Tax accounting issues for foreign trusts.

EXECUTIVE SUMMARY

* Fiduciary accounting generally will follow local law and the tax situs of the trust (i.e., foreign versus domestic).

* A change in trustee, and beneficiary residency and trust terminations may have many tax and reporting consequences.

* Fiduciaries and tax advisers should be aware of the tax laws and regulations before reporting the trust transactions.

This two-part article compares tax accounting and reporting consequences of foreign versus domestic trusts. Part II illustrates the tax, fiduciary and accounting issues involved in changes in foreign and domestic trust status.

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This two-part article compares domestic and foreign trusts for fiduciary, reporting and tax accounting purposes. Part I, in the June 2006 issue, described the differences between foreign and domestic trusts and some of the advantages and disadvantages of foreign trusts. Part II, below, illustrates the tax consequences of changing foreign and domestic trust status that fiduciaries and tax advisers need to understand to report trust transactions properly under local law and in accordance with the trust instrument.

Effect of Domestic vs. Foreign Trust Status

Fiduciary accounting will, in general, follow the tax status of the trust (i.e., domestic versus foreign). The accounting can be complex because of timing differences of tax payments (i.e., paid in a foreign currency during a reporting period as a domestic trust or in U.S. dollars during a period as a foreign trust). Under the comments of Section 102 of the Uniform Prudent Investor Act, the National Conference of Commissioners on Uniform State Laws (NCCUSL) commented that "constructional preferences or rules would also apply, if necessary, to determine the terms of the trust" (instrument). If the instrument does not stipulate the accounting for principal and income transactions, specifically with references to a change in the tax and legal jurisdiction (i.e., from a domestic trust to a non-U.S, trust), local law provides the guidance for the fiduciary.

Under Section 403 of the Uniform Trust Code (as last amended in 2005), the NCCUSL commented that a trust is valid under the law of the domicile or place of business of the designated trustee. However, a domicile in a foreign country may require trust reformation procedures to comply with local law provisions, including accounting for income and principal transactions. The fiduciary and the tax adviser should understand the tax laws and regulations before reporting the transactions under fiduciary accounting principles.

Domestic Trust Status

Example 1: J, and his spouse from a second marriage, A, are U.S. citizens residing in California. J died on Nov. 30, 2004. A engaged W, a family friend, as trustee of a qualified terminable interest property (QTIP) trust allocated with assets from J's estate. The trust instrument has a California situs. However, J's brother, M, is a U.K. resident and citizen, and the trust instrument stipulated that he will act as successor trustee. M's powers, as stipulated in the trust instrument, include the powers to make investment decisions, and to allocate income and principal distributions to the income beneficiary (A), as well as other significant powers accorded to successor trustees. The trust instrument has an "automatic migration clause" to allow M U.K. court jurisdiction, if it is necessary to allow him to fulfill his duties and responsibilities. The trust's remainder beneficiary is J's daughter, N, from his first marriage. N also is a U.K. citizen and resident.

The QTIP trust assets consist of a partnership (ABC partnership) and an S corporation (XYZ Corp.). ABC assets consist of commercial rental properties in Los Angeles, shopping center 1, shopping center 2 and shopping center 3. XYZ's assets consist of certificates of deposit in U.S. banks and some dividend-paying U.S. and U.K. stocks.

W, as trustee, performs his duties, which include distributing monthly income distribution checks to A and supervising the property management company for the rental properties. The trust instrument provides for a "pecuniary marital/residual credit" formula for the marital deduction formula. It stipulates a "date of distribution funding" (true worth funding).With A's assistance, W was able to fund the QTIP trust by Dec. 31, 2004.

W did not make an election to elect a fiscal year under Sec. 645. The trustee made a timely election to treat XYZ as a qualified subchapter S trust (QSST), as the trust owns 100% of the common stock under Sec. 1361(d)(2).

Based on the facts as outlined above, the QTIP could have qualified as a domestic trust for 2005. Thus, the accounting and tax reporting should have followed standard procedures for a U.S. trust (following California law).

Fiduciary Change

Example 2: The facts are the same as in Example 1, except that W died on May 1, 2005. M assumed trustee duties and responsibilities for the QTIP trust as successor trustee.

Due to the change of fiduciary (W to M), a change of residency has occurred for the trust from the U.S. to the U.K. Under U.S. law, the trust would have had 12 months to adjust M's residence to avoid a change in the residence of the trust. As an alternative, M could have resigned as trustee and the next successor trustee, if a U.S. resident, could have assumed his duties and responsibilities. M had until April 30, 2006 to move his residence to the U.S. to perform his duties as trustee. If he did not meet the physical presence test by April 30, 2006, the QTIP would be deemed a foreign mast, retroactively to May 1, 2005.

Gain recognition and reporting: If M decides to maintain his U.K. residency, the "outbound trust migration" rules require recognition of a tax gain to the extent that the fair market value (FMV) of the assets transferred exceed the adjusted basis of the assets in the transferor's hands. Because of the recognition of gain as of May 1, 2005, tax payments would be due to the U.S. Treasury. The reportable gain computation, accounting and tax payments are shown in the exhibit on p. 410.

Because California mast law gives a trustee the power to adjust, tax advisers might consider whether M could elect to distribute all or a portion of the gain to A, to pass through part or all of the gain to the income beneficiary and avoid taxes at the trust level. For tax purposes, such a distribution would have been required before May 1, 2005, to avoid capital gain tax on the trust as a result of its conversion to a foreign trust. Because the gain is recognized in the second quarter, the tax payments were due June 15, 2005, as shown in the exhibit.

Local law: For California purposes, the mast would continue to report its tax return as a domestic trust. Under California law, the gain recognition rule under Sec. 684 does not apply to transfers of property to a foreign trust, (44) but does in a transfer to a foreign estate.

It may be prudent for M, as trustee, to petition a California probate court (45) to transfer administration of the trust from California to U.K. jurisdiction. Although not necessary because of the automatic migration provision in the trust instrument, the California court would ensure that the successor U.S. trustee is established and available if any litigation or claims are made against the trust in California.

Under California law, (46) the residence of the trustee determines how much non-California-source income will be taxed to California. California law (47) follows Sec. 1446, which requires state withholding taxes on all U.S. partnership distributions (to foreign partners) connected with U.S. activities.

Foreign local law: With the change in trust situs to the U.K. as of May 1, 2005, the fiduciary and practitioner, as a precautionary action, should review the local law of that jurisdiction for:

1. Conflict with the terms of the trust instrument. It may be advisable to have the fiduciary seek legal counsel in the U.K. to review the trust in light of the change in trust situs. Such recommendations could then be reviewed with the practitioner.

2. Taxation of the trust under U.K. law. The U.S. and U.K. have a comprehensive tax treaty that should be reviewed to avoid any double taxation. Because the assets continue to generate California-source income from rental properties, ABC income will continue to be reportable annually on California returns. For U.S. tax purposes, the U.S. property manager is under the control of the foreign trustee. The manager transacts business in the U.S.; thus, the partnership is engaged in a domestic trade or business as a domestic partnership under Sec. 864(b) and (c). Because the income will be included in the year's gross income of the recipient trust under Sec. 871(b)(2), Federal withholding is required to be paid by the trust at 30% on the partnership's taxable income, under Sec. 1446(c).

The interest and dividend income will continue to be principally U.S.-source income, even though the trust is now a foreign trust. The Federal withholding rate of 30% also applies at the time the interest and dividends are paid to the corporation and withheld by the payer.

3. Reporting. The tax adviser will file a final return for year 2005, Form 1041, U.S. Income Tax for Trusts and Estates, and also file Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts. Form 3520 will indicate the new resident situs of the trust. Also filed with 2005 Form 1041 is Form 3520A, Annual Information Return of Foreign Trust with a U.S. Owner, in which the practitioner will provide information for an "Annual Return of Foreign Trust with U.S. Beneficiaries" (A in the example). Form 3520-A will need to be filed annually with the IRS. Form 1041-NR, Income Schedule for Nonresident Trusts or Estates, will be filed with the IRS for the period that the U.S. assets are reported as a foreign trust.

The taxation and individual income tax reporting responsibility for A will not significantly change. She will continue to receive annually Form K-1, Beneficiary's Share of Income, Deductions, Credits, etc.

She can continue to report a portion of her income on Form 1116, Foreign Tax Credit, based on the foreign dividend income from U.K. stocks, if she desires to claim the credit on Form 1040.

4. Other issues. Because of unique "local law" and tax laws in the U.K., M may investigate whether a tax adviser familiar with U.K. fiduciary accounting and trust tax laws should be engaged to assist or replace the U.S. practitioner. The QSST will cease to be a qualified shareholder as a foreign trust.

Examples of transactions that should be further researched or investigated include the tax payments made on June 15, 2005. If the tax payments are made in U.K. currency (i.e., British pound), should the fiduciary accounting reflect a currency fluctuation or conversion to U.S dollars to correspond to the trust transaction's other income and expenses in the U.S. derived from rental income, interest and dividends? At first glance, it would appear that the U.K.-source dividends would no longer be subject to withholding taxes. However, because the owner of the stocks is a U.S. corporation, the payer is most likely required to withhold U.K. taxes from dividend payments.

Under U.K. trust laws, will the QTIP trust continue to report income distributions to the extent of distributable net income (DNI) as deductions of the trust? Because A is not subject to U.K. tax reporting as a U.S. citizen, it is more likely the trust will be subject to U.K. taxation based on gross income less ordinary deductions. The tax payments on June 15, 2005 would not qualify as deductions on the U.S. tax return.

However, the fiduciary accounting would report the tax payments during the period that the trust is a foreign trust. The U.K. tax payments may be allocated to income under local law of the new situs, which will reduce the income distributions to A for U.S.-source income. However, foreign tax withholding on U.K. dividends would be allocated to corpus. The interest and dividend income that is U.S.-source income will be subject to U.S. income taxes. (48) These tax payments would be allocated to income in the U.K.-administered trust. Qualifying dividends on U.S.-source income would qualify for reduced capital gain rates if passed through to A.

Beneficiary Moves

Example 3: The facts are the same as in Example 2, except A decides to move her domicile and residency to the U.K. The income tax laws have some influence on her decision, as the income tax liability of the trust is reduced by income distributions to the beneficiary. A started her U.K. residence on March 1, 2006.

The fiduciary accounting and tax return reporting for the QTIP trust will again depend on "local law" provisions. The income beneficiary, as a U.K. resident after February 2006, will receive the income accordingly. Form 3520-A will no longer be filed with the IRS after 2006. A may be required to file Form 8854, Initial and Annual Expatriation Information Statement, with the U.S.

The most significant consequence of the change to foreign trust situs is the loss of eligibility to hold S stock by virtue of the trust being a foreign trust. (49) Thus, the flowthrough is gone and distributions from the new C corporation (XYZ) will be treated as dividends.

Trustee Resigns

Example 4: The facts are the same as in Example 3. Due to M's inability to monitor closely the real property rentals in California, income has fallen and expenses have risen. These circumstances have reduced the income distributions to A. M decides to resign as trustee. The trust instrument stipulates A's son, R, a U.S. resident and citizen, to be successor trustee. M resigns on Jan. 15, 2007, and R assumes his duties on the same date.

As a result of the event on Jan. 15, 2007, the QTIP trust has, for U.K. and U.S. purposes, converted from a foreign trust (for U.S. purposes) to a domestic trust. R and his tax adviser have to address:

1. Does the U.K. tax system have gain recognition similar to the U.S. system (i.e., Sec. 684)?

2. R may be advised to seek legal advice for the change in trust situs from the U.K. to the U.S.

Special attention should be given to automatic migration provision(s) in the trust instrument and to U.K. local law. These provisions should be analyzed in light of a former U.S. income beneficiary changing residence to the U.K.

The fiduciary accounting entries, commencing Jan. 15, 2007, for recording the rental income interest and dividends would be similar to those in Examples 1 and 2. For any U.K. tax payments after Jan. 15, 2007 that are on the 2006 fiduciary tax return, the payments would be allocated to principal.

Trust Terminated

Example 5: The facts are the same as in Example 4; however, animosity has grown between A (the income beneficiary) and N (the remainder beneficiary). The beneficiaries decide by mutual agreement to terminate the QTIP trust, which is approved by the court. The assets will be sold and the net proceeds, after sales and payment of trust expenses, will be distributed to the beneficiaries on a 50/50 basis in 2008.

The facts involve a domestic trust with two nonresident alien beneficiaries that is being terminated. Because the trust is a QTIP trust created from the estate of a U.S. citizen, a gift tax return is required to report the net gift under Sec. 2519, payable to the income beneficiary. The remainder beneficiary is responsible for any gift tax paid for the property transferred under Sec. 2519 (under Sec. 2207A(b)). As J was a U.S. citizen who died in the U.S., A's estate would include the QTIP in her estate on her death. However, because she is now a non-U.S, citizen under Sec. 2101 because of expatriation rules, only that part of the QTIP assets situated in the U.S. is reported on Form 709, Gift Tax Return, for the termination of the trust.

The fiduciary accounting would be similar to that of a domestic trust. Capital gains from the sale of the partnership and corporate assets would be paid by the trust and allocated to corpus. The trust would pay the income and capital gain taxes. The tax return K-1s, one to the income beneficiary for the DNI distribution and one to the remainder beneficiary, would report any taxable portion of the distributions.

Example 5 does not analyze the reporting and consequences of generation-skipping transfer tax reporting issues. It is assumed that a reverse QTIP election was made under Sec. 2652(a)(3) on J's Form 706 filed in 2005.

Conclusion

The examples above illustrate the intricate reporting issues with regard to domestic trusts, which can easily become foreign trusts as changes in residency and jurisdiction dictate. With an increasingly mobile society today, practitioners need to be more diligent to meet these challenges to pilot successfully fiduciaries and beneficiaries in fiduciary accounting and tax reporting.

(44) CA Rev. & Tax'n Code Section 17760.

(45) See CA Probate Code Sections 17400, 17401 and 17402 for petition of trust administration to a jurisdiction outside of California.

(46) CA Rev. & Tax'n Code Section 17743; the income taxable under Section 17742 shall be apportioned according to the number of fiduciaries resident in California.

(47) CA Rev. & Tax'n Code Sections 18666 and 18662.

(48) See Sec. 861.

(49) See Sec. 1361(c)(2)(A).

Lawrence H. McNamara, CPA

Sole Practitioner

Lake Forest, CA

Exhibit: Reportable gain computation

                                  FMV as of     Basis as of
                                     5/1/05     12/31 /04      Excess

Partnership interest in ABC       $4,000,000    $3,500,000    $500,000
100% common stock of XYZ           1,200,000     1,100,000     100,000
            Total:                $5,200,000    $4,600,000    $600,000

To record an adjustment to the carrying value of
trust assets based on recognized gains as of 5/1/05:

                                      Debit        Credit

ABC                                 $500,000
Gain allocated to corpus                          $500,000
XYZ                                 $100,000
Gain allocated to corpus                          $100,000

To record tax payments to U.S. Treasury on 6/15/05:
$600,000 x 35% = $210,000
(Federal tax on short-term capital gain) (a)

                                      Debit        Credit

Income tax allocated to corpus      $210,000
Cash in bank                                      $210,000

(a) See Sec. 684; under Sec. 684(c), if a domestic trust becomes
a foreign trust, it is treated as having transferred all of its
assets to a foreign trust, immediately before becoming a foreign
trust.