Tax accounting issues for foreign trusts.

• Author: McNamara, Lawrence H., Jr.
• Position: Part 2

EXECUTIVE SUMMARY

* Fiduciary accounting generally will follow local law and the tax situs of the trust (i.e., foreign versus domestic).

* A change in trustee, and beneficiary residency and trust terminations may have many tax and reporting consequences.

* Fiduciaries and tax advisers should be aware of the tax laws and regulations before reporting the trust transactions.

This two-part article compares tax accounting and reporting consequences of foreign versus domestic trusts. Part II illustrates the tax, fiduciary and accounting issues involved in changes in foreign and domestic trust status.

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This two-part article compares domestic and foreign trusts for fiduciary, reporting and tax accounting purposes. Part I, in the June 2006 issue, described the differences between foreign and domestic trusts and some of the advantages and disadvantages of foreign trusts. Part II, below, illustrates the tax consequences of changing foreign and domestic trust status that fiduciaries and tax advisers need to understand to report trust transactions properly under local law and in accordance with the trust instrument.

Effect of Domestic vs. Foreign Trust Status

Fiduciary accounting will, in general, follow the tax status of the trust (i.e., domestic versus foreign). The accounting can be complex because of timing differences of tax payments (i.e., paid in a foreign currency during a reporting period as a domestic trust or in U.S. dollars during a period as a foreign trust). Under the comments of Section 102 of the Uniform Prudent Investor Act, the National Conference of Commissioners on Uniform State Laws (NCCUSL) commented that "constructional preferences or rules would also apply, if necessary, to determine the terms of the trust" (instrument). If the instrument does not stipulate the accounting for principal and income transactions, specifically with references to a change in the tax and legal jurisdiction (i.e., from a domestic trust to a non-U.S, trust), local law provides the guidance for the fiduciary.

Under Section 403 of the Uniform Trust Code (as last amended in 2005), the NCCUSL commented that a trust is valid under the law of the domicile or place of business of the designated trustee. However, a domicile in a foreign country may require trust reformation procedures to comply with local law provisions, including accounting for income and principal transactions. The fiduciary and the tax adviser should understand the tax laws and regulations before reporting the transactions under fiduciary accounting principles.

Domestic Trust Status

Example 1: J, and his spouse from a second marriage, A, are U.S. citizens residing in California. J died on Nov. 30, 2004. A engaged W, a family friend, as trustee of a qualified terminable interest property (QTIP) trust allocated with assets from J's estate. The trust instrument has a California situs. However, J's brother, M, is a U.K. resident and citizen, and the trust instrument stipulated that he will act as successor trustee. M's powers, as stipulated in the trust instrument, include the powers to make investment decisions, and to allocate income and principal distributions to the income beneficiary (A), as well as other significant powers accorded to successor trustees. The trust instrument has an "automatic migration clause" to allow M U.K. court jurisdiction, if it is necessary to allow him to fulfill his duties and responsibilities. The trust's remainder beneficiary is J's daughter, N, from his first marriage. N also is a U.K. citizen and resident.

The QTIP trust assets consist of a partnership (ABC partnership) and an S corporation (XYZ Corp.). ABC assets consist of commercial rental properties in Los Angeles, shopping center 1, shopping center 2 and shopping center 3. XYZ's assets consist of certificates of deposit in U.S. banks and some dividend-paying U.S. and U.K. stocks.

W, as trustee, performs his duties, which include...