Expatriation and Foreign Trusts: Navigating US Tax Rules for Beneficiaries

For US citizens and long-term residents, the global reach of US taxation can create significant financial and tax-related burdens, especially for those with interests in foreign trusts. Expatriation may offer relief, but it comes with its own set of complex rules.

Understanding Expatriation and Trusts

Our article “US Citizenship Based Taxation: Is Expatriation the Only Way Out?” highlights the unique challenges faced by US citizens due to the citizenship-based taxation system utilized by the US tax system and explores whether expatriation is the optimal option to consider.

Expatriation involves renouncing US citizenship or terminating long-term residency. While this can relieve individuals from future US tax obligations, in some circumstances, it can trigger the exit tax regime under IRC Section 877A.

Trustees should consider how this tax regime impacts their US beneficiaries. For beneficiaries of non-US trusts classified as Foreign Non-Grantor Trusts, the value of their interest in the trust must be included when calculating the exit tax imposed on covered expatriates. Depending on the nature of the trust interest, valuation reporting may involve complex calculations using IRS -prescribed methods. There may also be ongoing US tax obligations imposed on trustees which need to be managed as detailed below.

Exit Tax and Trust Interests

The exit tax applies to covered expatriates, which includes individuals who meet specific criteria related to net worth, tax liability, and compliance with US tax filing requirements. Read more in the link above on how you can become a covered expatriate.

For covered expatriates, a mark-to-market regime is applied which requires the US person to recognize the gain on their worldwide assets as if they had sold them the day before expatriation.

However, interests in Foreign Non-Grantor Trusts are treated differently. Any direct or indirect distribution from the Trust to a covered expatriate is subject to a flat-rate 30% withholding tax on the taxable portion of the distribution.

Withholding on Trust Distributions for Covered Expatriates

Trustees of non-US trusts must be vigilant in applying the 30% withholding from distributions made to covered expatriates. The taxable portion of the distribution will need to be calculated using usual Foreign Non-Grantor Trust rules. This results in ongoing US tax obligations for the trustees and the newly expatriated beneficiary even after expatriation. Note: It is not clear how the US can enforce such an obligation on non-US trusts.

IRS Reporting Requirements

Form 8854: In the year of expatriation, the US beneficiary must file Form 8854 to certify their compliance with their US tax obligations and to report their assets and liabilities. For trust beneficiaries, this includes detailing each of their interests in non-US trusts and any distributions received in the expatriation year. In the year of expatriation, the US beneficiary must also decide to either:

• waive their right to claim any reduction in withholding (through a double tax treaty) on future distributions received from their trusts; or
• elect to be treated as if they had received the value of their entire interest in the trust as of the day before their expatriation date which will trigger an early tax charge on monies not yet received.

The trust beneficiary will also have an ongoing Form 8854 filing requirement to annually certify that no distributions have been received or to report details of any distributions they have received. Trustees will want to ensure that their beneficiaries are informed of any distributions made and note the wide definition of distributions, which can include direct and indirect distributions of money/assets, use of trust property and loans.

Form 1040 and personal tax forms: The expatriate is also required to file a final Form 1040 personal income tax return. Trustees should consider their obligation to comply with reporting requirements by providing their US beneficiaries with a Foreign Non-Grantor Trust Beneficiary Statement detailing relevant information so that the US beneficiary is able to complete their Form 3520 to report any trust distributions received.

Planning & Strategies

Assessing the situation before expatriation is crucial for taxpayers that have interests in a non-US trust.

1. Evaluate Trust Interests: Determine the value of the interest in the non-US trust. This includes understanding the trust’s assets, income, and any potential distributions due to be made.

2. Understand the Exit Tax Implications: Where the US beneficiary may be classified as a covered expatriate, it is worthwhile calculating the potential exit tax liability, including the US tax impact of future trust distributions.

3. Review Reporting Obligations: Ensure compliance with all reporting requirements, including the annual Form 8854 and any necessary trust-related forms.

4. Review covered expatriate conditions: The covered expatriate regime only applies to taxpayers who meet specific criteria relating net worth, tax liability, and compliance with US tax filing requirements. Exemptions from covered expatriate status are available (e.g. dual status exemptions). Reviewing the US beneficiary’s status before any planned expatriation may allow for potential planning to fall out of the covered expatriate net.

5. Plan Ahead: Work with US tax advisors to develop strategies that minimize the tax impact on US beneficiaries. This may include restructuring the Trust or reviewing the timing of distributions being made.

6. Maintain Compliance: Ensuring that all distributions are properly documented and reported. Trustees should stay updated on IRS regulations which may impact on the ongoing US reporting.

7. Consult with Tax Professionals: Our specialists have expertise in US tax reporting related to non-US trusts and expatriation options and can assist in navigating the complexities of expatriation. Contact us with any questions.

Conclusion

Expatriation can offer relief from the burdens of US citizenship-based taxation, but for beneficiaries of non-US trusts, it introduces additional complexities. Understanding the exit tax regime, withholding requirements, and reporting obligations is crucial to navigate this process successfully. By seeking expert advice and carefully planning, trust beneficiaries can manage their expatriation while ensuring compliance with US tax laws. If you have any questions, please contact us.

Written by Tas Meghani