Think twice before you delay the appointment of either a new domestic trustee or protector to an integrated estate planning trust after the prior-serving trustee or protector either dies or resigns as waiting more than one year will inadvertently cause such trust to automatically become a “foreign trust” for United States federal income tax purposes.
When a sole domestic trustee or a domestic protector dies or resigns, a trust will remain a “domestic trust” for U.S. tax purposes only if a new trustee or protector (as the case may be) who is a U.S. person is appointed within 12 months of the death or resignation. If a new appointment is not made within this 12-month period, then generally the trust will retroactively be classified as a “foreign trust” for U.S. tax purposes, resulting in additional tax filing requirements and exposure to fines and penalties for non-compliance.
Specifically, Treasury Regulation Section 301.7701-7(d)(2)(i) states that “[i]n the event of an inadvertent change in any person that has the power to make a substantial decision of the trust that would cause the domestic or foreign residency of the trust to change, the trust is allowed 12 months from the date of the change to make necessary changes either with respect to the persons who control the substantial decisions or with respect to the residence of such persons to avoid a change in the trust’s residency . . . [i]f the necessary change is made within 12 months, the trust is treated as retaining its pre-change residency during the 12-month period. If the necessary change is not made within 12 months, the trust’s residency changes as of the date of the inadvertent change.” Therefore, clients would be well served to inform their attorney as soon as possible after the change in status of either a domestic trustee or protector of a trust.
This 12-month period is permitted only in the event of an “inadvertent” change, which includes death or resignation. Conversely, in the event a domestic trustee or a domestic protector is removed (which would not be classified as an “inadvertent” change), then such 12-month grace period will not apply. In that case, the trust will automatically be classified as a foreign trust for federal income tax purposes as of the date of the removal. Therefore, we recommend that a successor domestic trustee or domestic protector be effectively appointed prior to or at the same time that the then-serving domestic trustee or protector, as the case may be, was removed.