One of the most important reasons to carefully draft a trust centers around the risk that it will be reclassified as “foreign”. Unlike a United States trust, a foreign trust has different reporting requirements, and the trust creator may have to pay more taxes.
What Is a Domestic Trust? What Is a Foreign Trust?
It is easier to understand the IRS’s definition of a foreign trust by learning what it is not. A domestic trust meets two requirements: (1) a U.S. court can exercise “primary supervision” over the trust’s administration, and (2) one or more U.S. people can control all substantial trust decisions.
If a trust does not meet those two requirements, it is a foreign trust. Note that California has different requirements for what makes a trust foreign, so if your trust is established under California law you will need to understand those laws too.
Why Would a Domestic Trust Be Reclassified as a Foreign Trust?
The IRS will consider a trust to be foreign if it no longer meets the two requirements described above. In other words, its status changes if another country has primary supervision over administration, or if someone who is not a U.S. person can control trust decisions. Usually, the second requirement is the one that a trust no longer meets. A trustee may change citizenship status, or a non-U.S. citizen may take over as a successor trustee.
What Happens If a Trust Is Reclassified as Foreign?
If a trust is reclassified from a domestic trust to a foreign trust, its creator may suddenly owe more taxes. The IRS assesses taxes on the U.S. owner of a foreign trust, based on the income of the trust.
Further, the U.S. owner must comply with reporting requirements designed to keep people from hiding assets in foreign trusts. Beneficiaries must report any income they receive from a foreign trust that was not reported by the U.S. owner. If the trust is a special type called non-grantor (the trust creator gives up control over the assets), then taxes may be due based on recognition of gain when assets are transferred into a foreign trust.
Foreign trusts can create many complications with estate planning as well. For example, trust creators could have trouble finding a trustee or beneficiaries who will stay in the United States to avoid their trusts’ reclassification as foreign. If the U.S. trustee retains control of the trust at his or her death, the estate could owe taxes in the U.S., in another country, or both. As a result, it is often better to keep a trust domestic if the creator is a U.S. citizen and the property in the trust is in the U.S.
Planning your estate? Look to Janet Brewer, Esq. for thorough and thoughtful estate planning advice. Janet’s more than 20 years of legal experience will give you confidence and peace of mind. To schedule a “Get Acquainted” meeting, visit Janet's website or call her office at (650) 469-8206.