Foreign Grantor Trust (FGT)
For U.S. Federal income tax purposes, a trust is foreign if it fails the “court” test or the “control” test, and is a Foreign Grantor Trust (FGT) if it either (1) the trust is fully revocable by the foreign Settlor or (2) the trust is irrevocable, and the only persons to whom income or principal may be distributed during the Grantor’s lifetime are the Grantor and his spouse.
Effect of Foreign Grantor Trust
If a trust qualifies as an FGT, the Grantor is treated as the owner of the income for U.S. Federal tax purposes, regardless of whether the trust income is actually paid to the Grantor, accumulated in the trust for later distribution, or paid out to US or foreign beneficiaries. Consequently, distributions from FGTs to U.S. beneficiaries of income that is earned or accumulated during the grantor’s life is not subject to U.S. income tax, although reporting obligations apply.
Most FGTs contain clauses identifying the trust as an FGT for Federal income tax purposes, and stipulating that the Grantor has the power to revoke the trust in his favor, retains the right to direct income, and contains date of death step-up provisions.
US Estate Taxes
In the case of a revocable FGT, on the death of the foreign grantor, U.S. situs property (such as shares in US companies and US real estate) held directly by the trust would be subject to U.S. estate tax, with an exclusion of only US 60,000. However, US estate tax can be avoided by holding US situs property through an underlying non-transparent foreign corporation.
Tax Consequences Following Death of Grantor
Following the Grantor’s death, the trust becomes a non-grantor trust, and distributions of income to US beneficiaries are subject to U.S. income tax. Income accumulated in the trust after the Grantor’s death has the further adverse tax consequence that when it is distributed to a U.S. person, it is taxed together with an interest charge and loss of preferential tax rates on the treatment of capital gains. The interest charges and loss of capital gains tax rates (but not the tax itself) can be avoided by migrating the trust to the US or pouring over the trust assets to a US trust.
Under the new 2017 tax reform (TCJA), which eliminated the 30 period to “check the box” following the death of the grantor, the underlying foreign company will immediately become a CFC, and US beneficiaries will be subject to tax on the appreciated value of securities held by the CFC. There are a number of mitigation strategies, including selling securities with unrealized gains periodically, or utilizing a tiered holding company structure.
Step-Up in Basis
If the trust is correctly structured, then on the death of the grantor, the assets held directly by the trust will receive a date of death step up in basis. In the case of an underlying offshore company, the shares of the company would receive a date of death valuation, but not the investments held by the company, which would carry their historical acquisition cost basis and potential built up taxable capital gains.
Estate, Gift, and Generation Skipping Tax
Distributions from the foreign Grantor trust to US beneficiaries, will not be subject to estate, gift or generation-skipping tax, although US beneficiaries will be liable to US income tax on income generated by the amounts distributed. If the trust continues for generations after the Settlor’s death, estate, gift or generation-skipping tax will never be imposed even if all beneficiaries of the trust are U.S. persons.
Following the death of the foreign grantor, the decision to keep the trust as foreign for income tax purposes or transform it into a domestic trust depends on the family situation and future objectives, citizenship and residency of the beneficiaries, etc.
CISA is not a legal or tax advisor, and this information is not offered as tax advice. We strongly recommend that clients obtain independent tax advice.