H. Jacob Lager

Posts Tagged ‘drop off trust’

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


When do I become a US “estate tax” resident? The shocking truth revealed!

In IRS regulations on April 16, 2012 at 12:32 pm

Well, maybe it’s not “shocking,” but it may be a bit surprising.  Last week, we discussed the estate tax planning benefits of “drop off” trusts for incoming foreign nationals.  One major point to remember from that post is that a drop off trust will only work if it’s funded prior to your estate becoming subject to US estate taxes.

The question remains, when are you subject to estate taxes?  Surprisingly, your subjectability to estate tax does not necessarily coincide with time you become subject to US income taxation.

While income tax residence is governed by a series of objective rules (the “green card” test, the “183 day” test, and a number of tax treaty modifications), estate tax “domiciliary” is determined by a much more subjective facts-and-circumstances test.  This means your estate may not be subject to US estate tax even though you have already obtained lawful permanent residence status.

A US estate tax domicile is established if you: (a) are living in the US and have the intention to remain in the US indefinitely; or (b) have lived in the US with such an intention and have not formed the intention to remain indefinitely in another country.   The focus on “intent” introduces a wide breadth of subjectivity (some might say “planning opportunity”) to when US domiciliary is established.  Often, the determination can turn on the location of your primary residence and where you carry on your family, social, religious, and business relations and activities.

Some of the factors which the IRS examines are: (i) the length of time you spent in the US and abroad and the amount of your travel to and from the US and between other countries; (ii) the value, size, and locations of your homes and whether they are owned or rented; (iii) whether you reside in a locale due to poor health, for pleasure, or for political reasons; (iv) where your valuable or meaningful tangible personal property is located; (v) where your close friends and family reside; (vi) where your religious and social and civic affiliations are located; (vii) where your main business interests are situated; (viii) your visa status; (ix) your stated residence on legal documents; (x)  your voter’s registration; (xi)  your driver’s license issuing jurisdiction; and (xii) your income tax filing status.

So, let’s assume you, a foreign national, are comfortable with claiming non-US domiciliary status and that you want to go forward with a drop-off trust.  What could go wrong? (Enter foreboding music.)

Answer coming next week in Part Three!


Photo courtesy of lalunablanca