If it is determined the entity is a trust for U.S. tax purposes, is it a foreign or domestic trust? The classification impacts how the trust activities should be reported and taxed for U.S. tax purposes. A trust will be considered a “foreign trust” for U.S. tax purposes unless it passes both the court test and control test. Trusts established outside of the U.S. is an example of a foreign trust. Let’s dive in.

What is the Court test?

• A court within in the United States can exercise primary supervision over the administration of the trust.
• The trust must be administered exclusively in the Unites States; and
• The trust is not subject to an automatic migration provision.

What is the Control Test?

• One or more United States Persons (citizen resident, or corporation) have the authority to control all substantial decisions of the trust with no other persons having the power to veto any of the substantial decisions.
• Substantial decisions are fiduciary decisions authorized or required under the terms of the trust agreement and applicable law, such as those dealing with distributions, selection of beneficiaries, investment decisions and changes of trustee.
• A non-U.S. person can serve as a trustee if there are at least two other U.S. trustees, and the trust provides that a majority rules.

Once a decision is made as to whether the entity is a foreign or domestic trust, the next step is to determine whether the trust is a grantor or a non-grantor trust. Determining whether a trust is a grantor or non-grantor trust is important because it affects who is taxed on the trust income and when they are taxed.

What is a Foreign Grantor Trust?

Every foreign trust is a grantor trust if it has a U.S. donor and a U.S. beneficiary. The grantor is treated as the owner of the trust. The U.S. owner of the foreign grantor trust is subject to U.S. income tax on the portion of the trust income he or she is considered to own.

What is a Foreign Non-Grantor Trust?

Any foreign trust not determined to be a grantor trust will be treated as a foreign non-grantor trust for U.S. income tax purposes. Foreign non-grantor trusts generally are not subject to U.S. income tax rules unless the trust earns U.S. source or effectively connected income.

A foreign trust may be an excellent tool for asset protection purposes or foreign tax purposes, but U.S. owners and beneficiaries should be aware of the Federal tax reporting requirements and tax obligations. This is a highly complex area of U.S. taxation.

Feel free to contact a member of our International Tax Services practice for a consultation.