For years, U.S. tax practitioners who focus in the area of international taxation have helped multi-jurisdictional families establish foreign grantor trusts, particularly in situations in which the client is a parent who is a non-U.S. person for all U.S. tax purposes (1) and the next generation is comprised of U.S. persons. (2) Such planning typically involves the nonU.S. person parent establishing a revocable trust in which the primary asset is a non-U.S. corporation (also referred to as a "foreign corporation" or "FC") that is an eligible entity for U.S. tax purposes, (3) with the FC having title to an investment portfolio. (4) Generally, this is considered one of the better U.S. tax-planning structures for families with a non-U.S. person parent and U.S. person children and grandchildren. The structure avoids the imposition of the U.S. estate tax upon the non-U.S. person parent's death and maintains certain U.S. income tax benefits afforded to a non-U.S. person investor while the trust is a grantor trust. In the post-mortem planning context, it was common prior to the enactment of H.R. 1, Tax Cuts and Jobs Acts, for the FC to be liquidated for U.S. tax purposes after the death of the non-U.S. person grantor. An FC that is an eligible entity can file Form 8832 (Entity Classification Election) to be treated as a partnership if it has two or more members or disregarded as an entity separate from its owner if it has a single owner (commonly referred to as a "disregarded entity"). (5) An FC making such an election (commonly referred to as a "check-the-box election") is deemed to liquidate for U.S. tax purposes at the end of the day immediately before the effective date utilized on the Form 8832. (6) The common planning technique was to cause the deemed liquidation to occur less than 29 days after the date of the grantor's death to prevent the harsh tax consequences of the U.S. anti-deferral regime associated with a "controlled foreign corporation" (CFC). (7) The act contains many modifications to the Internal Revenue Code, but one modification in particular will leave both U.S. tax practitioners and their clients reevaluating the traditional trust planning set forth above.
In a trust where the non-U.S. person grantor contains a power to revest title in the property contributed (e.g., a revocation power), the grantor is viewed as the "owner" of the trust's assets for U.S. income tax purposes; therefore, all tax attributes (i.e., income, deductions, credits, etc.) are attributable to said grantor. (8) Such a non-U.S. person grantor would be responsible for any U.S. income tax consequences associated with the revocable trust during his or her lifetime. As a non-U.S. person, the grantor should only be subject to limited U.S. income taxation on 1) nonexempt "passive" U.S.-source income; (9) and 2) income effectively connected with the conduct of a U.S. trade or business (ECI). (10) In the trust structure outlined above, the only asset directly held by the trust is an FC during the grantor's lifetime. Accordingly, the grantor would not have been liable for any U.S. income tax with respect to any income received from the trust as any such income would have been non-U.S.-source (e.g., a dividend from an FC). (11) Any U.S. income tax liability would have been borne by the FC under rules similar to those discussed above in relation to a non-U.S. person. (12) A U.S. person beneficiary of the trust would generally not include any of the income of the grantor trust in gross income being only a "future" beneficiary.
As long as the FC was properly formed, structured, and maintained, no assets of the trust should be subject to U.S. estate tax upon the passing of the non-U.S. person grantor because all assets would have been held through an FC. (13) Upon the death of said grantor, the trust ceases to be a grantor trust (assuming no other power makes the trust a grantor trust toward another taxpayer), and unlike a grantor trust (which is ignored as a taxable entity separate from the grantor), a nongrantor trust is a taxable entity for U.S. tax purposes. (14) A complete and detailed discussion of the income tax rules relating to nongrantor trusts and their beneficiaries is beyond the scope of this article. (15) The focus herein relates to the tax consequences that devolve upon the domestic nongrantor trust or U.S. person beneficiaries of a foreign nongrantor trust owning a CFC. (16)
As a result of the transition from grantor to nongrantor trust status, consideration needs to be given to the cost basis the non-grantor trust has in the assets thereunder (in our example, the basis in the FC). Generally, the property's cost basis in the hands of a person acquiring property from a decedent will be the property's fair market value at the date of the decedent's death. (17) This adjustment in basis can be quite beneficial in the case of an asset with unrealized appreciation at the time of the decedent's death. A "step up in basis" may be afforded without a corresponding income tax consequence. (18) In addition, non-U.S.-situs property that is inherited by a U.S. person from a non-U.S. person's estate should receive a basis adjustment at death (even if not includible in the decedent's U.S. gross estate). (19) The same is not necessarily true in relation to assets that pass via trust from a non-U.S. person. When dealing with a deceased non-U.S. person grantor, a revocable trust generally receives a basis adjustment of its assets upon the grantor's death if the grantor retained the power to revoke the trust as well as the power to direct or order income distributions from the trust. (20) For the purposes of this article assume that the grantor retained both powers allowing the trust to receive a step up in the basis of its assets.
During the lifetime of the grantor, the tax consequences associated with the underlying structure (including the FC) were attributable to the grantor. (21) Upon the death of the grantor, that would no longer be the case, and the rules associated with the CFC regime need to be considered. An FC is a CFC if U.S. shareholders own more than 50 percent of the FC stock (by vote or value). (22) A U.S. shareholder is a U.S. person who owns either directly or indirectly, through one or more foreign entities or through the application of certain constructive ownership rules, at least 10 percent of the total combined voting power of all classes of stock entitled to vote, or who owns 10 percent or more of the total value of shares of all classes of stock of an FC. (23) In the case of a domestic nongrantor trust, the trust itself would be the U.S. shareholder. (24) In the case of a foreign nongrantor trust, attribution rules may apply providing that a beneficiary will be deemed to...