UK families often have family members who reside in the US or are US citizens. The US and UK tax systems are close cousins of each other, and each have their respective complexities. One significant difference is trust planning. In the US, US families will nearly always use ‘revocable’ or ‘living’ trusts. These trusts offer the avoidance of probate in the US, which has a high value to US families for privacy and simplicity purposes. This type of planning does not offer a US tax advantage. In the UK, UK resident and domiciled individuals cannot so easily establish trusts because of a potential 20% UK inheritance tax (IHT) charge. We often work with UK families who are on the cusp of becoming UK domiciled with US resident family members, and we recommend that the UK resident establish a trust to benefit the US family members.
A UK settlor will want to consider whether they want to create a “Foreign Grantor Trust” (FGT) or a“Foreign Non-Grantor Trust” (FNGT). Proficient US tax advisors like Matthew Ledvina provides a clear insight on various cross-border tax planning and emphasizes that people should be aware of the various tax consequences of FGT and FNGT planning that may be considered by UK settlors who want to benefit US resident beneficiaries.
How to Create a FGT or FNGT
For US tax purposes, any non-US trust is either an FGT or FNGT. A FNGT is a US tax classification where a non-US person settlor cannot revoke the trust, or the non-US settlor does not have exclusive benefit during the settlor’s lifetime.
A UK resident on the cusp of becoming a deemed domiciled for IHT purposes (typically after 15 years of UK residence) is usually going to be advised to exclude himself or herself from the trust for UK tax advantages. This will mean that the UK settlor will be advised to ensure that the trust they establish is irrevocable (meaning the settlor cannot revoke the assets as settlor of the trust), and that the settlor and spouse is excluded from benefit. From a US tax aspect, this type of settlor described above can only create a FNGT. In contrast, if the UK settlor is not on the cusp of becoming deemed domiciled, then it will be possible for the UK settlor to create a FGT because the trust could either be revocable by the UK settlor, or the UK settlor could have exclusive benefit over the trust.
US Tax Aspects of Foreign Grantor Trust (FGT)
A FGT established by a UK settlor has several benefits for a US family member beneficiary. The US taxation rules identify Foreign Grantor Trust as a non-US trust whose grantor or settler is a US individual. Pertaining to an FGT, the settlor/grantor acts as the owner of the trust. One important criterion for such trusts is that the assets held within the trust should be owned by an individual rather than the trust itself. All the incomes generated by the assets of the FGT are transparent and flows through the owner’s tax return. In other words, the income made by an FGT will be treated as the income of the owner and must reflect in the owner’s US Federal tax return. It is the responsibility of the owner or grantor to report all their trust income using IRS Form3520.
Tax Reporting Duties for FGT
IRS or Internal Revenue Service is the tax authority of the US and it is the duty of the individuals associated with a Foreign Grantor Trust to provide all the tax-related information to IRS by filling and submitting certain forms.
The trust will have to file the form 3520-A, which comprises of 5 pages. The first two pages enquire about the general information of Trust including name and address along with the income statement and Balance Sheet of the Trust. The remaining three pages of the Form comprise of Foreign Grantor Trust Owner Statement and Beneficiary Statement. The 3520-A form is titled “Annual Information Return of Foreign Trust with a US Owner”.
The owner of the FGT will have to fill the Form 3520 identified as “Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts”. The 6-page form consists of 4 parts that require a variety of information related to transfers, distributions, and gifts. Additionally, a signed copy of page 3 of form 3520-A specifying the owner’s income from the trusts that are to be reflected in his/her Federal tax return, should also be present alongside Form 3520.
Beneficiaries also have to fill Form 3520 and present it along with page 4 of Form 3520-A, which is the beneficiary’s statement. The beneficiary statement contains information that is needed by the beneficiary while filing for individual Federal tax returns.
Tax Aspects of Foreign Non-Grantor Trust (FNGT)
An FNGT is a trust, which either does not have a US settlor/grantor or the US settlor/grantor has deceased. According to the US taxation rules, an FNGT trust is the one in which the assets are held by the trusts itself and not by any other person. In the case of FNGTs, it is not possible for the IRS to levy taxes directly on the grantor or settlor. As an alternative, IRS charge taxes on the distributions that are made to the beneficiaries of the trust.
How Beneficiaries of FNGTs Pay Taxes
Unlike FGT, there is no need to fill 3520-A form by the trust. Instead, the IRS requires that the FNGT should prepare Foreign Non-Grantor Trust Beneficiary Statements (FNGTBS), which will be created separately for each beneficiary of the trust. In case the distributions are made from the principal amount or the Corpus of the trust, no tax will be charged. However, if the distributions come from additional income generated by the assets of the FNGT, then a certain amount of tax will be levied on the distributions.
The yearly distribution made by the trust is known as Distributable Net Income (DNI) and attracts tax rates equivalent to that of the regular income tax rates. However, in case the trust does not distribute DNI before the end of a year, IRS will consider it as Undistributed Net Income (UNI) and higher tax rates will be charged upon them. One of the most important things to notice is that the tax rates attracted by DNI depend upon the type of income, which may be interest, capital gains, dividends, etc. Thus it’s important to specify the type of income that beneficiary is receiving as distributions while preparing FNGTBS.
Comparing both the FGT and FGNT, it is quite clear that IRS levy taxes on these entities differently. Moreover, the tax obligations for both foreign trusts are also quite dissimilar.