The United States is one of two countries in the world that imposes a tax on the worldwide income of its citizens. (The other is the East African country of Eritrea, which imposes a two percent tax on its citizens living abroad, far less than the top rate for U.S. income tax of 37 percent.)
Of course, trusts do not have citizenship like individuals, but trusts that are classified as domestic trusts for U.S. income tax purposes “suffer” the same fate: U.S. income tax is imposed on the worldwide income of the trust even if its income is earned from sources outside the United States or the Settlor and beneficiaries reside outside the United States.
So, what makes a trust a domestic trust and would it be better to avoid this classification? Paradoxically, a trust must meet two tests to be considered a domestic trust, and if it fails either of these tests, it will be classified as a foreign trust.
The first test the trust must satisfy to avoid foreign trust status is the Court Test. This test is satisfied when a U.S. court can exercise primary supervision over the trust. Although the test has its own complexities, it is typically satisfied when a trust agreement directs the law of a U.S. state to govern administration of the trust and the trust does not contain something called an “automatic migration” provision (i.e., a provision providing that upon a certain triggering event, such as a U.S. court attempting to assert jurisdiction over the trust, the trust will migrate outside the U.S. and a court within the United States will lose its ability to exercise primary supervision of the trust). The typical trust agreement drafted within the United States will usually satisfy the Court Test.
The Control Test is easier to fail—and is often failed unintentionally. This test is satisfied when U.S. persons have the authority to control all substantial decisions of the trust. If a foreign person controls even a single substantial decision, whether by vote or veto, the trust will fail the control test.
Suppose David executes a Will bequeathing all of his assets to a trust for the benefit of his son, Sherwin. David names his friend, Frank, as Trustee. However, Frank is not a citizen or resident of the United States. Accordingly, this trust will fail the Control Test.
What if Frank served with co-Trustees who are U.S. citizens or residents? If the trust had two other U.S. citizen or resident trustees and the trustees had to act by majority, Frank could serve as a co-Trustee without causing the trust to fail the Control Test. However, if the trustees had to act with unanimity—even on a single decision—the trust would fail the Control Test.
Even when a trust has only U.S. citizen or resident Trustees, a trust can still fail the Control Test if some other individual who is not a U.S. citizen or resident controls a substantial decision of the trust in a non-fiduciary capacity. For example, if the creator of the trust retains the power to remove and replace Trustees and the creator is not a U.S. citizen or resident, this power will cause the trust to fail the Control Test even if all of the Trustees are U.S. citizens or residents.
What happens if a trust is a foreign trust? As noted above, the good news is that foreign trusts, just like non-resident individuals, are subject to U.S. income tax only on U.S.-source income. Income from sources outside the United States are not subject to U.S. income tax. Comparatively, a domestic trust—just like a U.S. citizen or resident—pays tax on its worldwide income.
However, given the potential for tax avoidance, the tax law makes it almost impossible for a U.S. person to create a foreign trust for the benefit of U.S. persons. Any U.S. person who funds a foreign trust for the benefit of a U.S. person will be considered the owner of the trust while they are alive. This means the trust will be disregarded as a separate tax-paying entity, and the U.S. person will be considered the owner of all the assets of the trust for income tax purposes—including those assets that produce foreign-source income that would not be subject to tax if the foreign trust was considered its own tax-paying entity—and the U.S. person will be required to report all matters of income and deduction with respect to the trust on his or her own individual income tax returns.
The situation worsens after the death of the U.S. person who created the trust. At this time, the trust becomes a separate taxpayer, but any time it makes a distribution to its U.S. beneficiaries, the distribution may be accompanied by a punitive tax and interest charge (known as the “throwback tax”) if the trust retained any income from a prior year (i.e., the trust earned income in a prior year that the trustee did not distribute to a beneficiary).
What about asset protection? Despite these drawbacks, many U.S. persons believe they can protect assets using offshore trusts. Although the possibility of asset protection in a foreign trust is outside the scope of this article, it may be possible to achieve asset protection with a domestic trust that is governed under the laws of one of the growing number of U.S. states that permit asset protection trusts, such as Connecticut, Delaware, South Dakota, Nevada, and Alaska.
In sum, although it may sound great to create a foreign trust to avoid U.S. income tax, in most cases the result is too good to be true. If the trust has a U.S. funder and U.S. beneficiaries, making sure the trust meets the Court Test and Control Test—and is classified as a domestic trust—is likely the way to go.