As a follow up to last months column on distributions from a Bermuda trust to a U.S. beneficiary, this month we will review the ramifications of a U.S. citizen creating a Bermuda trust. As this subject involves both tax and legal issues, I have again asked Dina Kapur Sanna, a partner in the New York office of the US law firm of Day Pitney LLP to host the column for this month and her response follows.

US citizens residing in Bermuda are often encouraged to create irrevocable Bermuda trusts to hold their Bermuda assets, including Bermuda real estate. These “Bermuda-based US grantors” and their Bermuda advisors may not realize that there are US tax implications to creating such trusts. Almost always, the US grantors are subject to continued US taxation on the trust’s income, despite having parted with the underlying assets, and subject to detailed US information reporting requirements. 

The following is a greatly simplified summary of the US federal income and transfer tax rules, followed by a discussion of their applicability to a US grantor of a foreign (non-US) trust. For purposes of the following discussion, the term “foreign” will refer to a trust that is not a US trust. In virtually every case, any trust that has a trustee who is not a US person is considered a foreign trust for US tax purposes.

US persons are subject to income tax on worldwideincome at rates that range from 15% (on long-term capital gains) to 35% (on ordinary income and short-term capital gains). Note: These rates are scheduled to increase to 20% and 39.6% respectively, in 2011.

A US person for income tax purposes includes (i) a US citizen, and (ii) a non-US citizen who either (a) holds a US green card or (b) meets the physical presence requirements of the substantial presence test of the US federal income tax laws, which requires presence for at least 31 days in the current calendar year and presence in that year and the two immediately preceding calendar years to equal a weighted aggregate of 183 days or more.

US persons are subject to gift, estate and generation-skipping transfer tax on their worldwide assets at rates as high as 45%. The amount that can be transferred free of gift tax is $1,000,000 and the amount that can be transferred free of estate and generation-skipping transfer tax is $3,500,000. Note: The estate tax is scheduled to be repealed in 2010 but just for one year. It is extremely likely that Congress will take some action in 2009 to undo the one-year repeal and keep the existing rates and exemptions through 2010 and beyond.  

A US person for transfer tax purposes is (i) a citizen, and (ii) a non-US citizen whose primary residence, or domicile, is in the United States, based on the person’s physical presence in the United States and intention to remain indefinitely. 

Creation of Trust: A Bermuda-based US grantor is required to report the creation of or transfer to a Bermuda trust on Internal Revenue Service (“IRS”) Form 3520. While the statute contemplates that notice be given within 90 days of this reportable event, instructions to the Form permit the notice to be filed by the due date for the US transferor’s income tax return (June 15 for a Bermuda-based US grantor although tax must be paid by April 15). Failure to comply results in 35 percent penalty on the gross reportable amount (the value of property transferred to the foreign trust). 

The Bermuda-based US grantor may also be required to file a gift tax return and pay gift tax (or allocate his $1,000,000 exemption to the transfer) if the transfer constitutes a completed gift. A completed gift occurs, generally, if the US transferor is not a beneficiary of the foreign trust and does not retain any powers over the trust. In some cases, a completed gift can occur where the US grantor is also a discretionary beneficiary, if his creditors cannot reach the trust property in satisfaction of their claims under the governing law.

Ongoing Trust: If the Bermuda-based US grantor is also considered the “tax owner” of the foreign trust, he must include the trust’s income in his gross income and comply with the following:

à    He must provide additional information on Form 3520; this includes the value of the assets and the income treated as owned by him under grantor trust rules.

à    He must ensure the foreign trustee files IRS Form 3520-A. This Form is due generally on March 15 and requires (i) a complete accounting of the trust’s activities on an income statement (created under US income tax principles) and (ii) a balance sheet showing all assets and liabilities of the trust on hand at the beginning and close of the trust’s tax year at then fair market values. 

à    He must ensure the foreign trustee furnishes him with The Foreign Grantor Trust Owner Statement and the US beneficiaries with The Foreign Grantor Trust Beneficiary Statement. Failure by the trustee to provide the Statements (in the form required by the IRS) could result in penalties to the US owner, equal to 5 percent of value of the trust treated as owned by him (in addition to 35 percent penalty above). Reluctance on the trustee’s part to provide the information is not sufficient to avoid US penalties nor is the fact that the foreign country under whose laws the trust is established may impose a penalty on the trustee for such disclosure. Since the US has no jurisdiction over the foreign trustee, it imposes the penalties on the US grantor for the trustee’s failure to comply.

For purposes of the above, a US grantor is treated as the “tax owner” of a foreign trust for income tax purposes, if he retains one or more of the following powers:

·        the grantor retains a reversionary interest in income or principal;

·        the grantor or a nonadverse party has certain powers over the beneficial enjoyment of the income or principal;

·        the grantor retains administrative powers under which the grantor might benefit such as the power to deal with or borrow from the trust without adequate and full consideration or security;

·        the grantor or a nonadverse party has the power to revoke the trust and revest the principal in the grantor; and

·        the grantor or a nonadverse party has the power to distribute income to or for the benefit of the grantor or the grantor’s spouse.

Finally, under a law intended to prevent the tax-free accumulation of income in a foreign trust that could otherwise occur if the trust were established in a low-tax jurisdiction and invested in non-US source income,[1] a US grantor could be considered the “tax owner” of a foreign trust -- even if he retains none of the powers enumerated above – but the trust has a US beneficiary for the year in question. A trust is treated as having a US beneficiary for the taxable year unless (i) under the terms of the trust, no part of the income or corpus of the trust may be paid or accumulated during the taxable year to or for the benefit of a US person and (ii) if the trust were terminated at any time during the taxable year, no part of the income or corpus could be paid to or for the benefit of a US person. It is irrelevant whether the income or principal is actually distributed to a US person during the year and whether the US person’s interest is contingent on a future event. All that matters is that income may be distributed to, or accumulated for the future benefit of, or principal may be distributed to, or held for the future benefit of, a US person. 

In most cases, the Bermuda-based US grantor’s family members, some of whom may be US persons, are beneficiaries of the irrevocable Bermuda trust or the Bermuda-based grantor is himself a beneficiary. This results in the Bermuda-based US grantor being taxed on the trust’s income and subject to Form 3520 and 3520-A filings.

The IRS is aggressively pursuing US taxpayers with unreported foreign activities and income. There is currently in effect a voluntary compliance initiative with a deadline of September 23, 2009, for those who come forward.  Therefore, Bermuda-based US grantors should, if they have not already done so, insure they are in compliance with all US tax and reporting obligations.

[1]           The taxation of foreign trusts was discussed in an August 11, 2009 column, entitled “Tax Planning for US Children of Bermudian Families.”

 

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