Introduction

A United States Settlor of an irrevocable Foreign Trust having a United States beneficiary is deemed to be the owner of the Foreign Trust. Subject to statutory exceptions, the Settlor is the taxable party regardless of whether the Settlor has released all dominion and control of the trust assets by an irrevocable transfer and the right to alter, amend, or modify the trust document. This is the income tax treatment of a United States Settlor by Section 679 of the Code. (1) Because the Settlor is treated as the owner of the trust assets, the transfer of appreciated assets to a Foreign Trust does not occasion a taxable event as contemplated by Section 684 of the Code.

There are conditions that must be present when Section 679 is applicable to subject a Settlor to the income tax upon a Foreign Trust’s income. First, it must be a Foreign Trust by definition as previously explained. Second, it must be established that the trust has a United States beneficiary. The transferor of assets, the Settlor in this instance, must be a United States person. Last, the transferor must have made either a direct or indirect transfer of property to the trust. (2)

Foreign Trusts will be construed to have United States beneficiaries if income or corpus of the trust can be paid or accumulated during the taxable year or used for the benefit of a United States person. In furtherance of this rule, no part of the corpus or income can be deemed payable to or for the benefit of any United States person if the trust terminated at anytime during the taxable year. (3)

Where a Settlor is deemed to be the owner of the Foreign Trust, there is no United States gift tax because it is deemed to be an incomplete gift. There is also no United States federal estate tax if the Settlor becomes a decedent because United States federal estate tax provisions view that the Settlor has not relinquished the assets. Therefore, it will be included in his or her gross estate for estate tax purposes. (4) It is deemed not relinquished by virtue of the Settlor being recognized as the owner of the income.

It is thus apparent that even though United States Settlors relinquish their interest in assets to a Foreign Trust, the income generated will be taxable to the Settlor. It does not facilitate an opportunity to establish an estate plan as it would in the domestic trust setting.

Installment Sale Section 679 Exception

An exception to the provisions of Section 679 of the Code that taxes a Foreign Trust’s income to the Settlor was formerly described as an installment sale of property. This exception now incorporates the terminology of installment sale as one in which the debt obligation is termed as a qualified obligation. A qualified obligation is defined in Section 679 of the Code as an obligation that meets several criteria.

First the obligation is reduced to writing by an express written agreement. Secondly the term of the obligation cannot exceed a five-year term. Thirdly all payments in the obligation are required to be made in United States dollars. Fourthly the yield to maturity is not less than one hundred percent of the federal rate as provided by Section 1274(d) of the Code and not greater than one hundred and thirty percent of the federal rate stipulated by the Code.

The applicable rate is the rate established as of the date the obligation is issued. (5) Lastly, the United States transferor extends the statutory period for assessment for income or transfer tax for a period of three years pertaining to each year in which the qualified obligation is outstanding. (6)

This permits the Settlor to establish an irrevocable Foreign Trust and sell to the trust property owned by the Settlor on an installment basis, with periodic payments. The income from the assets would not be taxable to the Settlor. (7) The installment payments received by the Settlor would be income and taxable just as though the property had been sold to a bona fide third party in the United States. In this regard new language has been added that focuses upon the term fair market value that incorporates the terms arm’s length price for use of the property.

As an illustration of this type of financial planning, a trust often litigated in the United States by taxpayers in a domestic trust setting is illustrative of concepts that a taxpayer might consider. It also points out the problems of fixed or periodic payment treatment of offshore taxable entities. Those are the source of income issues that are discussed as a part of the analytical technique when establishing offshore structures. Often in the domestic setting it is a planning feature that has been utilized by taxpayers in the medical profession; it has been contested and is controversial. The taxpayer has prevailed in some instances.

A Settlor establishes an irrevocable Foreign Trust for the benefit of his or her three children as is often done in a domestic setting. The independent trustee is utilized and able to arrange a line of credit with a Financial Haven local bank in which the trust is established. Perhaps the line of credit is prefaced upon a chattel mortgage secured by equipment to be purchased.

A physician Settlor may have medical equipment originally purchased for $700,000 that, by virtue of the purchase, has a discounted value of $500,000. The Settlor sells the equipment, which has a certified appraisal to comport to the stipulation of fair market value, to the Foreign Trust. The terms of the sales contract are for $25,000 cash and a 3-year ballon promissory note for the balance at the interest rate of 5% with the assumption that that interest rate is the applicable rate on the date of sale.

The principle balance of $475,000.00 is amortized over a ten-year term with monthly payment of $17,787, provided that the entire principal balance would be due and payable on the 36th monthly installment in complete satisfaction of the qualified obligation. In connection with the sale, the trustee of the Foreign Trust and the Settlor as a professional corporation enter into a leaseback agreement whereby the Settlor leases the equipment from the Foreign Trust. The equipment leasing agreement is for a period of 10 years at the rate of $20,000 per month.

Section 679 of the Code specifically exempts this installment sale from being taxed to the Settlor and shifts the asset to the Foreign Trust. (8) The promissory note payments amortized over a 3-year period are reported as interest income and return of principal to the physician, Settlor’s medical practice corporation, and the lease payments from the Foreign Trust are a deductible equipment leasing expense. The Foreign Trust has income from the lease agreement payments of the equipment; a substantial part of it is sheltered by depreciation with minimal or no income tax providing an opportunity to accumulate tax-free income into corpus and paying any tax due thereon with the cash flow.

The taxation treatment of Foreign Trusts and the application of fixed or periodic payments received in a Financial Haven are beyond the scope of this writing. This presents a source-of-income issue and requires careful structure. A structure must be developed to make use of the depreciation and interest deductions. Fixed and periodic treatment of income as opposed to effectively connect to the Foreign Trust denies use of deductions in calculation of income under certain provisions.

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Footnotes

1. Section 679 IRC of 1986 and as thereafter amended.

2. Treas. Reg. Section 1.679 of the IRC of 1986.

3. Id. at 2.

4. Section 2511 IRC of 1986 and as thereafter amended. (Gift Tax); See Section 2031 IRC of 1986 and as thereafter amended. (Estate Tax).

5. Treas. Reg. 1.679-4(d)(iv) of the IRC of 1986.

6. Treas. Reg. 1.679-4(d)(v). of the IRC of 1986.

7. Treas. Reg. 1.679-4(a)(4) of the IRC of 1986.

8. Id. at 7.

In accordance with Circular 230 Disclosure