Accidental foreign trusts may present a number of unforeseen circumstances 

As relationships flourish and the world seemingly shrinks, it’s becoming more common for people to invest abroad or even inherit assets from abroad. In order to avoid going through the expensive and time-consuming process of probate, they are putting their assets in trust — but there may be consequences, especially if a foreign trust is involved.

“Having a foreign trust itself is not a problem as long as you realize it and are prepared to submit additional tax filings and think about the implications. The problems only arise if you don’t realize there is a difference,” says Brian L. Shetler, partner, Berliner Cohen. “When an American citizen sets up a foreign trust, if that trust is considered a grantor trust under the law, there is little difference from a regular domestic grantor trust. When its status changes from a grantor trust, it is a very different animal with surprises for the unwary.”

Smart Business spoke with Shetler on why a trust that crosses borders — international and even across state lines — is a different animal requiring special attention.

What are (foreign) grantor and (foreign) non-grantor trusts? 

For income tax purposes, grantor trusts are taxed as if everything in them is owned by the grantor. Foreign trusts will be more likely to be foreign grantor trusts if they are established by a U.S. citizen and more likely to be a foreign non-grantor trust if they are established by a non-U.S. citizen. This is because U.S. citizens are presumed to have established grantor trusts if they establish a foreign trust with the possibility of a distribution under the terms of the trust to a U.S. beneficiary.

What could happen to adversely affect the trust tax situation? 

People today are talking about what is called an accidental foreign trust, where they have a relative whom they trust and want to take care of their assets in a foreign country. This person may be a U.S. citizen/ relative who lives there. If that relative is made trustee of the trust by the U.S. grantor, the grantor may not realize that even though a U.S. citizen is a trustee, the trust might be a foreign grantor trust because the trustee is primarily subject to foreign court jurisdiction for the foreign real estate.

For example, consider what would happen if U.S. grandparents who no longer ski set up an irrevocable trust to hold their Whistler ski cabin for the sole benefit of their grandchildren and for a trustee, they name a relative who currently lives in the U.S. No problem. It is a domestic trust holding assets abroad.

Then, subsequently, the relative dies, and the grandchildren appoint a Canadian trustee. That can cause the trust to become a grantor foreign trust. Thereafter, all rents from the cabin will be taxable to the grandparents even though they are not entitled to the distribution of any of the net rent proceeds. They might not find this out until an audit years after the trustee changes and need to amend returns.

In addition, once the grandparents die, the trust would become a foreign non-grantor trust with some extreme traps for the unwary.

These are just the federal regulations. State regulations are another story.

Does California have its own special rules for trusts? 

California bases its taxation on a non-grantor trust in part on who the trustees or the non-contingent beneficiaries are, which is different from rules in other states. If the beneficiaries are non-contingent California residents, then the trust is taxable in California no matter who the trustees are. If a trustee resides in California, the trust is subject to income taxation by the state, even if the trust holds no California property and no California residents are beneficiaries.

These rules in California are applicable to both foreign and non-foreign trusts that cross outside of California’s own borders.

Is there a grace period for fixing an accidental foreign trust? 

If someone discovers that they have an accidental foreign trust, there is a 12-month grace period to fix it, and it is generally worth the expense — if you’re crossing borders — to get expert advice from the right people.  

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