Elyse Kirschner and Claire Murray examine the use of trusts for wealth and estate planning on both sides of the Atlantic and how families with members in the US and the UK can avoid potential obstacles and pitfalls.
Trusts are still commonly used for wealth and estate planning purposes by clients in both the US and the UK. With an increasingly mobile and international client base, advisers with clients in one of those jurisdictions will soon find that their clients, their clients’ children or grandchildren, or some other extended family members, move trans-atlantically.
Where there are family trusts already in place, or there is a desire to create new trusts for family members, a detailed understanding of the legal, tax and regulatory regimes of both jurisdictions becomes vital in order to avoid potential pitfalls for the clients, with their attendant liabilities and penalties.
This article draws on our experiences advising on trust issues across the US/UK divide.
Trusts with US Beneficiaries
It may sound like an obvious point to make, but it is extremely important that trustees understand whether any of their beneficiaries are or become US persons. This can happen where a beneficiary becomes a US citizen or Green Card holder, or where a non-US beneficiary has children with a spouse or partner who is a US person – those children will themselves be US persons.
Undertaking an exercise of this nature is likely to involve, for the trustees, a certain amount of time and effort getting to know their beneficiaries, as well as fees for that time spent, and possibly related advisory fees. In our experience, beneficiaries can be resistant to this sort of time investment by trustees, largely because of the costs involved, and it is not uncommon to find, particularly where an individual is a US person by virtue purely of their parentage, without ever having spent any significant time in the US, a level of denial about the tax and compliance implications of being a US person. Quite simply, particularly for individuals used to the British tax and compliance system, they do not believe the rules can apply to them when they have never lived in the US, or that the penalties for non-compliance can be so punitive.
If an existing UK resident or offshore trust finds that it has a US beneficiary, this raises an immediate potential problem for making distributions to the US beneficiary. The throwback rules apply to distributions to US persons made from most non-US trusts. If there is significant accumulated income and gains in the trust (‘undistributed net income’ or ‘UNI’), the throwback rules can result in a rate of tax which is, in effect, confiscatory making it tax-inefficient to provide benefits to a US beneficiary. In addition, US beneficiaries who receive distributions from a trust that is classified as a foreign trust for US income tax purposes will need to report those distributions to the Internal Revenue Service on the Form 3520. We have also seen situations where trustees of a UK trust have made small cash distributions to bank accounts held for minor UK resident beneficiaries who, being US persons, were then above the US$10,000 balance for making a FBAR filing. Since the FBAR return was not made, hefty penalties were due for non-compliance.
There are a number of issues to consider for a non-US donor wishing to establish a trust which will have US beneficiaries. If the trust holds residential property which the beneficiary will occupy, then if the trust is a non-US trust the charging provisions in FATCA are likely to apply. If the property in question is within the US, the donor could consider establishing a US trust to avoid this problem. Since FATCA became law, a number of non-US trusts holding US residential property occupied by US beneficiaries have been domesticated into the US for that reason.
If the proposed trust is to be used to make regular distributions to fund US beneficiaries, a foreign non-grantor trust (which would include a UK resident or offshore discretionary trust) may be suitable but distributions will be subject to the throwback rules. Provided distributions are made each year of all distributable net income (‘DNI’), and DNI for these purposes includes trust income and realised gains for the year, then there will be no build-up of UNI and the associated tax disadvantages. This removes a degree of flexibility, however, and some donors may not want the trustees to be in the position of having to make annual distributions.
Another possibility would be for a non-US donor to establish a trust classified as a grantor trust for US income tax purposes. Under current law, a non-US grantor can establish a grantor trust only if (1) the trust is revocable by the grantor without the approval or consent of another party or (2) the trust is irrevocable and the only permissible distributions are to the grantor or the grantor’s spouse. This tax treatment now enables a non-US grantor to establish a grantor trust, which can make distributions to US beneficiaries that will not be subject to US income tax at all (or, therefore, the throwback rules). Since the income and gains are treated as taxable in the hands of the grantor, there will be no build-up of UNI in the trust. The US beneficiary will still however be required to report the distributions from the foreign grantor trust to the IRS on the Form 3520.
Trusts with UK Beneficiaries
Just as it is important for trustees to know if any of the beneficiaries is or becomes a US person, it is equally important to know if a beneficiary becomes a UK resident. Given the current state of UK law on residence, beneficiaries regularly spending time in the UK over a number of years and establishing connections to the UK over that time risk becoming resident without realising (or earlier than they intended). The problem at present is that the application of the current rules can lead to an uncertain outcome. From 6 April 2012, the new wholly statutory residence test, if enacted, should enable an individual’s residence to be determined with certainty. This will not, however, remove the need for trustees to work with beneficiaries to ensure appropriate advice is taken.
If an existing US or offshore trust finds that it has a UK resident beneficiary, this raises a number of complex UK anti-avoidance rules which will apply to distributions to the UK beneficiary. Similar to the throwback rules, distributions are treated as carrying out undistributed income and gains in the trust structure and are subject to complex beneficiary charging rules on income and gains. The applicable rates of tax, however, follow the rates charged to the beneficiary on their personal income, with only a relatively small supplemental rate charged on distributions of non-current year gains. The trustees will need to engage specialist accountants to calculate the historic income and gains position of the trust, and to update it each year, in order to enable the UK resident beneficiary to determine his UK tax position.
In many cases, clients who move to the UK will have UK resident non-domiciled status, which enables them to claim the remittance basis of taxation and, provided they do not remit the distributed trust funds to the UK, or otherwise enjoy benefits in the UK, to pay no UK tax on those distributions or benefits. Where, however, the trust pays the UK beneficiary’s UK living expenses, or provides benefits enjoyed in the UK, remittances cannot be avoided.
Clients moving to the UK may still consider establishing offshore trusts, provided the donor of the trust assets is not a UK domiciliary, the assets are not UK situs and that there are no gift tax implications of another jurisdiction of giving assets to the trustees. Prior to the Finance Act 2008 changes, there were a number of tax advantages to establishing such a structure prior to the donor becoming resident in the UK, now the main advantages of doing so, however, tend to be UK inheritance tax advantages, and the establishment of an offshore trust for these purposes can often be postponed until the client has been resident in the UK for a number of years. It is important to know the domicile of the donor for UK tax purposes because of the hefty lifetime inheritance tax charge triggered by a UK domiciled donor settling assets into trust.
Trusts with Both US and UK Beneficiaries
It will be clear from what has been said above that donors wishing to establish a new structure for funding UK and US resident beneficiaries face an extremely complex landscape of tax and compliance considerations. One solution would of course be to create separate structures – one to provide benefits to US beneficiaries, and the other to provide benefits to UK beneficiaries. The donor could also consider establishing a revocable foreign grantor trust, which would be treated as a bare trust for UK purposes, in order to avoid both the throwback rules and the UK beneficiary charging rules. The suitability of this type of trust will very much depend on the donor’s other tax planning objectives.
What’s the Alternative?
The 2006 inheritance tax changes in the UK have made trusts less attractive for UK domiciled clients (because of the significant charge on assets going in). Since 2008, however, we have seen a trend developing when advising transatlantic non-UK domiciled clients considering international estate and wealth planning. In our experience, establishing new offshore trust structures increasingly tends to be attractive only to ultra high net worth clients. Non-‘ultra’ clients tend to baulk at the complex anti-avoidance taxation regimes applicable to such structures, as well as the not inconsiderable and inevitable ongoing advisory and compliance costs. Perhaps this is not surprising considering the combination of the Finance Act 2008 changes to the taxation of UK resident non-domiciliaries, the introduction of FATCA and the significant increase in compliance which has accompanied those developments.
Instead, we find ourselves advising on different approaches, in particular alternative entities, such as family limited partnerships and Delaware LLCs, which offer some of the benefits normally associated with trusts, such as the donor holding back outright control from the next generation, and some asset protection advantages, while also offering more straightforward tax treatment and an opportunity for the next generation to become involved in management of the family’s wealth.
We would be interested to hear if other practitioners are seeing a similar trend.
Elyse Kirschner, Partner, McDermott Will & Emery, New York and Claire Murray, Associate, McDermott Will & Emery, London