Bar News - March 16, 2016
Elder, Estate Planning & Probate Law: Uses and Considerations for Non-Resident Alien Trusts
By: Donald H. Sienkiewicz
Non-US residents sometimes use trusts to invest in US real estate and other property. Some situations may make these trusts appropriate or advantageous, but there are certain federal tax rules that must be considered related to trusts created by or benefitting non-immigrant, non-US nationals, who are also known as nonresident aliens or NRAs.
This discussion is limited to trusts created under the law of a US state or the District of Columbia and does not address “offshore” trusts used by Americans to hold assets in a current or former tax haven.
No federal or state law prohibits NRAs from owning real or personal property through a US trust, but whether the use of a trust is appropriate or advantageous is a question that must be addressed with each individual client by competent tax and legal counsel, in both the US and in the client’s home country.
NRAs use trusts for many of the same reasons that American citizens do: privacy; lifetime and post-death control of assets for the benefit of others; protection from creditors; and avoidance of the public disclosure, cost, delay, and judicial-decision risk of a state court probate process upon the grantor’s death.
NRAs often have additional reasons to invest in the United States, which may affect their decision to use a trust – for example, they may have a desire to take advantage of stable US real estate or equities markets and the relatively transparent and fair US legal system; to shelter assets and income from unstable or corrupt home governments; and to arbitrage tax rates between their home country and the US. They may also perceive ownership of US real estate as a first step to obtaining legal immigrant status.
For the purposes of this article, an NRA trust is a trust created under US state law by an NRA. An NRA trust is not necessarily a “foreign” trust, as that word is an Internal Revenue Code term of art – See 26 USC Section 7701(a)(30) and (3) and the regulations thereunder.
A trust is deemed “domestic” if (1) a US court can exercise primary supervision over trust administration (the “court test”), and (2) US persons control all substantial trust decisions (the “control test”). All other trusts are foreign. A US court has the ability to exercise “primary supervision” if it has the authority to determine “substantially all” issues concerning administration of the trust.
The control test is satisfied if US persons control all substantial decisions affecting the trust, and no foreign person can supersede a decision of the controlling US persons. For example, if an NRA creates a New Hampshire trust and names a New Hampshire corporation or natural person as trustee, and does not retain the right to remove or countermand said trustee, the trust will be a domestic trust, even if the New Hampshire trustee delegates investment decisions to an advisor in Switzerland pursuant to RSA 564-B:8-807.
An important tax distinction is whether a trust is treated as a “grantor” or “non-grantor” trust. Income of grantor trusts is generally taxed to the grantor and is done so in the same way as is income of natural persons. Non-grantor trusts are separate taxable entities, and the income is taxed to the trust (or sometimes to the beneficiaries), using the same rates as for individuals, but the rate scale is highly compressed (a trust hits the top rate of 39.6 percent at only $12,400 in annual income, whereas an individual would have to receive $413,200 to be in this tax bracket – and by the way, both would be subject to an additional 3.8 percent Net Investment Income Tax).
A foreign trust will be treated as a grantor trust only if it is revocable by the grantor, or if distributions may be made only to the grantor or the grantor’s spouse during the grantor’s lifetime, pursuant to IRC Section 672(f).
NRA beneficiaries are subject to US income tax on all income that is “effectively connected” to the conduct of a US business (at applicable income tax rates), but – painfully – they are subject to a flat tax of 30 percent, withheld by the payor, of any “fixed or determinable” income that is not so connected. Be careful – tax treaties between the US and the NRA’s home country may affect the treatment of trust income.
It is important to note that foreign trusts may become domestic, and vice-versa, due to changes in the status of persons named in the trust instrument. For example, if a US trustee dies and the successor trustee is a non-US person, a formerly domestic trust may become a foreign trust. If a US grantor creates a revocable trust in a US jurisdiction and later expatriates, that trust will become a foreign trust.
Similarly, if a foreign grantor spends a significant amount of time in the United States, that person may unintentionally cause his or her trust to change its federal tax status. For an explanation of how a foreign grantor can become a resident alien for income-tax purposes under the substantial presence test, see Michelle Radie-Coffin’s article “Immigration and Taxes: Who Has to Pay US Income Tax?” in New Hampshire Bar News (Feb. 17, 2016).
Unintentional changes in tax status may result in adverse tax consequences for the grantor or beneficiaries – and in malpractice claims against US counsel who assisted the NRA in the first place, so it’s important to tread carefully.
Donald H. Sienkiewicz practices trust and estate law in Massachusetts and New Hampshire. He will be studying European private law this summer at the University of Augsburg, Germany, and can be reached at (603) 554-8464 or by email.