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Navigating US Tax Implications with Foreign Trusts

by Tas Meghani

Alden, a Jersey resident, is setting up a Jersey Trust and seeks clarity on potential US tax implications for himself and his family. A US citizen by birth, Alden falls under the classification of 'US persons.' His Swiss-born wife, Nur, is a non-resident alien (a non-US person), while their Swiss-born children, Zara and Yan, are considered US persons due to Alden's previous US residence and US citizenship at their birth.

The Jersey Trust, established to benefit Alden's family, contains cash funds, a portion of his Jersey-based investment portfolio, and shares in his family company. Alden has relinquished any control over the Trust and is excluded from receiving any benefits from it.

Alden aims to understand the Trust's treatment for US tax purposes.

Initially, the Trust's 'foreign' status is determined through the 'Court' and 'Control' tests. The Court Test evaluates whether a US court holds primary supervision, while the Control Test assesses if US persons have substantial decision-making authority. It is concluded that Alden’s Trust will be treated as ‘foreign' for US tax purposes.

Subsequently, Trusts are categorized into Foreign Grantor Trusts and Foreign Non-Grantor Trusts. A review of the Trust, including analysis of the grantor powers retained and the potential US beneficiaries is required. Despite Alden's intention to distance himself from the Trust, US tax laws treat him as the owner of the Trust for income tax purposes as the Trust can benefit US persons. As the owner, all trust income and assets must be reported as though they belong to Alden for US tax reporting purposes. However, any trust distributions made to his US children are considered tax-free in the US. US beneficiaries are required to report such distributions, albeit without incurring additional US tax liabilities.

Given the US tax exposure, Alden must analyse the assets held in the Trust. These include an interest in a Jersey corporation and an investment portfolio comprising non-US mutual funds and collective investments. Complex tax laws affect investments meeting the definitions of Controlled Foreign Corporations (CFC) and Passive Foreign Investment Company (PFIC).  The US tax rules have been established to prevent US taxpayers from deferring taxes by investing in foreign entities that primarily generate passive income, such as interest, dividends, royalties, or capital gains. Alden realizes that the tax treatment of CFCs and PFICs can be complex and may lead to unfavourable tax outcomes.

Trustees, the US owner, and US beneficiaries are all subject to US tax filing requirements.

Alden’s original intentions may not align with the current US tax implications of the Trust. When Alden established the Trust, he did not foresee ongoing US taxation on its underlying income, especially given his higher US tax rates compared to those of his children. Alden should reconsider whether establishing a foreign trust supports his intentions.

Read also Guide to Foreign Trusts and US Tax Compliance for Foreign Trusts.

Tas Meghani is a Trusts Tax Director with 20 years’ US/UK tax experience and heads the USTAXFS global trust tax team. She focuses on US and international tax associated with non-US trusts and US beneficiaries to meet the complex US tax compliance and informational reporting.

19 April 2024