In May 2016 AFL Investments sponsored an International Tax and Planning Seminar for Bermuda Nationals who own U.S. investments, vacation homes and rental property in the United States. The sessions were chaired by Joel P. Schaefer, CEO of AFL Investments. Speakers were Stephen Ziobrowski, a senior international estate and trust attorney with the firm of Day Pitney in Boston and me. With reservations required and limited seating we are summarizing the presentation below for those who were unable to attend. The presentation will be split into 2 columns with the second to be published in November. The October column discussed how and when Bermuda nationals are subject to U.S. income tax. This column will discuss how to structure your U.S. investments to minimize or eliminate U.S. income tax.

Investing in the United States-Investor Options - As An Individual

Bermuda nationals would not be subject to double taxation but they would have

exposure to U.S. income taxes and filing requirements if investing in an unincorporated trade or business or real estate and they would also have exposure to U.S. estate tax on U.S. situs assets. The highest U.S. estate tax rate is 40% and nonresident aliens have only a $60,000 exemption from U.S. estate

Investing in the United States-Investor Options - As A Corporation

If a Bermuda national invests in the United States by forming a U.S. corporation they should be aware that the U.S. corporation will be subject to U.S. tax on worldwide income, that there is a risk of estate tax inclusion if investor is an individual, partnership, or trust, that U.S. tax on distributions to shareholders is collected by a withholding tax. Under FIRPTA – Gain on sale of stock of U.S. Real Estate Property Holding Corporation is subject to U.S. tax, there is no reduced capital gains rate. If investment is made by a non-U.S. corporation the entity would only be taxable on U.S. source income and the branch profits tax and there would be no reduced capital gains rate.

Investing in the United States-Investor Options - As A Partnership

This May create exposure to U.S. income tax (and tax return filing requirements). A question that will likely arise is whether the partnership has Effectively Connected Income (“ECI”)?

Sales of an interest in the partnership may trigger U.S. tax exposure and return filing requirements. A question that will likely arise is whether the partnership conducts a U.S. trade or business? There is also the risk of U.S. estate tax exposure and it is not clear if it matters whether the partnership is formed under U.S. laws.

 Investing in the United States-Investor Options - As A Trust

Non U.S. trusts created by Bermuda nationals will be nongrantor trusts unless the trust is revocable by the grantor or the only permissible beneficiaries during the grantor’s life are the grantor and the grantor’s spouse. A non U.S. trust is eligible for lower Capital Gain rates and is not subject to double taxation. However, the investor should take care to avoid estate tax inclusion.

What Type of Entity Is the Best Vehicle for Investing in the United States?

A partnership is usually not the best vehicle for foreign investment into the U.S.

A foreign corporation is often the best vehicle for foreign investment in stocks or bonds.

A non-grantor trust is often the beset vehicle for foreign investment into U.S. real estate or an unincorporated trade or business in the U.S.

 United States Taxation of Distributions to United States Citizens From A Foreign Trust

Before this question can be answered you first need to ascertain if the foreign trust is a grantor trust or a non-grantor trust.

 Grantor Trust – The Grantor is usually the person who formed the Trust, transferred property to the Trust and retains certain powers over the Trust Under United States tax law the Grantor is the person subject to tax on income earned within the Trust.  The “Grantor” is commonly determined by a reading of the trust instrument.

 Non-Grantor Trusts - A foreign trust commonly becomes a non-grantor trust on the death of the Grantor or upon the Grantor’s relinquishment of certain rights. The determination is commonly made by a reading of the trust instrument.

 A distribution to a United States citizen from a Foreign Grantor Trust is treated as a tax free gift and there is no United States taxation.  

 The taxation of a distribution to a United States citizen from a Foreign Non-Grantor Trust depends on whether the distribution if from “Distributable Net Income-DNI” or “Undistributed Net Income-UNI.” Distributable Net Income-DNI is income earned in the current year by the trust. Undistributed Net Income-UNI is income earned in prior years and distributed in the current year.

 DNI Distributions retain their character and qualified dividends and long term capital gains are taxed at a 20% tax rate and other income at ordinary graduated tax rates. UNI income loses its character and all income is taxed at ordinary graduated rates. A compounded floating interest rate is imposed on the tax. A ‘throwback tax” is also imposed so that the income is taxed at the beneficiaries highest tax rate over the years the income was deferred.

 Minimizing Taxes on Distributions to U.S. Beneficiaries of Bermuda Trusts

If the grantor trust rules apply, the grantor of the trust is treated as the owner of the trust property. U.S. beneficiaries of foreign grantor trusts are not subject to U.S. tax on trust distributions. The distributions must be reported on Form 3520.  Otherwise, a 35% penalty may apply. U.S. beneficiaries of foreign grantor trusts are not considered “indirect’ owners of property held by the trust and the Controlled Foreign Corporation (“CFC”) and Passive Foreign Investment Company (“PFIC”) rules will not apply.

 U.S. Persons Receiving UNI Distributions From a Foreign Nongrantor Trust

 Is there any way to avoid the confiscatory tax and penalty associated with a UNI distribution? The answer is “yes”, provided that a knowledgeable consultant is engaged before the distribution is made. There are 2 possible exceptions under the Internal Revenue Code and other possibilities may exist for converting a non-grantor trust to a grantor trust.

Pursuant to the requirements relating to practice before the Internal Revenue Service, any tax advice in this communication is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties imposed under the United States Internal Revenue Code, or (ii) promoting, marketing or recommending to another person any tax related manner.

The tax advice given by this column is, by necessity, general in nature. You should, of course, check with your own U.S. tax consultant as to how specific transactions affect you since tax advice varies with individual circumstances.