25 September 2023
A family trust remains a popular vehicle to allow for the passing of wealth to the next generation. This is because it can provide flexibility, discretion and an element of control which is attractive to many.
For US citizens, US trusts are often discussed in estate planning. They are an efficient vehicle to deal with often time consuming and costly probate processes in various states.
For transatlantic mobile families, the creator of a trust might be in one country and the beneficiaries in another. It is therefore very important to understand the rules applying to such arrangements.
In many cases, the UK and the US both consider trusts as separate taxable entities from those who create them and from those who can benefit from them. Both therefore have rules which establish the tax residence position of the trust.
In the UK, the residence of the trust is determined by the residence of the Trustees. A situation can arise where some of the Trustees are resident in the UK and some outside the UK. Where this happens, the domicile and residence of the settlor at the time when the trust was funded also has a bearing on its residence status.
From a US tax perspective, the residence of a trust is established by the Court and Control Tests. In order for a trust to be considered ‘US resident’, a US court must be able to exercise primary jurisdiction over the trust, and a US person or persons must have the authority to control all of the substantial decisions of the trust.
For US tax purposes, the income and gains of a US trust are tentatively taxable at the trust level. However, where distributions have been made to the beneficiaries, the trust is entitled to a deduction against its income (but generally not against its capital gains) for the amount distributed. That income is then passed on to the beneficiaries and subject to tax in their hands. Trust capital gains are generally taxed at the trust level regardless of distribution.
It is worth noting that, in general, US tax rates for trusts are less beneficial than those for individuals.
There is an exception to this in the case of trusts which are classified as “grantor trusts”. Trusts generally fall within this classification if the grantor is also a beneficiary of the trust or retains certain powers over the assets held in the trust. In these circumstances, the assets of the trust are considered to be owned by the grantor (or grantors) for US income tax purposes, and any income or gains would typically be taxed in their hands rather than at the trust level.
From a UK tax point of view, there would typically be no tax on a US trust at the trust level except to the extent that the trust held UK assets that generated UK taxable income (e.g. UK real estate or UK business interests).
The US tax treatment of a UK trust will depend very much on the nature of the trust.
If the trust is considered a “Foreign Grantor Trust” (broadly, any trust resident outside the US which was settled by a US person and could benefit a US person), the assets and any income or gains arising would be subject to tax in the hands of the grantor.
If the trust is not a “Foreign Grantor Trust”, the trust itself will not be subject to US tax except to the extent that the trust held US assets that generated US taxable income (e.g. US dividends, US real estate or US business interests). Distributions to US beneficiaries will however result in potential tax charges to those beneficiaries, as discussed below.
For UK tax purposes, a UK trust will be liable for tax on its income and gains. Generally, this tax will be applied at the highest rates (currently 45% for income, 39.35% for dividends, and 20% or 28% for capital gains).
There are special rules for “settlor interested trusts”. These are typically trusts where the settlor is also among the class of beneficiaries. In these circumstances, the settlor will typically be liable to UK tax on the income and gains of the trust with credit available for the tax paid by the trust.
Both countries also have their own rules as to how they regard distributions to tax resident beneficiaries.
In the UK, income distributions from a UK trust to a UK resident beneficiary result in that income being subject to tax in the hands of the beneficiary, but with a tax credit for the tax paid by the trust.
Where a UK resident receives an income distribution from a US trust, they will be subject to tax on that income. If the beneficiary is also a US taxpayer, the availability credits for foreign taxes will depend on the nature of the income and how it is dealt with under the terms of the UK/US tax treaty.
Capital distributions from foreign trusts to UK resident beneficiaries are often more problematic, as they can be matched to trust capital gains of the current year, prior years, and even future years. The resulting matched gains are then taxed in the hands of the beneficiary with penalty taxes applying in the case of distributions matched to historic capital gains. A key problem that can arise in these circumstances is that a UK beneficiary could be personally liable for UK tax on a capital gain realised by a US trust in an earlier year on which that US trust has already paid US taxes.
From a US perspective, beneficiaries receiving distributions of income from a US trust will be subject to US income tax on their share of the trusts income. The types of income generated at the trust level will retain their character in the hands of the beneficiary (e.g. distributions representing interest will be taxable as interest, distributions representing dividends will be taxable as dividends, etc.).
Beneficiaries receiving distributions from a foreign nongrantor trust are similarly subject to US income and capital gains tax, where the distribution represents current year income and gains.
However, if the income and gains of a foreign nongrantor trust (known as distributable net income or DNI) are not distributed within the calendar year or within 65 days of beginning of the new calendar year if an appropriate election is made, they become undistributed net income (UNI). If a distribution during the year exceeds the DNI of the trust, it is next considered to represent UNI.
The tax computations and reporting for distributions of UNI are extremely complex. When UNI is distributed to a beneficiary, it is taxed as ordinary income regardless of its original nature. The tax rate applied to this income is based on an average rate of three of the preceding five tax years (disregarding the highest and the lowest). Additionally, interest is chargeable on the tax due based on the number of years that the trust has been in existence.
Without careful planning, it’s very easy for inefficient tax situations to arise. For example, where the income and gains are taxed on the trust in one country. But the beneficiary is potentially being taxed on the income and gains of the trust in the other county. This can cause double taxation issues as it is a situation not well provided for in the double taxation agreement.
Are you a family considering setting up a family trust where there are people involved both in the UK and US? If so, it is important to carefully consider where the trust should be tax resident. You need to ensure it is set up appropriately. There are a number of factors to consider in this decision including the expected level of income and gains and expected distribution policy of the trust. It’s really important to take advice in order to be as tax efficient as possible.
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