Domestic and Foreign Trust Classification and Cross-Border Trusts

Scope of the chapter. Every trust is, for federal tax purposes, either a United States person or a foreign trust. The classification is made under a two-part statutory test, applied day by day. It governs how the trust's income is taxed, whether a transfer to the trust is a taxable event, whether accumulated income carries an interest charge when it is later distributed, and which information returns the settlor, the trustee and the beneficiaries must file. I.R.C. § 7701(a)(30)(E), (31)(B); Treas. Reg. § 301.7701-7(a). The test does not turn on where the trust was signed, which law governs it or where its assets are held. It turns on two facts that a drafter controls: whether a court in the United States is able to exercise primary supervision over the administration of the trust, and whether United States persons control all of its substantial decisions. A trust drafted under Wyoming law, with a Wyoming trustee and assets in New York, can be a foreign trust because a protector in London holds a veto over distributions. A trust drafted under Cook Islands law can be a domestic trust if its instrument and its administration meet both tests. This chapter is concerned with designing trusts that land deliberately on one side of the line and stay there, and with the consequences of crossing it.

Why the classification matters. A domestic trust is taxed under the rules of subchapter J on its worldwide income, its accumulated income is free of the throwback rules, and its return is Form 1041. A foreign trust is taxed like a nonresident alien who is never present in the United States, on United States source income and income effectively connected with a United States business. Treas. Reg. § 301.7701-7(a)(3); I.R.C. § 641(b). A transfer of appreciated property by a United States person to a foreign trust is treated as a sale unless someone is treated as the trust's owner. I.R.C. § 684(a)–(b). A United States person who transfers property to a foreign trust that has a United States beneficiary is treated as its owner. Id. § 679(a)(1). Income accumulated by a foreign nongrantor trust and later distributed to a United States beneficiary is taxed under the throwback rules with a nondeductible interest charge. Id. §§ 665–668. Creation of, transfers to and distributions from a foreign trust are reported on Forms 3520 and 3520-A, and the penalties for failing to report are large and assessed without a deficiency notice. Id. §§ 6048, 6677. A family that does not know which side of the line its trust is on can incur all of these consequences without having intended any of them.

Relation to other chapters. The classification tests appear in several earlier chapters from particular angles: the protector's powers as substantial decisions (see supra ¶ 1580), the tax consequences of moving a trust (see supra ¶ 2080), decanting into or out of foreign status (see supra ¶ 1880), and the grantor-trust rules on which the exceptions to section 684 depend (see supra ch. 40). This chapter gathers the rules in one place and adds the treatment of foreign grantors, foreign nongrantor trusts, reporting and the design of trusts for families who live outside the United States. The companion volume, Lighthouse on Asset Protection, examines the same rules from the standpoint of protective trusts settled offshore by United States clients, including the reporting calendar and the remediation of missed filings (companion volume, chs. 42, 43, 44 and 50). The discussion here takes the designer's view: which terms of the instrument, and which habits of administration, fix the trust's classification and keep it fixed.

Who files. The returns discussed in this chapter are the returns of the United States owner, the United States beneficiaries and the trust itself. They are prepared by the client's own return preparer. The trustee's part, and the drafter's, is to see that the instrument requires the information those preparers need to be produced on time and that the trust's classification is known when the year begins. A trustee that does not know whether its trust is domestic or foreign cannot tell the owner or the beneficiaries what to file.

Vocabulary. The Code uses "United States person" for any citizen or resident, domestic partnership, domestic corporation, domestic estate and domestic trust. I.R.C. § 7701(a)(30). A "foreign trust" is any trust that is not a United States person. Id. § 7701(a)(31)(B). The regulations call the first part of the test the "court test" and the second the "control test." Treas. Reg. § 301.7701-7(a)(1). A "foreign grantor trust" is a foreign trust treated in whole or part as owned by a grantor or another person under sections 671 through 679; a "foreign nongrantor trust" is a foreign trust that no one is treated as owning. Neither phrase appears in the Code, but both are used in the Service's forms and instructions, and this chapter uses them in the same sense.

Table 43-1. Consequences of Classification.