I read an article over the weekend that surprised me as to the impact of naming a noncitizen or a U.S. citizen- nonresident as a trust beneficiary. While the topic admittedly seems a bit off our normal beaten path, keep in mind that in the globalization of our world, the chances of a family member working and/or living abroad, or marrying a noncitizen, is dramatically increasing.

What I learned from my weekend reading was that in many civil law countries, e.g. France; Japan; Germany,  a distribution from an irrevocable U.S. based trust to a U.S. beneficiary who is a tax resident of that civil law country will be subject to that country’s gift tax, despite the payment of a federal transfer tax in the U.S. to fund the irrevocable trust- i.e. a second transfer tax is assessed.

In many civil law countries, France and Germany are notorious for this,  the applicable law does not recognize the existence of the trust; instead the civil law country simply treats the beneficiary as having received a gift from the settlor of the trust, whether or not the settlor is deceased. In many of those civil law countries the gift tax is imposed on the recipient of the trust distribution when the trust beneficiary is a tax resident in that country.

In some civil law countries the U.S. beneficiary may also be subject to income tax on the trust’s income, whether that beneficiary is entitled to, or actually receives, the income as a distribution.

A corollary issue is the public disclosure of the U.S. based irrevocable trust. Since 2011 France has required resident trust beneficiaries to file reports with its tax authorities that provide details on their trusts, and it just began to make that information available on the Internet this past June. The disclosed information includes: (i) the names, dates and places of birth of resident beneficiaries; (ii) the name of the trust and the trustee’s identity and address; (iii) the date the trust was created; and (iv) the identity of the settlor. Moreover, the identity of the other beneficiaries of the trust  can also be made available upon request.

The article did not offer too many  solutions to avoid the imposition of the second transfer tax on the trust beneficiary:

  1. If the trust instrument call for a large distribution at a designated date or event, e.g. when the beneficiary attains the age 35 the balance of her share is distributed to her, she could terminate her residency in the civil law country prior to that date or event. But that termination might be easier said than done. The physical removal from the country may not be sufficient to sever residency if the beneficiary continues to own a home in that country, or she leaves dependents behind.
  2. The trust instrument might be decanted to clarify that a trust beneficiary will not be entitled to a distribution [income or principal] so long as she is a tax resident of the civil law country- any rights to distributions will be suspended so long as that beneficiary is a tax resident of a civil law country that imposes taxes on distributions.
  3. Alternatively, a trust protector could be added to the trust instrument to amend its provisions to suspend the right to receive a distribution,  to circumvent the imposition of that a second transfer tax.
  4. Instead of a trust distribution to the tax resident beneficiary, a secured loan is made to the beneficiary from the trust, which avoids taxation under the applicable local law.

When children and grandchildren of clients  live abroad, that fact should trigger the topic of how many civil law countries ignore trusts and impose their own taxes on distributions, in addition to income taxes.