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Difference between a Foreign and Domestic Trust?

Under current tax law, a foreign trust is any trust other than a domestic trust. A domestic trust is any trust in which the following conditions are met:

(1) A court within the U.S. must be able to exercise primary supervision over the administration of the trust. (2) One or more U.S. persons have the authority to control all substantial decisions of the trust.

Therefore, under this test a trust may be considered a foreign trust even if it was created by a U.S. person, all of its assets are located in the U.S., and all of its beneficiaries are U.S. persons. Transferring assets to a foreign trust however, does not necessarily protect U.S. persons from U.S. taxation.

Under IRC Section 679, a U.S. person who “directly or indirectly transfers property to a foreign trust… shall be treated as the owner for his taxable year of the portion of such trust attributable to such property if for such year there is a U.S. beneficiary of any portion of such trust.” In other words, a U.S. person who transfers property to a foreign trust is still treated as owning such property, thus defeating any attempt by the U.S. grantor to evade U.S. tax by transferring property to a foreign trust. This rule also applies to any domestic trust that becomes a foreign trust while the U.S. grantor is still alive, or to any trust with foreign grantors who become a U.S. person within 5 years of a transfer to the trust.

In addition, under IRC Section 684, transfers of property from a U.S. person to a foreign trust triggers a taxable event, in which the U.S. person must recognize gain (but not loss) on the property transferred.