Foreign Grantor Trust Planning: A Flexible Planning Structure for U.S. Income Tax.

• Author: Callahan, Christopher R.,Snyder, Scott M.
• Date: 01 November 2023

Over the years, U.S. tax practitioners specializing in international taxation have established foreign grantor trusts (FGTs) to assist multi-jurisdictional families with their U.S. tax and succession planning. This is particularly relevant when the client (e.g., a parent) is a non-U.S. person for all U.S. tax purposes.

The approach involves the non-U.S. person parent setting up a grantor trust (that is typically revocable, but may instead be irrevocable in certain circumstances), which directly or indirectly holds certain U.S. and non-U.S. assets. Generally, the U.S.-situs assets are held through a non-U.S. corporation (hereinafter a "foreign corporation" or "FC"). The FC is generally an eligible entity for U.S. tax purposes.

This specific tax planning structure is widely regarded as one of the most effective solutions for families with a non-U.S. person parent that has U.S. children and U.S. grandchildren. The benefits of this arrangement are twofold: 1) it may avoid the U.S. estate tax (with proper planning for U.S.-situs assets) that would otherwise be imposed upon the death of the non-U.S. person parent; and 2) it preserves certain U.S. income tax advantages available to a non-U.S. person investor as long as the trust remains a grantor trust. Overall, this strategy proves advantageous in navigating the complexities of international taxation for such families.

Who Benefits Most From FGT Strategy

During the settlor's lifetime, a grantor trust, whether established in the U.S. or abroad, is treated as transparent for U.S. income tax purposes. (1) This means that any income or gains generated within the trust are attributed to the settlor (i.e., the "grantor"), and they are liable for taxes on such income. (2) If the settlor is a non-U.S. person, they are exempt from certain U.S. income tax concerning the trust's non-U.S. source income, U.S.-source capital gains, and interest income. (3) Consequently, neither the trust nor its beneficiaries may be subject to U.S. income tax when the trust sells certain appreciated assets (e.g., stock of most publicly traded companies, e.g., Amazon), unless the trust generates U.S.-source business income or other taxable U.S. income. (4) In such cases, the foreign settlor would be accountable for U.S. income tax on the trust's taxable income. (5) Moreover, U.S. beneficiaries would not be taxed on any distributions received from the trust. As a result of these intersecting rules, establishing a FGT can often be a potent tax-saving strategy during the settlor's lifetime for families whose settlor resides outside the U.S. (particularly, if they reside in a low-tax jurisdiction and/or in a country that doesn't tax overseas income within a trust).

In addition, utilizing a FGT during the settlor's lifetime, instead of direct ownership, offers advantages in transferring assets to U.S. beneficiaries. However, a FGT does not provide protection against U.S. gift or estate tax (transfer taxes) on the U.S.-situs assets. Thus, additional estate tax planning is generally recommended for such assets (as discussed below). (6) Regardless, by passing wealth (comprising non-U.S. situs assets) to their U.S. beneficiaries through a trust upon their death, foreign individuals can avoid any limitations imposed by U.S. tax law on the amount of wealth passing from one generation to the next without incurring transfer taxes. This approach allows the foreign settlor (i.e., the wealth creator) to effectively eliminate all transfer tax concerns for the U.S. beneficiaries throughout future generations, regardless of the size of their wealth. Conversely, if the U.S. beneficiaries inherit the assets directly, those assets will be included in their U.S. estates, subjecting them to issues surrounding transfer taxes when they pass the wealth to their own heirs. By utilizing trusts, the foreign settlor can establish a tax-efficient legacy for his or her U.S. beneficiaries, ensuring a seamless transfer of wealth for the next generations.

Furthermore, FGT planning can be particularly effective for families who currently have nominee arrangements. A typical example would be a family that owns a family business/company and transfers title (but not beneficial ownership) of certain company shares (nominee shares) to his or her children as succession planning. From a U.S. perspective, the patriarch or matriarch is still treated as the beneficial owner of such shares and, thus, can settle a FGT to benefit his or her children and fund the FGT with the nominee share. (7) This strategy helps to further confirm the nominee arrangement along with provide further confirmation that the children are meant to inherit the shares upon the death of the settlor or beneficial owner.

Grantor vs. Non-Grantor

A grantor trust is where the foreign settlor is considered the owner of the trust's income, subject to taxation, which may occur under two specific circumstances. (8) The first scenario arises when distributions from the trust during the settlor's lifetime, whether comprising income or capital, are limited only to the settlor or the settlor's spouse. (9) The second instance occurs when the settlor possesses the unilateral power, or with the agreement of a related or subordinate party, to revest the trust's assets in himself or herself. (10) A "related or subordinate party" is an individual or entity without any beneficial interest in the trust and can include the settlor's spouse if living with the settlor, the settlor's immediate family members (father, mother, descendants, or siblings), employees of the settlor, employees of a corporation where the settlor's equity interest and the trust's equity interest significantly influence voting control, or a subordinate employee of a corporation where the settlor is an executive. (11)

Despite the aforementioned circumstances, if the settlor has not made a gratuitous transfer to the trust, he or she will not be considered the owner of the trust's capital and income for U.S. income tax purposes. (12) However, if the trust is established through a distribution from another trust, the settlor of the transferor trust will be treated as the owner of the capital and income of the transferee trust, unless the person or entity responsible for settling the transferee trust (typically the trustee of the transferor trust) wields powers extensive enough to be deemed a general power of appointment. (13) A general power of appointment encompasses the authority to appoint assets to oneself, one's creditors, one's estate, or the creditors of one's estate. (14)

The grantor trust rules under [section]672(f) need to be carefully considered when the foreign settlor is married under the laws of a community property jurisdiction. If the FGT is not drafted carefully in consideration of the community property issues (e.g., the surviving spouse has the power to revest the entire trust property in himself or herself), it is possible that half of the trust could become a non-grantor trust upon the death of the first spouse.

Basics of Foreign vs. U.S. Trusts

Trusts are categorized as either domestic or foreign for U.S. income tax purposes. This distinction relies on two key tests, the "court test" (15) and the "control test." (16) A domestic trust meets both these tests, while a foreign trust fails to satisfy either one. (17) Thus, if a trust does not pass both the court and control tests, it is treated as a foreign trust for U.S. income tax purposes. (18)

To pass the court test, a federal, state, or local court within the 50 U.S. states and the District of Colombia must have the primary authority to oversee the trust's administration, entailing the ability to make decisions concerning all aspects of the trust. (19) In this context, trust administration entails the investment and preservation of trust assets, filing of any and all tax returns or other related filings, defending the...