|The Bahamas Investor Magazine
July 1, 2006
July 1, 2006
Steve J Sokic and Kelly Anne Kerr
It is increasingly common for families around the world to have a connection to the United States: non-US citizens who do not reside in the US may move to the US in the future; hold some form of US investment; and/or have family members who are, or will likely, become subject to some form of US taxation. This article will provide insight into these three scenarios and the related trust structures that can be designed to facilitate tax savings and protect assets.
There are several relatively common trust structures that can be used by non-US persons when there are existing or potential US connections. A properly structured offshore trust may protect against estate and gift tax exposure on assets situated in the US and, in some cases, may defer or eliminate US income and capital gains tax as well. Offshore trusts also offer significant non-tax-related benefits including the orderly distribution of wealth for future generations, increased protection against creditors, political risks, forced heirship laws and claims arising from marital disputes.
Taxation, particularly US taxation, can be a very complicated discipline within the realm of trust and estate planning. This article is neither intended to be an exhaustive review of US taxation, nor of Bahamian-based fiduciary structures; it is also not intended to infer or provide any form of tax advice. Obtaining personalized advice from a tax professional is strongly encouraged, and in many cases, absolutely required.
A non-US person who takes up residence in the US will become exposed to income and capital gains tax, and possibly gift and estate tax, on his or her worldwide income and assets, respectively. However, there are many estate planning opportunities for foreign nationals who are planning a move to the US.
Before establishing residency in the US, foreign nationals may transfer any assets that will not be needed for lifestyle expenditures while based in the US to a properly structured offshore trust. A trust settlor who is not yet domiciled in the US is not subject to US federal gift tax on transfers of non-US situs assets to the trust. The result is that the foreign national will not be liable for US gift, estate or generation-skipping tax on the trust assets. Although the settlor cannot retain a fixed-income interest in the trust assets, his or her spouse may do so, and the settlor may also be a discretionary beneficiary of the trust.
The income and gains on the assets of this type of pre-immigration trust, often called a “drop-off” trust, will be taxable to the settlor while he or she is a US resident. However, there is an opportunity to defer or potentially avoid US income taxes altogether by investing trust assets in an international variable annuity or an international variable universal life insurance programme (IVUL).
Offshore annuities are not subject to US income tax if surrendered in a year in which the investor is not a US resident. An IVUL held to maturity offers the potential for income-tax free accumulation and distribution of wealth. Furthermore, the trustee, as owner and beneficiary of the IVUL, can borrow against the policy’s cash surrender value as funds are needed. Since principal and interest typically only need to be repaid from a death benefit when it is actually distributed, the borrowed funds can be distributed income tax free to the trust beneficiaries without the trustees having to repay the loan or interest during the insured’s lifetime.
Holding US investments
Non-US persons are liable for US estate tax only on US situs assets, which include real property, shares of US corporations and tangible personal property, such as art or jewellery, located in the US. Non-US persons are also subject to gift tax on gifts of US situs real property and tangible personal property, with the notable exceptions of gifts of shares in US corporations and personal cash deposits with US banks.
Planning for non-US persons whose only US investment is a US securities portfolio typically involves the shifting of situs of such interests to a holding vehicle to ensure the investments are not exposed to US estate tax. Offshore corporations, as well as properly structured offshore trusts and partnerships, are commonly used for this purpose.
The type of offshore holding structure selected is highly contingent upon the individual’s circumstances. Factors include the type of asset (for example, with real estate, it makes a difference whether the property is income producing or not), how long an asset will be held, who will benefit from the asset now and in the future, privacy considerations and possible tax implications associated with the non-US person’s home jurisdiction.
Ideally, tax and estate planning should be undertaken prior to the acquisition of US situs assets; however, planning is possible for assets already owned as well.
Trusts for heirs in the US
In situations where a non-US person has US-resident heirs, unnecessary exposure to US estate and gift taxes may result if proper estate planning is not undertaken before assets are gifted or bequeathed. There are also opportunities to use trusts to shelter such assets from US income and capital gains taxation.
Non-US persons may avoid such gift and estate tax liability by transferring cash and other assets to a properly structured offshore trust, preferably to what is known as a foreign grantor trust. By establishing a trust offshore that allows for distribution of trust assets to the US beneficiaries, the non-US person may avoid all gift and estate taxes during the existence of the trust. Jurisdictions with long perpetuity periods, such as The Bahamas, where a trust may remain in existence for up to 150 years, offer longer-term protection against gift and estate taxes.
The US beneficiary can enjoy income-tax free capital distributions during the life of the non-US settlor of the trust (although such distributions would be reportable to the US Internal Revenue Service via Form 3520).
Upon the death of the settlor, the offshore trust, which would have previously qualified as a grantor trust, will become what is known as a foreign non-grantor trust. Perhaps the greatest disadvantage of a foreign non-grantor trust is the treatment of income and gains that are accumulated in such a trust and then eventually distributed to a US citizen/resident in a subsequent year. If such a foreign trust accumulates income and gains, the trust pays no US income tax on that income (other than withholding tax on US source income paid to the trust) and there is no US income tax currently payable by any US beneficiary on that income. However, assuming no further planning is undertaken, the trust would accumulate income, which may have harsh US tax consequences (including a punitive interest charge) if and when it is distributed to a US relative in the future. Once again, planning techniques are available in various scenarios to assist in mitigating such potentially negative tax consequences, which again raises the need for competent US tax advice.
The above scenarios illustrate how foreign nationals living outside the US must exercise caution when their tax and estate planning includes a possible move to the US, have US-resident family members, and/or have assets located in the US. Individual advice from professionals may result in significant tax savings and may help to avoid unexpected tax liabilities associated with a connection to the US.
Steve J Sokic
Steve J Sokic, BA, CMA, CFP, TEP is a senior manager with Royal Bank of Canada Trust Company (Bahamas) Ltd, Royal Bank of Canada’s Global Private Banking trust subsidiary in Nassau. He also co-leads RBC’s US Private Wealth Group in the Caribbean region, which establishes and administers tax-compliant fiduciary structures for Americans and people around the world who have US connections. Prior to joining RBC, Sokic was a senior tax manager with Deloitte & Touche in Toronto, Canada, practising primarily in Canadian and US international trusts and estate planning.
Kelly Anne Kerr
Kelly Anne Kerr, BA, LLB, LLM is a manager with Royal Bank of Canada Trust Company (Bahamas) Ltd. Prior to joining RBC, Kerr was an associate at a law firm in British Columbia, Canada, primarily practising insurance litigation. She recently obtained her Master of Laws, specializing in Banking and the Regulation of FInancial Markets, from the London School of Economics.