Domesticating a Foreign Trust

November 6, 2023

Historically, many high-net-worth families chose to create trusts offshore due to the extensive asset protection and privacy laws offered by foreign jurisdictions. The perception was that offshore jurisdictions offered greater privacy and therefore allowed families better planning options. However, with this increased privacy also came the negative perception that those choosing to engage in this type of planning were trying to hide something. In fact, many of the families utilizing offshore planning opportunities were not trying to hide anything, instead they were simply engaging in good planning by creating tax efficient structures and complying with all necessary reporting.

Over time, U.S. laws have caught up with those of foreign jurisdictions, and in some cases have outpaced them. For instance, asset protection statutes have developed throughout the U.S., making that aspect of trust planning more attractive to families within the U.S., with the added benefit of not being associated with the negative perception of offshore trusts. In addition, with the onset of the Common Reporting Standard (CRS) and other reporting burdens placed on offshore trusts, what was once an opportunity to protect family privacy has become a complex web of additional disclosure and tax requirements. As a result, many families have determined that it is time to bring their wealth back onshore. 

The decision to bring family wealth back onshore, or domesticate, an offshore trust is not without its own somewhat complicated processes. Initially, there are several reporting requirements to consider, including Forms 3520 and 3520-A, throw-back taxes, and generation-skipping transfer taxes to name a few. Each must be considered and analyzed carefully to avoid unnecessary complications as family trusts are brought back onshore — however, once the trust is domesticated, any associated U.S. grantors and beneficiaries should no longer be subject to the onerous tax and reporting requirements imposed on foreign trust.

Form 3520 Reporting Concerns

The reporting burdens placed on foreign trusts with U.S. connections have increased over the years. When bringing a trust currently considered a foreign trust back onshore, it is important to understand when a Form 3520 or 3520-A should be filed. Form 3520 must be filed by a U.S. person (which would include a U.S. trust) when (1) a foreign trust is created, (2) a foreign trust receives a transfer of assets, and (3) distributions are made from a foreign trust. 

The penalty for failing to file a Form 3520 is the greater of $10,000 or 35% of the value of the property transferred or received from a foreign trust, so, there are serious implications for U.S. persons who fail to appropriately file a Form 3520. This is particularly intimidating when you consider the fact that the Form is not a tax filing, but an informational filing which would otherwise generate no expense for the trust. When considered together, this means that a failure to understand and properly report a transfer on Form 3520 will ultimately have a significant cost to the trust despite the fact that the transfer itself is not taxed in response to the filing. 

When domesticating a trust, it may be prudent to file a Form 3520 in recognition of the distribution being made from the existing foreign trust to the new domestic trust. There are differing perspectives on the prudence of filing a Form 3520 when domesticating a trust. Some consider the domestication to be simply a change of situs, and have concerns that should the Form 3520 be filed, the domestication will be considered by the IRS to be a distribution from the non-U.S. trust to the grantor of the trust and then a transfer by the grantor to the domestic trust, thus destroying any GST-exempt status or existing tax other characteristics of the original trust. Others consider the filing of the Form 3520 in these instances to simply be a protective measure to ensure that the IRS is made aware of the change, and does not impose the steep penalties and interest mentioned previously. 

While the filing of Form 3520 at the time of the domestication may sound burdensome, consider that while the trust is a foreign trust, its U.S. owner of is required to file a 3520-A annually to report (1) the income generated by the assets of the trust, (2) the U.S. beneficiaries of the trust, and (3) the U.S. owners of the trust. Form 3520-A is also an informational return with a steep penalty for failure to file; however, its filing requirements are annual. So, filing Form 3520 when domesticating is not such a burden when considering that without domesticating, a form would need to be filed annually. In addition, since the U.S. is not a signatory to CRS, the domestication of the trust will eliminate any reporting associated with CRS as the trustees will now be entirely U.S. persons.

Throwback Rule Concerns

Where an offshore trust has been in existence for some time, there may be undistributed net income (“UNI”) accumulating in the trust for future distribution to beneficiaries, as a result of the trust not distributing all income currently. Any existing UNI held in the trust at the time of domestication will be subject to what is known as “throw-back” tax rules, which require a tax on the accumulated income that is carried out to trust beneficiaries when distributions are made. This throwback tax causes capital gains to lose their character and be taxed at higher ordinary income tax rates. 

In addition, UNI is treated as being taxed in the year it was earned, with interest. The IRS will consider all future distributions from the domesticated trust to include the built-up UNI until such time as it is fully distributed. Once the UNI is fully distributed, the trust will proceed as a standard U.S. trusts and any income earned after the domestication of the trust will only be subject to the regular U.S. tax rules applicable to trusts and subject to U.S. income tax on an annual basis as a U.S. taxpayer. 

Generation-Skipping Transfer Tax Concerns

When domesticating a trust, it is also important to be careful of loss of the Generation-Skipping Transfer (“GST”) tax exemption and violating the rule against perpetuities. If the trust is currently in a jurisdiction that requires a shorter perpetuity period than the US, especially in light of the fact that states like Delaware have long since abolished those limits, the original perpetuity period will attach to the assets transferred onshore. In addition, when domesticating a trust, since the applicable perpetuities period is not a matter of trust administrative law but the law of validity, merely changing the situs of a trust does not typically change the perpetuities period of the trust. 

It is also important to consider the GST tax exemption implications of the modification of an existing trust. Generally, the IRS takes the position that any change in a trust that “alters the quality, value, or timing of any powers, beneficial interest, rights or expectancies” will cause the trust to lose its GST tax exempt status. A simple change in the trust situs does not cause a change to the trust’s GST tax exemption status; however, the IRS has not definitively ruled on whether that coupled with a change in governing law would cause a loss of exempt status. 

There are some safe harbors imposed by the Treasury Regulations which provide a map for those attempting to preserve GST tax exempt status when domesticating a trust. When decanting, so long as the distribution is authorized by the trust instrument (or relevant governing law at the time the trust became irrevocable) and the new trust does not extend the perpetuities period, the trust will not lose its GST tax exempt status. With a trust modification, so long as there is no shift in beneficial interest to a lower generation and the perpetuities period remains the same, it too will allow a trust to retain its exempt character.

Deciding How to Domesticate

When to Domesticate?

Once the decision to domesticate an offshore trust has been made, the next choice is when to domesticate the trust. Aside from the “just do it” approach, many look to the timing of domestication as part of a larger family plan anticipating specific future events. Two such events include (1) the death of the foreign grantor if the trust is established for U.S. beneficiaries, and (2) when the beneficiary of a non-grantor trust becomes a U.S. person and thus subject to U.S. estate and income tax laws. 

In both situations, if the trust is migrated to the U.S. before any UNI is accumulated, the beneficiaries can avoid the complicated “throwback rules.” If there is already some UNI in the trust, it should be split off from the domesticated trust to avoid the “throwback rules” and the trust which maintains the UNI may continue as a foreign trust.

Which U.S. Jurisdiction is the Best Fit?

The choice of U.S. jurisdictions is typically reliant upon which will best meet the family’s needs. While there are several states which offer modern trust laws and experienced professional trustees, there is only one that also offers a sophisticated court system where trusts are well understood and fiduciary duty is the primary subject matter of review, and that is the Delaware Chancery Court. 

With more than 200 years of experience reviewing fiduciary matters and an abundance of precedent to rely upon, the Delaware Chancery Court is second to none in reviewing complex trust issues and providing reasoned, equitable decisions. For this reason, Delaware is most frequently chosen as the appropriate jurisdiction in which to domesticate a foreign trust.

Decanting v. Migration – What is the Best Method to Make Changes?

The domestication of a foreign trust can be a fairly routine process, much like the change of trust situs from one state to another. The simplest method involves replacing the existing trustee with a U.S. trustee and changing the place of administration to a U.S. jurisdiction. Of course, if the trustee is not vested with responsibility for all substantial decisions, as is the case with a directed trust, it will be necessary to replace any other fiduciaries currently serving in such roles with a U.S. persons as well. This process is often referred to as trust migration as it simply involves the movement from a trustee in one jurisdiction to another.

Alternatively, the current trustee of the foreign trust can opt to decant the trust’s assets into a newly created U.S. domestic trust, either created by the original settlor or declared by a new U.S. trustee. It is typically more common to decant as it is somewhat rare that the terms of the foreign trust will align with the administrative provisions required by the new U.S. trustee. In decanting, the new trust can be drafted to incorporate the U.S. trustee’s requirements as well as modern trust legislation. In Delaware, it is possible to utilize other non-judicial modification methods to modernize the trust language and accommodate any changes required by a new trustee. 

So, it is possible to simply domesticate the trust by changing fiduciaries and then utilizing Delaware administrative law to make any needed changes to the trust instrument. The method has the advantage of avoiding the possibility that the IRS might view a decanting as a split transaction and deem the decanting of the trust assets, followed by the trust termination of the first trust, in conjunction with the recreation of a new trust and receipt of the decanted assets, as a taxable event rather than as a mere change in form. 

The weakness of modification of the trust over decanting exists where there are GST tax exemption concerns. Modifying a GST exempt trust can result in a loss of exemption, causing the trust to incur substantial tax upon distribution to a skip beneficiary where it previously had no tax implications. Here, the Treasury Regulations identify a clear map as to safe harboring a trust’s GST exemption. No other method of modification has an expressly approved safe harbor that ensures the preservation of GST exemption to the trust. 

In the end, the decision to domesticate a trust is often in the best interest of its U.S. beneficiaries. It not only can reduce the reporting requirements for the trust and beneficiaries, but it can provide the beneficiary with increased certainty with regard to issues of taxation and predictable trust administration. It is however, important to consult with a trust professional who can assist in the domestication process and ensure the preservation of favorable tax status.

Commonwealth Trust Company is pleased to provide this article as a guide. Commonwealth Trust Company is not engaged in the practice of law and is not providing legal advice by the provision of these materials. Commonwealth Trust Company recommends that clients seek the opinion of their attorney regarding the specific legal and tax issues addressed in this article.