H. Jacob Lager

Three most common mistakes you will encounter using a drop-off trust

In Foreign taxes, Offshore Accounts on April 24, 2012 at 9:28 am

Part three in the series

Two weeks ago, we introduced the potential benefits of funding a drop-off trust prior to obtaining a US domicile.  Last week, we discussed how the IRS would determine when you actually obtained that US status and how to properly time your trust formation.

And now, the exciting conclusion!  This week, we focus on the most common mistakes and hidden traps incoming foreign nationals encounter when using a drop-off trust as part of their tax strategy.

1.  Don’t be a control freak.

The most important thing to remember about drop-off trusts is that you may not retain control over its assets.  You are completing a gift to a trust that benefits your descendants.  If you retain the right to revoke or amend the trust, the trust corpus will be included in your US taxable estate.

2.  Give up the benefits.

Because this is a completed gift to the future, you may not retain a right to possess, dispose, or enjoy any particular trust asset or income stream.  This means you may not retain a life interest or annuity payment related to a trust asset.  Similarly, a retained “reversionary” interest exceeding five percent of trust assets is disallowed.  Even a retained power of appointment that allows you to designate beneficiaries in the future will be treated as an excess benefit that can cause the subject property to be included in your US taxable estate.  Likewise, the power to change life insurance beneficiaries with respect to a life insurance policy that is owned by the trust will cause the attendant death benefit to be included.

That said, you may be permitted to retain a discretionary beneficial interest. This means the trustee may allow you to benefit from the trust assets, but you may not possess a right to legally force any such enjoyment.  For example, an informal non-written arrangement with a trustee that allows you continued enjoyment of trust assets will defeat the trust’s independent nature and cause inclusion in the taxable estate.  Also, if the trustee’s discretion is subject to a standard (i.e. for “support, health care, education, and maintenance”) that can be enforced by the settlor as a beneficiary, this retained right will cause inclusion.  If, under applicable local creditors’ rights laws, your creditors can force the trust income to pay your debts, this feature will be treated as a retained right that causes inclusion.

3.  Replace the trustee with a subordinate.

You are allowed to retain a right to remove and replace independent trustees. This power is often reserved to you as the designated “Trust Protector.” So long as the trustee is not “related and subordinate” to you, retaining this power will not cause US estate inclusion.  Generally speaking, a trustee will be “related and subordinate” if the trustee is a close family member, subordinate employee, or a company owned by you.

A properly planned and structured drop-off trust should allow you to both enjoy trust assets as a discretionary beneficiary and preserve the benefit of removing assets from your future US taxable estate.  If you have questions about setting up a drop-off trust, contact me.

Photo courtesy of Karen V. Bryan


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