Foreign trusts are required to file different disclosures with the Internal Revenue Service (IRS) than domestic trusts. Foreign trusts have different bases of taxation and other requirements than their U.S. domestic trust peers do. But that raises a fundamental question: When is a trust a foreign trust?
And the answer is less clear-cut than it would appear at first glance.
The Pre-1997 Test
For tax years before 1997, the IRS used a subjective test to decide if a trust was a domestic or foreign trust. If it was a foreign trust, then the trust was taxed as a nonresident alien. But this required examining if the trust was, in fact, not a resident and was an alien. This led the IRS and courts to use six factors in making these determinations:
- Where was the trust created?
- Where was the situs of the trust corpus?
- What was the nationality of the trustee, and where did the trustee reside?
- What was the nationality of the trust's grantor, and where did the grantor reside?
- What were the nationalities of the trust beneficiaries, and where did they reside?
Over time, the IRS and courts increasingly focused on the corpus's location, the grantor's nationality and residence, and the trust administration's location as determinative of the test.
However, even with this guidance, grantors and beneficiaries were unsure of the trust's status. The IRS refused to issue advisory opinions, so the status was never assured until after a court had rendered a decision.
A Change in the Law
The uncertainty led to provisions in the Small Business Job Protection Act of 1996 that intended to set out a new, objective standard that has been in operation since 1997. The relevant standard arises out of these two questions:
- Does a court in the U.S. have primary jurisdiction over the trust's administration?
- Are all substantial trust decisions under the control of one or more U.S. persons?
If the answer to both questions is yes, it's a domestic trust. But if the question to either is no, then it's a foreign trust.
While there has been some relief in the comparative clarity of this test, some legal scholars have warned the objective test expanded the definition of a foreign trust—because now the presumption is that a trust is foreign unless proven otherwise.
“The U.S. Court Test”
The first part of the test, now commonly referred to as “The U.S. Court Test,” relates to a court's ability to exercise jurisdiction over a trust. Any U.S.-located court is sufficient—be it state, local, federal, or a court located in the District of Columbia. However, courts in U.S. territories or other countries are not U.S. courts.
It helps, then, for trusts to state in organizing documents that the trust falls under a particular U.S. court. However, that statement alone is not automatically sufficient. The statute relates to the administrative authority of the court; it's not about substantive governing law. Therefore, even if a trust document says that it's organized under a state's law, if a foreign country can exercise jurisdiction over a substantive issue, the trust still won't pass the U.S. Court Test.
Additionally, a trust fails to meet the U.S. Court Test if there's an “automatic migration” clause. In this situation, if a trust instrument says that the trust will automatically migrate to a foreign jurisdiction if a U.S. court tries to assert jurisdiction or supervise the trust, it will fail the U.S. Court Test.
On the flip side, there is a “safe harbor” rule to protect domestic trusts. If a trust instrument does not direct foreign administration of the trust, the trust is administered in the U.S., and there's no automatic migration clause, then the trust should be able to pass the U.S. Court Test.
“The Control Test”
The second prong of the standard, “the Control Test,” relates to who holds the substantial decision-making authority over the trust, and it is equally important.
The Control Test itself has a two-part analysis: determining who has authority over the trust and what would constitute such a substantial decision that it should be considered control.
When deciding who has authority, the “who” is not limited to who makes decisions themselves; it also includes those who have any veto power over those decisions. This could refer to someone who delegates day-to-day trust administration but retains the right to override those decisions. But the principle's implications are broader than that. It can include others such as a governmental authority or creditor who could exercise authority over the trust's assets since the trust administrators couldn't act without their knowledge and approval.
Substantively, actions that are significant enough to meet the standard include things such as:
- Choosing whether or not to distribute income or the trust's corpus
- Determining the size of any distributions
- Selecting beneficiaries
- Being able to make investments on behalf of the trust
- Being able to terminate the trust
- Changing the makeup of the trustees (either by removing or adding them)
- Suing (or defending lawsuits) on behalf of the trust
If you have any questions about your potential liability for foreign trusts or other non-domestic holdings, contact an attorney specializing in tax law. Contact Senior Partner, Tax Controversy Attorney, and former IRS attorney Brandon A. Keim today by calling (602) 200-7399 or reaching him online to discuss your case. If you need help, call Senior Partner, Tax Controversy Attorney, and former IRS attorney Brandon A. Keim at (602) 200-7399 or contact him online to discuss your options.