Dynasty In The Details – U.S. Estate Planning Considerations For Global Families

INTRODUCTION

In the United States, creating "dynasty trusts" has become common planning tool for many estate planners. A dynasty trust is a trust that may continue for generations under applicable law. It has a myriad of benefits for strategic income, estate and gift tax planning, creditor protection and ensuring family inheritance.

All too often, a person will create a dynasty trust thinking that he or she has set up the best possible estate plan to protect the family legacy through generations. But what happens when an heir such as a child decides to move to a different country? Or the succession of trustees includes a noncitizen, nonresident of the U.S. (an "N.R.N.C. individual")? These seemingly trivial details could unintentionally cause severe tax and other planning consequences in the U.S. and abroad.¹

This article will explore various considerations for clients, advisors and fiduciaries when creating and administering U.S. dynasty trusts – a dynasty is in the details. It should not be set up and then forgotten.

ILLUSTRATIVE FACT PATTERN

The following typical fact pattern illustrates the continual care required by a trust and estate attorney who advises on the formation or maintenance of a dynasty trust.

Daniel and Jane Clark are prospective clients who meet with a trust and estate attorney for the first time. They wish to have the new lawyer review and update their estate planning documents.

• Daniel and Jane are married, U.S. citizens, residing in New York and have two adult children, Emily and John, each of whom are U.S. citizens. Emily is married with one child, and John is married with three children.
• The Clarks provide copies of two trust agreements – the Emily Clark Family Trust and the John Clark Family Trust – created by Jane ten years previously for the benefit of each child.
• The trust agreements provide that each trust is (i) irrevocable, (ii) for the benefit of the relevant child during the beneficiary's lifetime, and (iii) is to continue in further trust for the life of such child's children, and then (iv) is to continue to future generations.
• Each Clark Family Trust has only one trustee, who is a U.S. citizen, and no other fiduciaries are named. There are no trust protectors, distribution advisors, or investment advisors.
• Jane has the power granted to her in the trust agreement to remove and replace trustees.
• The trust agreements state that the laws of the State of New York apply in all matters of construction and interpretation.

In short, aside from the absence of replacement trustees and various advisers serving certain functions, each trust is a classic dynasty trust.

The Clarks understand that the dynasty trusts are irrevocable, but they want to make a few changes based upon Jane's limited retained powers in the trust agreements. They also want to learn how these trusts will be affected by new developments within their family.

TAX DEFINITION OF A U.S. DOMESTIC TRUST

The Clark Family Trusts are solely administered in the U.S. and the terms of the trust agreements provide that the laws of the State of New York apply in all matters of construction and interpretation. The Clark Family Trusts currently appoint only U.S. persons with decision-making authority. There is no indication that the courts of a foreign country would have any jurisdiction over any matters relating to the trusts in the event a child were to move to a foreign country.

As of its formation and through the review, each trust is a U.S. domestic trust for U.S. Federal taxation purposes. This means that the ordinary rules regarding the taxation of income and gains that appear in Subparts A , B, and C of Part I of Subchapter J of the Internal Revenue Code ("Code") – apply, beginning with Code §641 and continuing to Code §664) apply. In very broad terms, a domestic trust reports distributable net income ("D.N.I."), deducts distributions to beneficiaries and amounts required to be distributed beneficiaries, and pays tax on the balance. Beneficiaries receiving distributions from D.N.I. or required to receive distributions report those amounts as if they received a pro rata amount of the classes of income that comprise D.N.I. In certain limited instances, a fixed amount can be distributed to a beneficiary, and the distribution is treated as a gift from the settlor. Once a U.S. domestic trust incurs U.S. tax on retained D.N.I., no further tax is imposed on the beneficiary when the accumulated income is ultimately distributed.

A trust is a "domestic" trust if it passes each of the Court Test and the Control Test.² Generally speaking, a trust satisfies the Court Test if a court within the U.S. can exercise primary supervision over the trust administration.³ A trust satisfies the Control Test if one or more U.S. persons as defined in Code §7701(a)(30) control all substantial decisions of the trust.⁴ Substantial decisions include, but are not limited to, the following decisions:

• Whether and when to distribute income or corpus
• The amount of any distributions
• The selection of a beneficiary
• Whether a receipt is allocable to income or principal
• Whether to terminate the trust
• Whether to compromise, arbitrate, or abandon claims of the trust
• Whether to sue on behalf of the trust or to defend suits against the trust
• Whether to remove, add, or replace a trustee
• Whether to appoint a successor trustee to succeed a trustee who has died, resigned, or otherwise ceased to act as a trustee, subject to certain limitations
• Investment decisions made, including the unfettered authority of a U.S. persons to terminate a foreign investment adviser⁵

A trust that fails one test or the other is a foreign trust for U.S. Federal income tax purposes even if formed under the laws of state of the U.S.⁶ An unintentional foreign trust can cause adverse tax consequences for both the grantor (i.e., the creator of the trust) and the beneficiaries. These include the throwback rules with respect to accumulation distributions⁷ (the details of which are outside the scope of this article). Such a trust may also be subject to additional reporting requirements that carry penalties for noncompliance.⁸

For now, based on the above, the Clark Family Trusts appear to pass both the Court Test and the Control Test and would be considered U.S. domestic trusts.

ADDITIONAL FACTS

Jane advises that she is considering changing the trustee.

• The current trustee of the John Clark Family Trust is a U.S. person who is a family friend.
• There have been several disagreements with the trustee.
• Jane holds the power granted to her in the trust agreement to remove and replace trustees.
• She would like to name another family friend to serve as a replacement trustee. The individual is not a U.S. person.

NEW TRUSTEES/NEW PLACE OF RESIDENCE

As noted above, carefully selecting the trustees, trust protectors, distribution advisors, investment advisors, and their successors are key considerations in satisfying the Control Test. Continually satisfying this test over the life of the trust can prove difficult, especially when administering dynasty trusts that are expected to be in existence for many years.

Dynasty trusts often give the grantor, beneficiaries, or some other person the power to remove and replace trustees. This power is typically accompanied by cautionary language under which the holder's power to remove and replace a trustee is limited, requiring the replacement trustee to be independent and not "related" or "subordinate" to the person exercising such power. It is crucial to adhere to these rules for various U.S. taxation purposes that are outside the scope of this article.⁹

In addition, it is crucial for a replacement trustee to be a U.S. person at all times relevant. If (i) the replacement trustee is not a U.S. person and (ii) the replacement trustee has the ability to control any substantial decision listed above, the trust will fail the Control Test and will be deemed to become a foreign trust.

The same logic applies when dealing with the holder of any of the following powers granted in a dynasty trust regarding fiduciaries:

• The power to designate new fiduciaries other than trustees, such as trust protectors, investment advisors, and distribution advisors.
• The power to name a successor fiduciary in the event of vacancy.
• The power to designate additional fiduciaries.
• The of a beneficiary to become a co-trustee at a certain age when the beneficiary holding that power is not a U.S. person when the power is exercised.

If the holder of any of these powers is not a U.S. person, the trust runs the risk of failing the Control Test, meaning that it would become a foreign trust. This change of status brings Code §684 into play.

Code §684 provides rules that apply to transfers by U.S. persons of appreciated property to a foreign trust. Typically, the transaction must be reported on Form 3520 (Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts) and inherent gain on each appreciated asset must be recognized.

Somewhat different rules apply when a U.S. domestic trust becomes a foreign trust, sometimes referred to as a migration of the trust for tax purposes. Code §684 addresses the tax treatment of the migration in one of two ways, depending on whether the grantor of the trust is a U.S. person and whether the trust has U.S. beneficiaries.

• If there are U.S. beneficiaries and a U.S. grantor, the trust is treated as a grantor trust and the U.S. grantor becomes subject to tax on the income and gains under Code §679. Under that provision, a U.S. person who directly or indirectly transfers property to a foreign trust having one or more U.S. persons as beneficiaries is treated as the owner of the portion of the trust attributable to the transferred property.
  • If at some point in the future, the trust ceases to be treated as a grantor trust in whole or in part, the change in status causes the U.S. grantor to be treated as having transferred the underlying assets of the grantor trust to a foreign nongrantor trust. Gain must be recognized immediately before (but on the same date that) the trust is no longer treated as owned by the U.S. grantor.¹⁰ Only gain on the assets that are no longer treated as being owned by the U.S. grantor is deemed recognized.
  • If the U.S. grantor dies, gain on all assets in the portion of the trust that is a grantor trust is recognized. Recognition is deemed to occur immediately before the grantor's death.
• If at the time of migration of the trust, the facts are such that there are no U.S. beneficiaries or no U.S. grantor, Code §679 ceases to be applicable. The general rule of Code §684 applies. The trust recognizes gain as a result of the migration for tax purposes.¹¹

When looking at the Clark Family Trusts, the trustee is the only person with the authority to make substantial decisions. Consequently, to keep the John Clark Family Trust a domestic trust, and to avoid triggering the application of Code §§684 and 679 to Jane, the non-U.S. family friend should not be appointed as the new trustee. Only U.S. persons should hold the power to make decisions or to hold the power to replace a foreign financial adviser. The following language should be included with regard to the trustee and the persons holding the power to make substantial decisions:

FURTHER CHANGE IN FACTS

Daniel and Jane advise the following anticipated changes of facts:

• Their daughter, Emily, is planning on moving to "Country X" where her husband is to be stationed by his employer.
• Emily, her husband, and her son look forward to a new adventure.
• While the change is not intended to be permanent, it will last for several years.

Footnotes

1 The same issues arise if a U.S. resident trustee becomes an N.R.N.C. individual. See, for example, Nina Krauthamer and Galia Antebi, "Domestic Trust – Does Yours Satisfy the Court Test," Insights Vol. 8 No. 5, p. 38 (2021).

2 Code §7701(a)(30)(E); see also Treas. Reg. §301.7701-7(a)(1).

3 Code §7701(a)(30)(E)(i).

4 Code §7701(a)(30)(E)(ii).

5 Treas. Reg. §301.7701-7(d)(1)(ii).

6 Code §7701(a)(31)(B). There are a few safe harbors and relief provisions to retain domestic trust status, see Treas. Reg. §301.7701-7(c), and Treas. Reg. §301.7701-7(d)(2).

7 Code §§665-668.

8 Form 3520 (Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts) and Form 3520-A (Annual Information Return of Foreign Trust With a U.S. Owner).

9 A trust can be considered to be a "grantor trust" – meaning a person that settles or makes gratuitous transfers to the trust – where (i) a related or subordinate person (Code §672(c)) is trustee that controls beneficial enjoyment over the trust's assets or income (Code §674) or (ii) the grantor borrows from the trust and a related or subordinate person subservient to the grantor is the trustee (Code §675(3)). With regard to the imposition of estate tax, ordinarily property transferred during life is not subject to estate tax. But if the transferor retained rights to appoint persons who could possess the property or enjoy its income, the property is includible in the individual's taxable estate at the time of death (Code §2036). The same result exists if the transferor appoints a third person to make the decision, provided the third person can be removed by the transferor. This latter rule does not apply where the incumbent holder is an independent person and the transferor's power is limited so that only a successor independent person and be appointed. Rev. Rul. 95-58. The same result is reached under Code §2038 regarding revocable transfers, where the holder of the power is an independent person who can be replaced by the transferor only with a successor independent person.

10 Treas. Reg. §1.684-2(e).

11 Treas. Reg. §1.684-4(a).

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