Estate and Income Tax Aspects of Offshore Trusts

April 13, 2006

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Generally, the offshore asset protection trust will be deemed to be a "foreign grantor trust." The trust will be deemed a grantor trust because there will be a U.S. beneficiary. This status means that the contributions to the trust will be free of income tax consequences.

Such contributions will reduce your unified estate/gift tax exemption ($2 million for 2006-2008), unless you take advantage of the annual gift tax exclusion ($12,000 for 2006 and 2007). See our discussion regarding this issue and Alaska and Delaware asset protection trusts.

This status also means that the trust's income will be taxed to you as the trustor/beneficiary, and you can report it on your personal income tax return, Form 1040. This will serve to simplify the reporting of the trust's income.

Warning

Remember, a U.S. resident is taxed on all worldwide income. Further, as discussed above, when an offshore trust has a U.S. beneficiary, the trust will be deemed a grantor trust, which means that the trustor/beneficiary will be taxed on all of the trust's income even if the income is not distributed, as if the income were earned directly by the trustor/beneficiary.

Representations that an offshore trust is an effective means for a U.S. resident beneficiary to avoid U.S. income tax are false and misleading.

Given the nature of the offshore trusts' provisions, its assets should normally be excluded from the estate of the trustor/beneficiary. This result is identical to that of the domestic asset protection trusts.

That the trust will be a "foreign" trust has certain implications. As long as the foreign trust has a U.S. beneficiary, the income tax consequences will be as described above. However, upon the death of the U.S. beneficiary, the trust's assets will be deemed to have been contributed to a foreign trust without a U.S. beneficiary. The result will be that all of the appreciation in the value of the trust's assets, since the assets were first purchased by the trustor, will be treated as taxable gain.

While the law in this area is not settled, it may be possible to avoid this outcome by requiring that the trust distribute all of its assets to a U.S. beneficiary upon the trustor/beneficiary's death or, of course, if there is another surviving U.S. discretionary beneficiary of the trust.

This result also would be avoided if the foreign trust were deemed to be a "domestic" trust. This result seems contradictory, but is a possibility under the federal tax code.

A provision added to the Internal Revenue Code in 1996 provides an objective test to determine when an offshore trust will be deemed, for tax purposes, to be a domestic trust. Basically, the trust must consent to the U.S. courts' having primary jurisdiction over the trust and to primary control by a U.S.-based trustee. Complying with either of these requirements means that the very purpose for which the offshore trust is designed (i.e., asset protection) will no longer exist.

Similarly, a safe harbor exists to qualify the trust as domestic. Among other things, the safe harbor requires that the trust not have a flight clause. A flight clause is a standard, as well as a desirable, feature of an offshore trust.

In short, qualifying the offshore trust as domestic usually will not be advisable. However, you should discuss this issue with the attorney who will be drafting the trust.

In addition, a 1997 provision added to the Internal Revenue Code repealed a 35 percent excise tax that previously applied to contributions to a foreign trust without a U.S. beneficiary.