IRS Reporting and International Asset Protection Trusts

From Asset Protection Strategies & Forms by Alan Eber

A Low Profiler is a foreign trust that is a domestic trust for IRS reporting purposes until perhaps a lawsuit is threatened and the foreign trustee is given the discretionary power to fire the trustee in the jurisdiction of the threat; that trustee may or may not exercise it. If he does, the U.S. protector can still “negate” his action.

Thus, the “Low Profiler” takes advantage of all of the benefits of being foreign, and yet is exempt from IRS reporting requirements.

That is, these trusts are all tax-neutral to the U.S. Settlor.

The “Low Profiler” is most useful for those clients who:

• Do not want to spend the time and money involved in filing IRS reports.
• Are concerned that filing will raise their IRS profile.
• Fear that creditors will obtain their filing.
• Want no trace of their IAPT to be publicly available until after they are in litigation and only then, if and when the U.S. trustees are removed, does the trust turn foreign for IRS reporting purposes and only then does it need to begin to file the 3520s and 3520As.

Use Caution With This Type of Planning

There are differences of opinion about the use of the Low Profiler.

Some knowledgeable attorneys believe that moving the trust offshore after a challenge has arisen is a fraudulent transfer.

I disagree because:

• First, the person being sued (the settlor) is not involved in the transfer.
• Second, no U.S. person is directly involved in the transfer.

However, the practitioner, because of the differences of opinion in the profession, should review the law carefully.

In addition, some knowledgeable attorneys believe that unless the triggering mechanism is carefully thought out, the technique will draw a request by the service for IRS Forms 3520 and 3520-A.

Some believe it does not work under any conditions. I hold that it does work, based on the following Treasury Regulations:

The court test is not satisfied if the trust states that if a creditor attacks, a lawsuit is filed, or the court attempts to assert its jurisdiction over the trust, the trust will automatically migrate from the U.S. [Treas. Reg. §301,7701-7(c)(4)(ii) (emphasis added).]

The trust is not subject to an automatic migration provision described in paragraph (c)(4)(ii) of this section. [Treas. Reg. §301.7701-7(c)(3) (emphasis added).]

Automatic migration provisions. Notwithstanding any other provision in this section, a court within the United States is not considered to have primary supervision over the administration of the trust if the trust instrument provides that a United States court’s attempt to assert jurisdiction or otherwise supervise the administration of the trust directly or indirectly would cause the trust to migrate from the United States. [Treas. Reg. §301.7701-7(c)(4)(ii) (emphasis added).]

If Treasury wanted to say “any migration” it could have. Instead, the Regulations use the phrases “automatically migrate” and “automatic migration provision” and “would cause the trust to migrate.”

I believe that this technique works as long as the clause is drafted so that the action (which is always discretionary with the trustee, not mandated) can only be taken, after the right to take the action arises and the discretionary right arises. Thus, the action is not automatic; it is always “discretionary” with the trustee.

For a Low Profiler trust document from my book Asset Protection Strategies & Forms, see my article “International Asset Protection Trust.”

Alan R. Eber practices law in the fields of foreign and domestic asset protection and estate planning, trusts, business structuring, and wealth strategies. He is a pioneer in the asset protection field, having since 1974 established a wide variety of wealth preservation structures. Mr. Eber’s books on basic asset protection, family limited partnerships, and offshore planning have been adopted by the Education Foundation of the California Society of Certified Public Accountants and the American Institute of Certified Public Accountants (AICPA) for use in California and throughout the United States for professional education classes.

Risks and Abuses with Foreign Trusts

From Asset Protections Strategies & Forms by Alan Eber

Clients often ask if International Asset Protection Trusts (“IAPT”) are totally creditor proof. Generally, they are, provided they are conservatively structured and assets are transferred to them years before difficulties arise.

However, a U.S. court may obtain jurisdiction:

• If a settlor retains control over the appointment of the trustee.
• If the settlor is a trustee.
• If domestic trust protectors have the power to remove and replace the trustee and the trust does not specifically prohibit the protector from appointing a U.S. trustee.
• If a duress clause is not utilized.

If a U.S. court obtains jurisdiction, then it may require the trustee to repatriate assets, or require the U.S. protector to fire him and appoint a U.S. trustee. If the U.S. trustee and/or protector have the power and refuse, they can be held in contempt. Once the trustees are under the court’s jurisdiction, the court can require them to repatriate assets.

Delay Allows a “Lookback”

The client must take action before it is too late to do so. The most dangerous attack that a creditor can make against the planning strategy is to claim that the client transferred assets after a claim arose, and that the transfer was made to “hinder or delay” the collection action. Such a transfer is fraudulent.

The IAPT is not designed to allow individuals to defraud others or engage in tax evasion or criminal conduct.

If an IAPT is used to defraud creditors or evade taxation, or protect the proceeds of criminal or fraudulent activities, then a judge may ignore provisions of the trust and apply the leverage of a contempt order.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 became effective on October 17, 2005. That Act contains a “lookback provision” for transfers made to self-settled trusts:

(e)(1) In addition to any transfer that the trustee may otherwise avoid, the trustee may avoid any transfer of an interest of the debtor in property that was made on or within 10 years before the date of the filing of the petition, if—
(A) such transfer was made to a self-settled trust or similar device;
(B) such transfer was by the debtor;
(C) the debtor is a beneficiary of such trust or similar device; and
(D) the debtor made such transfer with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made, indebted.

[Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 §1402(e)(1).]

The Foreign Grantor Trust (“FGT”)

A Foreign Grantor Trust (FGT) is a trust formed by a non-U.S. citizen or resident, and there are U.S. beneficiaries.

The non-U.S. settlor (as well as earnings of the FGT) are not taxed by the IRS.

U.S. recipients need to report money received from an FGT. [Notice 97-34, IRB 1997-25 (6/2/97) Section V. U.S. Beneficiaries of Foreign Trusts.]

Generally, a U.S. person who receives a distribution from a foreign trust after August 20, 1996, must report the name of the trust, the aggregate amount of distributions received from the trust during the taxable year, and such other information as the Secretary may prescribe. [IRC §6048(c).] A U.S. beneficiary who fails to report a distribution is subject to a 35 percent penalty on the gross amount of the distribution. [IRC §6677(a).]

This type of trust is valid only if both:

• A real foreigner sets it up.
• The money that funds it is really the foreigner’s.

This type of trust is not valid when an American arriving in Belize (for example), turns to his poorly paid taxi driver and says: “Señor, how would you like to earn $500?”

“$500! My lord, what must I do?”

“You are a foreigner; set up an FGT for me!”

This is tax fraud. Be very careful when a client requests your assistance with an FGT for his “foreign friend.” Be certain who the client really is and who is providing the money.

The International Business Corporation (“IBC”)

Even if the earnings of an IBC are not repatriated, an American who owns an International Business Corporation that earns investment income must file the appropriate tax forms and declare the income.

Foreigners investing into the U.S., under the right circumstances:

• Are exempt from paying capital gains tax. [IRC §871(a)(2) (an NRA is not taxable on U.S. capital gain if he is not physically present in the U.S. for more than 183 days during the year; and is not engaged in a U.S. trade or business); IRC §864(b) (if an NRA trades in stocks for his own account through a U.S. broker, this is not a trade or business within the U.S., unless he has a fixed place of business in the U.S.).]
• Can benefit from structuring loans that comply with the Portfolio Interest Rules. [Portfolio Interest §871(h) is not subject to the normal 30% tax that applies to U.S. interest received by non-resident aliens unless it is effectively connected with U.S. trade or business.]

Many clients are told by promoters that IBCs can be structured to give them the same benefits that foreigners enjoy. They cannot. Unlike most countries, the United States taxes citizens on worldwide income. If you earn a dollar on the moon, and never repatriate it, you still best report it.

Many promoters in international jurisdictions tell clients that they, the foreign promoter, will register the IBC in their own name and give the client a “side letter.” They then explain to the client how to set up a U.S. brokerage relationship for the IBC and thereby avoid paying capital gains tax. This is a sham. If the potential client says that the IBC need not pay U.S. capital gains tax, be wary before you become involved.

Credit and Debit Cards

Many owners of IBCs have credit and debit cards issued in the name of the IBC and use them to withdraw cash from “their” IBC.

If they do so without paying tax, this activity is tax fraud.

Alan R. Eber practices law in the fields of foreign and domestic asset protection and estate planning, trusts, business structuring, and wealth strategies. He is a pioneer in the asset protection field, having since 1974 established a wide variety of wealth preservation structures. Mr. Eber’s books on basic asset protection, family limited partnerships, and offshore planning have been adopted by the Education Foundation of the California Society of Certified Public Accountants and the American Institute of Certified Public Accountants (AICPA) for use in California and throughout the United States for professional education classes.

Protecting Beneficiaries with Spendthrift Clauses

From Texas Trusts & Clauses by N. Dean Hawkins

Spendthrift clauses protect the interests of beneficiaries (except the settlor) from their creditors and prevent the beneficiaries from transferring their interests.

Specifically, the trust may provide that the interest of the beneficiary in the income or in the principal or in both may not be voluntarily or involuntarily transferred before payment or delivery of the interest to the beneficiary by the trustee. [Prop C §112.035(a).]

Example:

If a husband and wife form a revocable trust with a spendthrift clause:

• During the lifetimes of both settlors, the spendthrift clause will not protect the interests of the settlors. [See Prop C §112.035(d).]
• Upon the death of the first spouse to die, the spendthrift clause will protect the interest of the surviving spouse in the marital trust and the interests of the surviving spouse and all other beneficiaries in the non-marital trust. [See Prop C §112.035(a).] However, the surviving spouse will continue to hold an interest in his or her share of the assets of the revocable trust. Consequently, the spendthrift clause will not protect the surviving spouse’s interest in his or her share of the assets of the revocable trust. [See Prop C §112.035(d).]
• Upon the death of the surviving spouse, the spendthrift clause will apply to all trusts that remain in existence and will protect all interests in those trusts. [See Prop C §112.035(a).]

Establishing a Spendthrift Trust

Establishing a spendthrift trust does not require an elaborate provision in the trust. A declaration that the interest of a beneficiary shall be held subject to a spendthrift trust is sufficient to restrain voluntary or involuntary alienation of the interest by a beneficiary to the maximum extent permitted by the Texas Trust Code. [Prop C §112.035(b).]

Clause Does Not Protect Assets After Distributions

A spendthrift clause prevents seizure by creditors or transfer by the beneficiaries before payment or delivery of the interest to the beneficiary by the trustee. [See Prop C §112.035(a).]

However, once a distribution of property is made to the beneficiary the property distributed to the beneficiary is subject to seizure by creditors of the trust beneficiary.

FORM: Clause Establishing Spendthrift Trust

Comment:

Although simple language may be sufficient to establish a spendthrift trust, most trust instruments use more comprehensive language. This clause establishes a spendthrift trust and provides that property may not be seized prior to distribution to a trust beneficiary.

The clause excludes “Qualified Income” from the anti-alienation provisions of the trust, but only if a marital deduction is allowed with respect to the property under IRC §2056(b)(7).

For example, the anti-alienation provisions do not apply to the surviving spouse’s interest in the QTIP trust. However, the surviving spouse is prohibited from transferring any interest in the non-marital trust. If only a partial QTIP election is made, the surviving spouse is prohibited from transferring any interest to the extent the QTIP election is not made with respect to the trust.

Without these restrictions on transfer, the surviving spouse might gift an interest that is not otherwise includible in the surviving spouse’s gross estate and cause unnecessary transfer taxation. [See Chapter 11, Marital Trust Issues. See also Reg. §25.2519-1(g) Example (3).]

While transfers of Qualified Income may be excluded from the anti-alienation rule, such transfers are not advisable. Once a marital deduction has been allowed for the QTIP trust, transferring all or a portion of the income interest in the QTIP trust has severe gift tax consequences.

Spendthrift Trust

Each trust created under this Agreement shall be a “spendthrift trust,” as defined by the Texas Trust Code. Prior to the actual receipt by any beneficiary:

• No income or principal distributable from a trust created under this Agreement shall be subject to:
• The anticipation or assignment by any beneficiary; or
• The attachment by, or the interference or control of, any creditor of, any person seeking support from, any person furnishing necessary services to, or any assignee of, any beneficiary;
• No property shall be taken, seized or otherwise reached by any legal or equitable process in satisfaction of any debt or liability of any beneficiary (including governmental claims); and
• To the fullest extent permitted by law, any such attempted action by any beneficiary or by any claimant shall be null and void and wholly ineffectual.

This Section shall not prohibit the Surviving Spouse from assigning all or any part of his or her interest in any Qualified Income (as defined herein) to any individual or charitable organization (other than a creditor of the Surviving Spouse or of the Surviving Spouse’s estate).

Advantages and Disadvantages of QTIP Trusts

From Texas Trusts & Clauses by N. Dean Hawkins

Advantages

First Spouse to Die Can Control Disposition

QTIP trusts, unlike any other form of marital deduction transfer, allow the first spouse to die to control the disposition of his or her property after the death of the surviving spouse.

QTIP trusts are often used for this purpose, particularly when the spouses have been previously married and have children from prior marriages.

Not Included in Probate Estate

The assets remaining in a QTIP trust upon the death of the surviving spouse will not be either:

• Part of the probate estate of the surviving spouse or subject to probate proceedings.
• Subject to the claims of the surviving spouse’s creditors.

Post-Mortem QTIP Election Decisions

The availability of the marital deduction under IRC §2056(b)(7) and the resulting inclusion of the property in the QTIP trust in the surviving spouse’s gross estate is contingent upon the executor of the first spouse to die making a QTIP election.

In certain situations, it may be more advantageous to decline to make the QTIP election. In other situations, making a partial QTIP election, which is permissible, may be more advantageous.

A QTIP trust allows the executor of the first spouse to die to make these decisions after the death of the first spouse.

[For more, see §11:92.]

Reverse QTIP Election

With a QTIP trust, a reverse QTIP election may be made. [See IRC §2652(a)(3).]

A reverse QTIP election permits the executor of the first spouse to die to elect that the QTIP trust will continue to be treated, for purposes of the GST, as property transferred by the first spouse to die, even though the trust property is otherwise treated as belonging to the surviving spouse for estate and gift tax purposes.

Typically, a reverse QTIP election is made to allow the first spouse to die to utilize a portion of the GST exemption that otherwise might not be used. A reverse QTIP election is only necessary when the amount of the GST exemption exceeds the applicable exclusion amount. Presently, the amount of the GST exemption is equal to the applicable exclusion amount. [See IRC §2631(c). For more on reverse QTIP elections, see §11:110.]

Disadvantages

Conflicts Between Surviving Spouse and Remainder Beneficiaries

The primary disadvantage of a QTIP trust is the potential conflict between the surviving spouse and the remainder beneficiaries that may arise in regard to investment strategy, tax strategy, adequacy of accountings, and trust administration.

The potential for conflict is attributable to the surviving spouse’s lack of control over the remainder interest and the ability of the first spouse to die to control the disposition of his or her property after the death of the surviving spouse, which is of course the primary advantage of a QTIP trust.

The likelihood for conflict depends on:

• The relationships between the settlors and the designated remainder beneficiaries.
• The assets and income of the surviving spouses from sources other than the QTIP trust.

Inability to Obtain Funds to Make Tax Advantageous Gifts

Even though the requirements for QTIP trusts to qualify for the marital deduction do not prohibit granting powers to the surviving spouse to withdraw principal from the trust, the typical QTIP trust does not grant liberal withdrawal powers to the surviving spouse.

Such withdrawal powers, if granted, might be exercised by the surviving spouse to defeat the objectives of the first spouse to die regarding the division of the remainder interest upon the death of the surviving spouse.

Due to the surviving spouse’s lack of withdrawal powers, he or she may not be able to obtain from the QTIP trust the necessary funds to make inter vivos gifts to the next generation, even when the gifts would fall within the annual exclusion in IRC §2503(b). This is inconsequential if the surviving spouse has access to other assets with which to fund the gifts.

Drafting for Incapacity, with 4 Clauses

From Texas Trusts & Clauses by N. Dean Hawkins

The possibility of the future incompetence of one or both of the settlors raises special issues. In the event that one spouse might become incompetent, the trust must address:

• How to determine whether the spouse is incompetent and who makes the determination?
• What procedures will be followed for withdrawals to be made on behalf of the incompetent spouse?
• What class of marital assets will be used to support the incompetent spouse?

Determination of Incompetency

Without a trust, a guardianship proceeding must be filed in the probate court for an individual to be declared legally incompetent.

However, for purposes of administering a revocable trust, this proceeding is too expensive and time-consuming. Consequently, the trustee is usually given the power to determine competence. Of course, a finding of incompetence cannot be completely arbitrary.

Most trust agreements will either define incompetence or will allow the trustee to rely upon the opinion of physicians. However, a judicial determination of incompetence should not be required.

Withdrawal Procedures After Incompetency

After a spouse has become incompetent it is not practical to continue the procedure of requesting distributions because two different third parties become involved:

• An attorney-in-fact, acting pursuant to a durable power of attorney (executed prior to the incompetency), requests the distribution.
• The trustee, after receiving, reviewing and approving the request, makes the requested distribution.

To make the procedure simpler, it is recommended that the trust provide that distributions will be made to the incapacitated settlor to the extent that the trustee shall consider such distributions necessary for the health, maintenance and support of such incapacitated settlor.

Selecting the Assets

The issue of which assets should be used to support the incompetent spouse may be particularly important if the incompetent spouse has children from a prior marriage and has transferred both separate property and joint management community property to the revocable trust.

In most instances, clients want to preserve their separate property. Therefore the property interests of the incapacitated spouse are generally used in the following order for his or her support:

• First, his or her share of any joint management community property (after obtaining the consent of the competent spouse).
• Second, the sole management community property of the incompetent spouse.
• Third, the separate property of the incompetent spouse.

FORM: Trustee Determines Incapacity

A sample clause allowing the trustee to determine incapacity is as follows:

An adult individual beneficiary under this Agreement, including any settlor who shall be a beneficiary hereunder, shall be considered “incapacitated” upon a good faith determination made by the fiduciary charged with making such evaluation that such individual lacks the physical or mental capacity, personal stability or maturity of judgment needed to effectively manage his or her personal or financial affairs (whether by reason of a medical condition, substance abuse or dependency, or any other reason).

FORM: Trustee Obtains Opinions of Physicians Regarding Incapacity

This sample clause provides that the trustee may rely on the opinion of two physicians to determine incapacity:

An adult beneficiary under this Agreement, including any settlor who shall be a beneficiary hereunder, shall be considered “incapacitated” if the beneficiary is a person for whom a guardian of the estate could be appointed under Texas law. The fiduciary charged with making such determination shall not be required to obtain a court adjudication of incompetence, but may rely on the written opinion of two licensed physicians who are not related by blood or marriage to the settlors or any beneficiary of this trust.

FORM: Distribution to Incapacitated Spouse When Trust Holds Separate Property

This form is to be used when the trust holds joint management community property of the spouses and separate property of the incompetent spouse. To use this form, the trust must provide that each class of marital property will be treated as a separate trust or sub-trust.

If the assets of the incapacitated spouse are completely exhausted, this form does not provide that the incapacitated spouse can access the separate property of the competent spouse. If the incapacitated spouse were allowed to access the separate property of the competent spouse, the trust would be granting property rights that did not exist prior to the formation of the trust, and the rights of the creditors of the incompetent spouse might be increased.

However, the competent spouse can access his or her separate property if he or she chooses to do so.

In the event the trustee shall consider (Name Settlor 1) or (Name Settlor 2), as applicable, to be incapacitated, the trustee shall distribute to the persons and from the sources or sub-trusts as set forth below so much or all of the income and principal of this trust (or sub-trusts of this trusts), even if such distributions of income and principal shall exhaust the specified portion of this trust (or sub-trusts of this trust), as the trustee shall consider or deem advisable for the comfortable maintenance, health and support of (Name Settlor 1) or (Name Settlor 2), as applicable:

• To or for the benefit of (Name Settlor 1), if incapacitated, from the following and in the following order of priority:
  • The share of (Name Settlor 1) in any joint management community property; provided, however, that (Name Settlor 2) shall consent in writing to the distribution;
  • The sole management community property of (Name Settlor 1); and
  • The separate property of (Name Settlor 1).
• To or for the benefit of (Name Settlor 2), if incapacitated, from the following and in the following order of priority:
  • The share of (Name Settlor 2) in any joint management community property; provided, however, that (Name Settlor 1) shall consent in writing to the distribution;
  • The sole management community property of (Name Settlor 2); and
  • The separate property of (Name Settlor 2).

FORM: Distribution to Incapacitated Spouse When Trust Holds Joint Management Community Property

This form (in conjunction with the distribution form) is to be used when the trust does not own any significant amount of property other than joint management community property.

This form allows the assets of the trust to be completely exhausted if either spouse becomes incapacitated. However, the consent of the spouse who is not incapacitated is required due to the prohibition against unilateral partitioning. [See Tex Const art XVI §15.]

In the event the trustee shall consider (Name Settlor 1) or (Name Settlor 2) to be incapacitated, the trustee shall distribute, after obtaining the consent of the spouse who is not incapacitated, so much or all of the income and principal of this trust (even if such distributions of income and principal shall exhaust this trust) as the trustee shall consider or deem advisable for the comfortable maintenance, health and support for whichever one (or both) of (Name Settlor 1) or (Name Settlor 2) as shall be or become incapacitated.