For most types of assets, an exit tax applies in which you will have to pay tax on the gains. To shed some light on the relevant nongrantor trust interests we’re going to take a quick look at the key terms and concepts, and introduce some viable options you really need to know about.
What is a Nongrantor Trust?
It’s any trust where the beneficiary is not the owner. An example would be a trust set up by parents for a child living abroad.
Who are the beneficiaries?
This is the person in receipt of the assets and gains of the trust. An exit tax will be applied on the day before their expatriation date.
A Note on Taxation and Gain
The taxable portion of the trust’s distribution is taxed at a rate of 30% and there can be no pretend lump sum. This taxable portion represents income that would be part of the beneficiary’s gross income if they had continued to be subject to US tax because they were a citizen or resident of the US This level of taxation will remain in place after the expatriate has left the US, irrespective of whether or not the trust is deemed foreign.
The 30% tax has to be held back by the trustee during distribution, and the expatriate has no right to claim any tax breaks or treaties as a result of this withholding. The trust must also recognize the appreciation of any noncash assets by following a price that’s deemed fair by the market.
Understanding the Lump Sum Treatment
Applying for a private letter ruling from the IRS allows you to ask to be treated as someone who has been given your trust’s interest the day before the expatriation date. The IRS will have final say over the true value in this case, and you will then be eligible to complete Form 8854 which formalizes the agreement. This also gives you the ability to make use of potentially reduced withholding rates should you wish to do so on future distributions.
Is a Grantor Trust Worth a Closer Look?
Conversion to a grantor trust will be deemed a taxable distribution, and you may need to consider withholding. If you convert to a grantor trust before the expatriation date then you will become taxed as part of the mark-to-market regime. For an accurate picture of whether this will be in your best financial interests, always seek the advice of a trained legal professional.
Key Takeaway Points
- As the expatriate you will need to supply your trustee with Form W-8CE at whichever of these is first:
- 1 day before the first distribution that occurs after, or on, the expatriation date
- Within 30 days of the expatriation date
This formalizes the process of withholding so that you can ensure the trust is still working in your best financial interests.
- Interests from nongrantor trusts will not typically be taxed when expatriation occurs, but distributions afterwards will be taxed at 30%. As such, they need to be withheld by the trustee. This withholding needs to be formalized by the supply of Form W-8CE to the trustee, by the expatriate.
- You can get around these constraints with a single lump sum payment, but the letter ruling involves the input of the IRS, and as such can be costly and drawn out.
Expatriation and nongrantor trusts are highly detailed areas of taxation which have a number of cross border complications. Whilst an introductory article is a great way to familiarize yourself with the key concepts and definitions, there’s simply no substitute for seeking the advice of trained legal professional.
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