When you’re faced with the issue of cross-border tax and its various pitfalls, it can be hard to know what to do next. Foreign grantor trusts are a commonly used solution, and this article will introduce you to the basics you need to know.
What are they?
A Foreign Grantor Trust (FGT) is not considered a US domestic trust, which means the trust and the trustees will not need to pay tax in the US.
Who are they for?
FGTs are used when a non-US resident individual wants to financially benefit UStax residents via a trust fund. An example would be a Singaporean citizen (the grantor/settlor) who wants to benefit their US grandchildren without having the grandkids pay US tax.
The common mistake you need to know about
Whilst there are a number of tax advantages with the FGT approach, things can become especially complicated once the settlor passes away. For this reason, it’s essential to consider the local tax laws of all non-US tax residents involved, as well as the US tax code. Failing to do so can incur severe financial penalties in the long-term.
The pros of setting up an FGT
The key point here is legally paying as little tax as possible. This allows family members to benefit the next generation without paying tax on the money they have already amassed and paid tax on. Settlors will only incur US taxation on a small number of categories, such as US-source dividends (shares in American companies). Most other asset classes will be exempt, but it’s vital that long-term planning is used to ensure that the trust does not become subject to US taxation unintentionally.
2 types of FGT to consider
When considering the FGT route there are 2 key types of approach you need to know about. Revocable trusts are the first option and allow the US beneficiary to benefit tax-free from the FGT throughout the lifetime of the settlor. The only restriction is that they must report that they are doing so to the IRS for record-keeping purposes.
The other option is an irrevocable trust. Here the US beneficiary cannot directly benefit from the trust, but they are able to receive unlimited tax-free gifts. These could be given by the settlor or their partner, and only need to be reported when the gifted annual total exceeds 100,000 USD. The choice between the 2 types of trust is a complex one and requires research from all parties to ensure it makes the best use of the settlor’s local tax code, as well as the US system.
What are the disadvantages of an FGT?
FGTs work well during the lifetime of the settlor, but can quickly become complex when they pass away. At this point, the special US tax status ends, and the FGT automatically becomes a Foreign Non-Grantor Trust (FNGT). There are however a number of proven strategies that can be put in place in advance.
What are the solutions for US Person Beneficiaries of an FNGT?
3 of the most commonly employed strategies will highlight the approaches taken to minimize the tax due by US beneficiaries when receiving funds from an FNGT:
- Structure the FNGT so that it pays annual income and capital gains to the beneficiary, or a US resident trust. This prevents it from accumulating a large amount of income and gains which would then incur a substantial US tax bill
- Turn the FNGT into a full US resident trust so that it can be used as a domestic trust, and no longer has to pay annual benefits to minimize tax
- Depending on the specific structure of the FNGT the easiest approach can be to close it down and distribute the money to the various beneficiaries
The details of your approach are very much situation dependent and will be heavily influenced by the resident status of the various parties involved. The key point here is that planning and detail are crucial, and considering the cross-border implications at every turn is especially important.
About Matthew Ledvina
Matthew Ledvina works as a cross-border tax adviser, with US taxation among his specialties. He has worked with many high-profile clients and high-net-worth individuals. Follow Matthew Ledvina on LinkedIn, YouTube and Instagram for future updates.