxxxvi

F. Consequences of Not Filing Foreign Non-Grantor Trust Beneficiary State-ment. Failure to attach a Foreign Non-grantor Trust Beneficiary Statement or to provide adequate records of the foreign trust, results in subjecting the distribution received by the U.S. beneficiary to the tax on accumulation distributions (throwback rules),clxxxvii which is an extremely compli-cated and confiscatory tax on accumulations, and also subjects distributions to an interest charge (imposed at the tax rate for underpayments of income tax) on accumulation distributions from the foreign trust.clxxxviii Partial avoidance of this severe treatment may be available if the U.S. beneficiary treats a portion of the distribution received as a distribution of current taxable in-come, based on the average distribution from the trust to the U.S. beneficiary over the three most recently elapsed taxable years.clxxxix The excess over the average is treated as an accumulation distribution and is subject to the accumulated throwback tax and the interest charge, as stated above.cxc This partial default treatment is not affected by the calculation of distributable net in-come of the trust.cxci The method of calculation and the interest factors permitting the taxpayer to make the calculations required by these rules are included in Form 3520, Part III, Distributions to a U.S. Person From a Foreign Trust During the Current Tax Year, Schedule A–Default Calcula-tion of Trust Distributions, Schedule B–Actual Calculation of Trust Distributions, and Schedule C–Calculation of Interest Charge. If the beneficiary receives a Foreign Non-grantor Trust Bene-ficiary Statement, he completes either Part III, Schedule A–Default Calculation of Trust Distri-butions (Lines 31-38) of Form 3520, or Part III, Schedule B–Actual Calculation of Trust Distri-butions (Lines 39-47); however, if the beneficiary does not receive a Foreign Non-grantor Trust Beneficiary Statement, he completes Part III, Schedule A–Default Calculation of Trust Distribu-tions (Lines 31-38). Once Schedule A is completed by a U.S. beneficiary in any tax year, that beneficiary is required to continue to complete for all future years, whether or not that benefi-ciary can answer affirmatively to Line 30 of Form 3520 for all future years.cxcii The only excep-tion to this requirement to report on Schedule A in future years is that Schedule B may be used in the year that a trust terminates, if Line 30 is answered affirmatively.cxciii

G. Foreign Trust Treated as Having a U.S. Beneficiary. A foreign trust shall be treated as having a U.S. beneficiary for a taxable year unless: (i) under the terms of the trust, no part of the income or corpus may be paid or accumulated during the tax-able year to or for the benefit of a U.S. person; and (ii) if the trust were terminated at any time during the taxable year, no part of the income or corpus can be paid to or for the benefit of a U.S. person.cxciv The Treas. Regs. under I.R.C. § 679 ignore the existence of I.R.C. § 679(b) by stating that a foreign trust states that it will not terminate until the year following the settlor's death, and only then make a distribution to a U.S. person, has a U.S. beneficiary because principal may be


held for future distribution to a future U.S. beneficiary, causing the foreign trust to have a U.S. beneficiary.cxcv For purposes of determining whether a U.S. beneficiary exists, in accordance with the foregoing, attribution of ownership rules apply: (i) in the case of a foreign corporation, if it is a controlled foreign corporation as defined in I.R.C. § 957(a);cxcvi (ii) in the case of a for-eign partnership, a U.S. person is a partner of such partnership;cxcvii or (iii) in the case of a foreign trust or estate, such trust or estate has a U.S. beneficiary (as defined by I.R.C. § 679(c)(1)(A) and (B)).cxcviii If a foreign person transfers property to a foreign trust more than five years before be-coming a U.S. person, such beneficiary is not classified as a U.S. beneficiary.cxcix

H. Foreign Trust Acquiring a U.S. Beneficiary. If a transfer of foreign trust assets occurs in a year where there is a U.S. beneficiary and the trust, for the immediately preceding taxable year, would have been taxed as a grantor trust except there was no U.S. beneficiary, then the transferor shall be treated as having income for the tax-able year equal to the undistributed net income at the close of the immediately preceding taxable year.cc The amount of the additional income is equal to the undistributed net income of the trust, as defined in I.R.C. § 665(a), at the end of the U.S. transferor's immediately preceding taxable year and is subject to the rules of I.R.C. § 658, providing for an interest charge on accumulation distributions from foreign trusts.cci

VII. Planning for a Foreign Non-Grantor Trust at the Death of the Grantor of a Foreign Trust. A tax-neutral foreign grantor trust used as an asset protection vehicle and to provide access to attractive international investing opportunities becomes a foreign non-grantor trust on the death of the settlor. Through proper drafting of the testamentary provisions and with appropriate plan-ning, a foreign non-grantor trust can be structured so that capital gains taxes and ordinary in-come taxes derived from non-U.S. source investments may be substantially reduced for U.S. beneficiaries. Such planning, if implemented with a dynasty trust (one that is exempt from es-tate and generation-skipping transfer taxes) may result in a significant accumulation of wealth.ccii

By navigating the complex rules and reporting requirements regarding distributions from foreign non-grantor trusts, the foreign non-grantor trust provides an important vehicle for tax efficient multi-generational retention and growth of wealth.

A. Asset Protection Trust. The general offshore asset protection trust is classified, for U.S. income tax purposes, as a "grantor" trust. This trust is also referred to, for tax purposes, as a foreign grantor trust.

A grantor is a person to the extent such person either creates a trust, or directly or indirectly makes a gratuitous transfer of property to a trust.cciii In the event a person creates or funds a trust on behalf of another person, both persons are treated as grantors of the trust.cciv

B. Gratuitous Transfer. A gratuitous transfer is any transfer other than a transfer for fair market value. ccv A transfer of property to a trust may be considered a gratuitous transfer, whether or not the transfer is a gift for


gift tax purposes.ccvi A transfer is for fair market value only to the extent of the value of the prop-erty received, services rendered, or the right to use property of the trust.ccvii

C. Nongratuitous Transfer. A person who makes a nongratuitous transfer to a trust he settled is not treated as the owner of any portion of the trust under I.R.C. §§ 671-677 or 679.ccviii A nongratuitous transfer to a foreign trust by a U.S. person must be reported on form 3520.ccix A gratuitous transfer to a trust does not include a distribution to a trust, with respect to an interest held by such trust in certain described trusts,ccx or an entity (such as a distribution to a trust by a corporation with respect to stock in a transaction described under I.R.C. § 301).ccxi If a trust makes a gratuitous transfer to another trust, the grantor of the transferor trust is treated as the grantor of the transferee trust.ccxii How-ever, if the transferor trust grants a general power of appointment to another person who, in fact, exercises the power in favor of another trust, the power holder is treated as the grantor of the transferee trust.ccxiii

D. Tax Treatment of a Foreign Grantor Trust. A foreign grantor trust is a foreign trust that is funded by direct or indirect transfers of property by a U.S. person or persons, which trust includes one or more U.S. beneficiaries. This trust is treated as a so-called grantor trust (a tax neutral trust) and all trust income, gains and losses are passed through to the grantor.ccxiv The IRS defines a grantor trust as "any trust to the extent that the assets of the trust are treated as owned by a person other than the trust," ccxv meaning that the trust is tax-neutral.

E. Transfers of Property to a Foreign Grantor Trust. Except as may be provided in Treas. Regs., the transfer of appreciated property by a U.S. per -son who is treated as the owner, for tax purposes, to a foreign grantor trust is not subject to any recognition of gain.ccxvi

F. Tax Treatment at Death of the Grantor of a Foreign Grantor Trust.ccxvii Treas. Regs. under I.R.C. § 684 provide an exception from gain recognition for transfers by a U.S. person to a foreign trust at death if one condition is met.ccxviii At the death of the U.S. transferor, the basis of the property in the hands of the foreign trust must be determined under I.R.C. § 1014(a). This condition is met for a foreign grantor trust. At the death of the settlor, the foreign trust becomes a foreign non-grantor trust because the settlor, who is treated as the owner and taxed on the trust income, is now deceased.

G. Foreign Non-Grantor Trust–Tax Treatment. The taxable income of a foreign non-grantor trust is calculated similar to the taxable income of an individual with certain modifications.ccxix A foreign non-grantor trust is generally treated as an individual who is a nonresident of the U.S. and is not present in the U.S. at any time. ccxx How-ever, foreign non-grantor trusts are also subject to the withholding tax.ccxxi The withholding tax can be avoided by structuring the investments to qualify as "portfolio interest" or "portfolio debt" under the I.R.C.ccxxii These debt obligations may be in either bearer or registered form and can pay interest free of the 30% withholding tax.ccxxiii In addition, a foreign non-grantor trust is sub-


ject to U.S. taxation on: (i) gross income that is effectively connected with a trade or business within the U.S.;ccxxiv and (ii) U.S. source fixed or determinable annual or periodic income (pas-sive income), such as interest, dividends, rents and annuities.ccxxv

H. Taxation of Distributions to U.S. Beneficiaries of a Foreign Non-Grantor Trust. For a particular year, a U.S. beneficiary of a foreign non-grantor trust must include in income: (i) the trust income that is required to be distributed from a simple trust to the extent of the bene-ficiary's share of the distributable net income for the year;ccxxvi (ii) the amount of income required to be distributed from a complex trust to the extent of the beneficiary's share of distributable net income for the year;ccxxvii and (iii) other amounts required to be distributed (whether distributed or not) or actual distributions to the beneficiary from a foreign complex trust, to the extent of the beneficiary's share of distributable net income for such year.ccxxviii

I. Taxation of Accumulation Distributions—Prior Law. Prior to January 1, 1996, U.S. beneficiaries of a foreign non-grantor trust were taxed on their re-spective shares of trust income that was required to be distributed, as well as other trust income that was paid, credited, or distributed to them. Under the accumulation distribution rules (distri-bution from the trust in excess of the distributable net income for the tax year), a distribution of previously accumulated income generally was taxed at the U.S. beneficiary's average marginal rate for the prior five years, plus a six percent annual rate of interest, with no compounding.

J. Taxation of Accumulation Distributions—Current Law. Beginning January 1, 1996, the interest rate applicable to accumulation distributionsccxxix from a foreign non-grantor trust is the interest rate applicable to underpayments of tax under I.R.C. § 6621(a)(2),ccxxx with daily compounding.ccxxxi Interest is determined for a period beginning on the date that is the "applicable number of years" before the date of the distribution and that ends on the date of the distribution.ccxxxii The "applicable number of years" is a weighted average deter-mined by dividing the sum of the "products" with respect to each "undistributed income year" by the aggregate undistributed net income.ccxxxiii For each year in which all income is not distributed, the "product" is determined by the undistributed net income for that yearccxxxiv and the sum of the number of tax years between that year and the tax year of the distribution (counting in each case the undistributed income year but not counting the tax year of the distribution).ccxxxv The term "undistributed income year" means any earlier tax year of the trust for which there is undis-tributed net income, other than a tax year during all of which the beneficiary receiving the distri -bution is not a citizen or resident of the U.S.ccxxxvi

K. Undistributed Net Income. Undistributed net income limits the amount of an accumulation distribution that is subject to in-come taxation. No tax is imposed on accumulation distributions from a foreign non-grantor trust that has no undistributed net income. The undistributed net income for any particular year of a ccxxiv I.R.C. § 872(a).ccxxv

? I.R.C. § 871(a)(1)(A).©J. Richard Duke 2006 All rights reserved

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trust is equal to the amount that the distributable net income of the trust for such year exceeds the sum of: (i) the amount of trust accounting income required to be distributed in such year; (ii) amount of income properly paid or credited or required to be distributed for such year; and (iii) the amount of any taxes imposed on the trust that are attributable to the distributable net income of the trust for the year.ccxxxvii

Undistributed net income for a particular year of a trust is reduced by accumulat-ing distributions made in later years to the extent such distributions are deemed to have been made under I.R.C. § 666(a).ccxxxviii A distribution paid or used for charitable purposes in accor-dance with the provisions of I.R.C. § 642(c) is not treated as an accumulation distribution.ccxxxix

Thus, such distributions do not reduce undistributed net income.

L. Reporting Distributions from a Foreign Non-Grantor Trust. Except as provided by Treas. Regs., a distribution from a foreign trust includes any gratuitous transfer of money or other property, whether or not the trust is owned by another person and whether or not that person is U.S. or foreign.ccxl Distributions include: (i) loans; (ii) gifts; (iii) be-quests; and (iv) distributions of income or corpus.ccxli A distribution is reportable by a beneficiary whether actually or constructively received. For example, credit card charges paid by the foreign trust that are guaranteed or secured by the assets of the foreign trust are treated as distribu-tions.ccxlii Furthermore, if payment is received by a U.S. person from a foreign trust in exchange for property transferred to the trust or services rendered to the trust, and the fair market value of the payment received exceeds the fair market value of the property transferred or services ren-dered, the excess is treated as a distribution.ccxliii

A U.S. beneficiary who receives a distribution from a foreign non-grantor trust is required to complete Form 3520, Part III–Distributions to a U.S. Person From a Foreign Trust During the Current Tax Year. If the beneficiary receives a Foreign Non-grantor Trust Benefi-ciary Statement, he completes either Schedule A–Default Calculation of Trust Distributions (Lines 31-38) of Form 3520, or Schedule B–Actual Calculation of Trust Distributions (Lines 39-47). In addition, a Foreign Non-grantor Trust Beneficiary Statement (no prescribed form) must include six items:ccxliv (i) the first and last day of the taxable year of the foreign trust to which the statement applies; (ii) an explanation of the appropriate U.S. tax treatment of any distribution or deemed distribution for U.S. tax purposes, or sufficient information to enable the U.S. benefi-ciary to establish the appropriate treatment of any distribution or deemed distribution for U.S. tax purposes; (iii) a statement identifying whether the owner of the trust is a partnership or a foreign corporation; (iv) a statement that the trust will permit either the IRS or the U.S. beneficiary to in-spect and copy the trust's permanent books of account, records, and such other documents that are necessary to establish that the trust should be treated for U.S. tax purposes as owned by an-other person (the statement is not necessary if the trust has appointed a U.S. agent); (v) a descrip-tion of property (including cash) distributed or deemed distributed to the U.S. person during the taxable year and the fair market value of the property distributed; and (vi) a statement as to whether the foreign trust has appointed a U.S. agent. If the trust has a U.S. agent, the name, ad-dress, and taxpayer identification number of the agent must be included.


M. Accumulation Distribution. An accumulation distribution is a distribution under I.R.C. § 661(a)(2)ccxlv to the extent such dis-tribution exceeds the distributable net income of the trust for the year, reduced by trust account-ing income but not below zero, required to be distributed currently.ccxlvi

Two exceptions to the foregoing definition of an accumulation distribution are ap-plicable to distributions from foreign non-grantor trusts. The first is for distributions that do not exceed trust accounting income in the year in which distributions are made.ccxlvii The second ex-ception is for a gift of a specific sum of money or specific property described in I.R.C. § 663(a)(1), as discussed in detail below.

N. Calculating an Accumulation Distribution under the Default Method. Failure to attach a Foreign Non-grantor Trust Beneficiary Statement requires a U.S. beneficiary to use the "default" method of making the determination of whether or not an accumulation dis-tribution has been received.ccxlviii The default calculation with respect to trust distributions is de-termined as follows:

Step 1 – Line 31: enter the total distributions received during the current tax year (Line 27);

Step 2 – Line 32: list the number of years that the trust has been a non-grantor trust;

Step 3 – Line 33: enter the total distributions received from the foreign trust during the 3 preceding tax years (or number of years the trust has been a non-grantor trust, if fewer than 3);

Step 4 – Line 34: multiply Line 33 by 1.2;

Step 5 – Line 35: this line provides the average distribution by dividing Line 34 by 3 (or the number of years the trust has been a non-grantor trust, if fewer than 3);

Step 6 – Line 36: enter the smaller of Line 31 or Line 35 to determine the amount treated as ordinary income earned in the current year;

Step 7 – Line 37: subtract Line 36 from Line 31 to determine the amount treated as an accumulation distribution. If the number is zero or less, enter zero (and do not complete the remainder of Part III); and

Step 8 – Line 38: compute the applicable number of years of the trust by dividing Line 32 by 2 (but not entered if Line 37 is zero or less).


Once Schedule A under Part III of Form 3520 is completed by a U.S. beneficiary in any tax year, that beneficiary is required to continue to complete Schedule A for all future years, whether or not that beneficiary can answer affirmatively to Line 30 of Form 3520 for all future years.ccxlix The only exception to this requirement to report on Schedule A in future years is that Schedule B may be used in the year that a trust terminates, if Line 30 is answered affirma-tively.ccl

O. Throwback Tax on an Accumulation Distribution. Form 4970 (Tax on Accumulation Distribution of Trusts) is required to be completed in order to enter the calculation of the tax on the total of any accumulation distribution.ccli The comple-tion of Form 4970 results in penalizing recipients who receive accumulated distributions from foreign trusts. Where applicable, the Form 4970 is required to be attached to the Form 3520cclii

and is required to be filed with the beneficiary's tax return.ccliii A separate Form 4970 is prepared for each foreign trust in which the U.S. beneficiary receives an accumulation distribution during the particular tax year.ccliv

P. The Throwback Rule. The purpose of the throwback rule is to impose, on beneficiaries receiving distributions of accu-mulated income from a foreign trust, approximately the same income taxes that the beneficiaries would have paid if the trust distributed its income currently.

1. Computation of a Partial Tax on an Accumulation Distribution. The computation of a partial tax on an accumulation distribution under the throwback rule is determined in five steps. Once this is determined, an interest charge is added. Those five steps are as follows:

Step 1 – The number of preceding taxable years of the trust to which the distribution is attributable (thrown back) is determined.cclv The amount be-ing distributed and required to be included in income is then divided by this number of preceding taxable years.cclvi The distribution is attributable to the years that are the earliest years of the trust in which the trust had undistributed net income.cclvii

Step 2 – The average accumulation distribution is then added to a three-year base period that is determined from the five taxable years immedi-ately preceding the distribution, ignoring the highest and lowest taxable income.cclviii

Step 3 – The average annual accumulation is determined by dividing the total accumulation distribution, which includes taxes paid by the trust on the distribution (such as foreign taxes), by the number of years in which the distributions were accumulated. To the taxable income for each of these three years, the beneficiary adds the average accumulation distribu-


tion.cclix The taxable income of the beneficiary includes any amounts added to taxable income from prior accumulation distributions.cclx

Step 4 – The average additional tax for this three-year base period is then computed and multiplied by the number of years making up the throwback period.cclxi

Step 5 – The tax on the accumulation distribution is computed by multi-plying the average of the annual additional tax by the numbers of years of accumulation, and subtracting the credit for the taxes paid by the trust on the distribution.cclxii The beneficiary of an accumulation distribution re-ceives a credit for any taxes (such as foreign taxes) paid by the trust. Thus, the amount of these taxes must first be applied to the accumulation distribution and then credited against the taxes of the beneficiary. This rule applies to both foreign and domestic taxes paid by the foreign trust to the extent they are allocable to the undistributed net income and net capital gains or losses.cclxiii

2. Where Accumulation Distribution Exceeds Undistributed Net Income. If the accumulation distribution exceeds the undistributed net income of the trust for a taxable year, the excess is thrown back to the earliest of the proceeding taxable years of the trust for which there was undistributed net income.cclxiv The excess is then applied in the earliest year and moved forward, until exhausted, to each succeeding year in which the trust had undistributed net income.

Q. Specific Gifts. A distribution in satisfaction of a gift of a specific sum of money or of specific property, de-scribed in I.R.C. § 663(a)(1), is not an accumulation distribution.cclxv In addition, distributions that meet the requirements of IRC § 663(a)(1) are not deductible to the trust under IRC §661 and are not taxable to the beneficiary under IRC § 662.

1. Instrument is Required to Provide for a Transfer of a Specific Sum of Money or Specific Property. A trust instrument (or will) must provide for a gift or bequest of a specific sum of money or specific property to qualify under I.R.C. § 663(a)(1). The specific sum of money or specific property must be ascertainable under the terms of an irrevocable trust instrument at the inception of the trust.cclxvi A foreign non-grantor trust is settled as an irrevocable trust in order to provide asset protection benefits to the settlor. If a settlor retains the right to terminate a foreign non-grantor trust, a U.S. court can order the settlor to terminate said trust. Thus, the specific sum of money or specific property must be ascertainable under the terms of a foreign grantor trust at its inception. An amount that can be paid or credited only from the income of the trust is not a spe-cific sum of money or property that is determined at the inception of the trust.cclxvii

2. Examples of Specific Sums of Money or Specific Property©J. Richard Duke 2006 All rights reserved

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. The following are examples of specific sums of money or specific property that are ascertain-able under the terms of a trust at its inception:

(i) An irrevocable trust providing that $100,000 is distributed to a beneficiary when he attains age twenty-five (25) is a specific sum of money ascertainable under the terms of the trust at its inception.

(ii) An irrevocable trust that provides that upon the death of the settlor, a dis-tribution equal to $1 million is to be made to a beneficiary, with the trustee having the discretion to select the assets, is a gift of a specific sum of money that is ascertainable under the terms of the trust at its inception, even though the distribution can be made in cash or in kind.cclxviii

3. Examples That Are Not Specific Sums of Money or Specific Property. The following are examples that are not specific sums of money or specific property that can be ascertainable under the terms of the trust at its inception:

(i) An irrevocable trust providing that at the death of the settlor, a residuary portion of the trust assets that is payable to one or more beneficiaries is not a gift of specific property that is ascertainable under the terms of the trust at its inception.cclxix

(ii) An irrevocable trust providing, at the death of the settlor, that one-half of the principal of the trust is payable upon a beneficiary attaining age twenty-five (25), is not a gift of specific property that is ascertainable under the terms of the trust at its inception.

R. Three Installment Rule. A trust instrument that requires a specific sum or property to be paid or credited in more than three installments does not qualify under I.R.C. § 663(a)(1).cclxx A gift from the trust instrument that is subject to a condition precedent may qualify under I.R.C. § 663(a)(1) if the condition is in fact met so that the gift is properly paid.cclxxi For example, a distribution of $100,000, payable one-half when the beneficiary attains age twenty-five and the remaining at age thirty-five, quali-fies as paid in no more than three installments.

1. Income Earned by Specific Bequest Not Qualified. A distribution of income earned by a specific bequest does not qualify under I.R.C. § 663(a)(1) and, thus, is a deductible distribution by the trust under I.R.C. § 661.

2. Difficult for Trust Distributions to Qualify. In summary, it is difficult for trusts to qualify its distributions under I.R.C. § 663(A)(1).

3. Distributions from Trusts That Qualify.

With respect to trusts, few, if any, distributions will qualify under §663(a)(1). The only distributions that will qualify are those required to be paid


or credited in a specific amount or with specific property, in no more than three installments. Mandatory or discretionary distributions of current or accumulated trust income will not qualify. Discretionary distributions of principal, such as for the beneficiary's health or education, will not qualify as specific sums required to be distributed in no more than three install-ments. Annuity payments to be made out of income or principal for the life of a beneficiary will not qualify. Distributions of a percentage of prin-cipal at various ages will not qualify as bequests of specific property un-less the principal is required to be invested in specific property and all or a specified percentage of that property unless the principal is required to be invested in specific property and all or a specified percentage of that prop-erty is required to be distributed in no more than three installments. The final required trust distribution should not qualify because such distribu-tion usually is not of specific property, but of the remaining principal, as it then exists.cclxxii

S. Avoiding the Throwback Rule and Interest Charge. The foreign non-grantor trust involves testamentary planning, to preserve and protect the wealth in a foreign trust for the benefit of the beneficiaries, at the death of the settlor of the foreign grantor trust. This planning involves proper testamentary drafting of the trust instrument as well as educating the foreign trustee, the investment manager or managers and the trust protector.

1. A Number of Planning Possibilities. Through the use of a foreign non-grantor trust, after the death of the settlor of a foreign grantor trust, wealth may be preserved, increased and protected for the benefit of U.S. beneficiaries. A number of planning possibilities with respect to a foreign non-grantor trust are available.

2. Distribution of Yearly Net Income. The tax on accumulation distributions and the interest charge may be avoided by distributing the current net income of a foreign non-grantor trust to U.S. beneficiaries each taxable year.

3. Distribution of Specific Sum of Money or Property. The trust instrument can be drafted so that, at its inception, it provides for a specific sum of money or specific property to be paid or credited once or in not more than three installments so that distributable net income is not carried out of the foreign non-grantor trust. Such distribu-tions are not subject to income taxation to the U.S. beneficiaries. The provisions of the foreign non-grantor trust may provide that these distributions, under the three-year installment rule, can be paid to individual beneficiaries or to domestic trusts established on behalf of beneficiaries. Domestic trusts can be established as recipients of such distributions from a foreign non-grantor trust in order to provide asset protection benefits to those U.S. beneficiaries of the domestic trust or trusts.

4. Trustee May Acquire Growth Assets that Pay Little Income or Divi-dends


. The trustee of a foreign non-grantor trust may purchase securities or bonds that pay little or no dividend or interest income but appreciate in value. Upon the sale of those appreciated assets, the trustee can distributed those gains in the year of the sale so that those gains will be reported by the beneficiaries as long-term capital gains.

5. Acquire Foreign Variable Life Insurance on Lives of Beneficiaries. The trustee of the foreign non-grantor trust may acquire foreign variable life insurance on the life or lives of the beneficiary or beneficiaries.cclxxiii A tax compliantcclxxiv foreign variable life in-surance policy permits investments of the policy to grow tax-free during the insured's lifetime. And, upon the death of the insured, the insurance proceeds pass without income taxation.cclxxv

6. Dynasty Trust and Generation-Skipping Transfer Tax Planning. A "dynasty trust" may be established pursuant to the testamentary provisions if the governing law of the trust is in a jurisdiction that has abolished or extended the Rule against Perpetuities.

a. Choosing Jurisdiction that Abolished the Rule Against Perpe-tuities. If the Rule against Perpetuities is abolished under the governing law, then the dynasty trust may continue until the end of the age.

b. GST Exemption. A dynasty trust is a trust that is subject to the election to avoid U.S. generation-skipping transfer ("GST") taxes. A dynasty trust is also referred to as a GST exempt trust. The GST tax in 2005 is imposed at the rate of 47% on GSTs in excess of the amount of the deduction from tax by the transferor's GST tax exemption.cclxxvi Each transferor has a GST exemption of $2 million.cclxxvii

7. Implementing the Planning Concepts. The following describes some of the planning possibilities with respect to avoiding the accumu-lation distribution and throw back rules for testamentary foreign non-grantor trusts.

a. GST Planning. The foreign trust may be drafted so that at the death of the settlor, a GST exempt trust is funded with exempt property.cclxxviii This exempt trust, or dynasty trust, permits distributions, after the death of the settlor (and the settlor's spouse, if married) to the settlor's children, grandchildren or other lineal descendants, without GST income taxation on distributions and without GST taxa-tion on the continuation of the GST exempt trust as each level of descendants—children, grand-children, etc.—die. The GST exempt trust, however, like any foreign non-grantor trust, is sub-ject to the accumulation distribution rules; therefore, it is recommended that this trust distribute all current net income annually in order to avoid the accumulation distribution rules. See Exhibit A.

b. Acquiring Life Insurance from the GST Exempt Trust. The trustee, however, may acquire offshore variable life insurance on the life or lives of a bene-ficiary or beneficiaries with a part of the GST exempt trust assets. See Exhibit B. The internal


build up in a U.S. tax compliant policy is not subject to U.S. income taxation, including taxation under the so-called accumulation distribution rules. In addition, because the insurance proceeds are payable to the foreign trustee of a foreign non-grantor trust, the insurance proceeds are not subject to income taxation under I.R.C. § 684.cclxxix The trustee of a GST exempt trust may ac-quire the policy or policies directly as the applicant, owner and beneficiary, or may form another trust or even a limited liability company so that the additional trust or limited liability company is the applicant, owner and beneficiary or the policy or policies. Upon the death of a beneficiary, the insurance proceeds pass into the GST exempt trust or to the trust or partnership created by the trustee of the GST exempt trust, free of income, estate and GST taxation.

c. Remainder Distributed Under the Three Installment Rule. Irrespective whether the GST exempt trust acquires insurance, a portion of the remainder of the property in the trust can be distributed under the three installment rule of I.R.C. § 663(a)(1) in or-der to avoid the accumulation distribution rules. Additional property is placed in a nonexempt trust that is subject to the GST taxes; however, by giving the beneficiaries of the GST nonexempt trust a general power of appointment, the GST taxes are avoided causing, instead, estate taxation to apply. Flexibility can be provided with respect to the inclusion or exclusion of a general power of appointment by granting the trustee the power to create or eliminate a general power of appointment for a beneficiary. The general power of appointment may be restricted to permit ex-ercise only with the consent of a non-adverse party if complete control of the beneficiary is unde-sirable. Whether the GST or estate tax is the better choice depends on the facts in each case. For a large trust, it is generally preferable to subject the beneficiary trust to estate taxation because deductions and credits are available to reduce estate tax rates, but are not available to reduce the GST rates.

d. Nonexempt Trust Planning. Another planning possibility is for the trustee of the GST nonexempt trust to acquire life insur-ance on the life or lives of the beneficiary or beneficiaries. See Exhibit C. In this planning, the trustee distributes all net income from the GST exempt trust, distributes the property under the three installment rule for specified property, specifically stated in the trust instrument, and ac-quires variable life insurance with respect to part or all of the GST nonexempt trust. As stated above, by giving the beneficiaries of the GST nonexempt trust a general power of appointment, this trust is not subject to the GST tax but is subject to the estate tax. The payment of premiums from GST nonexempt trust assets reduces the principal of the trust and the amount of income tax to the beneficiaries, as well as avoiding the taxation of accumulation distributions under the throw back rule. At death, however, the life insurance proceeds on the life of a beneficiary, as well as the trust assets allocable to a beneficiary, are subject to estate taxation, or GST taxation if the beneficiary is not given a general power of appointment. Notwithstanding the estate taxation, income taxes to the beneficiaries are avoided during the lifetime of a beneficiary or beneficiaries.

8. Proper Drafting to Implement the Foregoing Planning. The trust instrument, at its inception, must be properly drafted in order to provide flexibility to the trustee in implementing the foregoing planning possibilities.


a. Designate Specific Property to be Distributed Under the Three Installment Rule. In order to avoid income taxation upon the distribution of property, the specific property must be designated under the three installment rule.cclxxx

b. Establishing a Testamentary GST Exempt Trust. It is recommended that the provisions of the foreign trust include the establishment of a GST exempt trust and a GST nonexempt trust, or provide an election to the trustee to establish a GST exempt trust after the death of the settlor. The following are provisions authorizing the trustee to establish a GST exempt trust:

c. Interests Regarding GST Tax. Notwithstanding any other provision of this instrument:

(i) Elections Regarding GSTs. The Trustee shall have the power, exercisable without court approval, to allocate any federal exemption from the federal GST tax to any property with respect to which Settlor is the transferor for purposes of the said tax and to exclude any such property from such allocation. Settlor empowers the Trustee to (i) make such elections under the tax laws as the Trustee deems advisable, including an election to create qualified terminable inter-est property for both estate and generation-skipping tax purposes or for es-tate tax purposes alone; and (ii) to allocate the unused portion, if any, of Settlor’s GST exemption to any property with respect to which Settlor is the transferor for generation-skipping tax purposes in such manner as the Trustee deems advisable, in each case without regard to the relative inter-ests of the beneficiaries. However, Settlor’s Trustee shall not make adjust-ments between principal and income, or in the interests of the beneficia-ries, to compensate for the effects of such elections and allocation. Any decision made by the Trustee with respect to the exercise of any tax elec-tion or the allocation of Settlor’s GST exemption shall be binding and con-clusive on all persons.

(ii) Division of Trust For Allocation of GSTs. If a trust held under this instrument would otherwise be partially exempt from generation-skipping tax due to the intended allocation of a GST ex-emption to it, then, before such allocation and as of the relevant valuation date under Section 2642 of the Code with respect to such allocation, the Trustee may (but need not) divide that trust (the “original trust”) into two separate trusts of equal or unequal value which shall be identical in all other respects to the original trust, so that the allocation of GST exemption can be made to one trust which will be entirely exempt from generation-skipping tax. The two trusts created under this subclause may have the same name as the original trust except that the trust to which the GST ex-


emption is allocated shall specifically provide that it is “GST exempt” or exempt from GST. The two trusts under this subclause are sometimes re-ferred to herein as "related."

(iii) Holding Property in Separate Trust. If property which is held in, or is to be added or allocated to, a trust pur-suant to this Settlement is subject to different treatment for any reason for purposes of the generation-skipping tax under Chapter 13 of the Code than other property being added or allocated to, or also held in, that trust, then the Trustee may (but need not) hold such property instead as a separate trust that is appropriately designated to distinguish it from the trust to which the property otherwise would have been allocated, but that is identi-cal in all other respects to that trust. The identical trusts resulting from ap-plication of this subclause are also sometimes referred to herein as "re-lated."

(iv) Segregation of Property. It is Settlor’s intent that the Trustee shall not be required to administer a trust hereunder that is only partially exempt from generation-skipping taxes, or to commingle property subject to different treatment for genera-tion-skipping tax purposes, whether or not the transferors with respect to the property are assigned to different generations. The provisions of this subclause are intended to enable the Trustee to avoid such situations by empowering the Trustee to segregate trust property (i) that is entirely ex-empt from generation-skipping tax from trust property that is not exempt; or (ii) that is otherwise treated differently from other trust property for purposes of the generation-skipping tax, and the provisions of this sub-clause should be applied in a manner consistent with this intention.

(v) Avoiding Distributions Subject to GST Tax. To the extent it is consistent with the Trustee’s fiduciary obligations, the Trustee, in making discretionary distributions of net income and principal from the related trusts created after Settlor’s death, shall take advantage of the opportunities provided by the creation of such related trusts to avoid or delay generation-skipping tax when making discretionary distributions, and to maximize the amount of trust property that eventually may be dis-tributed to Settlor’s grandchildren or more remote descendants without transfer tax of any kind at the termination of all trusts created under this Settlement.

d. Providing Flexibility for Trustee to Create or Eliminate Gen-eral Power of Appointment


. The Trustee may be given the power to determine whether to include a general power of ap-pointment, to avoid GST taxation and cause estate taxation with respect to the GST nonexempt trust, or to exclude a general power of appointment and cause GST taxation. The following is language that may be included:

e. Creation by Trustee of, and Elimination of, General Power. The Trustee may, in the Trustee's discretion, with respect to all or any part of the principal of the trust (including a pecuniary amount), by an instrument filed with the trust records (a) create in any child of Settlor a general power of appointment within the meaning of § 2041 of the Code and as defined below (including a power the exercise of which requires the consent of the Trustee) to dispose of the property upon the death of a child; (b) eliminate such power for all or part of the principal as to which it was created; (c) irrevocably release the right to create or elimi-nate such power; and (d) divide the trust principal into two fractional shares based upon the por-tion that would be includable in the gross estate of any child holding such power if any child died immediately before such division (in which case the power shall be over the entire principal of one share and over no part of the other share), and each such share shall be administered as a separate trust unless the Trustee, in the discretion of the Trustee, combines such separate trusts into a single trust, which the Trustee is authorized to do. The Settlor desires (but does not direct) that a general power be kept in effect when the Trustee believes the inclusion of the affected property in any child's gross estate may achieve a significant savings in transfer taxes by having an estate tax rather than a Chapter 13 tax imposed. For purposes of this paragraph, "general power of appointment" shall mean that any child may appoint to such child's estate or to the creditors of such child's estate.

f. Provide Flexibility of Trustee to Acquire Life Insurance on the Life of the Settlor or Beneficiaries. It is recommended that the foreign trust include language authorizing the trustee to ac-quire life insurance on the life of the settlor or any beneficiary. The following is included in the foreign trust:

T. Obtaining Offshore Life Insurance.

1. Life Insurance. The Trustee may acquire, pay premiums, maintain, convert, exchange and deal with life insur-ance in respect of all or any of the trust assets or with respect to the lives of the Settlor, any Ben-eficiary, or other person who bears a reasonable relationship to the Settlor or any Beneficiary of this Settlement.

2. Provide Flexibility of Trustee to Create Trusts, Partnerships or LLCs for Beneficiaries. The trustee may want to form a partnership or limited liability company on behalf of a benefi -ciary for various reasons, including the acquisition of variable life insurance through the partner-ship or limited liability company. For example, trust assets from both the GST exempt trust and


the GST nonexempt trust may be used to acquire life insurance on the life or lives of one or more beneficiaries. The trustee of these two separate trusts can form a partnership or limited liability company permitting that entity to acquire the life insurance as applicant, owner and beneficiary. See Exhibit D.

The following are provisions to include to authorize the trustee to settle a trust or form a partnership or limited liability company for one or more beneficiaries:

a. Settle a Trust for a Beneficiary. The Trustee may settle the trust estate for one or more of the Beneficiaries. Any such settlement made for the benefit of one or more of the Beneficiaries may be to a new trust established any-where in the world and may include such trusts, powers, and provisions as determined by the Trustee, PROVIDED THAT no Excepted Person may benefit thereunder.

b. To Form a Partnership or Limited Liability Company for a Beneficiary. The Trustee may form a limited partnership, general partnership, or a limited liability company anywhere in the world for one or more of the Beneficiaries. The partnership or limited liability company may include such provisions as determined by the Trustee, PROVIDED THAT no Ex-cepted Person shall benefit thereunder.

c. Change Situs of Trust so That the GST Exempt Trust May be a Dynasty Trust. For various reasons, the Rule against Perpetuities, under the governing law of the foreign grantor trust, may not be desirable after the death of the Settlor. It is recommended that the for-eign trust include language that permits the governing law of the trust to be changed. Thus, after the death of the settlor, a jurisdiction that has abolished or extended the Rule against Perpetuities becomes the governing law. It is imperative that, upon such change, the trustee is authorized to amend the trust to comply with the law of the new governing jurisdiction. The following is lan-guage to include in the foreign trust:

d. Change of Governing Law.

(i) By Trustee. The Trustee shall have the power by deed or other written instrument from time to time and at any time to declare that this Trust shall hence-forth be governed by and take effect according to the laws of such juris-diction as may be set forth in such deed or other written instrument and thereafter the rights of all persons and the construction and effect of each and every provision hereof shall be subject to the exclusive jurisdiction of and construed only according to the laws of the said jurisdiction, the courts of which shall become the forum for the administration of this trust.


(ii) Changes to Settlement. Where the law applicable to this Trust is changed pursuant to the powers forth herein, the Trustee shall have the power by deed or other written in-strument to make such changes hereto as may be necessary to ensure its continued validity and effect pursuant to such law.

(iii) Resulting Changes. If the Trustee exercises the aforementioned power to change the law gov-erning this Settlement, it shall have power to make such alterations to this instrument as shall be requisite or desirable to ensure that the trusts, pow-ers and provisions hereof, are as valid and enforceable after such change as before.

VIII. Inbound Foreign Non-Grantor Trusts. Inbound planning includes a foreign non-grantor trust with U.S. beneficiaries; a foreign grantor trust with non-U.S. beneficiaries; or a foreign non-grantor trust with both U.S. beneficiaries and non-U.S. beneficiaries.

A. Tax Rules Regarding Foreign Non-Grantor Trusts Formed by Non-U.S. Per-sons.

1. Foreign Source Income. Generally, the foreign source income is not subject to U.S. taxation.cclxxxi

2. Passive Income. Passive investments in the U.S. result in U.S. source income that is fixed or determinable, an-nual or periodic income (FADPI) and is subject to withholding tax on nonresident aliens, irre-spective of whether a fiduciary or a beneficiary is a U.S. person.cclxxxii FADPI includes items of income such as interest, dividends, rents, royalties, salaries, wages, premiums, annuities, com-pensation, enumerations, and emoluments, as well as various miscellaneous income and certain gains.cclxxxiii FADPI income is subject to a 30% withholding tax, unless reduced by an applicable treaty.

3. Trade or Business Income. A foreign non-grantor trust is subject to a 30% withholding tax unless reduced by an applicable treatycclxxxiv if it is engaged in a trade or business in the U.S. but has no U.S. office or fixed place of business.cclxxxv In addition, under such circumstances the trust is subject to graduated U.S. tax rates on income that is effectively connected with a U.S. trade or business. Foreign trusts that are engaged in the business of trading U.S. securities and commodities will not be treated as being engaged in a trade or business, which is an exception the general rule.cclxxxvi

4. Capital Gains Tax


. If the fiduciary of a foreign non-grantor trust is present in the U.S. for 183 days or more in a calendar year subjects capital gains income, not resulting from effectively connected with a trade or business, to 30% tax, or as reduced by an applicable treaty.cclxxxvii

5. Sale of Real Estate or Personal Property. The gain from the sale of real estate or personal property is not FADPI.cclxxxviii Gain from the sale of U.S. real property is subject to special rules requiring gain from sales, exchanges or other dispositions to be taxed as income effectively connected with the conduct of U.S. trade or busi-ness.cclxxxix The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA)ccxc and Economic Recovery Tax Act of 1981 (ERTA)ccxci generally subjects foreign investors (nonresidents and for-cclxxxvii I.R.C. § 871(a)(2).

cliv I.R.C. § 672(f)(2).

clv I.R.C. §§ 665-667.

clvi I.R.C. § 668.

clvii Treas. Reg. § 1.672(f)-1(a).

cliii I.R.C. § 672(f)(1). Also, a grantor does not include a foreign person who is acting as an accommodation party for another person. Treas. Reg. § 1.671-2(e)(3).

clviii I.R.C. § 672(f)(2)(A)(i); Treas. Reg. § 1.672(f)-3(a)(1).

clix Treas. Reg. § 1.672(f)-3(a)(2).

clx Treas. Reg. § 1.672(f)-3(a)(3).

clxi I.R.C. § 672(f)(2)(A)(ii); Treas. Reg. § 1.672(f)-3(b).

clxii A gratuitous transfer is defined as any transfer other than a transfer for fair market value under Treas. Reg. § 1.671-2(e)(2).

clxiii Treas. Reg. § 1.671-2(e).

clxiv Treas. Reg. § 1.672(f)-3(b)(2)(i).

clxv Treas. Reg. § 1.672(f)-3(b)(2)(i).

clxvi Treas. Reg. § 1.643(h)-1(e).

clxvii Treas. Reg. § 1.672(f)-3(b)(2)(ii)(A).

clxviii Treas. Reg. § 1.672(f)-3(b)(2)(ii)(B)(1).

clxix Treas. Reg. § 1.672(f)-3(b)(2)(ii)(B)(2).

clxx Treas. Reg. § 1.672(f)-3(b)(2)(ii)(B)(3).


eign corporations) to taxation on gain from disposition of U.S. real estate. Gain results from the disposition of a U.S. real property interest that is defined to include the following property classi-fications: (1) interests in U.S. or Virgin Islands sitused real property; and (2) interests in domes-tic corporations characterized as U.S. real property holding corporations.ccxcii Interests in foreign corporations are excluded from the definition of U.S. real property interests.ccxciii

6. FADPI and Trade or Business Income. A foreign trust that has both FADPI and trade or business income, with a U.S. office or fixed place of business, is subject to the 30% withholding rate on the FADPI income; graduated in-come rates on its U.S. source income; and graduated U.S. income tax rates on foreign source in-clxxi I.R.C. § 672(f)(2)(B); Treas. Reg. § 1.672(f)-3(c).

clxxii Treas. Reg. § 1.672(f)-2(a). However, if one of these entities makes a gratuitous transfer to a U.S. person or if such an entity is deemed to own a foreign trust under I.R.C. § 678 and makes a gratuitous transfer to a U.S. person, the entity is treated as a foreign corporation for purposes of authorizing the IRS to recharacterize purported gifts to donees under the rules of Treas. Reg. § 1.672(f)-4(c).

clxxiii Treas. Reg. § 1.671-2(e)(6), Example 6.

clxxiv Treas. Reg. § 1.671-2(e)(1).

clxxv Treas. Reg. § 1.671-2(e)(1).

clxxvi Treas. Reg. § 1.671-2(e)(1).

clxxvii Treas. Reg. § 1.671-2(e)(6), Example 4.

clxxviii See Exceptions at I.R.C. §§ 672(f)(2)(A) and (B). In the event a U.S. beneficiary is taxed on trust income and a foreign settlor is taxed by a foreign jurisdiction, the U.S. beneficiary is allowed to use the foreign tax credit attribut -able to the foreign taxes paid by the foreign settlor. I.R.C. §§ 901(b)(5) and 665(d)(2).

clxxix Taxable gifts are present interest gifts exceeding $11,000 per donee annually. I.R.C. §§ 2001(b), 2503(a) and (b)(1).

clxxx Treas. Reg. § 1.672(f)-4(d).

clxxxi I.R.C. § 672(f)(4); Treas. Reg. § 1.672(f)-4(a).

clxxxii Treas. Reg. §§ 1.672(f)-4(a)(1) and (2).

clxxxiii I.R.C. § 6039F provides that a U.S. person shall report the receipt during any taxable year of aggregate foreign gifts exceeding $11,273, as adjusted by I.R.C. § 6039F(d). The inflation adjusted amounts are: (i) for taxable years beginning in 1997, $10,276 (Rev. proc. 96-59, 1996-53 I.R.B. 17) (ii) for taxable years beginning in 1998, $10,557 (Rev. Proc. 97-57, 1997-52 I.R.B. 20); (iii) for 1999, $10,735 (Rev. Proc. 98-61, 1998-52 I.R.B. 18); (iv) for 2000, $10,931 (Rev. Proc. 99-42, 1999-46 I.R.B. 568); (v) for 2001, $11,273 (Rev. Proc. 2001-13, 2001-3 I.R.B. 337); (vi) for 2002, $11,642 (Rev. Proc. 2001-59, 2001-52 I.R.B. 623); (vii) for 2003, $11,827 (Rev. Proc. 2002-70, 2002-46 I.R.B. 845); (viii) for 2004, $ 12,097 (Rev. Proc. 2003-85, 2003-49 I.R.B. 1184).

clxxxiv Treas. Reg. § 1.672(f)-4(b)(2).


come that is attributable to an office or a fixed place of business in the U.S.ccxciv A foreign trust that is treated as engaged in a U.S. trade or business causes the beneficiaries to be treated as be-ing engaged in that trade or business.ccxcv

7. Deductions Attributable to Effectively Connected Income. The deductions attributable to effectively connected income are allocated in accordance with complicated provisions of the I.R.C.ccxcvi

B. Planning for Non-U.S. Persons with Foreign Non-Grantor Trusts.clxxxv Treas. Reg. § 1.672(f)-4(b)(3).

clxxxvi Treas. Reg. §§ 1.672(f)-4(b)(4) and 1.672(f)-4(c).

clxxxvii I.R.C. § 668.

clxxxviii I.R.C. § 6048(c)(2).

clxxxix Instructions for Form 3520, Part III, Schedule A–Default Calculation of Trust Distributions, 7-8, regarding Lines 33, 35 and 36 (2004).

cxc Form 3520, Part III, Schedule A–Default Calculation of Trust Distributions, Line 37.

cxci I.R.C. § 643(a).

cxcii Instructions for Form 3520, Part III, Distributions to a U.S. Person From a Foreign Trust During the Current Tax Year, Schedule A–Default Calculation of Trust Distributions, 6 (2004).

cxciii Instructions for Form 3520, Part III, Distributions to a U.S. Person From a Foreign Trust During the Current Tax Year, Schedule A–Default Calculation of Trust Distributions, 6 (2004).

cxciv I.R.C. §§ 679(c)(1)(A) and (B). The instructions for Forms 3520 and 3520-A, Definitions, 4 (2004), 2 (2004), re-spectively, state that "A U.S. beneficiary includes any person that could possible benefit (directly or indirectly) from the trust (including an amended trust) at any time, whether or not the person is named in the trust instrument as a beneficiary and whether or not the person can receive a distribution from the trust in the current year.

cxcv Treas. Reg. § 1.679-2(a), Example 5.

cxcvi I.R.C. § 679(c)(2)(A).

cxcvii I.R.C. § 679(c)(2)(B).

cxcviii I.R.C. § 679(c)(2)(C).

cxcix I.R.C. § 679(c)(3); Treas. Reg. § 1.679-2(a)(3).

cc Instructions for Form 3520 and 3520-A, Definitions, 4 (2004), 2 (2004), respectively, state "A foreign trust will be treated as having a U.S. beneficiary unless the terms of the trust instrument specifically prohibit any distribution of income or corpus to a U.S. person at any time, even after the death of the U.S. transferor , and the trust cannot be amended or revised to allow such a distribution." The italicized words in the foregoing sentence indicate the posi -


1. Non-U.S. Persons Moving to the U.S. A non-U.S. person can transfer assets to a foreign trust five years or more before his residency starting date in the U.S. and is not treated as a "grantor" under I.R.C. § 679(a) and, hence, is not subject to income taxation on distributions from the trust and is not subject to the tax reporting requirements with respect to foreign trusts.ccxcvii

2. Avoiding Branch Income. A foreign non-grantor trust that is engaged in a trade or business in the U.S. but has no U.S. of-fice or fixed place of business is subject to graduated U.S. tax rates on income that is effectively

tion of the IRS with respect to the provisions of I.R.C. § 679(b). Some practitioners take the position that the subject italicized words are contrary to the meaning of I.R.C. § 679(b), using the foreign non-grantor trust as their example. If a foreign non-grantor trust is settled by a person ("grantor") which includes no U.S. beneficiaries and, at the death of the grantor, the trust specifically prohibits the designation of a U.S. beneficiary until one taxable year after the lat-ter of the death of the grantor and grantor's spouse, any accumulations of income prior to death are not subjected to income taxation under the plain meaning of I.R.C. §§ 679(b) and 672(e)(1). The Treas. Reg. under I.R.C. § 679 sup-port the foregoing position by the IRS. First, the Treas. Reg. under I.R.C. § 679 do not mention I.R.C. § 679(b), the provision primarily relied upon to ensure that a foreign non-grantor trust continues to be treated as a foreign non-grantor trust after the death of the settlor (and the settlor's spouse). Treas. Reg. § 1.679-2(a)(2) states that for pur -poses of determining whether a foreign trust has a U.S. beneficiary "income or corpus may be paid or accumulated to or for the benefit if a U.S. person during the taxable year of the U.S. transferor if during that year, directly or indi-rectly, income may be distributed to, or accumulated for the benefit of, a U.S. person, or corpus may be distributed to, or held for the future benefit of, a U.S. person. This determination is made without regard to whether income or corpus is actually distributed to a U.S. person during that year, and without regard to whether a U.S. person's interest in the trust income or corpus is contingent on a future event." The IRS ignores the legislation under I.R.C. § 684(b) by stating that a "future event" includes a U.S. person becoming a beneficiary more than one taxable year after the death of the settlor under I.R.C. § 684(b) and the settlor's spouse under I.R.C. § 672(e)(1). It appears that the IRS is attempting to write legislation by ignoring the legislation under I.R.C. § 684(b). Treas. Reg. § 1. 679-2(c)(1).

cci Treas. Reg. § 1.679-2(c)(1).ccii

? See Taxation of Foreign Non-Grantor Trusts, supra.cciii

? Treas. Reg. § 1.671-2(e)(1).

cciv Id.

ccv Treas. Reg. § 1.671-2(e)(2)(i).

ccvi Id.

ccvii Treas. Reg. § 1.671-2(e)(2)(ii).

ccviii Treas. Reg. § 1.671-2(e)(1).

ccix I.R.C. § 6048(a)(3)(A)(ii).ccx

? These certain trusts include investment trusts, liquidating trusts or environmental remediation trusts described in Treas. Reg. §§ 301.7701-4(c), 301.7701-4(d), and 301.7701-4(e).


connected to a U.S. trade or business and to the 30% withholding requirement, unless reduced by an applicable treaty. It is recommended that such "branch" income be avoided by restructuring generally for the trustee of a foreign non-grantor trust to form a corporation in the U.S. in order to avoid the 30% withholding tax.

3. Avoiding Capital Gains Tax. A foreign non-grantor trust that has capital gains income in the U.S., not effectively connected with a trade or business, may avoid the 30% withholding tax by not designating a U.S. person to serve as trustee, co-trustee, trust protectorccxcviii or other fiduciary of the trust.

ccxi Treas. Reg. § 1.671-2(e)(2)(iii).

ccxii Treas. Reg. § 1.671-2(e)(5).ccxiii

? Id.

ccxiv I.R.C. § 679(a).

ccxv Instructions for Forms 3520 and 3520-A, Definitions, 3 (2004) and 2 (2004), respectively.

ccxvi I.R.C. § 684(b); Treas. Reg. § 1.684-3.

ccxvii See Kelley, Gassman, Gulecas, The Effect of Section 684 on The Death of The Grantor of a Foreign Grantor Trust, 4, 4, JOURNAL OF ASSET PROTECTION; Warren, Gorham & Lamont, at 23-31 (Boston, Massachusetts, 1999); Dudley, Karp, Continued Use of Foreign Trusts in U.S. Tax Planning, TRUST & ESTATES, 36 (June 1998). See also Carlyn S. McCaffrey, Learning to Live With the New Foreign Non-grantor Trust Rules, in INTERNATIONAL TRUST AND ESTATE PLANNING, ALI-ABA course of Study Materials, September 24-25, 1998; Joel J. Karp, Strategies for Drafting Estate Planning Documents for International Clients, ESTATE PLANNING FOR THE INTERNATIONAL CLIENT, The Florida Bar, 6.21-6.22, October 23, 1997; Zaritsky, 854 T.M., Foreign Trusts, Estates, and Beneficia-ries.

ccxviii Treas. Reg. § 1.684-3(c).ccxix

? These modifications are provided in I.R.C. §§ 642, 643, and 651.ccxx

? I.R.C. § 641(b).ccxxi

? See Treas. Reg. § 1.1441-3(f); Rev. Rul. 65-311, 1965-2 C.B. 322 (requiring withholding tax on payment of divi-dends to nonresident alien fiduciary).

ccxxii I.R.C. § 817(h).ccxxiii

? The term "portfolio interest" includes interest (and original issue discount) on one of two types of obligations: 1. Obligations (i) issued in bearer form; (ii) arranged to be issued only to foreign persons; (iii) bearing interest payable only outside the United States and its possessions; and (iv) bearing a prescribed legend (IRC §§ 871(h)(2)(A), 163(f)(2)(B)); and 2. Obligations (i) issued in registered form and (ii) with respect to which the withholding agent receives a prescribed statement certifying that the beneficial owner is not a U.S. person (IRC § 871(h)(2)(B). "Registered securities" for this purpose means that the principal and interest are registered on the books of the issuer and any transfer of the obligation may be effected only by surrender of the old instrument and either (1) reissuance of that instrument or issuance of a new instrument or (2) through a book entry system maintained by the issuer.


4. Foreign Non-Grantor Trust with a U.S. Beneficiary. Because distributions are subject to the throwback rules and an interest charge for accumulated distribution,ccxcix it is recommended that all net income attributable to a U.S. beneficiary or bene-ficiaries be distributed to those beneficiaries, or one or more of the techniques discussed previ-ously be implemented.ccc

Treas. Reg. § 5f.103-1(c).).

ccxxvi

? I.R.C. § 651(a).ccxxvii

? I.R.C. § 662(a)(1).ccxxviii

? I.R.C. § 662(a)(2).ccxxix

? The tax determined under I.R.C. § 667(a).ccxxx

? The Federal short-term rate, determined quarterly, plus three percentage points.ccxxxi

? I.R.C. § 668(a)(1).ccxxxii

? I.R.C. § 668(a)(2).ccxxxiii

? I.R.C. § 668(a)(3)(A).ccxxxiv

? I.R.C. § 668(a)(3)(B)(i).ccxxxv

? I.R.C. § 668(a)(3)(B)(ii).ccxxxvi

? I.R.C. § 668(a)(4).ccxxxvii

? I.R.C. § 665(a). Taxes with respect to the undistributed net income calculation include U.S. income taxes and for -eign income, war profits and excess profits taxes that are imposed on the trust and that are allocable to the undis -tributed portion of the distributable net income of the trust in accordance with I.R.C. § 665(d). Furthermore, if such taxes are imposed on a non-U.S. grantor of a foreign non-grantor trust and if that person is treated as the owner of the trust under the general grantor trust rules but is prevented from being so treated as the owner by I.R.C. § 672(f), such taxes may also reduce the undistributed net income of the trust under the provisions of I.R.C. § 665(d)(2).

ccxxxviii Treas. Reg. § 1.665(a)-1A(c).ccxxxix

? Treas. Reg. § 1.665(b)-1A(c)(2).ccxl

? I.R.C. § 6048(c)(1).

ccxli Instructions for Forms 3520 and 3520-A, Definitions, 2 (2004) and 1 (2004), respectively.


ccxlii Id.

ccxliii Id.

ccxliv Unlike the "Foreign Grantor Trust Beneficiary Statement" which is an attachment to Form 3520-A, since the trust here is a foreign non-grantor trust, no reference is made to this form under Form 3520-A. However, Line 30 of Form 3520 (2004) asks "Did you receive a Foreign Non-grantor Trust Beneficiary Statement from the foreign trust with respect to a distribution? This question at Line 30 is confusing because the Foreign Non-grantor Trust Benefi -ciary Statement is not required to be prepared and attached to Form 3520-A. Apparently, this form, prepared in ac -cordance with the Instructions for Form 3520, Part III–Distributions to a U.S. Person From a Foreign Trust During the Current Tax Year, for Line 30, 7 (2004), is to be attached to Form 3520 and furnished to each U.S. beneficiary. Otherwise, Form 3520, Part III– Distributions to a U.S. Person From a Foreign Trust During the Current Tax Year, Schedule A–Default Calculation of Trust Distributions (Lines 31-38) or Part III–Distributions to a U.S. Person From a Foreign Trust During the Current Tax Year, Schedule B–Actual Calculation of Trust Distributions (Lines 39-47) must be completed by each U.S. beneficiary.

ccxlv I.R.C. § 661(a)(2) relates to amounts properly paid or credited or required to be distributed other than trust ac -counting income required to be distributed currently.

ccxlvi I.R.C. § 665(b).ccxlvii

? Id.ccxlviii

? Instructions for Form 3520, Part III— Distributions to a U.S. Person From a Foreign Trust During the Current Tax Year, Schedule A–Default Calculations of Trust Distributions, 7 (2004).

ccxlix Id.

ccl Id.

ccli Form 3520, Part III–Distributions to a U.S. Person From a Foreign Trust During the Current Tax Year, Schedule C–Calculation of Interest Charge, Line 49 (2004).

cclii Instructions for Form 3520, Part III–Distributions to a U.S. Person From a Foreign Trust During the Current Tax Year, Schedule C-Calculation of Interest Charge, 8, regarding Line 49 (2004).

ccliii The first block of Form 4970 (2004) states, "Attach to beneficiary's tax return."

ccliv Instructions for Form 4970 (2004), Purpose of Form, Page 2.


cclv I.R.C. § 667(b)(1)(A).cclvi

? I.R.C. § 667(b)(1)(C).cclvii

? I.R.C. § 666(a).cclviii

? I.R.C. § 667(b)(1)(B).cclix

? I.R.C. § 667(b)(1)(C).cclx

? I.R.C. § 667(b)(4). In no case is the taxable income of the beneficiary treated as being less than zero. I.R.C. § 667(b)(2).

cclxi I.R.C. § 667(b)(1)(D).cclxii

? I.R.C. § 667(b)(1).cclxiii

? I.R.C. § 665(d).cclxiv

? I.R.C. § 666(a).cclxv

? Treas. Reg. § 1.665(b)-1A.cclxvi

? Treas. Reg. § 1.663(a)-1(b). The specific money or specific property must be ascertainable under the terms of the will as of the decedent's death. A revocable trust generally becomes irrevocable as of the date of death and the spe -cific sum of money or specific property must be determined under the revocable trust at the date of death.

cclxvii I.R.C. § 663(a)(1).cclxviii

? Rev. Rul. 66-207, 1966-2 C.B. 243.cclxix

? Rev. Rul. 57-214, 1957-1 C.B. 203.cclxx

? Treas. Reg. § 1.663(a)-1(b)(2)(iv).cclxxi

? Treas. Reg. § 1.663(a)-1(b)(4).cclxxii

? Acker, T.M., Income Taxation of Trusts and Estates, 852-2nd, § V.C.2.


cclxxiii See J. Richard Duke, Use of Trusts by U.S. Citizens in International Tax Planning, TRUSTS IN PRIME JURISDICTIONS, Kluwer Law International, at 43 (The Hague/London/Boston, 2000); See also Alan R. Eber, Cre-ative Use of Foreign Entities for Asset Protection and Tax Planning: Part II, 1, 2, ASSET PROTECTION JOURNAL; A Panel Publication, Aspen Publishers, Inc., at 1-11 (New York, New York, 1999); James A. Walker, Jr., "Interna-tional Tax Planning Using International Private Placement Variable Life Insurance and Annuity Policies," in 19th Annual International Tax Conference, The Florida Bar, January 25-26, 2001; James A. Walker, Jr., "International Estate Planning for Foreign Persons With Intended U. S. Beneficiaries Using a United States Tax Compliant Inter-national Private Placement Variable Life Insurance Policy," in 18th Annual International Tax Conference, The Flor-ida Bar, January 13-14, 2000; James A. Walker, Jr., "Offshore Life Assurance and the Individual Taxpayer," Work-ing Papers, International Tax Planning Association conference proceedings, Charleston Place, Nov. 8-10, 1998.

cclxxiv See I.R.C. §§ 7702 and 817.cclxxv

? I.R.C. § 101(a).

cclxxvi The cost-of-living adjustment under § 1(f)(3) is used for the inflation adjustment, with 1997 as the base year. For calendar years 1999, 2000, 2001, 2002, and 2003, the adjusted exemption amounts are $1,010,000, $1,030,000, $1,060,000, $1,100,000, and $1,120,000, respectively. Rev. Proc. 98-61, 1998-52 I.R.B. 18; Rev. Proc. 99-42, 1999-46 I.R.B. 568; Rev. Proc. 2001-13, 2001-3 I.R.B. 337; Rev. Proc. 2001-59, 2001-52 I.R.B. 623; Rev. Proc. 2002-70, 2002-46 I.R.B. 845. The 2001 Tax Relief Act, P.L. 107-16, continued the indexed $1,000,000 GST exemption amount through the end of 2003. For transfers made in 2004-2009, the GST exemption amount will be the same as the unified credit exemption amount applicable to decedents' estates in those years. Thus, the GST exemption amounts will be $1,500,000 for transfers in 2004-2005; $2,000,000 for 2006-2008; and $3,500,000 for 2009. See § 2010(c). The 2001 Act, § 501, terminated the generation-skipping tax for transfers after 2009, although § 901 of the 2001 Act sunsets the termination after 2010. The GST tax rate is reduced to 50% in 2002 and is further reduced by one percentage point per year until 2007, when the GST tax rate reaches 45%, where it remains.

cclxxvii The 1998 IRS Reform Act, § 6007(a), clarifies that the inflation indexing of the GST exemption applies to lifetime gifts. The increase in the GST exemption for any calendar year, however, applies only to generation-skip-ping transfers made during or after that year. Thus, the additional exemption cannot be allocated to prior gifts that exceeded the then-applicable exemption. § 2631(c)(2) also provides that an increase in the GST exemption for cal-endar years after the year in which the transferor dies does not apply to transfers by the deceased transferor.

cclxxviii I.R.C. § 2631.

cclxxix The Treas. Regs. apply only to a "U.S. transferor." See §§1.684-1(a)(1) and (b)(2) and Treas. Reg. § 1.684-3(c). The foreign trustee is not a U.S. transferor.

cclxxx I.R.C. § 663(a)(1).©J. Richard Duke 2006 All rights reserved

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cclxxxi I.R.C. §§ 864(c)(4)(A), 872(a), and 882(b)(1).

cclxxxii Treas. Reg. § 1.1441-3(g).

cclxxxiii I.R.C. §§ 871(a) and 881(a); Treas. Reg. §§ 1.1441-2(a)(1), 1.1441-2(a)(2), 1.871-7(a), 1.881-1(b), and 1.881-2.

cclxxxiv Treas. Reg. §§ 1.871-2(a) and 1.1441-3(f); Rev. Rul. 69-70, 169-1 CB 182.

cclxxxv I.R.C. § 871(b).

cclxxxvi I.R.C. §§ 864(b)(2)(A) and (B).

cclxxxix I.R.C. § 897(a)(1). For purposes of computing the alternative minimum tax, the "taxable excess" amount may not be less than the individual's net U.S. real property gain for the tax year. I.R.C. § 897(a)(2).

cclxxxviii Treas. Reg. § 1.1441-2(a)(3).

ccxc Pub. L. No. 96-499.

ccxci Pub. L. No. 97-34.

ccxcii I.R.C. § 897(c)(1)(A).

ccxciii I.R.C. § 897(c)(1)(A).

ccxciv I.R.C. §§ 864(c)(4)(B) and 865(c)(5); Treas. Reg. § 1.864-7.

ccxcv I.R.C. § 875(2).

ccxcvi Treas. Reg. §§ 1.861-8 and 1.861-8(f)(1)(iv).

ccxcvii I.R.C. § 6048.

ccxcviii A trust protector may or may not be deemed to be fiduciary. It is recommended that if a trust protector is to be appointed, that the trust protector be a non-U.S. person or a non-U.S. entity.

ccxcix See Throwback Tax on an Accumulation Distribution, supra.
