The topic of foreign trusts conjures up alluring images of secret bank accounts in exotic locations far from the prying eyes of the Internal Revenue Service. However, a U.S. tax-compliant offshore strategy is completely legal and can provide unparalleled asset protection while also reducing income and estate taxes. Wealthy individuals have used compliant offshore tax planning for years, and more recently these techniques have become available to those of more modest means. Although a foreign trust can save taxes through legitimate strategies, protect assets, and provide privacy, there are a number of pitfalls that the professional needs to consider.
The offshore asset protection and tax havens exist because of a powerful demand by individuals in many countries to shelter their wealth from a variety of perceived threats. In the U.S. these threats are often the product of a legal system that unfairly targets those with wealth. In other countries with fewer lawyers and lawsuits, the threat of litigation is not the primary concern. Instead, asset protection and privacy issues are related to the political and economic climate that poses risks to an individual’s life and livelihood, such as kidnapping, confiscation, exchange controls, and so forth.
A Foreign Asset Protection Trust (FAPT) is a discretionary irrevocable trust that is set up in a country other than the United States and that contains sophisticated drafting and, sometimes, tax planning to protect its assets. Proper drafting can endow the FAPT with the ability to take advantage of choices offered by using the laws of various countries, always with an eye on emerging international standards.
United States tax structuring can provide the FAPT with the ability to legally take advantage of benefits offered in the Internal Revenue Code and Treasury Regulations–advantages not available to the domestic-only planner. Although it is almost universally understood that because of IRC ?672-679, the foreign trust is a grantor trust and is therefore tax-neutral, to the professional advisor, this may not be exactly the case.
Making FAPTs Less Foreign
Let’s review the history and structure of trusts, especially FAPTs.
Trusts were first formed centuries ago when members of monastic orders, having taken vows of poverty, were embarrassed by their huge land holdings. To resolve their moral problem, they asked the king to hold and own the land or take “legal title” for their benefit, which was called an equitable interest. The king was the trustee and the monks were the beneficiaries.
All foreign trusts transfer legal title to a trustee, generally a trust company, whose business is domiciled outside the U.S. The person setting up the trust is the settlor or grantor. The trust is created in the form of a legal document–a deed of trust or trust deed. The protector is a person, appointed under the trust, with whom the trustee may consult when administering the trust and who has the power to negate actions the trustee may want to pursue. The protector, who can be a foreign or U.S. person, including a best friend of the grantor, can be authorized to remove trustees and appoint non-U.S. trustees.
The trustee is a fiduciary who is governed by stringent rules to act in the best interests of the beneficiaries and can be discharged by the protector. Assets may be held by financial institutions, which could be required to sign off on any asset transfer, and are insured. All persons with possible access to trust assets can be bonded.
The letter of wishes or, in cases where privacy is paramount, a memoir to the attorney, is an informal and confidential letter from the settlor that provides guidance as to how the trustee might exercise his discretion. Included in the trustee’s discretion is the power to accumulate or distribute income among a specified class of beneficiaries. The letter of wishes is not part of the trust and can be amended.
The trustee holds trust property in accordance with the obligations imposed by the trust deed and administers trust assets. Beneficiaries can be named specifically or generally as members of a class (e.g., “my descendants”), and beneficiaries have recourse under the law to compel the trustee to act according to the terms in the trust deed.
With an FAPT, the settlor is in control. While the FAPT gives the trustee discretion to make decisions, the letter of wishes suggests how the trustee should exercise that discretion. The settlor appoints a protector with power to enforce the letter of wishes. If the settlor dies, the FAPT can, if so drafted, act like an asset protected living trust.
During the grantor’s life, the FAPT is income tax-neutral, though not necessarily estate tax-neutral. However, an FAPT loses its grantor trust status at the grantor’s death–since the grantor is dead, there is no grantor to tax–and the grantor’s estate will not be treated as owner of the trust assets. On death, the grantor trust becomes a Foreign Non-Grantor Trust (FNGT) and its income is taxed by the country in which it is located. The U.S. can only tax distributions that the trust makes to U.S. taxpayers. If the FNGT is situated in a zero-tax jurisdiction, its assets will grow tax-free.
If FNGT assets are distributed to U.S. beneficiaries, they may or may not be taxed, depending on how the FAPT was structured. If not structured for tax benefits–and the vast majority of FAPTs are not–after the death of the settlor a non-deductible interest charge will be applied to the tax attributable to a distribution multiplied by the number of years the distribution was accumulated in the FNGT. Throwback rules will affect the tax as well. The purpose of the throwback rules is to prevent avoidance of U.S. income taxes through the accumulation of income taxed at lower rates than the beneficiary would have paid if the income had been distributed. The tax and interest due may quickly reach 100% of the distribution.