Question 1: If I transfer property to a foreign trust, who is responsible for paying the tax on trust income?

Answer: You, as the U.S. person transferor, are responsible for the income tax. Under United States Internal Revenue Code sections 671 and 679, foreign trusts that have one or more U.S. beneficiaries are deemed “grantor trusts” for income tax purposes. This means that you are responsible for the income tax. Under Internal Revenue Regulation §301.7701-7, a trust that is not controlled by a U.S. entity and that is not subject to the jurisdiction of a United States court is a foreign trust. Although there are exceptions to this rule (Reg. 1.679-4), none of them applies to the typical foreign asset protection trust.

Question 2: What are the exceptions that would permit me not to pay the tax on income?

Answer: The regulations offer four exceptions: (1) Any transfer of property to a foreign trust by reason of your death; (2) Any transfer of property to a foreign trust described in sections 402(b) (employee’s trust), 404(a)(4) (stock bonus, pension or profit sharing trust organized outside the United States, or 404A (foreign deferred compensation plan; (3) Any transfer of property to a foreign tax-exempt trust described in section 501(c)(3) (without regard to the requirements of section 508(a)); and (4) Any transfer of property to a foreign trust to the extent the transfer is for fair market value. Reg. 1.679-4.

Question 3: If I transfer appreciated assets into my foreign asset protection trust, will have to pay capital gains when I make the transfer?

Answer: No. Generally, I.R.S. considers the transfer to a foreign trust a “sale” that triggers capital gains (Reg. 1.684-1), but the Code also provides an exception to the general rule for transfers to a grantor trust (Reg. 1-684-3). See question 1, above for the description of a grantor trust.

Question 4: If my foreign asset protection grantor trust sells appreciated property, will I be responsible for paying capital gains tax?

Answer: Yes. You are responsible for tax on all rents, royalties, dividends, interest, profits and gains from the sale of property in excess of your cost basis. IRC Sec. 61(a).

Question 5: If I suffer a loss within my foreign asset protection trust, may I claim a deduction?

Answer: You may deduct losses to the same extent that you could deduct them if the property were owned in your own name.

Question 6: In addition to asset protection, I want income tax benefits; may I reduce my income tax liability using an asset protection trust?

Answer: Yes. By combining a trust with a Variable Universal Life Insurance Policy you may enhance your asset protection and reduce your income tax liability. Please refer to the Q & A on International Variable Life Insurance. Remember that a FAPT is income-tax neutral; the trust alone does not offer income-tax reduction.

Question 7: I have a large estate and would like to legally reduce the tax that my estate will have to pay. May I accomplish this with a Foreign Asset Protection Trust?

Answer: Yes, but if your primary objective is to reduce estate taxes, an FAPT alone will not accomplish the objective any better than a domestic, irrevocable trust. On the other hand, if you combine the FAPT with a VUL and a business risk management component, you may realize substantial asset protection, estate and gift tax reduction and income tax benefits. Please refer to the Q & A on Business Risk Management using international structures.

Question 8: Will the value of the assets in my FAPT be included in my estate when I die?

Answer: It depends on how the trust is drafted. Most clients who establish FAPTs do so for the primary purpose of protecting assets from creditors and predators. The client wants the assets available if the client needs or wants them. The following are three common retained powers that would cause trust assets to be included in your estate,

(1) If you establish the trust and retain the right to the income, use and enjoyment for life, the value of the trust assets as of the date of your death will be included in your estate. IRC 2036

(2) If you transfer assets into your trust and provide that your beneficiary cannot possess or enjoy the property until your death and you have retained a reversionary interest valued in excess of five percent of the trust assets, the trust assets will be included in your estate. IRC 2037

(3) If you transfer assets into your trust and retain the right to alter, amend or revoke the trust or provisions of the trust or the right to control the timing and amounts of distributions, the value of assets will be included in your estate. IRC 2038

Question 9: Will I have to pay gift tax when I transfer assets into my FAPT?

Answer: It depends on how the trust is drafted. Ordinarily, you retain powers that make the gift incomplete and not subject to tax.

The gift tax applies to completed gifts. The gift is complete when you have so parted with dominion and control over the property or interest in property so as to leave you with no power to change its disposition whether for your own benefit or for the benefit of another. Reg. 25.2511-2(b).

A gift is incomplete if you reserve the power to regain the beneficial ownership. A gift is also incomplete if a reserved power gives you the power to name new beneficiaries or to change the interests of the beneficiaries. Reg. 25.211-2(c)

A gift is not incomplete merely because you reserve the power to change the manner or time of enjoyment. Reg. 25.211-2(d)

A grantor of a trust does not make a gift to trust beneficiaries by paying the income tax on trust income taxable to the grantor under the grantor trust rules. Rev. Rul. 2004-64.

Question 10: In the answer to question 1 you write “a trust that is not controlled by a U.S. entity and that is not subject to the jurisdiction of a United States court is a foreign trust.” Where should I set up my foreign asset protection trust and who controls it?

There are a number of jurisdictions available where you can establish your FAPT. I suggest the Caribbean Island nation of Nevis for the following reasons.

Nevis permits an individual to establish a self-settled, spendthrift trust. Nevis law prohibits attorney contingency fees and fee shifting. Nevis trusts are exempt from Nevis taxes and duties.

Nevis requires the creditor to prove “beyond a reasonable doubt” that the trust was established “with principal intent to defraud that creditor” and that the trust’s establishment or funding left “the settlor insolvent or without property by which that creditor’s claim (if successful) could have been satisfied.” The settlor’s sworn declaration of solvency at the time of settlement of the trust is prima facie evidence that the settlement and disposition of assets was not made with the requisite intent to defraud.

A creditor must bring an action to set aside a fraudulent transfer within two years after the cause of action accrued.

Nevis prohibits the Courts of Nevis to entertain any proceedings for or in relation to the enforcement or recognition of a judgment obtained in a jurisdiction other than St. Christopher and Nevis against an international trust; a settlor of an international trust; a trustee of an international trust; a protector of an international trust; a beneficiary of an international trust; a person appointed or instructed in accordance with the express or implied provisions of an instrument or disposi­tion to exercise a function or undertake any act, matter or thing in connection with an international trust; or property of either an international trust or of a trustee or a beneficiary thereof if that judgment is based upon the application of any law inconsistent with the provisions of Nevis law or that judgment

relates to a matter or particular aspect that is governed by the laws of St. Christopher and Nevis.

Nevis prohibits the application of non-Nevis law to void any trust or set aside any transfer into the trust or compel any distribution from a Nevis trust.

Nevis requires every creditor before bringing any action or proceeding against any trust property to first deposit with the Permanent Secretary in the Ministry of Finance a bond in the sum of $25,000.00 from a financial institution in Nevis, for secur­ing the payment of all costs as may become payable by the cred­itor in the event of his not succeeding in such action or proceeding against the trust property.

All judicial proceedings, other than criminal proceedings, relat­ing to international trusts, are heard in camera and no person may publish any details of the proceedings without leave of the Court.

Circular 230 disclaimer: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax information contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

The information contained in this communication is not legal advice and shall not be considered as such. It is for information purposes only. The use of foreign asset protection trusts is case specific. Whether or not this technique is appropriate for any individual depends on a complete analysis of the individual’s assets and liabilities and personal circumstances. Consult knowledgeable professionals before employing this technique.

© 2007 Michael B. Mangini – All Rights Reserved