My trustee or beneficiary isn't a U.S. resident or citizen. Now what?

To start, a trust is a legal entity created to hold and administer funds and assets. The trustee then oversees the management of the trust assets for the benefit of the trust's beneficiaries.

As an entity, your trust is either considered “domestic” or “foreign” under U.S. law. This distinction is important, as it determines how the trust is taxed. Generally, it's much more favorable for your trust to be considered domestic for tax purposes.

A trust is “domestic” if it is considered a U.S. entity. To be viewed in this way under the law, two things must be true:

1. A U.S. court must have jurisdiction over the trust, meaning an American court has the authority to supervise the trust (the court test).
2. One or more U.S. persons have the authority to make substantial decisions about the trust (the control test).

The court test

To meet the first requirement of a domestic trust, any federal, state or local court in any of the 50 states or the District of Columbia must have primary supervision over the administration of the trust.

There are a few different established rules to be aware of when considering whether your trust will meet the court test:

1. If you register your trust with a U.S. court, it will automatically meet this requirement.
2. If your trust is created in your will (otherwise known as a testamentary trust) and your will is probated in the U.S., then your trustees can be qualified by a U.S. court to ensure its treatment as a domestic trust.
3. If your trust is created during your lifetime and your trustees or beneficiaries take steps to have a court exercise primary control over the trust, then it will meet this test.
4. Even if your trust document provides that another country's laws will govern, that doesn't mean your trust will fail the test, as long as the documents also give a U.S. court primary authority to enforce applicable laws.

There is also a safe harbor rule, which may prevent your trust from being treated as foreign as long as:

• Your trust documents do not provide for administration outside of the U.S.
• Your trust is only administered in the U.S.
• Your trust documents do not include an automatic migration provision.

An automatic migratory provision directs your trust's administration be transferred to another country whenever a specific event or occurrence happens. In order to avoid being classified as a foreign trust, you must ensure that your trust instrument does not contain this kind of language.

It's also important to note here that even if you choose a U.S. citizen to serve as your trustee, if they are a resident of another country, then you may come across issues in this regard. If the court views administration as taking place outside of the U.S. and subject to administration by a foreign country instead, then your trust could be categorized as foreign and taxed as such.

The control test

As mentioned above, the control test requires that one or more U.S. persons have the authority to make substantial decisions about your trust for it to be domestic.

A “person” can be an individual, but it can also be a corporation, partnership or other entity.

To pass the control test, your trustee cannot be both a non-citizen and non-resident. If they are, then your trust will likely fail this requirement and be considered foreign for tax and other purposes. You also may be placing your trust's status as a domestic trust at risk by naming either a non-U.S. citizen or a non-U.S. resident as your trustee.

In terms of what is considered “substantial” decision-making, this means anything other than minor administrative actions. Substantial decisions can include the following:

• Timing of income or principal distributions
• Distribution amount
• Beneficiary selection
• Trust termination
• Pursuing or defending against litigation
• Trustee removal or replacement
• Investment decisions

Overall, you should take careful consideration to ensure that your trust meets both the court and control tests. If you intend to include either non-U.S. citizens or non-U.S. residents in your trust plans, then you may need to ensure that specific language is used in your documents to guarantee that a U.S. court has primary authority over your trust's administration and that a “U.S. person” is in control of it.

If possible, it also may be preferrable to avoid having a non-U.S. resident or citizen serve as your trustee. However, even if all of your family members and close friends do not meet this requirement, you still have options. You may consider appointing an American corporation or professional trustee based in the U.S. to fulfill this role for you.

The difference between having your trust considered domestic or foreign can be extremely consequential, as the tax code provisions provide different treatment for your trust based on this difference. Certain benefits afforded to domestic trusts, like the unlimited martial estate tax exclusion, are completely lost with a foreign trust. There are also differing reporting requirements for each, which can mean greater administration expenses and costly penalties for failure to comply if you have a foreign trust.

There are also other significant federal income tax implications of having a foreign trust vs. a domestic one. These may include:

• Income taxes on non-U.S. source income for your beneficiaries: With a foreign trust, all non-U.S. source income and capital gains are included in any taxable income distributed to your beneficiaries. Normally, these are not considered part of your beneficiary's distribution for tax purposes unless you specifically allocate them to him or her.
• Undistributed net income taxed: When you have trust income that's not distributed in the year that it's earned, it becomes what's called “undistributed net income,” or “UNI.” If UNI has to be distributed from a foreign trust to your U.S. beneficiary, then that trust income will be taxed at ordinary federal income tax rates. This means that favorable capital gains rates can be lost with a foreign trust.
• Added interest charges: With a foreign trust, there's also a non-deductible interest charge imposed on distributions to your U.S. beneficiary when they exceed the trust income for that year. The interest charges on these distributions are exorbitant, as they're based on the rate imposed on underpayments of federal income tax. They're also compounded daily.
• The “throwback tax”: Another disadvantage of a foreign trust is that is your U.S. beneficiaries can be subjected to harsh federal income taxes through a “throwback tax.” When this happens, a complex formula is used to capture the tax that would have been due for accumulated gains held within the trust. Your beneficiary must then pay taxes on those unrealized gains at the less favorable ordinary income tax rate.

In addition to these ongoing added taxes and charges, there's a huge downside to a foreign trust over a domestic trust if your spouse is one of your beneficiaries. This is because with a foreign trust, your spouse no longer receives the substantial benefit of the unlimited marital estate tax exclusion. This is an important distinction, as the exclusion allows you to transfer an unrestricted amount of income and/or assets to your spouse at any time, including after your lifetime. Without this significant tax benefit, your loved one could be hit with a huge tax bill whenever they receive the benefit of your trust.

Foreign trusts also have added reporting requirements over and above those required for a domestic trust. So, you must have a savvy, experienced trustee in place with a foreign trust to ensure that you can meet these requirements. Otherwise, the penalties for non-compliance are extremely steep. For example, if you have a U.S. beneficiary who receives a distribution from your foreign trust, then they must file a Form 3520 in which they have to provide the amount and form of the distribution. If your beneficiary fails to file this form, then they will have to pay a huge penalty - one equal to 35% of their gross distribution.

Additional planning will be required if you are married to a non-U.S. citizen whom you wish to name as a beneficiary of your trust, even if your trust meets both the court and control tests detailed above.

Non-U.S. citizen spouses also do not receive the benefit of the unlimited marital estate tax exclusion. So, even if you have everything in place for a domestic trust, your spouse will have to pay applicable taxes on their inherited trust if they are not a U.S. citizen.

Working with an experienced Legacy Plan Network Attorney will be critical if this situation applies to you, because without proper planning, your spouse could be subjected to an enormous tax burden even if your trust isn't considered foreign under federal tax law.

If you have loved ones who are non-U.S. citizens or non-U.S. residents, there are a few useful ideas to consider employing regardless of your particular circumstances:

Consider a “backstop provision”

In addition to addressing the requirements of both the court test and the control test directly as they apply to your situation, it's always a good option to incorporate a “backstop provision” into your trust documents. With this kind of provision, you can direct that the trust must always qualify as a domestic trust for tax purposes, and you can require your trust to always have a majority of U.S.-based trustees. While this provision won't act as a failsafe should your trust not comply with the court and control tests, it will at least alert your trustees to the issue and potentially help to avoid any changes that could jeopardize your trust's domestic status.

Choose your successor trustee carefully

In general, it's unadvisable to name a non-U.S. citizen as successor trustee for your trust. Even if your spouse is your preferred successor trustee, if they are not a U.S. citizen, you're placing them in a potential terrible tax situation both during your lifetime and afterward. In this circumstance, it's typically advisable to choose another successor trustee who is a U.S. citizen (either a person or a corporate entity) to avoid having your trust treated as foreign.

Overall, it's important to understand that including non-U.S. citizens and residents in your trust can complicate your planning for the future. There are ways to avoid being overly taxed and having your loved ones receive the benefit of your hard-earned wealth, but it requires thoughtful planning and the assistance of a knowledgeable Legacy Plan Network Attorney. Working with someone experienced will be key for ensuring your trust accomplishes your goals for yourself and your family, regardless of their citizenship or geographic status.