A. NRAs Generally: Reducing U.S. Taxes
The three cardinal rules for NRAs who wish to minimize U.S. taxes are:
1. Minimize contacts with the United States to avoid becoming U.S. residents for income or estate tax purposes.
2. Minimize U.S. situs assets to avoid estate taxation. Typically, this means holding
U.S. real estate, tangibles located in the United States and shares of stock of U.S. corporations through non-U.S. corporations (or entities that can elect to be treated as non-U.S. corporations). This step offers no protection from income taxes on U.S. source income; the income is still payable to a non-U.S. entity and thus subject to income tax withholding. Also, the transfer of U.S. real estate to the non-U.S. corporation may have income tax consequences. (In some cases, an irrevocable trust may be structured to serve as an effective estate tax blocker.)
3. Minimize taxable U.S. source income to avoid U.S. income taxation. Increase bond interest income and decrease stock dividend and rental income.
The creation of an offshore revocable trust by an NRA to hold assets will not in itself reduce taxes payable by the NRA. U.S. source income paid to the trust will still be subject to U.S. withholding tax. Also, if the grantor has a retained interest in the trust (such as the power to revoke), it will not shield U.S. assets from U.S. estate tax. A foreign trust can own the shares of a foreign corporation that in turn holds financial assets, in which case the corporation (provided it is appropriately administered) will shield U.S. stocks from U.S. estate tax.
However, the trust offers substantial nontax benefits: the retention of the wealth for future generations, with discretionary income and principal payments, which is not available in most civil law jurisdictions; protection from foreign taxes; protection from creditors; protection from nationalization and political risks; and protection from forced heirship and marital claims. The trust may also save estate and GST taxes for future generations.
A properly structured and administered irrevocable trust in an appropriate jurisdiction can also protect the U.S. assets from U.S. estate tax.
It is important to confirm with foreign counsel that holding assets through an offshore trust or corporation will not create tax complications in the NRA's home jurisdiction.
B. Estate, Gift and GST Taxes
As previously noted, transfers by an NRA to a U.S. beneficiary (including a U.S. trust) may be subject to reporting, but they are not subject to U.S. estate, gift or GST taxes except on assets that have U.S. situs. This is a significant benefit that should always be taken full advantage of when planning for NRAs.
C. Foreign Trust Planning
As noted, there are still great advantages to having an NRA create a multigenerational trust for the benefit of U.S. persons because the trust assets will not be subject to estate, gift or GST taxes. Moreover, there are strong reasons for the NRA to create a foreign grantor trust for the U.S. beneficiary in order to avoid U.S. income taxes during the life of the NRA.
An NRA can create a long-term trust for U.S. beneficiaries (which can be a foreign or U.S. trust) and escape all transfer taxes for the life of the trust on assets that remain in the trust. Because a longer term results in a longer avoidance of transfer taxes, the trust should be created in a jurisdiction that has a long perpetuities period.
For estate and gift tax purposes, it does not matter whether the trust is a U.S. trust or a foreign trust. However, for income tax purposes, if the trust is a domestic trust it will be subject to U.S. income taxes unless it is treated as a grantor trust with an NRA grantor. If the trust is a foreign nongrantor trust but the beneficiaries are in the United States and receive distributions, they will be subject to U.S. income tax on the distributions to them, with interest on the tax attributable to prior years' UNI and additional reporting requirements (as described above). Therefore, if the trust cannot be structured to qualify as a grantor trust, and if it is expected that all beneficiaries will remain in the United States for the long term, there may be no disadvantage to the trust being in the United States, and it may actually be preferable in some cases.
In light of the foregoing, a good strategy for an NRA grantor who wants to benefit a U.S. beneficiary through an offshore trust would be the following:
1. Make the trust revocable by the grantor or, if it is irrevocable, make the grantor (and/or the grantor's spouse) the sole trust beneficiaries during their lives. They can receive trust distributions and make gifts to the U.S. beneficiary as needed. The U.S. beneficiary must report the gifts if they exceed $100,000, but no income or gift tax is due.
Alternatively, the trust could be fully revocable by the grantor, making it a grantor trust, and could then make payments directly to a U.S. beneficiary without being subject to U.S. income tax. In this case, the beneficiary would be required to report receipt of any trust distributions identify the trust and appoint a U.S. agent or else have the foreign trustee represent to the IRS that it will allow access the trust’s books and records to prove that it is in fact a grantor trust. The grantor may not want this for privacy purposes. (Alternatively, the grantor could partially revoke the trust on certain assets and then make a gift of those assets to the U.S. beneficiary.)
2. After the death of the grantor and the grantor's spouse, the trust should continue for the U.S. beneficiary and descendants for the longest term permissible, possibly with a limited power of appointment granted to the beneficiaries at each generational level. For income tax purposes, the following options are available:
(a) Pay all current income (including capital gains) to the U.S. beneficiary, who then pays U.S. income tax on the income, thus avoiding any accumulations problem. This, however, increases the assets that are distributed to the U.S. beneficiary and will ultimately be subject to estate tax on the beneficiary's death, particularly if there are high realized capital gains that must be distributed. Paying all income annually to a U.S. trust avoids this.
(b) Move the trust situs to the United States. If this is done, all income will be taxed currently, but income can be accumulated without resulting in an interest charge and realized gains can be accumulated without being converted to ordinary income when later distributed.
(c) If the U.S. beneficiary is not a U.S. citizen and expects to leave the United States in the future, or is a citizen who expects to expatriate and so will no longer be subject to U.S. income tax, the trustee should leave the trust offshore, accumulate the trust income free of U.S. income tax and make a qualified loan to the beneficiary if necessary. Once the beneficiary leaves the United States, the trust can pay out current and accumulated income without U.S. income tax. (However, this may not be the case if the beneficiary is a covered expatriate, as discussed below.)
(d) Invest the trust assets in annuity or variable life insurance products. Investments in policies that are qualified for tax purposes can build up income and avoid the interest charge on accumulations. In addition, if non-modified endowment contract life insurance policies are used, distributions can be made to the beneficiaries without U.S. income tax up to the amount of the premiums.
Underlying Entities: During the grantor's lifetime, the trust should hold assets through one or more underlying offshore corporations to avoid U.S. estate tax. (Many other countries also levy death taxes on their domestic securities if held outright by foreign individuals but recognize a foreign corporation as a shield against such taxes; therefore, an underlying corporation may be advisable even if the assets are not U.S. situs assets.)
However, after the death of the NRA grantor, if the trust has U.S. beneficiaries, the underlying corporation may become a controlled foreign corporation (CFC) or a passive foreign investment company (PFIC), with negative tax consequences for the U.S. beneficiaries. To avoid this problem, after the grantor's death, the corporation should elect to be disregarded for U.S. tax purposes and possibly liquidated outright. Under the U.S. "Check the Box" regulations (Treas. Reg. §§ 301.7701-1, 301.7701-2 and 301.7701-3), it is possible to simply elect for most foreign corporations to be treated as a pass-through for U.S. tax purposes. However, not all foreign corporations are eligible to make this election, so it is important when setting up the structure to choose an entity type that has not been designated as a "per se" corporation by the IRS. (Treas. Reg. § 301.7701-2(b)(8)) Additionally, this election must not be made during the grantor's lifetime if the corporation holds U.S. situs assets, since the pass-through treatment will apply for estate tax purposes as well and could eliminate the estate tax shelter for U.S. assets that the foreign corporation is intended to provide.
Note: An election postmortem may result in some phantom income inclusions for the U.S. beneficiaries due to changes in the rules governing CFCs introduced by the Tax Cuts and Jobs Act of 2017 (TCJA). However, the phantom income inclusion can usually be minimized with proper planning and in most cases will result in a much lower overall tax liability than the estate tax inclusion that could result from a pre-mortem election.
D. Non-U.S. Person Who Is Moving to the United States
If a non-U.S. person (the "pre-immigrant") is planning to become a U.S. resident in the near future, he or she should consider taking the following steps (in coordination with a tax advisor in his or her current country of residence) before becoming a U.S. resident for income or estate tax purposes:
1. Make Gifts to Non-U.S. Persons: The pre-immigrant should make irrevocable gifts to non-U.S. persons either outright or in the form of a trust that is for a closed class of beneficiaries, none of whom are U.S. person and is not permitted to be amended to have any U.S. beneficiaries. In addition, the pre-immigrant should not retain any other powers or interests that would otherwise cause the trust to be considered to be a grantor trust after he or she becomes a U.S. person. This will avoid U.S. income taxes on future income earned by the gifted assets and will also avoid later gift and estate taxes on the transfer of those assets.
2. Make Gifts to U.S. Persons: The pre-immigrant should make irrevocable gifts to U.S. persons and to long-term trusts for U.S. beneficiaries. Although the preimmigrant can use either a U.S. or a foreign trust, a U.S. trust may be preferable if the U.S. beneficiaries anticipate receiving distributions. These gifts in trust will avoid later gift, estate and GST taxes.
A foreign trust with any permissible U.S. beneficiaries that is created or funded by the pre-immigrant will be a grantor trust if the pre-immigrant becomes a U.S. person within five years after creating it, and so will not avoid U.S. income taxes on the income that the gifts generate.
3. Create Irrevocable Discretionary Trusts: The pre-immigrant should consider transferring a portion of his or her assets to an irrevocable discretionary trust of which the pre-immigrant and other family members are permissible discretionary beneficiaries. If the transfer is properly structured and administered in a jurisdiction (either U.S. or foreign) which protects such a trust from the claims of creditors, the assets should not be subject to U.S. estate tax on the pre-immigrant's death. Note that it often will be preferable to structure the trust as a U.S. trust for tax purposes (in which case it will have to be administered in the U.S.). The reason for this is that when a foreign grantor trust with a U.S. grantor becomes a foreign nongrantor trust (for example, upon the grantor's death), gain may be recognized if there are appreciated assets in the trust. (IRC § 684) This outcome may be avoided by setting up the trust in the U.S. (or later domesticating the trust if it is already a foreign trust).
The trust will become a grantor trust for U.S. income tax purposes and its income will be subject to U.S. income tax.
4. Sell Appreciated Assets: The pre-immigrant should not own appreciated assets when he or she becomes a U.S. resident or citizen, since the United States will tax the entire capital gain on the later sale of the asset, regardless of when it was bought or acquired. The pre-immigrant should sell appreciated marketable securities before entering the United States and reinvest the proceeds. The pre-immigrant should also sell or otherwise dispose of appreciated residences and closely held securities, possibly to other family members.
5. Dispose of Interests in Foreign Corporations: The pre-immigrant should try to dispose of all interests in foreign corporations that are closely held by U.S. persons or that have primarily passive income, or should consider filing entity classification elections to treat such corporations as pass-through entities (if they are not per se corporations) and possibly step up the inside basis of the underlying assets.
6. Make Gifts Between Married Couples: If a married pre-immigrant couple become U.S. residents but not U.S. citizens, any gifts made between them in excess of $155,000 per year (2019 figure) will be subject to gift tax. Therefore, any gifts that will be made between the spouses should be made before they enter the United States with non-U.S. assets.
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