Upon our being retained, we begin each trust audit by sending our specialized trust audit questionnaire to the trust company. This questionnaire is specifically designed to solicit pertinent information which significantly reduces the amount of time necessary for us to review various trust documents. After reviewing the completed questionnaire with the trust company, we then review the inventory of all trust documents, including, but not limited to, the trust deed, the letter(s) of wishes and trust accountings.

Upon completion of our review, we are then in a position to provide the following advice:

1. Whether for United States tax purposes the trust is considered to be a foreign trust or a domestic trust and under what circumstances that status may be changed.
   

2. The extent to which the trust is (and has been) a grantor trust and/or a nongrantor trust for United States income tax purposes.
   

3. Who (if anyone) is treated as a grantor of the trust and who (if anyone) is treated as the owner of the assets of the trust, and under what circumstances that result may change.
   

4. The United States income, estate, gift and generation skipping transfer tax consequences to the settlor and each beneficiary who is a United States person, whether due to (a) powers or rights in connection with the trust or the entities owned by the trust and/or (b) the direct or indirect receipt of distributions from the trust. There may also be state income tax consequences depending upon whether and in which state in the United States the beneficiary may be resident.
   

5. The United States reporting requirements, if any, of the trustees, the settlor(s) and the beneficiaries of the trust (i.e., Internal Revenue Service Forms 3520, 3520-A, TD F 90-22.1, 8621, 5471, 1040, 1041, etc.). There may also be state reporting requirements depending upon whether and in which state in the United States the relevant person may be resident.
   

6. What changes should be made to the trust deed, letter of wishes and/or the entities owned by the trust.
   

7. In which manner should the trust company maintain the trust and the entities owned by the trust in a tax efficient manner aimed at minimizing future tax and reporting consequences.
   

8. What type and situs of investment structures should not be held through the trust.
   

9. What procedures should be followed for making any additions to the trust so as to avoid adverse tax and reporting requirements.
   

Trust companies have found our trust audit to be a very useful tool to assure themselves and their clients that their trust inventory has been properly reviewed and that important United States tax and reporting issues have been properly addressed.

The information contained in this newsletter is predicated upon the following assumptions:

• The trust is a foreign trust that is revocable by its sole settlor during his lifetime without the consent of any person;
  

• The sole settlor of the trust has never been and will never be a citizen, resident or domiciliary of the United States;
  




• At least one beneficiary of the trust is a United States person (as such term is defined in Section 7701(a)(30) of the Internal Revenue Code of 1986, as amended); and
  

• The entire trust is a grantor trust during the lifetime of the settlor.
  

Timely United States Tax Advice. It is unfortunate that many times neither the settlor nor the trustee of a trust seek the appropriate United States tax advice until it is too late. In a perfect world, both the settlor and the trustee would obtain independent United States tax advice prior to creating the trust if it is known in advance that at least one United States person will be a beneficiary of the trust. If it is not known in advance that a United States person will be a beneficiary of the trust, ideally both the settlor and trustee would obtain independent United States tax advice at such time that a United States person becomes a beneficiary of the trust. It may even be appropriate for the beneficiary to obtain independent United States tax advice as well. While it is no secret that the amount of attorneys' fees incurred to obtain such advice is typically nominal compared to the United States tax savings that can be achieved, oftentimes United States tax advice is not timely obtained due to the costs involved and the reluctance of the trustee to demand such advice.

Flexibility. It is impossible to predict the future, so why set everything in stone? Many estate planning practitioners prepare trusts that include specific dispositive provisions requiring mandatory distributions (i.e., when the beneficiaries thereof attain a certain age or certain ages) and do not take into account any potential for change in the place of residence, citizenship or domicile of any of the beneficiaries. Taking such an approach may result in several unfavorable tax and nontax consequences. Accordingly, in most cases the provisions of the trust instrument should be flexible in order to deal with contingencies and unforeseen events.

United States Person With Powers Over The Trust. Many trusts provide an individual with various powers over the trust in the capacity as a protector or otherwise. If, for example, a United States person is a beneficiary of a trust and has the power to remove and replace the trustee of the trust without any restrictions as to the reason for the removal or as to who can serve as the new or additional trustee, such power may be treated as a general power of appointment over the assets of the trust with adverse tax consequences (particularly if the trustee can make discretionary distributions). Any power over a trust should be carefully considered before the trust instrument is executed in order to determine whether there would be any tax consequences in connection with such power if the power holder is or becomes a United States person.

Maintaining Foreign Entities. For various reasons, most trusts hold title to financial assets indirectly through a wholly-owned foreign corporation. Holding title to assets in this manner triggers various United States tax issues, particularly if the foreign corporation is ever treated as a passive foreign investment company or controlled foreign corporation. The remainder of this article addresses some of those tax issues and points out some planning ideas.

Purported Gift From Foreign Corporation. A purported gift is any transfer of property made by a foreign corporation to a person who is not shareholder, except a transfer for fair market value. With certain exceptions, if a United States person receives a purported gift directly or indirectly from a foreign corporation (as opposed to a distribution directly from the trust which is the sole shareholder of the foreign corporation), the purported gift must be included in the United States person's gross income as if it were a distribution from the foreign corporation. Based upon our experience, the exceptions to the foregoing rule rarely apply and they are therefore outside the scope of this article. Trustees should avoid making purported gifts from a foreign corporation to any United States person.

Dividends. If the foreign corporation has retained earnings when the trust becomes a nongrantor trust (i.e., upon the death of the settlor), then part or all of the retained earnings may be subject to United States income tax when they are distributed from the foreign corporation to the trust. To avoid this result, the foreign corporation should regularly declare and pay dividends to the trust. The trust should thereafter re-contribute to the foreign corporation any funds not needed by the trust. Following this procedure regularly should minimize or eliminate the amount of retained earnings within the foreign corporation when the trust becomes a nongrantor trust.

Recognize Gains. Upon the death of the settlor, the trust would receive a "step-up" in its adjusted basis in the shares of the foreign corporation. This "step-up," however, would apply only to the shares of the foreign corporation and not to the underlying assets of the foreign corporation. If the assets of the foreign corporation have appreciated in value during the lifetime of the settlor, part or all of such appreciation may be subject to United States income tax after the death of the settlor. In order to minimize or eliminate such income tax, from time to time during the lifetime of the settlor (i.e., at least semi-annually) the foreign corporation should "step-up" its adjusted basis in its assets. To do so, the foreign corporation would sell its appreciated assets and then reinvest the proceeds from such sale; provided, however, that if the same assets will be repurchased immediately after such sale, they should not be repurchased on the same day they were sold. Before selling any assets, the foreign corporation should consider the domestic and foreign tax and non-tax costs and other issues associated with selling assets and purchasing new assets.

Utilizing A Disregarded Entity. If a foreign revocable trust directly or indirectly owns assets which are not "situated within the United States" for United States estate tax purposes, it may be prudent for the trust to hold title to those assets through an entity which is disregarded for United States tax purposes (such as a single member domestic limited liability company or a foreign company that has validly "checked-the- box" to be treated as a disregarded entity) instead of through a foreign corporation. If, at the time of the death of the settlor, the trust holds title to assets which are not "situated within the United States" through a disregarded entity, then the adjusted basis of the assets of such disregarded entity would be "stepped-up" and the disregarded entity would never have any retained earnings (for United States tax purposes). In other words, it would not be necessary to regularly recognize gains and regularly pay dividends. In addition, those assets would not be subject to any United States estate tax by reason of the death of the settlor. Certain exceptions may apply, however, such as if the trust was not properly funded.

The foregoing strategies are a small sampling of the vast number of applicable planning opportunities. Resolving issues posed by a United States beneficiary of a foreign trust is best achieved by acting preemptively. Sometimes, however, the international estate planning practitioner must make the best of a bad situation for the client to avoid severe penalties and adverse tax consequences.