Outbound Migration of Domestic Trusts Tax and Reporting Traps

Outbound Migration of Domestic Trusts Tax and Reporting 

When a US trust migrates outbound, that means that the domestic trust is at risk of becoming re-categorized as a foreign trust. This is common in situations in which the US person may relocate overseas and give up their US citizenship (aka expatriate) or when the domestic trust is a DAPT (Domestic Asset Protection Trust) that may become subject to a lawsuit or other enforcement and the trust wants to hightail it out of the United States. When the trust is migrated, it seeks to avoid becoming subject to US tax laws. The problem then becomes that once the domestic trust is migrated offshore, it will generally be treated as a foreign trust for US tax purposes. Whether the trust has US beneficiaries or not will impact whether the trust or the grantor becomes taxable on the transfer. Once the trust becomes foreign there may be additional US Tax requirements (including throwback tax rule complications) — along with requiring certain foreign reporting on Forms 3520 and 3520-A. Let’s look at the federal regulation involving the migration of domestic trusts.

26 CFR 1.684-4 – Outbound migrations of domestic trusts.

• • • In general.

      • If a U.S. person transfers property to a domestic trust, and such trust becomes a foreign trust, and neither trust is treated as owned by any person under subpart E of part I of subchapter J, chapter 1 of the Internal Revenue Code, the trust shall be treated for purposes of this section as having transferred all of its assets to a foreign trust and the trust is required to recognize gain on the transfer under § 1.684-1(a). The trust must also comply with the rules of section 6048.

    • Date of transfer.

      • The transfer described in this section shall be deemed to occur immediately before, but on the same date that, the trust meets the definition of a foreign trust set forth in section 7701(a)(31)(B).

    • Inadvertent migrations.

      • In the event of an inadvertent migration, as defined in § 301.7701-7(d)(2) of this chapter, a trust may avoid the application of this section by complying with the procedures set forth in § 301.7701-7(d)(2) of this chapter.

    • The following examples illustrate the rules of this section.

      • In all examples, A is a U.S. citizen, B is a U.S. citizen, C is a nonresident alien, and T is a trust. The examples are as follows:

        • Example 1. Migration of domestic trust with U.S. beneficiaries. A transfers property which has a fair market value of 1000X and an adjusted basis equal to 400X to T, a domestic trust, for the benefit of A’s children who are also U.S. citizens. B is the trustee of T.

          • On January 1, 2001, while A is still alive, B resigns as trustee and C becomes successor trustee under the terms of the trust.

          • Pursuant to § 301.7701-7(d) of this chapter, T becomes a foreign trust.

          • T has U.S. beneficiaries within the meaning of § 1.679-2 and A is, therefore, treated as owning FT under section 679.

          • Pursuant to § 1.684-3(a), neither A nor T is required to recognize gain at the time of the migration.

        • Section 1.684-2(e) provides rules that may require A to recognize gain upon a subsequent change in the status of the trust.

        • Example 2. Migration of domestic trust with no U.S. beneficiaries. A transfers property which has a fair market value of 1000X and an adjusted basis equal to 400X to T, a domestic trust for the benefit of A’s mother who is not a citizen or resident of the United States.

          • T is not treated as owned by another person.

          • B is the trustee of T.

          • On January 1, 2001, while A is still alive, B resigns as trustee and C becomes successor trustee under the terms of the trust.

          • Pursuant to § 301.7701-7(d) of this chapter, T becomes a foreign trust, FT.

          • FT has no U.S. beneficiaries within the meaning of § 1.679-2 and no person is treated as owning any portion of FT.

          • T is required to recognize gain of 600X on January 1, 2001. Paragraph (c) of this section provides rules with respect to an inadvertent migration of a domestic trust.

Foreign Trust and US Persons

The key takeaway from the regulations is the fact that the outbound migration of a domestic trust may result in the trust becoming a foreign trust – which may result in an immediate tax liability for the grantor or the trust.

Foreign Trusts are Presumed to Have Beneficiaries

In general, Grantors have to be especially careful of potential tax implications in light of the fact that the trust will be presumed to have US Beneficiaries.

As provided by the IRS Practice Unit:

• • • “The IRC presumes every foreign trust has a U.S. beneficiary unless the transferor can demonstrate otherwise. To establish the trust does not have a U.S. beneficiary, the transferor must submit information regarding the transfer(s) and must demonstrate, to the satisfaction of the Secretary of the Treasury, the transfer(s) satisfies the requirements of IRC § 679(c)(1)(A) and (B).

    • This statutory presumption is effective for transfer(s) of property after 3/18/2010.”

679(c)(1)(A) & (B)

• • • (c) Trusts treated as having a United States beneficiary

      • (1) In general For purposes of this section, a trust shall be treated as having a United States beneficiary for the taxable year unless—

        • (A) under the terms of the trust, no part of the income or corpus of the trust may be paid or accumulated during the taxable year to or for the benefit of a United States person, and

        • (B) if the trust were terminated at any time during the taxable year, no part of the income or corpus of such trust could be paid to or for the benefit of a United States person. For purposes of subparagraph (A), an amount shall be treated as accumulated for the benefit of a United States person even if the United States person’s interest in the trust is contingent on a future event.

IRC 679(d)

• • • (d)Presumption that foreign trust has United States beneficiary

      • If a United States person directly or indirectly transfers property to a foreign trust (other than a trust described in section 6048(a)(3)(B)(ii)), the Secretary may treat such trust as having a United States beneficiary for purposes of applying this section to such transfer unless such person—

        • (1) submits such information to the Secretary as the Secretary may require with respect to such transfer, and

        • (2) demonstrates to the satisfaction of the Secretary that such trust satisfies the requirements of subparagraphs (A) and (B) of subsection (c)(1).

Form 3520 and Form 3520-A

Once a trust is considered a foreign trust, the owners of the trust will have to file Forms 3520 and 3520-A. There are limited exceptions, exclusions, and limitations for reporting.

Throwback Tax Rule

Another complex issue involving foreign trust is the application of UNI and DNI principles in accordance with the throwback tax rule and certain annual elections that must be made. In general, the throwback tax rule calculation is very complex.

Penalties for Non-Compliance

The failure-to-file Forms 3520/3520-A may also result in foreign trust reporting penalties. And, for the past few several years the IRS has actively pursued fines and penalties against Taxpayers who are out of compliance. Some Taxpayers may qualify for penalty avoidance or a penalty abatement (see below)

Statute of Limitations

Until the proper and correct international trust reporting forms have been filed, the statute of limitations does not begin to run – even if the tax return was filed timely. See Section 6501(c)(8) and the recent US Tax Court ruling in Fairbank which we summarized here.

Resolving the Inadvertent Migration 301.7701-7(d)(2)

• • • (2) Replacement of any person who had authority to make a substantial decision of the trust –

      • (i) Replacement within 12 months. In the event of an inadvertent change in any person that has the power to make a substantial decision of the trust that would cause the domestic or foreign residency of the trust to change, the trust is allowed 12 months from the date of the change to make necessary changes either with respect to the persons who control the substantial decisions or with respect to the residence of such persons to avoid a change in the trust’s residency. For purposes of this section, an inadvertent change means the death, incapacity, resignation, change in residency or other change with respect to a person that has a power to make a substantial decision of the trust that would cause a change to the residency of the trust but that was not intended to change the residency of the trust. If the necessary change is made within 12 months, the trust is treated as retaining its pre-change residency during the 12-month period. If the necessary change is not made within 12 months, the trust’s residency changes as of the date of the inadvertent change.

      • (ii) Request for extension of time. If reasonable actions have been taken to make the necessary change to prevent a change in trust residency, but due to circumstances beyond the trust’s control the trust is unable to make the modification within 12 months, the trust may provide a written statement to the district director having jurisdiction over the trust’s return setting forth the reasons for failing to make the necessary change within the required time period. If the district director determines that the failure was due to reasonable cause, the district director may grant the trust an extension of time to make the necessary change. Whether an extension of time is granted is in the sole discretion of the district director and, if granted, may contain such terms with respect to assessment as may be necessary to ensure that the correct amount of tax will be collected from the trust, its owners, and its beneficiaries. If the district director does not grant an extension, the trust’s residency changes as of the date of the inadvertent change.

      • (iii) Examples. The following examples illustrate the rules of paragraphs (d)(2)(i) and (ii) of this section:

        • Example 1. A trust that satisfies the court test has three fiduciaries, A, B, and C. A and B are United States citizens and C is a nonresident alien. All decisions of the trust are made by majority vote of the fiduciaries. The trust instrument provides that upon the death or resignation of any of the fiduciaries, D, is the successor fiduciary. A dies and D automatically becomes a fiduciary of the trust. When D becomes a fiduciary of the trust, D is a nonresident alien. Two months after A dies, B replaces D with E, a United States person. Because D was replaced with E within 12 months after the date of A’s death, during the period after A’s death and before E begins to serve, the trust satisfies the control test and remains a domestic trust.

        • Example 2. Assume the same facts as in Example 1 except that at the end of the 12-month period after A’s death, D has not been replaced and remains a fiduciary of the trust. The trust becomes a foreign trust on the date A died unless the district director grants an extension of the time period to make the necessary change. (3) Automatic migration provisions. Notwithstanding any other provision in this section, United States persons are not considered to control all substantial decisions of the trust if an attempt by any governmental agency or creditor to collect information from or assert a claim against the trust would cause one or more substantial decisions of the trust to no longer be controlled by United States persons.

Current Year vs Prior Year Non-Compliance

Once a taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist that specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties.

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