Offshore Trust

Title:
Offshore Trusts overview and their utilities under the new requirements of small Business Job Protection Act of 1996.

Overview:

Offshore trusts have been a successful tool for wealthy individuals to protect their assets from the claims of creditors, minimize income taxes as allowed by tax laws during the lifetime of the grantors, eliminate or reduce estate taxes payable upon the death of the grantors and to facilitate foreign investments. A foreign trust is defined as any trust other than a U.S. Trust. A trust is considered as a U.S. trust when a U.S. trustee has primary control over the trust and it is under U.S. court jurisdiction.

The Asset Protection Trust (APT) is established by a U.S. citizen or resident for the life benefit of the settlors with other U.S. beneficiaries receiving the remaining trust assets after the death of the settlors. It is usually irrevocable for a specified period of time. When the irrevocability expires, the settlor has the right to revoke the terms of the trust and the trust assets will revert back to the settlor. During this time, the grantor will retain maximum control of the trust assets, including the right to change trustees and have trust assets distribution authority.

The APTs are normally established in the countries that have favorable asset preservation laws that make it difficult for the creditors to file judgments. Therefore, a country with well-established trust laws can offer legal protection certainty and as a deterrent against creditors claims.

APT is normally tax neutral, that is, the trust is taxed as if it is a domestic U.S. trust. As a grantor trust, APT is not subject to the 35% excise tax under section 1491. However, if the trust is not structured properly, the APT might be subject to gift and generation-skipping transfer taxes. Any Offshore Trust Service Provider advertises tax benefits from establishing an offshore trust is not telling the truth. There are no income tax benefits that result from creating APT.

A quick search of Offshore Trust services providers in the Internet yielded over 50 responses. Most of them provide legal, accounting and trustee services. Some clients are concerned with placing the assets in the hands of foreign trustees. This is a valid concern, but it is no different from selecting a trustee for a domestic trust. Careful selection of a trustee is a must.

The structure of an APT normally involves a Family limited partnership (FLP) where the settlor is a general partner with one to two percent interest. An APT will be a limited partner who owns the remaining interest of the FLP. Since the APT is a limited partner, it has the right to receive future distribution of the assets from the FLP.

Small Business Job Protection Act of 1996 (SBJPA):

In response to an increased growth of asset-protection trusts, the Treasury Department believed that offshore trusts were primarily used as tax avoidance vehicles for many U.S. persons, and the existing reporting and compliance systems were insufficient to monitor the transactions of the foreign trusts with U.S. beneficiaries. Therefore, the new Small Business Protection Job Act increases required reporting requirements as well as a penalty for non-compliance to curb any abusive practices.

Under the prior law, U.S. persons who had foreign trusts were not required to file any special reports to the Treasury Department unless they had taxable distributions from the trusts, which would be reported on their individual income tax returns. In addition, U.S. persons receiving of foreign gifts were not taxed nor required to file any other information return.

Effective August 20, 1996, a U.S. person who receives any distribution from a foreign trust is required by the amended Section 6048(c) to notify annually the Internal Revenue Service, with the following information:

1.the name of the trust,
2.the accumulative distribution amount in the tax year and
3."other information" as required by the Treasury Department. The detail of the "other information" is yet to be prescribed by the Treasury Department.

Further, a U.S. owner of a foreign trust is responsible to file an annual return providing full accounting of the trust’s activities for the taxable year. If the proper records are not maintained by the beneficiary, interest charges based on Section 668 will be calculated as if all trust income is earned in the initial trust year. This will result in a much higher interest charged to the taxpayers. There is an exemption to abate the penalty, which applies only when the foreign trust appoints a U.S. agent to act as a limited agent before the IRS for service of process.

Congress expects the increased reporting requirement to provide the Treasury department with more information so that they can perform their audits more effectively, discourage abusive use of offshore trusts, as well as enhance the IRS’s ability to collect taxes from U.S. beneficiaries who receive distributions from foreign trusts.

Congress decided that taxpayers needed to be encouraged to file all necessary information to the Treasury and to enforce the reporting requirement, Congress imposes severe penalties for non reporting. Amended Section 6677(a)(2) provides a penalty of 35 percent of the gross reportable amount if a person fails to report the transfer of property to a foreign trust or a distribution by a foreign trust to a U.S. person. The failure to file the trust’s annual activity report will result in a penalty of 5 percent of the U.S. person’s trust value at the end of the tax year. For failure to comply within 90 days after the mailing of an IRS notice, the U.S. person is subject to an additional $10,000 penalty per month until compliance. However, the penalty can be abated if "reasonable cause" can be shown.

One little known tax trap is the new section 6039F, which is added by SBJPA Section 1905(c) to provide a new foreign gift reporting requirement. The new provision has a profound effect on foreign persons and their U.S. counterparts. The new law requires reporting of any U.S. person receiving gifts or bequests from foreign persons during the year totaling more than $10,000. The reportable gifts do not include qualified transfers for medical care and tuition expense as well as gifts properly disclosed and distributed to a U.S. beneficiary of a foreign trust. The minimum reportable amount of $10,000 is indexed to cost of living adjustment after 1996.

This provision does not change the nontaxability of gifts, tangible or intangible property wherever it is situated, made by foreign persons to U.S. persons. The purpose of this provision is to allow the Treasury Department to account for all taxable income distributions. Currently the Treasury has not yet prescribed the procedures to report such gifts, any future regulations will likely to be retroactive back to August 20, 1996, the effective date of the provision.

If U.S. clients have funds transferred from overseas, and non-resident alien clients have made transfers to their relatives in the U.S., they should be advised of the filing requirement and gather all necessary information such as amount of gifts, date of the gifts and the nature of the gifts.

This provision caused a big alarm for people in the countries such as Hong Kong and Taiwan, where many of their relatives are U.S. immigrants or citizens. It is very common that foreign persons use their U.S. connection to invest in the U.S. as well as transfer their wealth out of their country to the U.S. due to the unstable political situations. The provision of the new law will require the U.S. persons to disclose the purpose of the funds. They have to determine whether the funds transfers are gifts, bequest or not to comply with the new law. Further, U.S. persons will also reveal their overseas relationship to the Treasury Department, that information many of them are reluctant to report.

The penalty of failing to file the required information without reasonable cause is severe. The gifts can be recharacterized by Internal Revenue Service as income, such determination can only be reversed if it is " arbitrary or capricious"as defined by judicial review standard. In addition, a penalty equal to 5 percent of the amount of such foreign gift for each month up to a maximum of 25 percent will be imposed on the U.S. person.

The States have yet to conform with the changes in the new law. However, any redetermination of income raised due to the new law will definitely become an issue for the taxpayers’ state taxes.

Foreign Grantor Trusts:

Under the prior law, when a trust was created by a nonresident alien grantor, who was deemed to be the owner of the trust’s assets, the trust income and or gains were attributed to the foreign grantor, and generally, not subject to U.S. taxation. This was true even the foreign grantor had a limited power over the trust and the trust assets were all for the sole benefit of the U.S. beneficiaries. Thus, the foreign grantor trust had no current or accumulated income, and the U.S. beneficiaries received the trust distribution free of U.S. income and gift tax liabilities during the grantor’s life. However, without proper planning, a U.S. grantor might be taxed on trust income even with no trust distribution nor power to execute the trust under Section 679.

Now, the new rules require that either the trust be taxed as if it is a U.S. domestic trust or the U.S. beneficiaries be taxed on the trust distributions. However, it will not apply to the foreign person owner portion. The Treasury Department is authorized to issue regulations to clarify the rules for such beneficiaries to claim foreign tax credit for the foreign tax paid or incurred by a foreign grantor due to the trust income.

There are two exceptions to the "no foreign grantor" rules (1) the foreign grantor can revoke the trust agreement without the consent of someone or related or subordinate persons, (2) the trust distribution is made to the grantor and or his spouse during the grantor’s life time. In additional, certain foreign grantor trusts are also "grandfathered" if the trusts were in existence on September 19, 1995 provided the trusts are operated under Section 676 or 677. Further, transfers to certain charitable trusts after February 6, 1995 is excluded from section 679(a)(1)as amended.

Residence of Trusts and Excise Tax:

When it was pre-SBJPA, Congress was concerned that the existing multi-factor tests used to determine the residence of the trust were not clear and could be manipulated to obtain tax benefit. Therefore, the SBJPA sec. 1907(a) amended IRC Sec. 7701(a)(30)(E) and (31)(B) such that a trust is considered a U.S. trust if (1) a U.S. court can exercise primary supervision over trust administration and (2) a majority of U.S. fiduciaries have authority to control all substantial decision of the trust.

If a domestic trust is converted to a foreign trust, a 35 percent excise tax will be imposed on the trust as if the domestic trust had transferred all of its assets to a foreign trust immediately before becoming a foreign trust, unless one of the Section 1491 exceptions applies. Further, the converted trust is subject to the reporting requirements of Section 6048 as well as Section 679 as amended to allow gain or loss recognition in certain situation. The failure to file a return with respect to a Section 1491 transaction will result in penalties provided in Section 6677 in the same manner as if such a failure were a failure to file a notice under Section 6048(a).

Foreign Nongrantor Trusts - Accumulation Distributions and Trust Loans:

Under the prior law, a flat six percent simple interest was charged on accumulated distribution for the previous tax deferral. The interest was computed based on the tax that would have been due had distributions been made to U.S. beneficiaries when the trust income was earned.

Under the new Act, the interest rate used is pegged to the rate that is applied to tax underpayment under IRC Section 6621 and is compounded daily.

Further, to limit the use of loans from non-grantor foreign trusts as nontaxed distribution to U.S. persons, Congress amended IRC Section 643(i) to include loans of cash and marketable securities to a U.S. beneficiary or related party made after September 19, 1995 as a distribution, which thus is taxable to the extent of the trust’s current or accumulated income. The Treasury Department is authorized to issue regulations to exempt arm’s length loans with a reasonable expectation of repayment.

Anti-Abuse Regulation Authority:

The Treasury Department is authorized to prescribe anti-abuse regulations to prevent tax avoidance of the rules applicable to estates, trusts and beneficiaries.

Conclusion:

Offshore Trust is still a good tool to protect one’s assets from the claims of creditors. However, the additional filing and reporting requirements impose on the offshore trusts and their related U.S. persons by the SBJPA of 1996 might have diminished the usefulness of APT. The effect of the new legislation is yet to be determined. Treasury still needs to prescribe regulations to clarify the methods of reporting and its procedures. However, it is clear that tax planning using offshore trusts are under closer scrutiny and the new compliance requires cautious planning.