Cross-Border Planning with Delaware Trusts

When international families grow, and grow their wealth, they should consider developing a comprehensive plan to address their estate and tax planning needs. Depending on the circumstances, these families could often benefit from the use of trusts, which are versatile planning tools for wealth succession planning. The U.S is often considered one of the premier trust jurisdictions worldwide. In an article about the best states to set up a trust, we covered why Delaware has long been considered a premier trust jurisdiction, and the opportunities and benefits of Delaware trusts extend to individuals residing outside of the U.S. This article is intended to provide an overview of why foreign individuals and families may establish U.S.-situs trusts, with a focus on the benefits of Delaware as a leading jurisdiction.

Why Non-U.S. Persons May Look to the U.S. to Establish a Trust

Stability and Reputation

The U.S. has historically been seen as a pillar of stability across the world, especially in the context of the security of one’s property held or custodied within the U.S. This is notwithstanding any particularly high levels of political discord occurring within the country at any given time or any international conflicts involving the U.S. 

Established and Regulated Corporate Trustees

The corporate trustee industry is well regulated in the U.S. Nationally chartered banks and trust companies are regulated by the Office of the Comptroller of the Currency (OCC), while state-chartered trust companies are regulated by their respective state’s state bank commissioner. Regular audits performed by respected regulating bodies reinforce a jurisdiction’s high standard regarding trust administration by trust institutions, ensuring a consistent quality of trust administration and information security. 

Privacy

Certain jurisdictions, such as Switzerland, the British Virgin Islands and the Cayman Islands have historically been seen as offering financial privacy to worldwide clients who establish trusts with institutions in those countries. This perception, and the reality of such privacy, changed markedly with the implementation of the Common Reporting Standard (CRS) and the Foreign Account Tax Compliance Act (FATCA), implemented in 2014 and 2010, respectively.

Both the CRS and FATCA were enacted with the intention of combating and preventing tax evasion by individuals holding assets outside of their home countries. The CRS was implemented at a global level through the Organisation for Economic Co-operation and Development (OECD). The CRS involves an automatic information exchange between the 120 participating countries, wherein individuals who hold investment or other financial accounts abroad have certain personal and financial information regarding those accounts reported back to their home country.

FATCA is strictly a U.S. law, requiring foreign financial institutions to report on accounts held abroad by U.S. taxpayers. The U.S. does not participate in the CRS. As a result, unlike most developed jurisdictions, it does not engage in the CRS automatic information exchange; however, information may still be shared with foreign tax authorities if it is required under other legal mechanisms. 

Why Non-U.S. Persons May Look to Delaware

It is important to understand the statutory framework that allows someone domiciled outside of the U.S. to form a Delaware trust that is governed under the laws of Delaware. 

 

Under 12 Del. C. § 3332 (b) and § 3340, a trust will be treated as administered in Delaware if it has a qualifying Delaware trustee. This requirement is satisfied if either (1) the sole trustee resides in Delaware or is a Delaware trust company, or (2) one of multiple trustees is a Delaware trust company. If this requirement is met, Delaware law will generally govern the administration of the trust. This is true even if that trust is considered a foreign trust for U.S. income tax purposes, or if the trust has other fiduciaries who reside outside of Delaware or the U.S. Delaware is often recognized as a preeminent trust jurisdiction, not just in the U.S., but worldwide, due to a trust infrastructure supported by well-developed statutes, an experienced judiciary and administrative flexibility.

Courts

The Court of Chancery is a court of equity that has exercised primary jurisdiction over Delaware trusts for more than 200 years. Matters are decided by the Chancellor and Vice Chancellors, who are appointed by the governor and confirmed by the Senate for 12-year terms. Delaware has a long history of well-developed case law, and its courts have demonstrated a consistent interpretation of Delaware’s trust laws. All trust administration and interpretation matters are exclusively within the jurisdiction of Court of Chancery, and on appeal, are heard directly by the Delaware Supreme Court. Other favorable trust jurisdictions in the U.S. may have similar trust laws but cannot match the predictability and efficiency provided by a specialized court system with over two centuries of experience.

Legislative Framework

The state legislature works closely with both the Delaware Bar Association and Delaware Bankers’ Association to maintain modern trust laws, which are reviewed and updated on an annual basis. Delaware has historically been influential in the development of trust legislation, with other states adopting similar laws. Delaware’s trust laws are also clearly written and accessible, even to those who are not directly involved in the Delaware trust industry, a result of periodic review and refinement by the legislative drafting committee.

Flexible Administrative Tools

Delaware also has a long history with directed trusts. These statutes allow traditional trustee duties to be divided among multiple fiduciaries, with clear rules governing their respective responsibilities and liabilities. See our prior article, What is a Directed Trust? for a more detailed summary of the benefits of Delaware directed trusts.

 

Additionally, there are multiple options for modifying irrevocable trusts, including decantings, non-judicial modification agreements and trust mergers. These tools provide flexibility to settlors, beneficiaries and fiduciaries to address any unforeseen future changes in circumstances. 

Tax Advantages

Delaware does not tax income accumulated by a Delaware resident trust for future distribution to non-resident beneficiaries. A Delaware resident trust is not subject to Delaware income tax unless it has Delaware-source income or beneficiaries residing in Delaware. If there are Delaware resident beneficiaries, only their share of accumulated income is taxed.

As one of the first states in the U.S. to abolish the common-law rule against perpetuities, Delaware allows for the creation of perpetual dynasty trusts.

Asset Protection

The Qualified Dispositions in Trust Act (12 Del. C. § 3570 et seq.) prohibits a creditor from bringing an action for attachment of any property contributed to a trust through a qualified disposition (such trust commonly referred to as a “DAPT”). A settlor who contributes assets to a properly structured DAPT is generally protected from creditors, unless a creditor proves a fraudulent transfer by clear and convincing evidence. In addition, the limitations period for a creditor to bring an action for fraudulent conveyance is generally limited to four years after the transfer. This protection extends to settlors residing outside of Delaware contributing non-Delaware situs assets to the DAPT.

 

Delaware courts have generally respected legitimately created and properly structured DAPTs, which can provide greater predictability for a foreign settlor who wishes to ensure trust assets will be protected from foreign judgments (subject to the principles of comity and applicable laws in the settlor’s country of residency).

Common Planning Structures

Depending on several variables, establishing a U.S.-situs trust to hold certain assets can be a significant tax saving strategy for a non-U.S. domiciliary. The following are some of the many examples of U.S.-situs trusts as tools for foreign persons and their advisers to incorporate into their cross-border estate plan.

Example 1: A non-U.S. domiciliary who owns U.S.-situs property

As discussed in our previous article on the common uses and benefits of entities held in trusts, a non-U.S. domiciliary who holds U.S.-based assets can use a trust entity structure for potentially significant transfer tax savings.

 

Under I.R.C. §§ 2101-2105 and accompanying Treasury Regulations, a non-U.S. domiciliary who owns property considered U.S.-situs property when they die can be subject to U.S. estate tax on that property. U.S. situs property for estate tax purposes includes the following:

 

•   Real property located in the U.S.
•   Tangible personal property physically located in the U.S. at the time of death
•   Stock in U.S. companies, even if the stock is held in a non-U.S. account

 

Because non-U.S. domiciliaries only have a $60,000 lifetime federal estate tax exemption (not indexed for inflation), in the absence of a treaty between their country of domicile and the U.S., the non-U.S. taxpayer’s estate would incur substantial U.S. taxes upon their death.

 

A potential solution to this issue involves the use of a foreign entity created to hold those non-U.S. situs assets. Interests in a non-U.S. entity (such as a foreign corporation) are generally not treated as U.S.-situs assets for estate tax purposes. As a result, the entity can function as an “estate tax blocker,” even if it holds U.S. assets. 

 

The foreign entity can be held within a revocable trust established by the non-U.S. domiciliary. The trust can be administered in a U.S. jurisdiction such as Delaware while still being treated as a foreign trust for income tax purposes. With proper planning, it may also allow for a step-up in basis at the grantor’s death. This approach should be carefully evaluated by an experienced tax adviser for potential exposure under the Foreign Investment in Real Property Tax Act (FIRPTA), if the estate tax blocker holds U.S. real estate, and anti-deferral rules.

Example 2: Non-U.S. domiciled parents with children living in the U.S.

Many cross-border families include parents who are non-U.S. domiciliaries, but whose children reside in the U.S. The U.S. tax regime can create headaches for families who do not plan accordingly. A U.S. beneficiary of a foreign non-grantor trust may be subject to tax and interest charges on prior years’ undistributed net income (UNI) when distributions are received by that beneficiary.

 

Careful planning is required to ensure a U.S. beneficiary does not encounter massive unintended tax consequences. Several complex planning structures have been developed to mitigate this issue. One potential solution could be to name a U.S. domestic trust as a beneficiary of the foreign non-grantor trust. The U.S.-domiciliary children could be named as beneficiaries of the U.S. domestic trust, and the U.S. domestic trust would receive any distributable net income (“DNI”) of the foreign non-grantor trust. This type of structure requires careful drafting due to complex DNI and distribution ordering rules but may help to avoid the accumulation of income in the foreign trust that would be taxed to the U.S. beneficiaries upon distribution.

Example 3: NonU.S. domiciliaries planning a move to the U.S. 

Proper planning can yield significant tax savings for foreign individuals who intend to move to the U.S. at some point in the future. This planning often involves multiple trusts with different tax classifications depending on facts and circumstances for each individual family. This structure will look different for each individual depending on the particular needs of their family and the assets they own, but the following are three rules to consider that will likely influence their planning:

 

1. A U.S. citizen or domiciliary is subject to U.S. federal estate tax on his or her worldwide assets whereas a non-U.S. domiciliary is subject to U.S. federal estate tax only on his or her U.S.-situs assets.
2. Similarly, a U.S. Person for U.S. federal income tax purposes is taxed on his or her worldwide income whereas a non-U.S. Person is taxed only on U.S.-source income. The internal revenue code definitions of “U.S. Person” and “non-U.S. Person” include trusts. 
3. Under I.R.C. § 679(a)(4), a foreign non-grantor trust can become a U.S. grantor trust if the non-U.S. grantor later becomes a U.S. tax resident. This applies if the trust has a U.S. beneficiary and the grantor becomes a U.S. resident within five years of funding the trust. In that case, the trust’s income is taxable to the grantor from the date U.S. residency begins.

 

With these rules in mind, foreign individuals who intend to move to the U.S. should strongly consider meeting with an experienced tax planning attorney who can help that individual navigate U.S. federal income and transfer tax laws.

 

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Tax planning and drafting of U.S.-situs trusts for international and cross-border clients is complex and full of potential pitfalls. It requires careful coordination between both U.S. and non-U.S. tax advisers to ensure planning will have intended results in all potentially taxable jurisdictions. Depending on how the trust is classified from a federal income tax perspective, there are also likely tax reporting obligations, some with extremely high penalties if not timely filed. 

 

Working with experienced tax advisers and trustees is essential. When properly structured and properly administered by an experienced trustee, U.S.-situs trusts can play a significant role in cross-border estate planning. Given these considerations, selecting the right jurisdiction for a trust is critical and Delaware consistently distinguishes itself as the premier U.S. jurisdiction for cross-border planning.