Beneficiaries abroad

In the UK private client space, trusts can play a key role, particularly with optimising income tax, reducing estate tax exposure and providing asset protection. But what happens when you discover one or more of your beneficiaries is a resident in the United States? Then there are tax implications to bear in mind, both by trustees and their UK professional advisers.

UK trustees

The legal and ethical responsibilities of trustees is an area under constant scrutiny, now more than ever. For UK resident trusts with UK resident beneficiaries, the tax and accounting requirements are generally clear. Trustees are readily able to engage appropriate legal and accounting professionals to ensure the principal trustee duties are met.

For trustees to act in the best interest of the beneficiaries, it is recommended that they really get to know those beneficiaries, understanding aspects such as: 

• Are they looking to make a significant purchase soon? 
• Are they good at managing their finances? 
• Are there any personal health concerns? 

But what about understanding the beneficiaries’ personal tax residence position and the impact a benefit from the trust could have in their country of residence (when this is not the UK)? The US is one such jurisdiction in which a lack of any pre-entry tax planning can lead to adverse tax implications for the beneficiary in respect of their trust interest.

Trustees were given a flavour of the extensive reach of the US Internal Revenue Service with the enactment of the Foreign Account Tax Compliance Act back in 2010. As a result of this act, trustees have spent hours understanding their requirements and have carried out various informational reporting. But let us push that aspect to one side and focus on the core US tax impact for US beneficiaries of UK trusts.

US tax regime

As a ‘US person’, you are subject to US tax on your worldwide income and gains. At the individual level, a US person can be defined as one of the below:

• US citizen
• US lawful permanent resident (green card holder)
• US resident.

If you fall within the first two categories, you are in an almost unique tax regime of being subject to US tax irrespective of where you are physically present. The third category, US resident, is effectively where an individual (not falling into the first two categories) spends enough days in the US that they meet a ‘substantial presence test’ to be subject to US tax on their worldwide income and gains. This test consists of two parts, both to be met.

Let us assume we want to assess whether the substantial presence test has been met for the 2023 calendar year. We apply the test as follows:

1. You must be present for at least 31 days in 2023. 
2. You combine all the days present in the US during 2023, one-third of all the days present in the US in 2022 and one-sixth of all the days present in the US during 2021. If the sum of these days adds up to 183 or more, this part of the test is satisfied.

Exempt individuals

The substantial presence test is clear; however, quite often we come across beneficiaries of trusts who are temporarily in the US, such as a student attending a US university. There is a concept of ‘exempt individual’ when it comes to US residency. This effectively allows certain individuals, present on a particular visa, to exclude days to be factored into the substantial presence test. 

One such visa we commonly come across is the F-1 student visa. There are additional requirements to adhere to, but, in general, the student can achieve a ‘non-resident alien’ tax status, which broadly would subject that individual to US tax on ‘US-sourced income’.

The issue trustees commonly face is when the individual no longer qualifies for the exempt individual status, perhaps because they fall foul of their visa requirements, fail to keep up with the compliance associated with exempt individuals or decide to remain in the US after their studies.

Trust taxation

The starting point for understanding the tax implications for the US resident beneficiary is understanding the tax ‘status’ of the trust. This can be complex, requiring a detailed review of the trust instrument and background / facts around the trust. For simplicity (if this is even possible) and for the purpose of this article, let us consider a trust settled by a UK national (currently living or deceased) in the last 25 years. Most of these trusts, absent any US tax planning, fall within the category of being treated as a ‘foreign non-grantor trust’. With this type of trust (assuming there are no US assets), the US taxing point and any filing obligations firmly rests with the US beneficiary. Where the US person receives a benefit from the trust – which could be in the form of cash / assets in specie distributions, an income entitlement, use of trust property and certain trust loans – the value of these benefits needs to be quantified. Once the benefit is quantified, there is effectively a matching process in characterising the tax treatment of the benefit. The matching is to the ‘income’ of the trust. When we consider the income of a trust for US tax purposes, this includes both income and gains (calculated on US tax principles). There is no separate income and capital account for US tax purposes.

So, first, you allocate any current year (US calendar year) income to the quantified benefit. Then, for any unmatched benefit (assuming benefit exceeds current year income), you match to the trust’s accumulated, previously unmatched, income, on a first-in, first-out basis. If after this round you still have an excess unmatched benefit, this portion is simply treated as tax-free capital.

Simple, right? Not quite

Where you have a benefit matched to the accumulated income of the trust, this carries with it a ‘penalty’ in the form of tax at ordinary income rates and interest on this tax, dependent on the number of earlier years of the trust and accumulated income amount.

There are added complexities where the trust holds assets not considered US ‘tax friendly’ or with a more complex underlying structure, such as corporate holdings, partnership interests or other underlying trust holdings. This can potentially give rise to ‘attribution’ rules coming into play; that is, the US beneficiary potentially picking up income regardless of actual distributions. 

Key takeaway

The above complexities may leave trustees feeling confused and overwhelmed. Some may argue that the US tax reporting and US tax liability cost is all the responsibility of the US person. But there is also the view that, as part of the trustees’ duty to have the beneficiaries’ interests at heart, tackling the above on behalf of their beneficiaries is crucial.

Trustees are diligent in providing UK beneficiaries with the appropriate R185 form and support in establishing their UK tax position, but what about the support with the beneficiaries’ US reporting? The US beneficiary is unlikely to optimise their US tax position and fulfil their US tax reporting requirements without trustee cooperation and support.

It is therefore prudent for trustees to take appropriate US tax advice where either a beneficiary has already been identified as a US person, or they expect a beneficiary to move to the US soon. Even if that beneficiary is a student or other exempt individual, trustees should seek advice as soon as practically possible – there could be tax planning opportunities for the trustees to minimise or mitigate any adverse US tax impact on prospective US beneficiaries.