Foreign Grantor Trusts (FGTs) are one of the most popular and advantageous vehicles for foreign parents to plan for their U.S. resident children. A FGT allows the foreign grantor to move assets out of their name and into a trust for the benefit of U.S. beneficiaries, and at the same time, avoid paying any taxes on the non-U.S. trust assets held in the FGT.
However, since FGTs present so many benefits, the Internal Revenue Service will also be aware that there can be abuse. The U.S. government wrote the Internal Revenue Code sections 671-678 to properly characterise certain trusts as grantor trusts by making sure certain criteria are met. Basically, if the grantor of the trust holds certain interests or power, they are considered the owner of the trust assets, even though the assets are in the trust’s name and possession. This rule helps avoid the abuse of FGTs to avoid U.S. tax.
Even with these restrictions, FGTs are beneficial when the grantor is not a U.S. person, and they are deemed as the owner of the trust assets. Under U.S. taxation rules, income from trust assets is taxed as if owned by the non-resident alien grantor — thus, unless the income is U.S. sourced, it is not taxable in the U.S. Furthermore, any distribution to U.S. beneficiaries will not be taxed as income. However, the U.S. beneficiaries are obligated to report the distribution as foreign gifts received. Foreign gifts of non-U.S. assets received by U.S. beneficiaries are reportable transactions, but not taxed.
Care needed with distributions
It should be noted though that distributions from the trust could create other income and reporting for the beneficiaries by piercing the structure of the FGT. In general, distributions to beneficiaries or interactions/ control between beneficiaries and trust assets need to be handled very carefully. If beneficiaries have certain powers or control of the trust, this may trigger rules that deem the beneficiaries as owners of trust assets.
When this happens, the beneficiaries’ deemed shares of the trust assets or income will be subject to U.S. taxation. In addition, the trust must also provide enough powers to the foreign grantor to satisfy the grantor trust rules. If the powers are not enough to satisfy the grantor trust rules, the trust could be considered a foreign non-grantor trust, which carries a substantially different tax outcome. In most circumstances, a foreign non-grantor trust with a U.S. beneficiary is not beneficial in U.S. taxation.
Although the FGT is a very advantageous tool, one must also make sure the terms of the trust do not create other issues. For example, it is important to make sure the foreign grantor of the trust will stay foreign. If the foreign grantor plans to immigrate to the U.S. in the future, a FGT may not be a good idea. All the trust assets and income will be taxable to the U.S. when the grantor becomes a U.S. resident.
The FGT generally only lasts for the lifetime of the grantor. When the grantor passes away, the FGT becomes a foreign non-grantor trust. The U.S. beneficiaries will be deemed as the owners of the trust assets for foreign financial reporting purposes, which completely changes everything. In sum, FGTs can be an excellent planning tool, but they must be used for the right reasons and with proper planning.
This article was first published in our newsletter, The Custodian Issue 21 on Apr, 2022. Click here to access our latest newsletter.