For U.S.-based investors, offshore trusts were once a highly effective and traditional vehicle for tax planning and asset management. Trusts established for the benefit of U.S. persons, both foreign and domestic, could freely accumulate income and convert it to principal. Eventually, distributions could be made when the tax environment became more favorable, lowering the overall U.S. tax burden on the beneficiaries of the trust in question. This article focuses on planning for distributions from foreign trusts with U.S. beneficiaries.
The practice of converting accumulated income to principal was seen as abusive by the Internal Revenue Service. Eventually, in 1954, what would later become known as the "throwback rules" were first put into place by Congress. The original rules were a limited solution to the problem because they applied to income accumulated within the last five years prior to any given trust distribution to U.S. beneficiaries (Cunningham, "The Trust Throwback Rules: The Solution Remains After the Problem Fades," 24-1 Akron Law Review 24–25 (1990)). The 1954 rules have undergone many changes, growing both stricter and more lenient for domestic trusts at various times, but foreign nongrantor trusts with U.S. beneficiaries have always been highly regulated under the throwback rules (Cunningham, 25–28).
The throwback rules hinge upon the distinction between distributable net income, or DNI, and undistributed net income, or UNI. All of the income earned by a complex foreign nongrantor trust, with some modifications, is regarded as DNI under Internal Revenue Code (IRC) Sec. 643. To the extent that the income is distributed to a U.S. beneficiary, it is subject to income taxation in the hands of the beneficiary. However, under the throwback rules, annual DNI that is not distributed within 65 days of the end of the year in which it is earned becomes reclassified as UNI (Sec. 663(b); (see Harrison et al. "The Throwback Tax," p. 22 (N.Y. State Bar Ass'n. February 2015)). For later years after the accumulation of UNI, any distributions over and above the amount of the year’s DNI attributable to the foreign trust will be regarded first as distributions of UNI, until any UNI in the trust is exhausted. Only then will distributions from the trust be deemed to be from principal (Secs. 665(b) and 666).
The IRS uses a multistep process to calculate the base tax on accumulation distributions from foreign trusts; this process is found on Schedule J, Accumulation Distribution for Certain Complex Trusts, of Form 1041, U.S. Income Tax Return for Estates and Trusts; Form 4970, Tax on Accumulation Distribution of Trusts; and Part III, "Distributions to a U.S. Person From a Foreign Trust During the Current Tax Year," of Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts.
The amount of the accumulation distribution is allocated to preceding years in which the amount of DNI exceeded distributions, modified based on the taxes the trust paid that are attributable to that value, and taxed as an increase to income tax within the computation years (see IRS, Instructions for Form 1041 and Schedules A, B, G, J, and K-1 (Jan. 12, 2017); Silverman, "Taxation of Foreign Nongrantor Trusts: Throwback Rule," 23-2 Tax News & Comment 1 (August 2014)). Additionally, an interest charge, essentially equivalent to a penalty, is added to the tax on the UNI, as determined by a table indexing the applicable years of the throwback tax to a given rate to be applied to the taxable amount (Sec. 668). With this “penalty,” the potential tax burden of the throwback rules may equal up to 100% of the value of the accumulation distribution itself (Sec. 668(b)).
Making Principal Available While Avoiding the Throwback Rules
Mitigating the negative effects of the throwback tax is a crucial concern for any professional involved in planning and administering a foreign nongrantor trust. Where UNI has been allowed to accumulate, the question is how to access the trust principal, which represents "clean capital" for the U.S. beneficiary, without triggering an accumulation distribution. Because UNI is deemed distributed before principal, to make principal accessible for the beneficiary, it is necessary to find some way to move the UNI out of the trust without the throwback rules applying.
A simple and effective way to do this is to move the trust income out into a foreign subtrust (Harrison, pp. 21–22). These sorts of trust-to-trust distributions, if not carefully planned, could lead to the application of the throwback tax. A successful distribution at the trust level, however, avoids bringing the assets within the remit of a U.S. beneficiary while placing the entire accumulation distribution within an offshore entity and, therefore, avoiding any trigger of the throwback tax.
The subtrust should possess a few qualifications to effectively receive the carried-out UNI of the initial trust. First, it should afford the trustee absolute discretion to distribute to multiple beneficiaries. This provides a safeguard against vesting issues that might arise from a single-beneficiary foreign trust. There is a risk, with single-beneficiary trusts, that the IRS might interpret them as vesting the assets in the beneficiary who holds the sole right to gain from the trust, resulting in a deemed distribution to the U.S. beneficiary and the application of the throwback tax. Giving the trustee absolute discretion ensures that no beneficiary has the right to any portion of the trust assets, and maintains the integrity of the trust as an entity. When the trustee of a complex trust is granted reasonably broad latitude to act, the creation of and distribution to a subtrust incorporating beneficiaries other than the U.S. beneficiary should be achievable without any asset allocation to the U.S. persons in question.
The other consideration that should be taken into account when creating the subtrust is the beneficiaries' character. Foreign beneficiaries are preferable to U.S. beneficiaries to avoid U.S. “on-shoring,”here is a special issue to be aware of with the use of charitable interests for this role, especially for U.S. beneficiaries without clearly identifiable foreign beneficiaries at hand: Should the subtrust be constructed so that all of the discretionary interest in the trust is held by organizations that qualify as exempt charitable organizations, the carrying out of UNI will fail. Contributions to such a trust by the original trust would be treated as a below-the-line deduction rather than a distribution, with the effect being that UNI will still be regarded as present within the trust and distributable to the beneficiary (Sec. 4947). Charitable interests must be paired with non-charitable and, ideally, non-U.S. beneficiaries to carry out the UNI.
It must be noted that a distribution to a subtrust only serves to make principal accessible to the beneficiary of the initial trust; it does not eliminate the throwback tax issue. The characterization of the income as UNI will follow it into the subtrust and, with that, the compounding interest rate for applicable years of accumulation. If it is desired that the UNI eventually be distributed to the U.S. beneficiary, prior discussion and planning will be necessary to mitigate the eventual throwback tax burden.
Charles F. Schultz III is a partner at FGMK LLC in Chicago, who leads FGMK's Estate and Succession Planning practice.
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