Part one:  Foreign “drop off” trusts 

It can be tough to remember in an election year, but people still like to move to the US.  When they do, new taxpayers are often surprised by our global tax system that taxes residents on their worldwide assets and income.  With just a little planning before the person becomes a US taxpayer, his beneficiaries may actually get to keep a little of his hard-earned cash.

Enter the drop-off trust.

A pre-immigration trust (sometimes referred to as a “drop-off” trust) is a trust created in a non-US jurisdiction by a non-resident alien before he becomes a US taxpayer whose taxable estate includes his global holdings.  By setting up the drop off trust, the trust grantor can effectively remove from his US taxable estate all his non-US assets since the initial trust transfer escapes US jurisdiction.

Before 1996, this strategy was even more effective because the grantor could also use the drop-off trust to avoid US income taxes on gains attributable to the trust assets. The trust, as a non-US person, would invest only in non-US source income, and would thereby escape US taxation.

However, in 1996 Congress caught up with this scheme, and instituted the so-called “five-year rule.”  Under this rule, if a non-US person becomes a US person within five years after funding a foreign trust, then the foreign trust is treated as a “pass-through” grantor trust that attributes the trust’s income to the grantor himself. This rule essentially eliminated any income tax benefit from using a drop-off trust, since most immigrants don’t plan their US residency five years in advance.

Still, the estate tax benefits of a drop-off trust are very real.   With careful planning, an incoming foreign national can effectively remove large portions of his wealth from US estate taxation by depositing those assets in a properly domiciled foreign situs trust.  One important note: the trust’s creation and funding must occur prior to the moment the foreign national establishes his US domicile for estate tax purposes. As a result, planning with a US tax attorney before arriving in the US is crucial.

More about this process in Part Two of the series.  Tune in next week for more exciting adventures in the world of International Tax Law!

*Photo provided by Phil of Photos.