Will Funding a Trust Help You Avoid U.S. Exit Taxes?

Will Funding a Trust Help You Avoid U.S. Exit Taxes?

Will Funding a Trust Help You Avoid U.S. Exit Taxes?

When a U.S. Citizen or Long-Term Lawful Permanent Resident (LTR) is ready to expatriate from the United States, they may become subject to an exit tax depending on their:

• • • Net Worth

    • Net Income Average Tax Liability, and

    • History of U.S. Tax Compliance

When a Taxpayer is considered ‘covered ‘and potentially subject to the exit tax, they may try utilizing various planning techniques to minimize or avoid the exit tax. Unfortunately, these planning techniques usually do not work because the IRS has developed many rules to counteract taxpayers’ creative exit tax planning techniques. Oftentimes, in trying to circumvent U.S. exit taxes, Taxpayers may try to use sophisticated trust planning strategies and form an irrevocable trust – with the intent of converting the trust post-expatriation. Still, unfortunately, these typically do not work either. Let’s focus specifically on how the non-grantor trust rules interact with the expatriation rules for taxpayers who are considered covered and have an interest in or ownership of a non-grantor trust.

 Are You Covered?

The first issue to remember is that the exit tax only impacts covered expatriates. Therefore, if the taxpayer is not a covered expatriate at the time they exit the United States, then they generally do not have exit tax implications.

Grantor Trusts vs Non-Grantor Trust

Let’s begin with Grantor Trust expatriation tax rules:

Grantor Trust

There is a distinction between a grantor trust and a non-grantor trust. With a grantor trust, the expatriate grantor is the owner of the trust, and the value of the trust is included in their exit tax calculation — they are taxed on the mark-to-market calculation the day before expatriation. As provided by the IRS:

• • • Notice 2009-85: If the covered expatriate is treated as the owner of any portion of a trust under the grantor trust rules (sections 671 through 679) on the day before the expatriation date, the assets held by that portion of the trust are subject to the mark-to-market regime (but see section 4 of this notice concerning coordination with section 684).

    • Section 684. Section 877A(h)(3) provides that if the expatriation of any individual would result in recognition of gain under section 684, the provisions of section 684 apply before the provisions of section 877A. Section 684(a) and the regulations thereunder generally require immediate recognition of gain when a U.S. person directly, indirectly, or constructively transfers appreciated property to a foreign trust of which the U.S. person is not treated as the owner under the grantor trust rules (sections 671 through 679). Section 672(f) limits the circumstances in which a foreign person may be treated as the owner of a trust under the grantor trust rules.

Non-Grantor Trust Expatriation Tax Rules

The rules for non-grantor trusts are markedly different because the person who is expatriated is not the owner of the non-grantor trust, and therefore, the mark-to-market rules would not apply at the time of exit. As provided by the IRS:

• • • “The mark-to-market regime does not apply to any interest in a nongrantor trust.

    • For this purpose, section 877A(f)(3) provides that the term “nongrantor trust” means the portion of any trust, whether domestic or foreign, of which the covered expatriate is not considered the owner under subpart E of Part I of subchapter J, determined as of the day before the expatriation date. Section 877A(f) provides that in the case of any direct or indirect distribution of property (including money) to a covered expatriate from a nongrantor trust of which the covered expatriate was a beneficiary on the day before the expatriation date, the trustee must deduct and withhold from the distribution an amount equal to 30 percent of the taxable portion of the distribution.”

When a taxpayer has ownership of certain assets such as securities, they may be subject to the mark-to-market regime when they expatriate. Using a very basic example, if the taxpayer has a $500,000 basis in securities that are now worth $3,000,000, then they may become subject to an exit tax on the $2.5 million gain — subject to any applicable exclusion amount. This applies whether the taxpayer sells the assets before expatriation or holds on to the assets post-expatriation.   Likewise, if a taxpayer has an interest in a non-grantor trust, they may be subject to exit taxes, just not under the mark-to-market rules.

How are Non-Grantor Trusts Taxed at Expatriation?

With a non-grantor trust, the covered expatriate does not have an ownership in the trust, so they are not taxed under the mark-to-market regime — because technically, if they do not have any ownership, then they do not have any mark-to-market gain at exit. However, if the non-grantor trust was to issue a distribution to a covered expatriate who was considered a beneficiary of the non-grantor trust on the day before expatriation, then this distribution is taxable. Since the taxpayer is now a non-resident alien, post-expatriation, the withholding tax is 30% of the distribution.

How to Determine if the Expatriate is a Beneficiary

• • • “For purposes of determining whether a covered expatriate is a beneficiary of a nongrantor trust on the day before the expatriation date, a beneficiary is a person

      • (a) who is entitled or permitted, under the terms of the trust instrument or applicable local law, to receive a direct or indirect distribution of trust income or corpus (including, for example, a distribution in discharge of an obligation of that person),

      • (b) with the power to apply trust income or corpus for his or her own benefit, or

      • (c) to whom the trust income or corpus could be paid if the trust or the current interests in the trust were then terminated.”

The IRS Knows Your Sleight of Hand Maneuvers

The IRS is aware that some taxpayer beneficiaries of a non-grantor trust will intend on converting the non-grantor trust to a grant or trust after expatriation — with the hopes of owning the trust (now as a non-resident alien grantor) without the trust being subject to the grantor tax rules — since the owner is no longer a U.S. Person (e.g. a non-resident alien owner of a foreign trust). To counteract this strategy, the IRS developed specific rules for covered expatriates who convert a non-grantor trust after expatriating.

• • • “If a trust that is a nongrantor trust immediately before the expatriation date subsequently becomes a grantor trust of which the covered expatriate is treated as the owner, directly or indirectly, then the conversion is deemed to be a taxable distribution under section 877A(f)(1) to the covered expatriate to the extent of the portion of the trust of which the covered expatriate is then treated as the owner.”

    • Section 877A(f)(2) provides that the term “taxable portion” means, with respect to any distribution, the portion of the distribution that would have been includible in the covered expatriate’s gross income if the covered expatriate had continued to be subject to tax as a citizen or resident of the United States.

Relevant portions of trust taxation from Notice 2009-85 are reproduced below:

Withholding

• • • • Section 877A(f)(4)(A) provides that rules similar to the rules of section 877A(d)(6) shall apply. Thus, the tax that is imposed by section 877A(f) is imposed under section 871, but the payment is subject to withholding under section 877A(f)(1)(A) and not under section 1441. Any amount due under section 871 that is not paid by means of withholding must be reported on the income tax return filed by the covered expatriate for the relevant taxable year. In addition, rules similar to the rules of section 1461 through 1464 apply. Thus, the trustee, as the person required to deduct and withhold the tax, is liable for such tax as stated under section 1461. The covered expatriate must notify the trustee of his or her covered expatriate status by submitting Form W-8CE to the trustee on the earlier of (1) the day prior to the first distribution on or after the expatriation date or (2) 30 days after the expatriation date. For more information about Form W-8CE, see section 8 of this notice.

      • Section 877A(g)(1)(C) provides, in part, that in the case of any covered expatriate who is subject to tax as a citizen or resident of the United States for any period beginning after the expatriation date, such individual will not be treated as a covered expatriate during such period for purposes of the 30 percent withholding tax on the taxable portion of a distribution from a nongrantor trust. Thus, the taxable portion of the distribution would not be subject to tax under section 871, but would be subject to the tax imposed on distributions to a citizen or resident of the United States.

Interaction with Treaties

• • • Section 877A(f)(4)(B) provides that a covered expatriate shall be treated as having waived any right to claim any reduction under any treaty with the United States in withholding on any distribution to which section 877A(f)(1)(A) applies unless the covered expatriate agrees to such other treatment as the Secretary determines appropriate. Until further guidance is issued, a covered expatriate may preserve his or her right to claim a treaty benefit with respect to a distribution to which section 877A(f)(1)(A) applies by electing on Form 8854 to be treated as having received the value of his or her interest in the trust as determined for purposes of section 877A, on the day before the expatriation date.

    • In order to make the election described in the previous paragraph, the covered expatriate must obtain a letter ruling from the IRS as to the value, if ascertainable, of his or her interest in the trust as of the day before the expatriation date by following the procedures set out in Revenue Procedure 2009-4, 2009-1 I.R.B. 118 (or any subsequent publication that replaces Revenue Procedure 2009-4). Until the trustee receives a copy of the letter ruling from the covered expatriate and a certification signed under penalties of perjury that the tax due on the value of the interest in the trust has been paid to the IRS, the trustee must withhold as provided in section 877A(f)(1). The amount of tax due on the value of the interest in the nongrantor trust as of the day before the expatriation date will be adjusted by the amount of any tax withheld on or after the expatriation date and prior to receipt of the letter ruling. The covered expatriate may not make the election if the IRS determines that his or her interest in the trust does not have an ascertainable value as of the day before the expatriation date.

    • If the covered expatriate provides the trustee with a copy of the letter ruling and a certification written under penalties of perjury that the tax due on the value of the interest in the trust has been paid to the IRS, then the tax imposed under section 877A(f) with respect to the trust will be deemed to have been fully satisfied. Accordingly, no subsequent distribution from the trust to the covered expatriate will be subject to 30 percent withholding under section 877A(f)(1)(A), and the covered expatriate will not be precluded by section 877A(f)(4)(B) from claiming treaty benefits with respect to any distribution from the trust under the appropriate article of an applicable treaty.

    • Example 20. On Date 1, Trustee of a complex, nongrantor trust, distributes a painting to A, a covered expatriate who was a beneficiary of the trust on the day before A’s expatriation date. The painting is a capital asset and has a basis of $100,000 and a fair market value of $400,000. The trust is a domestic trust that excludes gains from the sale or exchange of capital assets from its distributable net income (DNI) under section 643(a)(3). On Date 1, the trust is deemed to have recognized capital gain of $300,000 under section 877A(f)(1)(B). The trust must include the $300,000 of capital gain in its gross income and may not deduct that amount under section 661 in computing its taxable income under section 641. The trust is taxable on the $300,000 capital gain (reduced by the applicable exemption amount under section 642(b) and any applicable deductions) and is not required to deduct and withhold any amount pursuant to section 877A(f)(1)(A). A is not taxable on the $300,000 capital gain.

    • Example 21. The facts are the same as in Example 20except that the trust is a foreign trust that includes capital gain in DNI pursuant to section 643(a)(6)(C). Although the trust must include the $300,000 of capital gain in its gross income, it may deduct that amount under section 661 in computing its taxable income under section 641. If A, now a nonresident alien, had continued to be subject to tax as a citizen or resident of the United States, the capital gain of $300,000 would have been includible in A’s gross income pursuant to section 662. Accordingly, the trust is required to deduct and withhold $90,000 (30 percent of $300,000) pursuant to section 877A(f)(1)(A).