Lewis Saret authored the following column, published in CCH Taxes - The Tax Magazine, The Estate Planner: Estate Planning During 2012 (March 2012).  The full column may be downloaded by clicking the following link: Saret_MAG_03-12.pdf

Generally

We are all familiar with testamentary devices such as Wills and Trusts. However, few are familiar with ethical wills, which deal with our clients' values. While clients come to advisors primarily to help them transfer property between generations, many also are concerned about the legacy they leave to their loved ones in the form of the values passed on, the meaning of their lives and the love they feel for their family members. These clients feel the need to address this concern, but do not know where to turn. We have found that such clients are not only receptive to learning about ethical wills, but in fact grateful. By exposing clients to ethical wills, you will satisfy your clients' needs, earn their gratitude and feel increased professional satisfaction.

What do ethical wills accomplish and what are their benefits?

Ethical wills are really not wills at all. They are a very personal form of communication, often in the form of a letter but sometimes in other forms, such as video or audio recordings, from individuals to their loved ones telling the recipient what they would say if they were alive. Authors of ethical wills often intend for their ethical wills to share their values, important life lessons, wisdom and/or family history with loved ones. They also often use ethical wills to express their love and affection, and sometimes to ask for forgiveness.

The first ethical will is generally attributed to Jacob, in Genesis, chapter 49, when Jacob gathers his sons around him to tell them how to live. This is an example of an oral ethical will. Other examples include the New Testament, where Jesus gives his parting blessings and advice to his loyal followers, and Hamlet, where Polonius gives such sage advice to his son, Laertes, as "Give every man your ear, but few thy voice... (and) This above all: to thine own self be true."

While still rare when compared to legal wills, the interest in ethical wills has significantly increased in recent years. We believe this reflects several factors, including an aging population coming to grips with its own mortality, increasing affluence in our society which allows for greater self-reflection and a general societal shift over the past thirty years to more conservative values.

Among other possible things, ethical wills may do the following:

• Help instill values in children or other family members by describing the author's values and what he or she hopes the recipient also will come to value. Parents with newborn or young children often find ethical wills appealing for this reason, particularly when they engage in estate planning and contemplate the possible impact of death on their newborn child.
• Transfer wisdom from one generation to the next by imparting important life lessons to family members, which would otherwise be permanently lost upon the author's death.
• Pass on personal reflections, and personal and family history to children and family members. Often, when children experience the death of a parent, in addition to the acute sense of loss, they often experience a great deal of frustration from not being able to learn more about their parent(s) and ancestors. Ethical wills can mitigate this by providing personal biographical information.

• Convey the love and affection of the author. In a sense, the ethical will serves as a love letter to spouses, children or others. Legal wills rarely convey such emotions to the testator's loved ones, and without an ethical will or other form of communication, no other vehicle does this. In this regard, an ethical will is a beautiful gift to the author's loved ones.
• Help the author's loved ones remember him or her after the author is gone.

Ethical wills also have significant incidental benefits. Writing an ethical will forces the author to articulate his or her values. This is extremely beneficial where the author desires to implement an overall plan to transfer values along with human and intellectual capital between generations, which is sometimes referred to as a values based estate plan. To illustrate, articulating the senior family members' values greatly facilitates the creation of a family mission statement, implementation of enhanced family rituals, creation of incentive trusts and a more formal structure for family philanthropy, each of which may be included in such a plan.

In addition, the self-reflection implicit in the preparation of an ethical will may also cause authors to re-examine their lives and in some cases cause them to change the direction of their lives to one more aligned with their personal values and objectives.

As authors gain greater identification with their values and beliefs, they may wish to share the thoughts and words expressed in their ethical wills with other family members during lifetime rather than after or near death. Under the right circumstances, this can bring family members closer together and greatly enhance the education of younger family members.

What types of clients are ethical wills appropriate for?

While an ethical will can benefit anyone, certain types of clients tend to be more interested in them than others. One such group consists of parents with young or newborn children. The birth of a child begins a thought process, which sooner or later causes new parents to focus on who will raise their child if something happens to them. A named guardian is only a substitute, often a poor to fair substitute at best, for the real parent. An ethical will may give new parents some degree of comfort that their child will learn and understand their values.

Another such group consists of terminal patients. Terminal illness forces an individual to come to grips with his or her own mortality. One common result of this is a desire to find meaning in one's life. An ethical will may help in this situation.

Ethical wills are often important to individuals with a strong religious affinity as such individuals typically want their children to understand their religious beliefs. An ethical will may assist with this effort by articulating and explaining the author's religious beliefs and why they are important to the author.

Owners of family businesses may also be attracted to the concept of an ethical will. Family businesses often serve as the glue that binds a family together. In such cases, this results in a focus on the values and other characteristics of the family itself, which distinguish that family from other families. In such an environment, ethical wills not only are greatly appreciated, but also often assist with family business succession issues and multi-generational family plans.

Finally, other life changes that may prompt an interest in ethical wills include the following:

• Marriage
• Birth
• Remarriage
• Marital turmoil
• Divorce
• Geographic move
• Death of a spouse
• Death of a parent
• Change of career
• Retirement
• Health challenge

How to write an ethical will

Each ethical will is a unique, highly personal document. Having said this, many ethical wills follow a similar organizational structure. Individuals who want to write an ethical will may use the following outline as a guide. Specifically, they may pick and choose those headings that are important to them and ignore those which are not.

1. Opening. Determine to whom the author is directing the ethical will. This can be more than one person or alternatively the author can write more than one ethical will. The opening may also discuss the author's reasons for writing an ethical will.
2. Topics to be discussed. The author may want to consider discussing one or more of the following topics in his or her ethical will:
   1. The formative events in the author's life
   2. The world in which the author grew up
   3. Important life lessons learned by the author
   4. Description of important people in the author's life
   5. Explanation of decisions made by the author in his or her legal Will and other testamentary documents
   6. The philanthropic causes that are important to the author
   7. Mistakes that the author has made
   8. The author's reflections on his or her life, how he or she feels about events in the author's life and what the author has accomplished
   9. Expressions of love and gratitude
   10. Discussion of values that are important to the author
3. Hopes for the future. The author may wish to share his or her hopes for the future. Often this relates to the author's hopes for the future with respect to the recipient of the ethical will and may build off of topics discussed as part of the above discussion.
4. Concluding thoughts. When authors are tempted to make negative comments, they should bear in mind that once they pass away they can never retract the words they use. In addition, such comments may cause significant pain to the recipient. Therefore, all authors of ethical wills should carefully review, self-proof or ask a third party to proof their ethical wills to ensure that they reflect their true intent without causing unintended harm
   
   In terms of format, ethical wills were originally made orally. Subsequently, written ethical wills became common and this is the predominant form today. However, audio and video recorded ethical wills are becoming increasingly popular. These offer the benefits of capturing the author's tone, emotions and other intangibles. Unfortunately, however, these forms of ethical wills are subject to technological change and less permanency. Therefore, when using video or audio ethical wills, authors should prepare a written manuscript. All written ethical wills should be written on acid free archival paper.

Conclusion

We firmly believe that ethical wills add substantial value to the estate planning process for clients. They are a beautiful gift from the author to the recipient of the ethical will. In many cases, they convert a horrible chore to a labor of love. For estate planners, suggesting an ethical will may result in a closer bond with clients, greater client satisfaction and increased personal and professional satisfaction from helping clients transfer values and wisdom between generations.

Additional Resources

Books

Barry K. Baines, Ethical Wills: Putting Your Values on Paper (2002).

Barry K. Baines, The Ethical Will Writing Guide Workbook (2001).

Jack Riemer & Nathaniel Stampfer, So That Your Values Life On - Ethical Wills and How to Prepare Them (2003)

Web Sites

www.ethicalwill.com

www.lifebio.com

Family Philanthropy: It Does a Family Good

By

Lewis J. Saret, Esq.

 

Many people give to charity without much thought. Often they give because that's what their parents taught them to do, or it feels good - the right thing to do.  However, there is an additional, excellent, reason why families should consider giving to charity.  Namely, when families give to charity in an organized way (often referred to as family philanthropy), charitable giving can be a very effective parenting tool with significant benefits for the family. 

For example, parents may use family philanthropy to teach their children how to manage financial assets. Schools don't teach children how to manage money, and parents often do a very poor job of this, resulting in young adults with no clue about how to manage their money.  This is particularly true for first generation affluent parents.  Such parents learned to manage money because they had to, their parents were not wealthy and they had a burning desire to achieve financial security.  In contrast, their children grow up affluent and don't have to worry about money. Therefore, they don't learn the same financial skills their parents did. Family philanthropy works particularly well in these situations. 

But, you ask, how can giving away your money teach your children how to keep and grow their money.  There are various ways to do this, but a popular method is to create an informal investment advisory committee for family charitable vehicles, such as family foundations or donor advised funds.  Families then place children on such committees, beginning when their children become teenagers, with an adult retaining ultimate investment authority. When this is part of a family philanthropic plan designed to develop and nurture the entire family's passion for its philanthropic initiatives, these teenagers who would otherwise not care about money management will typically care enough to learn such financial concepts. They will do this because they understand that money management directly impacts the amount the family will make available to give to charitable causes that they care about.  Once learned, these skills are directly transferable to the child's personal financial assets as he/she matures and accumulates wealth, as well as to any family assets that such child may inherit in the future.

Families may also form informal charitable grant committees, often involving children as young as age six and grandparents, which provide additional benefits. The grant committee holds annual or other periodic meetings at which children present their grant proposals.  The requirements for these proposals are tied to the child's age and maturity. For example, for older children more written material about the grant recipient, including more due diligence such as site visits may be required.  Each child makes an oral presentation advocating his or her grant proposal, about which he/she will feel passionate.  Following the presentation, the parents, grandparents, and other children and grandchildren should, with great care and love, critique the request and vote on the application.  Naturally, comments should be tied to the child's age.  As you can see, such activity provides an excellent opportunity to teach children public speaking, writing, problem solving and decision making skills. In addition, it teaches family members how to work together as a family.

Finally, by engaging children in family philanthropy, parents can pass on core values to their children and grandchildren. This includes core values such as generosity, volunteerism, and individuality, but goes far beyond this. Such values may include promoting rights of women and minorities, helping the underprivileged, and promoting environmental conservation and faith-based values including those related to Judaism. Often, when families begin to engage in family philanthropy, they begin by determining what their core values really are.  There are various exercises that can help families articulate their core values. In the author's experience, this often yields unexpected and pleasantly surprising results.  Because these exercises typically involve the entire family, they promote a family dialogue that might not have occurred otherwise, and can lead families down roads providing great fulfillment and bonding for all family members. Ultimately, this can also result in a greater family cohesion, which results from a sense of higher purpose and cooperative effort.

1)    Introduction.

Historically, foreign trusts have been very useful tools for sophisticated estate planners.  However, they have also been the focus of great suspicion and scrutiny by the IRS. Before 1976, properly designed foreign trusts created in low tax jurisdictions provided significant income tax deferral and, in some cases, complete income tax avoidance, even where both the grantor and current trust beneficiaries were US persons.

However, over the years, Congress has repeatedly attempted to discourage the use of foreign trusts by US individuals by passing legislation that has gradually reduced the tax benefits accruing from such trusts. Such legislation has included the following:

·      Revenue Act of 1962.[1]

·      Tax Reform Act of 1976.[2]

·      Revenue Reconciliation Act of 1990.[3]

·      The Small Business Job Protection Act of 1996.[4]

·      Taxpayer Relief Act of 1997.

Because of the aforementioned legislative changes, the tax and other benefits flowing from foreign trusts to US persons have been greatly eroded.  Notwithstanding this, foreign trusts continue to be very useful in certain circumstances.[5]

2)    What constitutes a foreign trust?[6]

a)     Importance of classification of trust as "foreign" or "domestic."

i)      Generally.            Classification of a trust as "foreign" or "domestic" has significant tax consequences.

ii)    Domestic trusts.      Domestic trusts are both:

(1)  Treated as US persons, and

(2)  Are subject to tax on worldwide income.

iii)   Foreign trusts.      Foreign trusts are both:

(1)  Treated as nonresident aliens ("NRAs"), and

(2)  Are subject to tax only on US source income or income effectively connected with a US trade or business.[7]

iv)   Other effects of classification.      Classification of trust also impacts:

(1)  Whether a grantor will be treated as the owner of the trust for income tax purposes under the grantor trust rules.

(2)  Whether gain must be recognized upon transfers to the trust.

(3)  The application of certain withholding provisions.

b)    What makes a trust a "foreign trust?"

i)      Generally.           

(1)  A different set of rules applies to determine whether a trust constitutes a foreign trust, as opposed to a domestic trust, depending on whether the amendments enacted as part of the Small Business Job Creation Act of 1996 (the "1996 Act") apply to the trust.  The 1996 Act generally applies to tax years beginning after December 31, 1996, and at the trustee's election to tax years ending after August 20,1996.

(2)  Before the enactment of the 1996 Act, a subjective analysis was required to determine whether the US treated a trust as domestic or foreign for US tax purposes. The 1996 Act changed the classification scheme to one that determines a trust's nationality based on a set of objective criteria.

(3)  Note.            The situs of a trust for tax years beginning before January 1, 1997 may be relevant, among other things, because that situs may determine the character of accumulated trust income that will be taxed when ultimately distributed to a US beneficiary.

ii)     Definition of foreign trust before the 1996 Act.

(1)  Statutory Rule - IRC § 7701(a)(31).            For tax years beginning before January 1, 1997, IRC § 7701(a)(31) provided that a foreign trust was one "the income of which, from sources without the United States which is not effectively connected with the conduct of a trade or business within the United States, is not includible in gross income under subtitle A."

(2)  Application of the Rule.

(a)  Essentially, the pre-1996 Act version of IRC § 7701(a)(31) provided for a subjective analysis of whether the trust was more comparable to a resident or a nonresident alien individual.[8] 

(b)  Generally, the pre-1996 Act version of IRC § 7701(a)(31), by itself, provided no guidance as to how to determine whether a trust would be classified as domestic or foreign.

(c)   Judicial and administrative authority partially filled the void left by the pre-1996 Act version of IRC § 7701(a)(31) by providing for a test that required a weighing of a trust's foreign contacts against its US contacts.[9]

(d)  The cases and rulings provided that the following six major factors in were to be considered determining the situs and nationality of a trust:

(i)   The country under whose laws the trust was created.

(ii) The situs of the trust's corpus.

(iii)                 The nationality and residence of the trustee.

(iv) The situs of the trust administration.

(v)   The nationality and residence of the grantor.

(vi) The nationality and residence of the beneficiaries.

(e)  Where the various indicia were inconsistent, this test was extremely difficult to apply.

(f)   Courts and the IRS tended to place more weight on the following factors:

(i)   The situs of the trust's corpus.

(ii) The nationality and residence of the trustee.

(iii)                 The situs of the trust administration.[10]

iii) Current (i.e., Post-1996 Act).

(1)  Generally.

(a)  General Rule.            For tax years beginning after December 31, 1996, a trust is a US trust if both:

(i)   A court within the US is able to exercise primary supervision over the trust's administration ("Court Test"); and

(ii) One or more US persons have authority to control all substantial decisions of the trust ("Control Test").[11]

1.     Note 1.      A trust that does not satisfy both of these tests will constitute a foreign trust.[12]

2.     Note 2.      For purposes of the foreign trust definition:

a.     A trust is a US person on any day that the trust meets both the court test and the control test. 

b.     A domestic trust means a trust that constitutes a US person.

c.     A foreign trust means any trust other than a domestic trust.[13]

d.     Treasury regulations apply the terms of the trust instrument and applicable law to determine whether the court test and the control test are met.[14]

(b)  Background - Rationale for enactment of the post-1996 Act Rule.

(i)    Congress's primary objective was clearly to provide an objective test, rather than the prior subjective test.[15]

(ii)  In addition, it appears that one of the principal objectives for the post-1996 definition of foreign trusts was to level the competitive playing field for trust administration business between US and foreign institutions. The pre-1997 rule effectively acted as an incentive for a foreign person to avoid using a US financial institution as trustee because of the significant risk that this would cause the trust to be taxed as a US domestic trust.  Under the post-1996 Act rule, a foreign person can easily use a US financial institution without creating a domestic trust.[16]

(c)   Effective Date.      The post-1996 Act rule applies to tax years beginning after December 31, 1996, and at the lection of the trustee, to tax years ending after August 20, 1996.

(d)  Example 1.      Ms. Havisham, a US citizen who resides in Maryland, creates a trust for her children, all of whom are US citizens. She names the Dickens Trust Company, a Delaware corporation, and her brother, Pip, a Bermuda citizen and resident, as co-trustees. The trust instrument (a) gives Pip the right to determine the ages at which each child receives its share of the trust fund, and (b) directs that the trust funds be maintained in the US in the custody of the Dickens Trust Company, and that Maryland law governs the trust's administration. Here, the trust will be treated as a foreign trust because a foreign person will possess control over a substantial trust decision.

(2)  Court test.

(a)  Generally.      The court test is one of the two tests that a trust must satisfy in order to be classified as a domestic trust.

(b)  General Rule.      To satisfy the court test, a court within the US must be able to exercise primary supervision over the trust's administration.[17]

(c)   Safe Harbor.      Under Treasury Regulations, a trust satisfies the court test if:

(i)    The trust instrument does not direct that the trust be administered outside of the US;

(ii)  The trust in fact is administered exclusively in the US; and

(iii) The trust is not subject to an automatic migration provision described in Treas. Reg. § 301.7701-7(c)(4)(ii).

(d)  Example 2.[18] Charles creates a trust for the equal benefit of his two children, Biddy and Pip, called the Dickens Trust. The trust instrument provides that DC, a Virginia corporation, is the trustee of the Dickens Trust. DC administers the trust exclusively in Virginia and the trust instrument is silent as to where the Dickens Trust is to be administered. In addition, the Dickens Trust is not subject to an automatic migration provision. Here, the Dickens Trust satisfies the court test.

(e)   Definitions.      The following definitions apply for purposes of the court test:

(i)    Court.[19] "Court" means any federal, state, or local court.

(ii)  The United States.[20] "United States" is used in a geographical sense. Thus, for court test purposes, the United States includes only the States and the District of Columbia.

1.     Caution.      A court within a territory or possession of the United States (e.g., Puerto Rico) or within a foreign country is not a court within the United States.

(iii) Is able to exercise.[21]  "Is able to exercise" means that a court has or would have the authority under applicable law to render orders or judgments resolving issues concerning administration of the trust.

(iv) Primary supervision.[22] "Primary supervision" means that a court has or would have the authority to determine substantially all issues regarding the administration of the entire trust. Note that a court may have primary supervision under this definition notwithstanding the fact that another court has jurisdiction over a trustee, a beneficiary, or trust property.

(v)  Administration.[23] "Administration" of the trust means the carrying out of the duties imposed by the terms of the trust instrument and applicable law, including maintaining the books and records of the trust, filing tax returns, managing and investing the assets of the trust, defending the trust from suits by creditors, and determining the amount and timing of distributions.

(f)   Bright line rules for satisfying or failing the Court Test.      Treasury regulations provide the following bright line rules for determining when a trust will satisfy or fail the court test, which are not intended to be an exclusive list:[24]

(i)     Uniform Probate Code.[25]            A trust satisfies the court test if an authorized fiduciary registers the trust in a court within the US pursuant to a state statute containing provisions substantially similar to Uniform Probate Code, Article VII, Trust Administration.

(ii)  Testamentary trust.[26]            A testamentary trust created by a will probated within the US (other than ancillary probate) will satisfy the court test if all fiduciaries of the trust have been qualified as trustees by a court within the US.

(iii) Inter vivos trust.[27]            For inter vivos trusts, if the fiduciaries and/or beneficiaries take steps with a court within the US that cause the trust's administration to be subject to the primary supervision of such court, the trust will satisfy the court test.

(iv) A US court and a foreign court are able to exercise primary supervision over the administration of the trust.[28] If both a US court and a foreign court can exercise primary supervision over the trust's administration, the trust satisfies the court test.

(g)   Automatic migration (i.e., flight) provisions.[29]      A court within the US is not considered to have primary supervision over a trust's administration if the trust instrument provides that a US court's attempt to assert jurisdiction or otherwise supervise the trust's administration, directly or indirectly, will cause the trust to migrate from the US. Such provisions are commonly referred to as "flight provisions," "migration provisions," and "duress provisions." This rule will not apply, however, if the trust instrument provides that the trust will migrate from the US only in the case of foreign invasion of the US or widespread confiscation or nationalization of property in the US.

(h)  Example 3.[30]      Oliver, a US citizen, creates a trust for the equal benefit of his two children, both of whom are US citizens. The trust instrument provides that the Dickens Trust Company, a US corporation will serve as trustee and the trust shall be administered in Bermuda. The Dickens Trust Company maintains a branch office in Bermuda with personnel authorized to act as trustees there. The trust instrument provides that Maryland law governs the trust. Assume that under Bermuda law, a Bermuda court may exercise primary supervision over the trust's administration. Pursuant to the trust instrument, a Bermuda court applies the Maryland law to the trust. However, under the terms of the trust instrument, the trust is administered in Bermuda, and no court within the US is able to exercise primary supervision over its administration. Here, the trust fails to satisfy the court test. Therefore, it constitutes a foreign trust.

(i)    Example 4.[31]      Estelle, a US citizen, creates a trust for her own benefit and the benefit of her spouse, Pip, a US citizen. The trust instrument provides that the trust is to be administered in Maryland, by Copperfield Corporation, a Maryland corporation. The trust instrument further provides that if a creditor sues the trustee in a US court, the trust will automatically migrate from Maryland to Gibraltar, a foreign country, so that no US court will have jurisdiction over the trust. Here, a court within the US is unable to exercise primary supervision over the trust's administration because of the flight provisions. Therefore, the trust fails to satisfy the court test from the time of its creation and constitutes a foreign trust.

(3)  Control Test.           

(a)  Generally.      The control test is one of the two tests that a trust must satisfy in order to be classified as a domestic trust.

(b)  General Rule.      To satisfy the control test:

(i)   One or more US persons

(ii) Must have authority to control

(iii)                 All substantial decisions of the trust.[32]

(c)   Definitions.

(i)    US person. The term "United States person" means a US person within the meaning of IRC § 7701(a)(30).[33] For example, a domestic corporation is a US person, regardless of whether its shareholders are US persons.[34]

1.     Note.      The control test, as originally enacted in the Small Business Job Protection Act of 1996, required that one or more "US fiduciaries" have the authority to control all substantial decisions of the trust in order for the trust to be treated as a domestic trust.[35] Treasury regulations use the term "persons" as defined in IRC § 7701(a)(30), which includes US citizens and residents, and domestic corporations and partnerships.[36]  As a technical correction to the Small Business Job Protection Act of 1996, the Taxpayer Relief Act of 1997 substituted the term "US persons" for "US fiduciaries."[37]

(ii)  Substantial decisions.

1.     Definition under Treasury Regulations.      Treasury regulations define "substantial decisions" as non-ministerial decisions that persons are authorized or required to make under the terms of the trust instrument and applicable law.[38]

2.     Ministerial decisions.      Ministerial decisions, which do not constitute "substantial decisions," include decisions regarding details such as the bookkeeping, the collection of rents, and the execution of investment decisions.[39]

3.     Non-exclusive list of substantial decisions.[40]      Treasury regulations provide the following non-exclusive list of substantial decisions:

a.     Whether and when to distribute income or corpus;

b.     The amount of any distributions;

c.     The selection of a beneficiary;

d.     Whether a receipt is allocable to income or principal;

e.     Whether to terminate the trust;

f.      Whether to compromise, arbitrate, or abandon claims of the trust;

g.     Whether to sue on behalf of the trust or to defend suits against the trust;

h.     Whether to remove, add, or replace a trustee;

i.      Whether to appoint a successor trustee to succeed a trustee who has died, resigned, or otherwise ceased to act as a trustee, even if the power to make such a decision is not accompanied by an unrestricted power to remove a trustee, unless the power to make such a decision is limited such that it cannot be exercised in a manner that would change the trust's residency from foreign to domestic, or vice versa; and

j.      Investment decisions

i.      Note.      With respect to investment decisions, if a US person hires an investment advisor for the trust, investment decisions made by the investment advisor will be considered substantial decisions controlled by the US person if the US person can terminate the investment advisor's power to make investment decisions at will.

(iii) Control.[41]

1.     Treasury regulations define "control" as having the power, by vote or otherwise, to make all of the substantial decisions of the trust, with no other person having the power to veto any substantial decisions.

2.     In order to determine if US persons have control, it is necessary to consider ALL persons who have authority to make substantial decisions of the trust, not only the trust fiduciaries.

3.     Note.      A trust can have a foreign fiduciary and still be a domestic trust, if the foreign fiduciary can be outvoted by domestic fiduciaries. For example, if the trust has one foreign trustee, two domestic trustees, and the trust instrument provides for a majority vote for trustee decisions, the trust satisfies the control test as a domestic trust.[42]

(d)  Safe harbor for certain employee benefit trusts and investment trusts.      Certain employee benefit trusts will be deemed to satisfy the control test as long as US fiduciaries control all of the substantial decisions to be md to benefit a US person, but the law applicable to the trust may require payments or accumulations of income or corpus to/for the benefit of a US person (by judicial reformation or otherwise), all potential benefits that could be provided to a US person pursuant to the law must be taken into account, unless the US transferor demonstrates to IRS satisfaction that the law is not reasonably expected to be applied or invoked under the facts and circumstances; and

c.     If the parties to the trust ignore the trust instrument's terms, or if it is reasonably expected that they will do so, all benefits that have been, or are reasonably expected to be, provided to a US person must be considered.

(iv) Attribution Rules.           

1.     For IRC § 679 purposes, an amount is treated as paid or accumulated to or for the benefit of a US person if the amount is paid to or accumulated for the benefit of:

a.     A controlled foreign corporation.

    Therefore, transfers by will of US decedents to a foreign nongrantor trust will generally not trigger gain recognition under IRC § 684 because the foreign nongrantor trust will take a stepped up basis under IRC § 1014.

(2)  Exception to General Rule.            

(a)   Some commentators argue that there may be IRC § 684 gain recognition upon deaths of US transferors to foreign trusts, which occur in 2010. The argument in favor of this result is as follows:[115]

(i)    Until the US person's death, such person is treated as the owner of the property for US income tax purposes under IRC § 671.

(ii)  The US grantor's death terminates the trust's grantor trust status.

[129]

2.     Beneficiaries.     

a.     Beneficiaries of a complex FNGT must include in their gross income all income that the trust is required to distribute and all income actually distributed to the beneficiaries pursuant to the trust instrument.[130] 

b.     Each beneficiary must include in his gross income an amount equal to his pro rata share of the trust's DNI.[131]

c.     Distributions that exceed the FNGT's DNI are treated either as nontaxable distributions of principal or as distributions of accumulated income from prior years, which are taxable under the throwback rule (discussed below).[132]

b)    Tax at the FNGT level.

i)     Generally.            Unlike the gross income of domestic trusts, which includes the domestic trust's worldwide gross income, the gross income of an FNGT, for purposes of taxation imposed on the trust (as opposed to tax imposed on the trust beneficiaries), consists only of:

(1)  Non-trade/business US source gross income.            Gross income derived from sources within the US that is not effectively connected with the conduct of a trade or business within the US; and

(2)  Trade/business within US.            Gross income that is effectively connected with the conduct of a trade or business within the US.[133]

(a)   Note.      FNGTs generally are not subject to US income taxation on undistributed foreign source income because of a lack of a nexus between the US and the FNGT for income tax purposes. However, foreign source income of an FNGT that is distributed to US beneficiaries may be taxed to such beneficiaries.[134]

ii)    Imposition of US income tax - generally.           

(1)  Income earned by a foreign nongrantor trust ("FNGT"), which as mentioned above is taxed as an NRA, will generally fall into one of two taxing regimes. For FNGTs  "engaged in a trade or business" in the US, the US taxes the net income that is "effectively connected" with the conduct of such trade or business in the same manner as net income earned by a US resident.[135] In contrast, fixed or determinable annual or periodical gains, profits, and income from US sources (commonly referred to as "FDAP" income), which an FNGT earns is typically taxed on a gross basis at a flat 30 percent rate.[136]  In other words, the IRC taxes trade or business income on a net basis at graduated rates. In contrast, the IRC taxes non-business income on a gross basis, without the benefit of deductions, at a flat rate of thirty percent.<%his would allow the FNGT to be able to deduct expenses associated with its US real property rental activity, rather than to pay a flat 30 percent tax on a gross basis.

iv)   Taxation of FNGT Not Engaged in US Trade or Business - FDAP Income.

(1)  Generally.

(a)   IRC §§ 871 and 881 tax NRAs, and therefore, FNGTs, at a flat 30 percent tax on several types of nonbusiness income.  The tax is imposed at a flat 30 percent rate without any deductions or other allowances for costs incurred in producing the income and is typically collected through withholding.[156]  This tax applies to interest, dividends, rents, royalties and other "fixed or determinable annual or periodical" income ("FDAP" income) if such income is: (1) includible in income; (2) from US sources; and (3) not effectively connected in the conduct of a US trade or business.

(b)  FDAP income from sources outside the US is generally not taxable when received by an FNGT. FDAP income from sources within the US that is effectively connected with the conduct of a US trade or business is taxed in the manner described above.

(c)[162] In addition, the tax cannot exceed the amount of the payment less any part of the payment that represents expressly stated interest.[163]

(ii)  OID taxed on a payment is not taxed subsequently on the sale or exchange of the OID obligation.[164] Upon disposition of an OID obligation, all untaxed OID accruing during the time the obligation was held by the FNGT is taxed, even if the accrued amount exceeds the gain on disposition.

(b)  Portfolio Interest.      Portfolio interest on certain types of obligations, which is paid to an FNGT, is not subject to the 30 percent tax.[165]

(c)   Interest on Bank Deposits.      Interest received by FNGTs or foreign corporations on deposits with banks, savings institutions or insurance companies are exempt from tax if they are not effectively connected with the recipient's US trade or business.[166]

(3)  Gain on Sale of Capital Asset.            If an FNGT is not engaged in the conduct of a US trade or business, then the FNGT's US source non-real estate capital gains will not be subject to US federal income tax.  This results because (1) FNGTs are taxed as NRAs not present in the US at any time,[167] and (2) in order for the capital gains of an NRA (which an FNGT is treated as) to be subject to US federal income tax, the NRA must be physically present in the US for at least 183 days.[168]

(a)  Note.      An FNGT's US capital gains will be subject to US income tax at the beneficiary level if the FNGT distributes them to a US beneficiary.

v)     Source Rules.

(1)  Generally.            An FNGT is subject to income tax on income from US sources, including both US source passive income (i.e., FDAP)[169] and income that is effectively connected with the conduct of a trade or business in the US.[170] Because FNGTs are taxed only on income from US sources, it is critical to know the source of the FNGT's income.

(2)  In very general terms, the IRC statutorily provides the following source rules:

(a)   Interest.      Interest is generally sourced by reference to the payer's residence.  Therefore, interest from US borrowers; except for interest from US bank deposits (unless effectively connected with a US trade or business) and portfolio interest, is treated as US source income.[171]

(b)  Dividends.      Dividends paid by a US corporation are US source income.  If a foreign corporation is engaged in a US trade or business, a portion of any dividend payment may be treated as US source income.  Specifically, if 25 percent or more of the foreign corporation's gross income for the three preceding years is US business income, the portion of the dividend attributable to the corporation's US business income will be treated as US source income.[172]

(c)   Personal service income.      Income from the performance of personal services in the US is US source income, subject to the de minimis exception, discussed above.[173]

(d)  Rental income.      Rental income from property located in the US is US source income.[174]

(e)   Royalty income.      Royalty income generated in the US is US source income.[175]

(f)(i)    The deduction for losses allowed by IRC §§ 165(c)(3) if the loss occurred with respect to property located in the US;

(ii)  The deduction for charitable contributions allowed by IRC § 170; and

(iii) The deduction for personal exemptions allowed by IRC § 151.[181] 

(2)  Distributions to beneficiaries.            In addition to the foregoing, distributions to beneficiaries made by either a simple trust[182] or a complex trust[183] are deductible.  However, this merely shifts the taxability for such amounts from the trust to the beneficiaries.

ii)    Deductions related to other income.      No deductions are permitted against US source fixed or determinable annual or periodic income, except to the extent such income is effectively connected to a US trade or business.

iii)   Foreign Tax Credit.      A FNGT engaged in a trade or business within the US that pays foreign income, war profits or excess profits taxes on income that is effectively connected with such trade or business may, subject to certain limitations, credit the foreign tax against its US income tax liability.[184] Alternatively, it may deduct such taxes.[185]

d)    Applicable tax rates.

i)      Income effectively connected with a US trade or business.      For FNGTs  "engaged in a trade or business" in the US, the US taxes the net income that is "effectively connected" with the conduct of such trade or business in the same manner as net income earned by a US resident.[186] In other words, this type of income is subject to the normal tax rates applicable to trusts under IRC § 1(e).[187]

ii)   FDAP income.      In contrast to income effectively connected with a trade or business, fixed or determinable annual or periodical gains, profits, and income from US sources, which an FNGT earns is typically taxed on a gross basis at a flat 30 percent rate.[188]  In other words, the IRC taxes trade or business income on a net basis at graduated rates. In contrast, the IRC taxes non-business income on a gross basis, without the benefit of deductions, at a flat rate of thirty percent.

(1)  Caution.            The 15 percent maximum tax rate applicable to dividend income does not apply to income received by FNGTs.

e)     Withholding.[189]            FNGTs are subject to withholding, which are set forth in very detailed and extensive treasury regulations, and which are too extensive to cover in detail in this outline.  However, it is important for practitioners to be aware that these rules exist.

 

4)    Tax treatment of beneficiaries of FNGTs.

a)    Generally.            As noted above, FNGT income may be entirely taxable to the FNGT, the FNGT's beneficiaries, or partly to each. Under IRC §§ 651 and 661, trusts may deduct amounts properly paid or credited to beneficiaries. Therefore, trusts are treated as conduits to the extent of distributed income, and as separate taxable entities to the extent of undistributed income.  Because DNI is so critical to the tax consequences of distributions to FNGT beneficiaries, this outline next discusses DNI.

b)    Distributable Net Income ("DNI").

i)     Simple versus complex trusts.

(1)  Simple trust.           

(a)  Definition.      A FNGT will constitute a "simple" trust if it satisfies all of the following requirements:

(i)   all income must be distributed currently.

(ii) no amounts may be paid, permanently set aside for, or used for a charitable beneficiary.

(iii)                 no distributions are made other than of current income (i.e., no distributions of accumulated income or corpus).[190]

(b)  Tax treatment.      All of a simple FNGT's income will be taxed to the beneficiaries. In turn the FNGT will receive a deduction for its current income, which it must pay to the beneficiaries, regardless of whether such income is actually distributed or not.[191] The amounts that the beneficiaries must include in their gross income, along with the trust's deduction, are both limited by the trust's DNI.[192]

(2)  Complex trust.

(a)  Definition.      A FNGT will constitute a "complex" trust if any of the following are true:

(i)   It is not required to distribute all of its income currently.

(ii) it distributes accumulated income or principal

(iii)                 or it has a charitable beneficiary.[193]

(b)  Tax treatment.     

(i)   Trust.            A complex FNGT receives a deduction for that portion of its current income that it must distribute plus that portion of its current income that the trustee actually distributes to the beneficiaries pursuant to the trust instrument.[194] The trust's deduction is limited to the amount of its DNI.[195]

(ii) Beneficiaries.           

1.     Beneficiaries of a complex FNGT must include in their gross income all income that the trust is required to distribute plus all income actually distributed to the beneficiaries pursuant to the trust instrument.[196] 

2.     Each beneficiary must include in its gross income an amount equal to his pro rata share of the trust's DNI.[197]

3.     Distributions that exceed the FNGT's DNI are treated either as nontaxable distributions of principal or as distributions of income accumulated from prior years, which are taxable under the throwback rule, which is discussed later in this outline.[198]

ii)   Computation of DNI.

(1)  Generally.            A trust's DNI generally equals its taxable income computed  with the following modifications:

(a)  There is no deduction for distributions to beneficiaries.

(b)  There is no personal exemption deduction.

(c)   The trust's taxable income is increased by any tax-exempt income (net of allocable expenses).[199]

(2)  Modifications to DNI for FNGT.            The DNI of a FNGT is calculated in the same manner as for a domestic trust, with the following modifications:

(a)  Worldwide income.     

(i)   A FNGT's DNI begins with its worldwide taxable income, including both US and foreign source income, without any distribution deduction or personal exemption, and increased by net tax-exempt income, as with a domestic trust.[200]

(ii) The FNGT's DNI specifically includes gross income from sources outside the US, reduced by disbursements allocable to such income that would have been deductible were it not for the IRC § 265(a)(1) limitation, which disallows certain deductions with respect to tax-exempt income.[201]

(iii)                 The FNGT's DNI also includes US source gross income, determined without regard to IRC § 894, which otherwise extends to taxpayers the benefits of an US income tax treaties.[202]  In other words, income that is exempt from tax by treaty must nevertheless be taken into account in computing the FNGT's DNI.[203]

(iv) The two foregoing adjustments are reduced proportionately to the extent that the FNGT is allowed a deduction for charitable distributions or set asides.[204]

(b)  Capital gains.      Unlike domestic trusts, for which DNI generally does not include capital gains, the DNI of FNGTs includes capital gains, regardless of whether they are allocated to income or to corpus under either the governing law or instrument, and regardless of whether they are currently distributed.[205] Capital losses reduce such capital gains to the extent that they do not exceed capital gains.[206] If a FNGT recognizes both capital gains and ordinary income in one tax year, then distributions to US beneficiaries will include a proportionate share of both ordinary income and capital gains, based on the relative inclusion of both in the FNGT's DNI.

c)     Taxation of current distributions.

i)     Generally.            FNGT beneficiaries are taxed on the trust's income to the extent such income is either distributed or required to be distributed.[207] However, the exact US income tax treatment of income distributed to FNGT beneficiaries depends on the following:

(1)  Whether the distribution is of current income (i.e.,. DNI) or accumulated income (i.e., UNI).

(2)  Whether the beneficiary is a US or foreign person.

(3)  Whether the FNGT's income is from within the US or from outside the US.

ii)   Distributions to US beneficiaries.

(1)  Generally.            US beneficiaries of FNGTs must include the following in their gross income:

(a)   From simple trusts:      The amount of any trust income required to be distributed to such beneficiary in the year in question, regardless of whether such income is actually distributed, but limited to the extent of that beneficiary's share of the trust's DNI for that year;[208]

(b)  From complex trusts:      Both:

(i)    The amount of any trust income required to be distributed to such beneficiary in the year in question, regardless of whether such income is actually distributed, but limited to the extent of that beneficiary's share of the trust's DNI for the year;[209] and

(ii) Any other amount (1) required to be distributed to such beneficiary, regardless of whether such amount is actually distribute, or (2) that is properly and actually distributed to such beneficiary, to the extent of such beneficiary's share of the trust's DNI for the year in question.[210]

(2)  Determining the beneficiaries' share of DNI.

(a)   Simple trusts.     

(i)    If the amount of income required to be distributed currently to beneficiaries exceeds the FNGT's DNI, each beneficiary includes in his gross income his proportionate share of such DNI.

(ii)  Example 18.            Adam, a beneficiary of Simple FNGT, a simple trust, is to receive two-thirds of the trust income. Bob is to receive one-third. The income required to be distributed currently is $99,000. Here, Adam will receive $66,000 and Bob will receive $33,000. However, if the DNI is only $90,000, Adam will include two-thirds ($60,000) of the DNI in his gross income, and Bob will include one-third ($30,000) in his gross income.

(b)  Complex trusts.[211]     

(i)    Generally.            The IRC breaks income from complex trusts into two (2) groups (or tiers) of income. However, the amount of income that can be taxed to a beneficiary is limited to the trust's DNI.

(ii)  DNI > Tier 1 income.            If the entire amount of income in tier 1 (i.e., income required to be distributed currently) is less than the trust's DNI, then the entire amount of the trust's income is taxable to the trust's beneficiaries.

(iii) DNI < Tier 1 income.            If the entire amount of income in tier 1 is more than DNI, then each beneficiary is taxable only to the extent of his proportionate share of DNI.

(iv) Tier 2 distributions.                        Tier 2 distributions (i.e., other amounts properly paid, credited or required to be distributed to beneficiaries for the tax year) are taxed to beneficiaries only if the trust's DNI exceeds distributions falling into tier 1. If DNI exceeds distributions falling into tier 1, distributions are taxable to a beneficiary to the extent that they do not exceed his proportionate share of the trust's DNI after reduction for amounts required to be distributed currently.

(3)  Tax character of income.            The tax character of distributions that a beneficiary receives in a year proportionately reflects the character of the trust's income for that year.[212] If the trust agreement or local law requires the trust to allocate particular types of trust income to particular beneficiaries, then the character of distributions to such beneficiaries will reflect that allocation if it has economic significance independent of the tax consequences.[213]

(4)  Credit for US income tax withheld at source.

(a)   FNGT beneficiaries may claim a credit against their US income tax for US income taxes withheld at the source on US source income paid to the FNGT (e.g., withholding on FDAP income or FIRPTA withholding).[214]

(b)  The withholding tax is treated as if it were paid by the beneficiary.

(c)   Note.      To claim the credit, however, the beneficiary must report as his income from the trust the sum of the tax withheld in addition to the amount actually distributed to him.[215]

(5)  Credit for foreign taxes paid by FNGT.

(a)   Although most FNGTs are established in a low/no tax jurisdictions, the FNGT may nevertheless incur foreign taxes or it may be established in a foreign country that does impose taxes upon the trust.

(b)  If an FNGT pays foreign taxes, its US beneficiaries who receive income distributions on which such taxes have been paid may elect to take a credit for the share of foreign taxes attributable to their share of the income.[216] Alternatively, such beneficiaries may deduct such taxes as an itemized deduction.[217]

(c)   To claim the credit, however, it appears that the beneficiary must report as his income from the trust the sum of the foreign taxes paid in addition to the amount actually distributed to him.[218]

iii) Distributions to NRA beneficiaries.

(1)  Foreign source income.            NRA beneficiaries of FNGTs are generally not subject to US income tax on an FNGT's foreign source income. This results because there is no US nexus on which to tax such income to the foreign beneficiary.

(2)  US source income.           

(a)  NRA beneficiaries of FNGTs are subject to US income tax on such FNGT's US source income. Generally, such beneficiaries are liable for US income taxes on the lesser of (1) the income the FNGT actually distributes or is required to distribute, or (2) the FNGT's DNI.

(b)  The character of the FNGT's US income (i.e., as either effectively connected with a US trade or business, or as FDAP income) establishes the beneficiary's US tax liability in the same manner that it establishes the FNGT's tax liability on undistributed income.[219]

(3)  Withholding.            As a practical matter, most of an NRA's US tax liability stemming from an FNGT with US source income may be paid in the form of withholding.[220]

d)    Taxation of Accumulation Distributions.

i)     Generally.

(1)  If an FNGT makes distributions that exceed its DNI in any particular year, the US beneficiaries receiving such distributions must apply the throwback rule, which may subject such distributions to both taxation and an interest charge.

(2)  Generally, the IRC allocates a foreign trust's income for income tax purposes each year between the trust and the trust beneficiaries by means of its DNI.[221] To the extent that DNI is either actually distributed or required to be distributed, (a) the trust deducts such DNI from its taxable income,[222] and (b) the beneficiaries are taxed on such DNI.[223]

(3)  If a trust does not distribute all of its DNI in any year, the amount of its DNI that it does not distribute becomes "undistributed net income" ("UNI"),[224] to which the throwback rule may apply in a future year. [In other words, UNI is the excess of the amount available from DNI for distribution to trust beneficiaries over the amount that the trust actually distributes to such beneficiaries.]  In any year that the trust makes a distribution to its beneficiaries that exceeds its DNI for such year, if it has UNI from prior year(s), the IRC will treat the trust as making an "accumulation distribution." As noted above, the IRC then applies the throwback rule, which may subject such distributions to both taxation and an interest charge.

(4)  The throwback rule is designed to impose on trust beneficiaries approximately the same income taxes that would have been imposed had the trust distributed all of its income on a current basis.

(5)  Application of the throwback rule involves the following concepts:

(a)  The mechanics of the throwback rule.

(b)  Definition of "accumulation distribution."

(c)   Definition of "undistributed net income" ("UNI").

(d)  Computation of the interest charge imposed on accumulation distributions from foreign trusts.

(e)  Application of the character rule.

ii)   Throwback rule mechanics.

(1)  Step 1 - Determine number of preceding tax years of trust to which distribution attributable.           

(a)  Determine the number of preceding taxable years of the trust to which the distribution is attributable. The years to which the distribution is attributed are the earliest years of the trust in which the trust had UNI.[225] These are the actual years in which the income was accumulated based on the trust records.

(b)  Caution.      If the trust's records are insufficient to establish which years have UNI, the accumulation distribution will be allocated to the earliest year that the trust was in existence.[226]

(c)   If the amount of the trust's UNI in one of the accumulation years is less than 25 percent of the average annual accumulation, (i.e., the total accumulation distribution divided by the number of years of accumulation) that year is disregarded in determining the number of years in which the distribution has been accumulated. However, amounts accumulated in any such disregarded year still are considered part of the total accumulation distribution.[227]

(d)   Example 19-A.      Chandler creates the Chandler trust, an FNGT, in 2000.  In 2004, the Chandler trust distributes $35,000 to its beneficiary, Marlowe, when it has DNI of $10,000.  The Chandler trust had the following amounts of UNI: 2000 - $8,000; 2001 - $10,000; 2002 - $7,000, and 2003 - $18,000.  Here, the accumulation distribution would be attributed to three years (i.e., 2000, 2001, and 2002).

(2)  Step 2 - Determine beneficiary's average years.

(a)  Determine the beneficiary's average years. This is determined by examining the beneficiary's taxable income for the five immediately preceding tax years and then ignoring the high and low years.

(b)  Example 19-B. Marlow has the following amounts of taxable income in the five years preceding the 2004 accumulation distribution:

(i)   2003.            $100,000.

(ii) 2002.            $10,000.

(iii)                 2001.            $75,000.

(iv) 2000.            $75,000.

(v)   1999.            $65,000.

Here, Marlowe's average years are 2001, 2000, and 1999.

(3)  Step 3 - Determine the average annual accumulation.

(a)  Determine the average annual accumulation, which is calculated by dividing the total accumulation distribution (including any taxes that the trust paid on the such amounts) by the number of years in which such accumulation distribution was accumulated.

(b)  Note - the number of years in which the accumulation distribution was accumulated was determined in step 1.

(c)   Example 19-C.      Here, the average annual accumulation equals $8,333.33. This amount is calculated by dividing the total accumulation distribution of $25,000 by the number of years in which that accumulation distribution was accumulated, which was three.

(4)  Step 4 - Add average annual accumulation to beneficiary's average years.

(a)  The average annual accumulation, calculated in Step 3, is added to each of the beneficiary's (three) average years, determined in Step 2.

(b)  Example 19-D.      Here, this step would yield the following adjusted amounts of taxable income for Marlowe:

(i)   2001.            $83,333.

(ii) 2000.            $83,333.

(iii)                 1999.            $73,333.

(5)  Step 5 - Compute the average additional tax.

(a)  Compute and average the increase in the beneficiary's tax caused by the addition of the average annual accumulation in each of the beneficiary's average years.[228] If the beneficiary is an NRA during some or all of the applicable years, this should be reflected by a change in the additional tax in such years.

(b)  Example 19-E.      Assume that this step yields the following increase in Marlowe's tax for each of his average years:

(i)   2001.            $2,531.

(ii) 2000.            $2,573.

(iii)                 1999.            $2,573.

This yields an average increase in tax of $2,559.

(6)  Step 6 - Calculate the partial tax on the accumulation distribution.

(a)  Determine the partial tax on the accumulation distribution by multiplying the average additional tax (computed in Step 5) by the number of years of accumulation.[229]

(b)  Example 19-F.      Here, ignoring the credit for taxes paid on the distribution, the partial tax would be $7,677, which equals $2,559 (average additional tax) multiplied by 3 (number of years of accumulation).

(7)  Step 7 - Subtract credit for the taxes paid on the UNI being distributed.

(a)  Subtract from the partial tax, determined in Step 6, a credit for the taxes paid on the UNI by the trust.[230] 

(b)  Note.      Because the beneficiary is given a credit for the taxes paid by the FNGT, the accumulation distribution must be grossed up to reflect such taxes. In other words, such taxes must be added to the accumulation distribution.

(c)   Note.      If a beneficiary receives accumulation distributions from more than two trusts, he/she can only subtract a credit for the taxes paid by the first two trusts.  Taxes by any additional trusts are ignored for purposes of this step.[231]

(d)  Example 19-G.      Assume that the Chandler Trust paid $2,000 of tax on the UNI that it distributes to Marlowe as part of the accumulation distribution. Here, the partial tax is reduced by $2,000.

iii) Character Rule.

(1)  Generally.            Under IRC § 667, the IRC taxes accumulation distributions that FNGT beneficiaries receive as ordinary income, regardless of the character of the income that the trust itself receives, with certain exceptions.[232]

(2)  Exceptions.

(a)  Tax-exempt income.      This rule does not apply to tax-exempt income, which does retain its character in the hands of the beneficiary in the form of an accumulation distribution.[233]

(b)  NRAs.      Accumulation distributions that an FNGT makes to NRA beneficiaries retain the character of such income as recognized by the trust.[234]

(3)  Capital gains.            Since capital gains are included in DNI, if they are not distributed currently, but instead are distributed to a US beneficiary as part of an accumulation distribution, such capital gains will be taxed at ordinary income tax rates when the US beneficiary receives them.

(4)  Elimination of character rule is not limited as to types of character of income to which it applies.            The elimination of character rule does not limit the character of income to which it applies.   Therefore, among other things, it results in the following types of implications:

(a)  Foreign tax credit.      Because a US beneficiary of an FNGT cannot treat any part of the foreign income included in an accumulation as foreign income, such beneficiary loses the benefits of the foreign tax credit.

(b)  Passive activity income.      If passive activity income is included in an accumulation distribution, the beneficiary cannot use such income to offset passive activity losses.

(c)   Tax preference items.      If tax preference items are included in an accumulation distribution, the beneficiary does not have to take such items into account for alternative minimum tax purposes.

iv)   Interest charge.

(1)  Generally.

(a)  IRC § 668 imposes a nondeductible "interest" charge on an FNGT beneficiary's tax, which the IRC imposes on accumulation distributions from the FNGT.[235]

(b)  The IRC imposes the interest charge in addition to any other tax liabilities of the beneficiary of such FNGT.

(c)   The interest charge is imposed on the amount of additional tax imposed on the beneficiary because of the accumulation distribution, but after reduction for any credit for any taxes that the FNGT paid on such distributed income.

(2)  Pre-1996 interest charge.            Under pre-1996 law, the interest rate was a simple 6 percent per year rate.

(3)  Post-1995 interest charge.            The 1996 Act changed the interest rule. Under rules enacted by the 1996 Act, the following rules apply:

(a)  Simple interest accrues at the rate of 6 percent through December 31, 1995.[236]

(b)  Compound interest accrues, beginning January 1, 1996, using the monthly underpayment rate.[237] This compound rate also applies to the total simple interest that accrues for pre-1996 periods.

(c)   The accumulation distribution is allocated proportionately to prior trust years in which the trust has UNI (as opposed to the earliest of such years), and is treated as reducing UNI from prior years proportionately from each year.[238]

(4)  Limit on interest charge.           

(a)  IRC § 668(b) provides that the interest charge, when added to the federal tax imposed on the accumulation distribution (i.e., under the throwback rules described above), cannot exceed the amount of the accumulation distribution itself.

(b)  To illustrate, if you arrived at an additional tax of $70 and an interest charge of $50 on an accumulated distribution of $100, the interest charge would be limited to $30, and after taxes and the interest charge, you would be left with $0 (i.e., rather than being worse off by $20).

(5)  Not deductible.            The IRC § 668 interest charge is not deductible.[239]

v)     Planning to avoid throwback rule and interest charge.      Commentators have suggested the following methods of avoiding taxation of accumulation distributions under the throwback rules.

(1)  Specific gifts.[240]            Distributions in satisfaction of a gift of a specific sum of money or of specific property described in IRC § 663(a)(1) do not constitute an accumulation distribution. Therefore, such distributions will not trigger the throwback rules. For this purpose, a specific sum of money or of specific property described in IRC § 663(a)(1) is an amount that the trust instrument requires to be paid to a beneficiary as a gift of a specific sum of money or of specific property and which is actually paid to such beneficiary all at once or in no more than three installments.[241] 

(2)  Distributions in kind.[242]            FNGT trustees can distribute appreciated securities in kind, but not claim a distribution deduction for the value distributed that exceeds the FNGT's adjusted basis.[243] This defers the tax until the US beneficiary recognizes the capital gain and, therefore, will distribute greater value to the beneficiary without exceeding DNI.

(3)  Use of holding company.[244]            If an FNGT holds investments through a holding company, the trust will have not DNI (and therefore no UNI) until the holding company pays dividends to the FNGT. This allows the trust to accumulate income at the holding company level and ensure that all distributions to FNGT beneficiaries constitute current distributions.

(a)  Caution.      This strategy runs the risk of running afoul of the following tax regimes, each of which has negative tax consequences:

(i)    Passive foreign investment company, which subjects US beneficiaries to the PFIC tax.[245]

(ii)  Foreign personal holding company.[246]

(iii) Controlled foreign corporation.[247]

(4)  Investment in high yield securities.[248]            Because the throwback rules only apply to accumulation distributions after the current year's DNI is exhausted, one effective way to avoid the throwback rule is to change the FNGT's investment mix in years that distributions are desired to increase DNI. If DNI equals or exceeds the contemplated distribution, there should be no accumulation distribution.

e)     Loans to US beneficiaries treated as distributions.

i)      Generally.            IRC § 643(i) provides that, if a foreign trust loans cash or marketable securities directly or indirectly to any US grantor or beneficiary, or any US person who is related to such grantor or beneficiary, then the amount of such loan is treated as a distribution by that trust to such grantor or beneficiary.

ii)    Definitions and special rules.  For purposes of this rule, the following definitions and special rules apply.

(1)  Cash.            Cash includes foreign currencies and cash equivalents.[249]

(2)  Related person.            For purposes of this rule, a person is related to another person if the relationship between them would cause a loss disallowance under IRC § 267 (but applying IRC § 267(c)(4) as if the family of an individual includes the spouses of the members of the family) or IRC § 707(b).[250]

(3)  Trust not treated as simple trust.            A trust that is treated as making a distribution under this rule is treated as a  complex trust.[251]

(4)  Subsequent transactions regarding loan principal.             IRC § 643(i)(3) provides that this rule applies, then "any subsequent transaction between the trust and the original borrower regarding the principal of the loan (by way of complete or partial repayment, satisfaction, cancellation, discharge, or otherwise) shall be disregarded for purposes of this title."

iii)   Note re loans of marketable securities.            As noted above, under IRC § 643(e), unless the trustee elects otherwise, the amount of a distribution other than cash is the lesser of (a) the trust's basis in the distributed property or (b) its fair market value. Therefore, it appears that if an FNGT trust lends marketable securities with a fair market value that exceeds its basis, the deemed distribution under this rule will be the amount of the basis unless the trustee elects to recognize gain on the distribution.

f)     Intermediary rule - distributions through intermediaries.

i)      General Rule.       The IRC treats a US person (i.e., recipient) who receives property from another person (i.e., an intermediary) who received such property from a foreign trust as having received the property directly from such trust if the property the recipient receives was derived directly/indirectly from such foreign trust.[252]

ii)    Exception for grantors.      This rule does not apply if the person from whom the recipient receives the property is the grantor of the foreign trust.

iii)   Treasury regulations - limit rule to tax avoidance transactions.      Treasury regulations only apply this intermediary rule if the transaction in question has a principal purpose of avoiding US tax. (Note, the IRC itself does not make tax avoidance a prerequisite to application of the intermediary rule).[253]

iv)   Tax avoidance purpose.            Treasury regulations deem tax avoidance motivation to exist for purposes of the intermediary rule if all the following requirements are satisfied:[254]

(1)  Relationship.            The US recipient is related[255] to a grantor of the foreign trust, or has another relationship with a grantor that establishes a reasonable basis to or conclude that the grantor would make a gratuitous transfer to such recipient;

(2)  Time frame.            The US recipient receives from the intermediary, within the period beginning twenty-four months before and ending twenty-four months after the intermediary receives the property from the foreign trust, either:

(a)   The property the intermediary received from the foreign trust;

(b)  Proceeds from such property; or

(c)   Property in substitution for such property; and

(3)  Lack of alternate explanation.            The US recipient cannot prove to IRS satisfaction that:

(a)   The intermediary has a relationship with the US recipient that establishes a reasonable basis to conclude that the intermediary would make a gratuitous transfer to such recipient;

(b)  The intermediary acted independently of the grantor and the trustee of the foreign trust;

(c)   The intermediary is not an agent of the US recipient under generally applicable United States agency principles; and

(d)  The US recipient timely complied with the reporting requirements of IRC § 6039F (notice of large gifts from foreign persons, which is filed on Form 3520), if applicable, if the intermediary is a foreign person.

v)    Exceptions.      The intermediary rule does not apply in the following cases.

(1)  Non-gratuitous transfers. The intermediary rule does not apply to the extent that either the transfer from the foreign trust to the intermediary or the transfer from the intermediary to the US recipient does not constitute a gratuitous transfer within the meaning of § 1.671-2(e)(2).[256]

(2)  Grantor as intermediary.            The intermediary rule does not apply if the intermediary is the grantor of the portion of the trust from which the transferred property that is derived.[257]

vi)   Effect of application of intermediary rule.

(1)  General rule.            If the intermediary rule applies, then:

(a)   The intermediary is treated as an agent of the foreign trust.

(b)  The property is treated as transferred to the US recipient in the year the property is transferred, or made available, by the intermediary to the US recipient (as opposed to when the trust transfers the property to the intermediary).

(c)   The fair market value of the property transferred is determined as of the date of the transfer by the intermediary to the US recipient.

(2)  Alternative treatment. If the IRS determines, or if the taxpayer can prove to IRS satisfaction, that the intermediary is the US recipient's agent (rather than the foreign trust's agent), then:

(a)   The IRS will treat the property as transferred to the US recipient in the year the foreign trust transfers the property to the intermediary.

(b)  The fair market value of the property transferred will be determined on the transfer date from the foreign trust to the intermediary.[258]

(3)  Intermediary's taxation.            If the intermediary rule applies to cause the property to be treated as transferred directly by the foreign trust to a US recipient, the intermediary does not take into account such property's fair market value in computing his/her gross income.[259]

vii) De minimis rule.      The intermediary rule does not apply if, during the US recipient's tax year, the aggregate fair market value of all property transferred to such person from all foreign trusts either directly or through one or more intermediaries does not exceed $10,000.

viii)         Related parties.      For purposes of the intermediary rule, a United States recipient is treated as related to a foreign trust grantor trust if the US recipient and the grantor are related for purposes of IRC § 643(i)(2)(B), with the following modifications:

(1)  For purposes of applying IRC § 267 (other than IRC § 267(f)) and IRC § 707(b)(1), "at least 10 percent" is used instead of "more than 50 percent" each place it appears; and

(2)  The principles of IRC § 267(b)(10), using "at least 10 percent" instead of "more than 50 percent," apply to determine whether two corporations are related.

5)    Tax treatment of US beneficiaries of foreign grantor trusts ("FGTs").

a)     Background.           

i)      Prior to the 1996 Act, trusts created by non-US persons were subject to the "grantor trust" rules to the same extent as trusts created by US persons. As a result, the grantor trust rules shifted such a trust's income, for virtually all US income tax purposes, from the trust to its non-US grantor.

ii)    Where a foreign person was treated as the owner of the income because of the grantor trust rule, then (i) the foreign grantor-owner was taxed on such income only under the limited rules for taxing NRA individuals and foreign corporations; and (ii) distributions from the trust to US beneficiaries were treated as gifts from the foreign grantor-owner. Such gifts generally were not taxable to the US beneficiary as income.[260] Gift tax would frequently not be imposed (e.g., where the subject matter of the gift was situated outside the US).

iii)   Today, IRC § 672(f) generally denies grantor trust status to trusts with non-US grantors.

b)    General rule - no grantor status for foreign grantors.

i)      IRC § 672(f)(1) provides that the grantor trust rules apply only to the extent that they cause an amount to be currently taken into account (directly or through one or more entities) in computing the income of a US citizen/resident or a domestic corporation. Accordingly, they apply to the extent that any part of a trust, upon application of the grantor trust rules without regard to IRC § 672(f), is treated as owned by a US citizen or  resident, or domestic corporation.

ii)    The grantor trust rules specifically do not apply to any part of a trust to the extent that, upon application of the grantor trust rules without regard to IRC § 672(f), that part would be treated as owned by a non-US citizen or resident, or a foreign corporation.

iii)   Any portion of the trust that is not treated as owned by a grantor or another person is treated as a nongrantor trust.

iv)   For purposes of this rule, the determination of the part of a trust treated as owned by the grantor or other person is made based on the trust terms, application of the grantor trust rules, and IRC § 671 and the regulations thereunder.[261]

v)    Example 20.[262]

(1)  Chandler, an NRA, funds an irrevocable domestic trust, DTrust, for the benefit of his son, Marlowe, a US citizen, with X Corporation stock. Chandler's brother, Raymond, also a US citizen, contributes Y Corporation stock to the Dtrust for Marlowe's benefit. Chandler has a reversionary interest within the meaning of IRC § 673 in the X stock, which would cause him to be treated as the owner of the X stock upon application of the grantor trust rules without regard to IRC § 672(f). Raymond has a reversionary interest within the meaning of IRC § 673 in the Y stock that would cause Raymond to be treated as the owner of the Y stock upon application of the grantor trust rules without regard to IRC § 672(f). The trustee has discretion to accumulate or currently distribute income of DTrust to Marlowe.

(2)  Here, because Chandler is an NRA, the grantor trust rules (ignoring IRC § 672(f)) would not cause the portion of the trust consisting of the X stock to be treated as owned by a US citizen/resident. Therefore, Chandler is not treated as an owner of the portion of the trust consisting of the X stock under the grantor trust rules. However, because Raymond is a US citizen, the foregoing rule does not apply to him, and he is treated as the owner of the portion of the trust consisting of the Y stock under the grantor trust rules.

c)     Exceptions to the General Rule.

i)      Certain revocable trusts.

(1)  The IRC § 672(f) foreign nongrantor trust rule does not apply to any part of a trust if the grantor retains the power to revest[263] absolutely in him/herself title to such part, and such power is exercisable solely by the grantor without the approval or consent of any other person.[264]

(a)   This exception is satisfied if, in the event of the grantor's incapacity, this power is exercisable by a guardian or other person who has unrestricted authority to exercise such power on the grantor's behalf.[265]

(b)  This exception is also satisfied if the grantor can exercise such power only with the approval of a related or subordinate party who is subservient to the grantor.[266]

(2)  Grandfather rule for certain revocable trusts in existence on September 19, 1995.             The IRC § 672(f) foreign nongrantor trust rule does not apply to any part of a trust that was treated as owned by the grantor under IRC § 676 (revocable trusts) on September 19, 1995, if it would continue to be so treated thereafter. However, this exception does not apply to any portion of the trust attributable to gratuitous transfers to the trust after September 19, 1995. This exception also is subject to certain rules relating to separate accounting for gratuitous transfers to the trust after September 19, 1995, under Treas. Reg. § 1.672(f)-3(d).[267]

(3)  Example 21.[268]             Dashiell, a foreign person, creates and funds a revocable trust, Hammett Trust, for the benefit of his children, who are resident aliens. The trustee is a foreign bank, Maltese Bank, which is owned and controlled by Dashiell and Nick, who is Dashiell's brother. The power to revoke the Hammett Trust and revest absolutely in Dashiell title to the trust property is exercisable by Dashiell, but only with the approval or consent of Maltese Bank. The trust instrument contains no standard that Maltese Bank must apply in determining whether to approve or consent to the revocation of the Hammett Trust. There are no facts that would suggest that Maltese Bank is not subservient to Dashiell. Therefore, the revocable trust exception applies to the Hammett Trust.

(4)  Example 22.[269]            Assume the same facts as in Example 21, except that Dashiell dies. After Dashiell's death, Nick has the power to withdraw the assets of the Hammett Trust, but only with the approval of Maltese Bank. There are no facts that would suggest that Maltese Bank is not subservient to Nick. However, the revocable trust exception is no longer applicable, because Nick is not a grantor of Hammett Trust.

(5)  Example 23.[270] Assume the same facts as in Example 21, except that neither Dashiell nor any member of Dashiell's family has any substantial ownership interest or other connection with Maltese Bank. Dashiell can remove and replace Maltese Bank at any time for any reason. Although Dashiell can replace Maltese Bank with a related or subordinate party if Maltese Bank refuses to approve or consent to Dashiell's decision to revest the trust property in himself, Maltese Bank is not a related or subordinate party. Therefore, the revocable trust exception does not apply.

ii)    Trusts that can distribute only to the grantor or grantor's spouse.

(1)  In general.            The IRC § 672(f) foreign nongrantor trust rule does not apply to a trust of which, at all times during the grantor's lifetime the only amounts distributable from such trust are amounts distributable to the grantor or the grantor's spouse.[271] For purposes of this exception, payments of amounts that are not gratuitous transfers do not constitute amounts that are distributable.

(a)   Note.      This exception may also apply to only part of a trust.[272]

(2)  Amounts distributable in discharge of legal obligations.

(a)   Generally.      A trust will not fail this exception solely because amounts are distributable from the trust to discharge a legal obligation of the grantor or the grantor's spouse. For this purpose, an obligation is considered a "legal obligation" if it is enforceable under the local law of the jurisdiction where the grantor or his/her spouse resides.[273]

(b)  Obligations to related parties.

(i)    Generally.            For purposes of this exception, obligations to related persons do not constitute legal obligations unless they are either:

1.     Contracted bona fide and for adequate and full consideration in money or money's worth; or

2.     The related person is legally separated from the grantor under a decree of divorce or separate maintenance; or

3.     The obligation is to support an individual who both: (a) would be treated as the grantor's (or his spouse's) dependent under IRC § 152(a)(1)-(9) (without regard to the requirement that over half of the individual's support be received from the grantor or the spouse of the grantor); and (b) is either permanently and totally disabled, or less than 19 years old.[274]

iii)   Compensatory trusts.      The IRC § 672(f) foreign nongrantor trust rule does not apply to a certain compensatory trusts. Specifically, treasury regulations provide that it does not apply to any part of

(1)  A nonexempt employees' trust described in IRC § 402(b), including a trust created on behalf of a self-employed individual;

(2)  A trust, including a trust created on behalf of a self-employed individual, that would be a nonexempt employees' trust described in IRC § 402(b) but for the fact that the trust's assets are not set aside from the claims of creditors of the actual or deemed transferor within the meaning of Treas. Reg. § 1.83-3(e); and

(3)  Any additional category of trust that the Commissioner may designate in revenue procedures, notices, or other guidance published in the Internal Revenue Bulletin.

d)    Recharacterization of certain purported gifts.            IRC § 672(f)(4) provides that direct or indirect transfers from a partnership or foreign corporation that are treated as gifts by the transferee may be recharacterized in the manner that the Treasury Department deems appropriate to prevent the avoidance of the IRC § 672(f) rules. The preamble to the proposed regulations under IRC § 672(f)(4) indicated that this provision was intended as a backstop to IRC § 672(f) and was intended to "prevent taxpayers from avoiding the general rule of section 672(f) by using a partnership or foreign corporation as a substitute for a trust."[275]

e)     Trusts created by certain foreign corporations.

i)      IRC § 672(f)(3) and the regulations thereunder provide that the IRC § 672(f) foreign nongrantor trust rule does not apply to controlled foreign corporations ("CFC"), passive foreign investment companies ("PFICs"), or foreign personal holding companies ("FPHCs"). This prevents CFCs,  PFICs, and FPHCs from using foreign trusts to avoid US tax.

ii)    Note.      Although IRC § 672(f)(3) treats CFCs, PFICs and FPHCs as domestic corporations for grantor trust rule purposes, IRC § 674(f)(4) (discussed above) gives the IRS authority to recharacterize purported gifts to US persons that are made directly or indirectly from foreign corporations. The regulations treat gifts to US persons that are made from a trust funded by a foreign corporation as if made indirectly by such corporation if that incurs more US tax.

f)     Recharacterizing beneficiary as grantor of inbound trust.

i)      Generally.      If a foreign person is treated as owning part of a trust, any US beneficiary of such trust is treated as grantor to the extent he directly/indirectly transferred property[276] to such foreign person in excess of transfers to the US beneficiary from the foreign person.[277] This rule applies without regard to whether such beneficiary was a US beneficiary at the time of any transfer.[278]

ii)    Exception.      This recharacterization rule does not apply to the extent the US beneficiary can prove to IRS satisfaction that his/her transfer to the foreign person was wholly unrelated to any transaction involving the trust.

iii)   Example 24.      Dashiell, an NRA, contributes property to the Maltese Corporation, a foreign corporation that is wholly owned by Dashiell. Maltese Corporation creates a foreign trust, Maltese Trust, for the benefit of Dashiell and his children. Maltese Trust is revocable by Maltese Corporation without the approval or consent of any other person. Maltese Corporation funds Maltese Trust with the property received from Dashiell. Dashiell and his family move to the US. Under the recharacterization rule of IRC § 672(f)(5), Dashiell is treated as a grantor of Maltese Trust.

(1)  Note.            Dashiell may also be treated as an owner of Maltese Trust under IRC § 679(a)(4).

iv)   Example 25.      Nick, a US citizen, makes a gratuitous transfer of $1 million to his aunt, Nora, an NRA. Nora creates a foreign trust, the Charles Trust, for the benefit of Nick and his children. Charles Trust is revocable by Nora without the approval or consent of any other person. Nora funds the Charles Trust with the property that she received from Nick. Under the recharacterization rule of IRC § 672(f)(5), Nick is treated as a grantor of the Charles Trust.

(1)  Note.            Nick also would be treated as an owner of the Charles trust as a result of IRC § 679.

g)     Pre-immigration trusts.

i)      Generally.      If an NRA becomes a US person and has a residency starting date within five years after transferring property to a foreign trust (the "Original Transfer"), the IRC treats him as having transferred to the trust on the residency starting date an amount equal to the portion of the trust attributable to the property he transferred in the Original Transfer.[279]

ii)    Cessation of application of grantor trust rules.      If an NRA who is treated as owning any part of a trust under the grantor trust rules, subsequently ceases to be so treated, he/she is treated as making the original transfer to the foreign trust immediately before the trust ceases to be treated as owned by him/her.

iii)   Treatment of undistributed income.       For purposes of the pre-immigration trust rules, the property deemed transferred to the foreign trust on the residency starting date includes undistributed net income, as defined in IRC § 665(a), attributable to the property deemed transferred. However, undistributed net income for periods before the individual's residency starting date is taken into account only for purposes of determining the amount of the property deemed transferred. In other words, an NRA who immigrates to the US within five years of creating a foreign trust is deemed to have transferred to the trust both (a) the amounts previously transferred, plus (b) the undistributed income and appreciation in the assets held by the trust and attributable to the original transfers, on the date that the NRA becomes a US resident.

6)    Reporting requirements.

a)     Form 3520:            Annual return to report transactions with foreign trusts and receipt of certain foreign gifts.

b)    Form 3520-A:            Annual information return of foreign trust with US owner.

c)     Form 1040 NR:            US nonresident alien income tax return.

d)    Form 4970:            Tax on accumulation distributions of trusts.

e)     Form TD F 90-22.1:             Report of foreign bank and financial accounts.

f)     FIRPTA reports.

By Lewis J. Saret[1]

 

1)    Introduction.

The world that we live in, as well as the world economy, is becoming increasingly global. To illustrate, an estimated four to ten million US nationals live abroad.[2]  In this increasingly global environment, there are an increasing number of migratory families and other nonresident aliens who have substantial contacts with the US.

These individuals include foreign executives moving to the US to run US companies or US subsidiaries of foreign companies, wealthy aliens who acquire homes in the US for retirement or vacation purposes, and young aliens with substantial wealth.  They also include migratory families or family members, what the media once called "jet setters," who have homes and substantial assets in various parts of the world, including the US, and who constantly move from one locale to another. Many of these individuals come from countries with very different tax systems than ours.  They typically would be shocked to learn that their contacts with the US may cause them to be treated as US resident aliens for tax purposes, thereby subjecting them to US income taxation on their worldwide income, and US estate and gift taxation on their worldwide assets.

The US also continues to be one of the most desirable destination countries for immigrating families and individuals. Despite the September 11 terrorist attacks, the US continues to have the most stable political system in the world, and it remains one of the safest countries to live in.  It also has one of the highest standards of living in the world, and it remains the sole "superpower" today. 

In addition, the character of individuals immigrating into the US today differs from the historical character of immigrants into the US.  Today, many immigrants come to the US with substantial assets and either a high level of income, or a high probability of receiving a high level of future income. This is in stark contrast to the huddled masses that once immigrated to the US.

Based on the foregoing, we believe that international issues in estate and tax planning, which have always been important, will become even more important as time goes by. This is also the clear historical trend. In this regard, estate and tax planners can provide substantial tax and estate planning benefits to such individuals, frequently, by using very simple techniques.

2)    Federal estate and gift taxation of nonresident aliens ("NRAs")

a)    Generally.

NRAs are subject to federal estate taxes at the same rates applicable to US citizens and residents - but only on assets situated in the US at the time of their deaths.[3] They are subject to federal gift taxes only with respect to transfers (by trust or otherwise) of real or tangible property (but generally not intangible property) situated in the US, after taking into consideration the annual gift tax exclusion, which is currently $11,000 per year, per donee.[4]

b)    Who is an NRA?

i)     Generally / Significance of issue.

If an individual is a US citizen or resident alien, the US subjects that individual to US estate and gift taxation on his/her worldwide assets. In contrast, if an individual is an NRA, then: (a) the US subjects him/her to US estate and gift taxation only on assets situated in the US; and (b) with proper planning, that person may avoid virtually all US estate and gift tax.

To be an NRA, an individual must be neither a US citizen, nor a US resident.

ii)   Citizenship.

Citizenship is generally an objective factual issue. Most individuals know, with a high level of confidence, whether they are US citizens.  In cases of doubt, it is prudent for tax practitioners to consult with immigration lawyers.

Occasionally, individuals may mistakenly believe that they have lost their US citizenship for US tax purposes by the commission of certain acts. However, not only must a person commit one of the several acts set out by statute, but he/she must do so voluntarily and with the intent to surrender his/her US nationality.[5]  Therefore, when presented with a client who was once a citizen, the practitioner must carefully review that client's citizenship status.

If client is in fact a US citizen, then he/she is subject to estate and gift taxation on his/her worldwide assets, just as any other citizen would be, regardless of the location of his/her residence or domicile.  Example 1 illustrates the situation where an estate planner is most likely to encounter this type of situation.

Example 1.            Carl, a US citizen and resident, retains Edith Estate-Planner to prepare his estate plan.  In the course of the initial client interview, Edith asks Carl if he expects to inherit any substantial wealth. Edith learns that Carl expects to inherit several million dollars from his father, Frank, who lives in Switzerland, where Frank has lived for the past fifty years. Upon further inquiry, Edith learns that Frank was born in the US and holds a US passport, even though he has not stepped foot in the US for more than forty years. Edith also learns that Frank has just assumed that he is not a US citizen for US tax purposes, since he does not live in the US. More precisely, because frank has intended to remain outside the US for his remaining life, he has not even thought about whether he is a US citizen for tax purposes, and has just assumed that he is not treated as a US citizen for US tax purposes. Therefore, Frank has not filed any US income or other tax returns for the past fifty years.

Caution.            The facts illustrated by Example 1, which are more common than one would expect, raise significant and serious tax issues.  Estate planners must tread very carefully in such situations because, in certain circumstances, they may inadvertently both (1) expose themselves to civil and criminal tax liability, and (2) expose their clients to additional civil and criminal tax liability.  A full discussion of the issues raised by such situations exceeds the scope of this article.  However, in such cases estate planners, unless they are familiar with these issues, should immediately contact tax counsel who has previously dealt with these issues.

(1)  Special treatment for citizens/residents of US possessions.           

The IRC treats US citizens and residents of US possessions differently in certain respects than other US citizens and residents for estate and gift tax purposes. Specifically, the IRC treats US citizens as NRAs for estate and gift tax purposes if both:

·      They acquire US citizenship solely by reason of their (a) being a citizen of such US possession, or (b) birth or residence within such possession, and

·      They are both a citizen and resident of such possession at their death or at the time of the gift in question.[6]

If this context, if a US citizen acquires citizenship by birth in one possession and dies in a different possession, he/she is also treated as NRA.[7]  In addition, where a US citizen acquires citizenship by virtue of his/her parent's residence in one possession and then dies in a different possession, he/she is also treated as NRA.[8]

Example 2.            Paul is born in Texas.  When Paul is two years old, his parents move to Puerto Rico, where Paul lives until his death, at the age of 43.  Here, this special rule does not apply, and Paul is treated as any other citizen for estate tax purposes.

Example 3.            Same facts as Example 2, except that Paul is born in Puerto Rico, and his parents move to Texas when Paul is two years old.  When Paul is 40 years old, he moves to Puerto Rico, where he dies three years later.  Here, Paul is treated as an NRA for estate tax purposes.

iii) Residence.

(1)  Domicile is test.

For estate tax purposes, a nonresident decedent is a decedent who, at the time of his death, had his domicile outside the US.[9] Consistent with the above discussion, the term "United States" means only the fifty states and the District of Columbia.  It does not include US possessions.

Caution.            Many accountants and attorneys mistakenly confuse the estate and gift tax residence test with the US income tax residence test. The estate and gift tax residence test differs from the income tax residence test.  Consequently, an individual can be a resident for income tax purposes but not for transfer tax purposes, and vice versa.

(2)  Domicile Defined.

Treasury regulations provide that a person acquires a domicile in a place by living there, even for a brief period of time, with no definite intention of later removing therefrom. Residence without the requisite intention to remain indefinitely will not suffice to constitute domicile, nor will intention to change domicile effect such a change unless accompanied by actual removal.[10]

Whether a person is domiciled in the US is a fact issue.  Proof of the required intent to remain depends on all of the relevant facts and circumstances.  Relevant factors include the following:[11]

·      Immigration status of the individual.

Note.            The US issues two types of visas, immigrant and nonimmigrant visas.  Most non-immigrant visas limit visa-holders to a specified time period during which they may remain in the US.  All other things being equal, holding a non-immigrant visa would seem to indicate nonresident status, since such a visa does not allow the holder to legally remain in the US. However, this is not always the case.[12]  Conversely, all other things being equal, if a person holds an immigrant visa, this would seem to indicate intent to remain in the US indefinitely. Having said this, a green card holder is not necessarily an ipso facto resident. Again however, a green card would appear to be strong evidence of residence.[13]

·      Presence within the US, including duration of stay in the US and elsewhere, the frequency and nature of travel, etc.

·      Nature, extent, and reasons for temporary absence from the foreign home.

·      Individual's own statements, including statements made to immigration authorities, and contained within legal documents (e.g., wills, deeds, divorce petitions, etc.).[14]

·      The size, cost, location, and nature of the individual's home or other dwelling places, and whether such home is owned or rented.[15]

·      Marital status and residence of individual's family. To illustrate, if a person moves his/her family to the US and places his/her children in US schools, this would indicate an intent to remain in the US.[16]

·      Situs of clothing and personal belongings.

·      Participation in community activities.[17]  To illustrate, if an individual becomes active within the community within which he lives in the US by joining a Rotary or Lions club, this would seem to indicate an intent to remain in the US indefinitely.  On the other hand, if a foreign business executive joins a private social club for business entertainment purposes, this would appear to be irrelevant with respect to the executive's intent concerning establishing a new domicile in the US.

·      Phone listing, US driver's license, and auto registration.

·      US bank accounts and investments.

·      Participation in US business ventures.[18]

·      Payment of taxes.

·      Voting.

·      Return ticket.

·      Registration.

·      Stationary.

·      Mail.

Example 4.[19]                       

Facts.            D was an illegal alien who entered the US in 1959.  Two years later, D's wife illegally immigrated into the US. D remained in the US until his death, in 1978. Between 1959 and 1978, D purchased a home in the US, and remained there until his death.  He was a member of several local clubs and an active participant in the community.  In 1964 and in 1972, D purchased rental real property in his native country, which he rented out.  At his death, D's estate took the position that D was an NRA, and therefore, that the real property located in D's native country was not includible in his federal gross estate.

Ruling.            The IRS ruled that an illegal alien who lived in the US for 19 years with his family, purchased a residence, and established strong community ties was domiciled in the US at his death. Therefore, his taxable estate is subject to the estate tax imposed by IRC § 2001, including estate tax on the real property located in D's native country.

Example 5.[20]

Facts.            D, a citizen of a foreign country, was an employee of an international organization at his death. In 1965, D entered and remained in the US with a "G-4" visa. A "G-4" visa is a non-immigrant visa granted to employees of international organizations. After arrival, D formed the intent to remain in the US indefinitely, and the intent persisted until D's death in 1978.

Ruling.            At date of death, D was a US resident. Therefore, the transfer of D's taxable estate, both situated inside and outside the US, is subject to federal estate tax under IRC § 2001.

c)     Gross Estate And Situs Rules.

i)     Generally.

The issue of situs is extremely important because only an NRA's US situs property is subject to estate, gift, and GST tax.[21] The appropriate analysis is as follows:

·      Determine the gross estate of the NRA.

·      Determine if any treaties apply.  This is because treaties may modify the situs rules applicable to an NRA's property. As of the date of this article, countries with which the US has estate tax treaties include the following:

Ø  Australia,

Ø  Austria

Ø  Denmark

Ø  Finland

Ø  France

Ø  Germany

Ø  Greece

Ø  Ireland

Ø  Italy

Ø  Japan

Ø  Netherlands

Ø  Norway

Ø  South Africa

Ø  Sweden

Ø  Switzerland

Ø  United Kingdom

·      Determine the situs of the NRA's property, under an applicable treaty, if one applies, or under the situs rules, discussed below.

ii)   Real Property.

Real property is deemed to have its situs in the place where it is located.[22]

The issue occasionally arises as to what constitutes real property.  Because neither the IRC nor treasury regulations define "real property," either an applicable treaty or the law of the jurisdiction governs the issue of what property constitutes real or personal property.[23]  To illustrate, generally, real property includes land, buildings, improvement and fixtures, growing crops,[24] timber cutting rights,[25] and mineral rights.[26]  Conversely, real property generally does not include leasehold interests, unless the lease term is sufficiently long,[27] and security interests such as mortgages.[28]

Planning Pointer.            NRAs acquiring real property may do so through a non-US company.  This will effectively convert US real property into non-US intangible personal property for federal estate tax purposes.[29] This analysis assumes, of course, that the non-US company is a valid and bona fide corporation, with all proper corporate formalities maintained.[30]  In this regard, NRAs who already own US real property can also effectively convert US real property into non-US intangible personal property for federal estate tax purposes. However, there may be FIRPTA issues in doing this.  A common structure for this purpose is to have US real property owned by a US company, which in turn is owned by a foreign holding company.

Caution regarding Earnings Stripping Rule.            When using a foreign holding company that owns a US subsidiary to hold US real property, practitioners should examine carefully any debt that the US company uses to finance the acquisition of the real estate.  Specifically, there is an issue of whether such debt triggers the IRC § 163(j) earnings-stripping rule. 

As a general matter, the earnings stripping rule applies to a corporation for tax years where (a) its ratio of debt to equity at the close of the tax year exceeds 1.5 to 1, and (b) it has excess interest expense for the year.[31]  Generally, "excess interest expense" would be the amount by which the US subsidiary's "net interest expense" exceeds 50 percent of its adjusted taxable income.[32]

To the extent the earnings stripping rule applies to a US subsidiary for a taxable year, "disqualified interest" paid or accrued during such tax year would be nondeductible, except to the extent that such interest exceeds the US subsidiary's excess interest expense.  For this purpose, disqualified interest includes (1) interest payable to a related person not subject to US tax on such interest; (2) interest payable to an unrelated person under an obligation guaranteed by a related person that is either tax-exempt or a foreign person; or (3) interest paid or accrued by a taxable real estate investment trust ("REIT) subsidiary to the REIT.[33]

It should be noted that this issue, earnings stripping, is a favorite one for IRS international examiners.  The issue is usually "picked up" as a result of the US company, filing its Form 5472, Information Return of 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade of Business, disclosing the fact that it is more than 25 percent owned by a foreign person and that there is a related-party transaction.

Finally, advisors should note that the earnings stripping issue is not limited to US real estate holding companies.  It can crop up for many types of US subsidiaries of foreign parents.

Caution regarding use of debt to reduce value of real property.                        Sometimes NRAs get creative and try to reduce the value of US real property, particularly US homes, by encumbering such property with a mortgage.  This strategy is problematic in that for it to succeed, the mortgage must be non-recourse debt, secured solely by the real property.  Unless this is the case, the mortgage will not reduce the value of the real property house for purposes of inclusion in the NRA's gross estate.  Instead, such mortgage would constitute a deduction for US estate tax purposes.  More important, as discussed below, it would be only partially deductible. Specifically, the mortgage would be allocated to the US gross estate, for deduction purposes, in proportion to the US gross estate over the worldwide gross estate.  In other words, the mortgage would be multiplied by a fraction, the numerator of which would be assets includable in the NRA's US estate, and the denominator would be the NRA's worldwide assets, even though the entire mortgage relates to US assets.[34]

iii) Tangible Personal Property.

The situs of tangible personal property is determined by its physical location at the time of death or gift.[35]  However, items of personal property accompanying an NRA who dies while temporarily visiting the US are not includible in his/her gross estate.[36]

One type of tangible personal property that is particularly problematic is art. This is because art is portable and highly valuable.  It is not unusual for an NRA to loan art to a US museum or to send art to the US to be cleaned or sold.  Under the general situs rule for tangible personal property, if an NRA who has loaned property to a US museum dies during the period of such loan, that NRA would be subject to estate tax on such art.  Because this is obviously unfair, the IRC provides an exception for this type of situation.  Specifically, works of art owned by an NRA decedent are not included in the NRA's estate if such art was:

·      Imported in the US solely for exhibition purposes;

·      Loaned for exhibition purposes to a public gallery or museum, no part of the net earnings of which inures to the benefit of any private shareholder or individual; and

·      At the time of the NRA decedent's death, on exhibition, or en route to or from exhibition, in such a public gallery or museum.[37]

Caution.            If an NRA sends artwork to the US to be cleaned or sold, and dies in the interim, such artwork will be subject to US estate taxation.

Planning Pointer.            In the facts of private letter ruling 199922038, an NRA loaned 31 works of art to a US museum, which rotated its art so that all 31 works of art were generally not on display continuously. The museum stored those pieces not on current display.  The IRS ruled that none of the 31 works of art, including any in storage, would be subject to US estate tax if the NRA died during the loan period.  It reasoned that the entire collection was "on exhibition for purposes of section 2105(c) even though only part of the collection will actually be on display to the public at any given time on a rotating basis." Based on this rationale, an NRA could enter into a similar arrangement with a museum, loaning several pieces to such museum, and requiring the museum to clean or restore such art as a condition of the loan.  Such arrangements with museums are common. 

Currency or cash.            Currency or cash that an NRA owns is not considered to constitute a debt obligation or intangible property. Currency or cash owned by an NRA, which is located in the US (e.g., in a safe deposit box) constitutes tangible personal property subject to US estate tax.[38]

Personal property of diplomatic personnel.            Personal property of diplomatic personnel in the US is not includible in the NRA's gross estate if such property is used in the conduct of such NRA's official mission and is reasonably required for such purpose.[39]

iv)   Shares Of Stock Of A Corporation.

US tax law deems shares of stock issued by a US corporation that are beneficially owned (or deemed beneficially owned) by an NRA at his death to be situated in the US.[40]  In contrast, US tax law deems shares of stock issued by a foreign corporation that are beneficially owned (or deemed beneficially owned) by an NRA to be situated outside the US.[41]

The location of the stock certificates, evidencing ownership of stock, is completely irrelevant for federal estate tax purposes.The decedent's tangible property situated in the US;

Other non cash-assets acquired by US persons from the decedent with a value in excess of $60,000; and

Appreciated property acquired by a US person from the decedent if that property was acquired by the decedent by gift within three years of the date of gift and a gift tax return for such property was required to be filed by the donor.[108]

i)     Gift Tax.

The US imposes a gift tax on donors, not the donee.[109]  In addition, a donee's citizenship or residence is irrelevant for federal gift tax purposes. Therefore, NRAs can make unlimited gifts to US persons without any liability for US gift tax if the property gifted has a situs located outside of the US.[110]

As an incidental note, the IRC's estate tax provisions for NRAs are contained within a separate subchapter (i.e., Subchapter B, Estates of Nonresidents Not Citizens, of Chapter 11, Estate Tax).  In contrast, the IRC's gift tax provisions for NRAs are not contained in a separate subchapter. Instead, they consist of specific provisions within Chapter 12, Gift Tax.

i)  %Text" style="margin-bottom: 6pt; line-height: 150%;">[55]             IRC § 871(h).