Barry S. Engel, Esq., F.O.I., is a principal in the Denver, Colorado law firm of Engel Reiman & Lockwood pc. Mr. Engel is the lead author of the Asset Protection Planning Guide, a State-of-the-Art Approach to Integrated Estate Planning published by CCH Incorporated, Chicago. He has acted as a consultant to several offshore jurisdictions and was a co-author of the asset protection trust law enacted by the Parliament of the Cook Islands in 1989.


Over the course of the past fifteen years or so, planners have witnessed a broad expansion of the use of trusts in client wealth planning. This is particularly the case with regard to trusts settled in a country foreign to the settlor (typically, in one of the world's many Offshore Financial Centers, or "OFCs"). This article will summarize the more material types and uses of such "foreign situs trusts."


[1] Asset Protection Planning
Asset protection planning is the process of organizing one's assets and affairs in advance so as to safeguard them against risks to which they would otherwise be subject. Asset protection planning should not be based on hiding assets or on secrecy, although many clients do appreciate the confidentiality in their financial affairs that can be obtained. It should not be a means or excuse to evade or avoid taxation in the United States or other jurisdictions. It should also not be a means or excuse for making fraudulent conveyances. Asset protection planning typically involves the use of more than one planning tool, and Asset Protection Trusts are commonly used.

[2] Asset Protection Trusts
An Asset Protection Trust ("APT") may be defined as a trust the primary purpose of which is to protect assets. While some have stated that all trusts protect assets and as such the name "asset protection trust" is misleading, not all trusts are created for the primary purpose of protecting assets.

[3] Foreign Situs Asset Protection Trust
A foreign situs asset protection trust is an APT established in a country other than the settlor's home country. For settlors of such trusts who are U.S. citizens or residents for United States tax purposes, this type of trust is almost always designed to be tax neutral for United States income and gift and estate purposes, and is frequently domiciled in an OFC having protective trust legislation.

[4] Domestic (U.S.) vs. Foreign Situs Asset Protection Trusts
While an asset protection trust can certainly be settled using the law of one of the 50 states as the applicable law, foreign situs trusts are more often than not the preferred vehicle. There are a number of reasons for this.

[a] Increased Ability of Settlor to Retain Benefit and Control
The trust laws of some foreign jurisdictions allow the settlor to retain a greater degree of benefit and control while still having the assets protected. Domestic trust law will generally restrict the nature and extent of benefit and/or control that a settlor can retain through a trust. Domestic law generally provides that if a settlor does not place property out of the settlor's own reach, the trust assets will not be placed out of the reach of a creditor, whether present, subsequent or future potential. Thus, a domestic trust that is settled at a time when there are absolutely no fraudulent conveyance issues may still be successfully attacked, even years after settlement, if the settlor has retained either benefit or control.

By comparison, the level of both benefit and control over a foreign trust governed by the trust laws of certain foreign jurisdictions will represent a significant enhancement over the rights and powers that may safely be retained by grantors of domestic trusts.
One of the primary benefits of a foreign situs asset protection trust includes giving greater effect to favorable and flexible spendthrift provisions as to the settlor of the trust. In other words, the "self-settled spendthrift trust" receives greater recognition under the trust law of a number of offshore jurisdictions.

[b] Foreign Trust Less Likely to be an Automatic Target in Litigation Against Settlor
A foreign trust is less likely than a domestic trust to be an automatic target in litigation against the settlor. A domestic trust may be as much a target for litigation as its settlor, particularly if the trust holds assets of substantial value. A plaintiff's lawyer need not be particularly creative in order to craft a legal theory of liability against a domestic trust when the principal claim is against the settlor. Due to jurisdictional and other considerations, such as whether the judgments and orders of the domestic court will be recognized by the foreign court, a foreign trust will not be such an "automatic" defendant.

[c] Foreign Element Will Impact A Creditor's Decision In Pursuing Assets
One of the advantages of foreign trusts over domestic trusts in the asset protection planning arena is that the foreign element will impact a creditor's decision as to how far the creditor is willing to go in the course of pursuing trust assets. Whether one considers the psychological barrier of dealing with foreigners and foreign systems, the cost of pursuing litigation overseas (particularly if the matter must be litigated anew in the foreign jurisdiction in the absence of comity), the added uncertainty of prevailing, or the increased time factor that results, the practical hurdles obtained simply through the use of foreign entities can prove to be formidable barriers. Some of these hurdles include the following:

[i] Burden of proof
Under domestic law, the burden of proof regarding fraudulent intent rests with the plaintiff. However, it shifts to the defendant under certain circumstances (e.g., if the transferee is related to the defendant). A creditor will have to check to see whether the APT-style legislation of a particular foreign jurisdiction requires that the plaintiff under all circumstances carry the burden of proof in this regard. It is entirely possible that a foreign jurisdiction's burden of proof will discourage a creditor from instituting litigation.

[ii] Standard of proof
Assuming the applicable law requires the plaintiff to carry the burden of proof in establishing fraudulent intent on the part of the transferor/defendant, the creditor must next inquire as to whether the applicable standard is: (1) the lesser standard of "by a preponderance of the evidence;" (2) the more difficult standard of "clear and convincing evidence;" or (3) the most difficult standard of "beyond a reasonable doubt." If a creditor does not have a strong case or is unable to satisfy the applicable standard of proof, then the creditor may be discouraged from instituting litigation in a foreign jurisdiction.

[iii] Statute of limitations
Under the fraudulent transfer law of some states, the statute of limitations on challenging transfers as fraudulent can be unlimited. A foreign jurisdiction may provide a period of time after which transfers to an APT cannot be assailed. In the interest of comfort and certainty, a foreign jurisdiction will ideally, through its law, provide for a period that is more short than it is long. Given that one's solvency can be challenged, particularly when contingent or speculative liabilities are involved, the question remains as to how long a period of time must pass before an opponent is barred from challenging the transferor's solvency. It is very likely that the foreign jurisdiction's statute of limitations will have already expired by the time the creditor seeks to enforce a claim.

[iv] Costs and fees
A creditor can expect to incur an exorbitant amount of costs and fees in litigating a claim within a foreign jurisdiction. Costs and fees will include additional items such as travel expenses to and from the foreign jurisdiction, lodging expenses for an unknown amount of time in an unfamiliar setting and loss of potential income by being obligated to stay for the duration of the litigation within a foreign jurisdiction. In most instances, a creditor may decide that the high amount of costs and fees, coupled with the unknown element involved with a foreign legal system is not worth pursuing.

[v] Foreign court may not be able to award punitive or treble damages
If a creditor successfully attacks a trust in a U.S. court, punitive and/or treble damages may be an allowable remedy. However, in foreign jurisdictions, remedies such as punitive and/or treble damages may not be provided for pursuant to the foreign jurisdiction's laws.

[vi] Discovery and interim remedies may not be as broad
The discovery process and the obtaining of certain interim remedies within the United States is very broad. Parties are entitled to receive and inspect all unprivileged documentation possessed by the other side. Also, the American legal system allows for remedies such as injunctions when necessary in order to preserve one's rights. There are no guarantees that these processes are similar in foreign jurisdictions. Therefore, the potential uncertainty of the outcome of processes such as discovery and interim remedies may create more obstacles to a creditor than he or she is willing to endure.

[d] Foreign element ultimately more protective
The trust law of some foreign jurisdictions is simply more protective than domestic trust law. In fact, the past few years have witnessed a number of OFCs passing legislation designed to lend clarity to many APT issues, thus providing a substantial degree of certainty to a rapidly developing planning area. The leader in clarifying legislation is the Cook Islands, an OFC located in the South Pacific.

[e] No "full faith and credit" issues
In the event that a legal claim is successfully pursued in a state that has not passed a domestic asset protection statute, a domestic trust may provide little asset protection, particularly if the state that has passed asset protection legislation is nevertheless obligated under the Full Faith and Credit clause of the U.S. Constitution to enforce a judgment of another state against a trust. Foreign jurisdictions may not recognize full faith and credit issues in the same manner as a United States court.

[f] No "supremacy clause" issues
What if a judgment creditor decides to petition for the involuntary bankruptcy of a client? The bankruptcy court is a federal, not a state, court. Under the supremacy clause of the U.S. Constitution, federal law preempts state law. Therefore, the question may become whether a bankruptcy court will apply federal law (or the law of some other state) in determining the validity of a self-settled spendthrift clause in a domestic asset protection trust? In a situation where a foreign trust has been settled, supremacy clause issues will typically not arise because the trust is beyond the jurisdiction of United States law.


[1] Integrated Estate Planning Explained
Estate planning for individuals encompasses a number of planning goals. These goals include protecting the estate from any number of threats that can arise over the course of time to dissipate wealth (e.g., taxes, probate, family disputes and other forms of litigation). Some estate planning goals focus on what can happen at or following death. Others focus on what can happen during one's lifetime (e.g., the goal of protecting estate assets when it matters most to the typical client; i.e., during the client's lifetime). Death time planning goals have historically received a disproportionate share of the planning focus. Through integrated estate planning, the lifetime planning component and the deathtime planning component are married into one overall, balanced planning process. As used hereinbelow, "IEP" refers to either "integrated estate plan" or "integrated estate planning," as the context may indicate, and "IEPT" refers to an Integrated Estate Planning Trust.

The estate planning component of an overall integrated estate plan focuses heavily on what happens upon a client's death, and takes into account estate and gift tax planning. This component can incorporate lifetime gift-giving arrangements, marital deduction and unified credit tax planning, charitable giving and charitable trusts, and other gift and estate planning vehicles.
The asset protection component of an integrated estate plan focuses primarily on protecting a family's assets from unforeseen creditor threats and liabilities, and recognizes that the best estate plan will be of little value to an estate that itself becomes of little value. The foreign situs IEPT will employ the laws of a foreign jurisdiction for lifetime asset protection purposes, and incorporate traditional estate planning concepts for purposes of the family's gift and estate tax planning. The uses and purposes and intended goals of an IEPT are thus broader than the narrow asset protection goal of an asset protection trust.

[2] Benefits of using an IEPT
The benefits of using an IEPT also include: 1) avoiding probate; 2) a higher level of confidentiality and privacy; 3) creation of a vehicle suitable for global inverting; 4) simplicity in the transferring of assets; 5) avoiding the potential of monetary exchange controls; 6) the creation of a substitute for a will; 7) facilitating handling the affairs of the individual in the event of disability or unavailability; 9) increased levels of flexibility; and 10) the concept of the trust's "protector" may be better established under the foreign nation's laws.

[3] Efficacy
Whether one is talking about an APT or an IEPT, the question arises, "Do they work?"

It must first be acknowledged that the word "work" is defined by reference to where a particular asset protection planning client would have landed had he not earlier engaged in asset protection planning. As has been this author's view for over a decade, the ultimate goal of asset protection planning is realized if the client weathers a legal storm at least moderately better than he otherwise would have in the absence of any planning.
The many variables that exist under any given plan prevent one, in all fairness, from making blanket statements like "APTs work" or "APTs do not work." The many variables applicable to an APT and an IEPT include: 1) the facts peculiar to a given client's situation; 2) the client's goals; 3) the manner and extent to which the client's goals are or can be incorporated into the design of the trust; 4) the skill with which the trust was crafted; 5) the nature of the asset or assets transferred to the trust; 6) the skill with which the trust is attacked; 7) the skill with which the trust is defended; 8) the thoroughness and protectiveness of the trust's applicable law; 9) whether the opposing party is a governmental agency; 10) whether any criminal sanctions would result from the trustees (or others involved) exercising certain options they would otherwise be free to exercise if the litigants were all private parties; 11) the law of the forum court; and 12) any biases or the bent of the presiding judge.
One cannot-and should not-be so black and white as to say "this planning technique works" or "that planning technique does not work." It is not that easy or that basic. In fact, the author has seen dummy real estate liens and fraudulent transfers "work" (which by the way are not techniques advised by the author), and proper family limited partnerships not "work" in the asset protection context.


[1] Irrevocable Life Insurance Trusts in General
Irrevocable Life Insurance Trusts ("ILITs") are often recommended as an estate planning tool for individuals who have more than just a modest estate. Insurance proceeds that are paid to an ILIT can avoid all estate taxes. The ILIT's assets pass to the designated beneficiaries free from U.S. gift and estate taxation. The insurance proceeds are available for use to pay other taxes and to support surviving family members. As a result, ILITs are an excellent means to leverage tax credits and exemptions under the U.S. federal estate and gift tax regime.

[2] The Foreign Irrevocable Life Insurance Trust
For an enhanced level of asset protection, one may desire to set up a foreign irrevocable life insurance trust ("FILIT"). FILITs differ from ILITs in that a FILIT is set up under the laws of a foreign jurisdiction. In addition, in order for a creditor to initiate litigation against the FILIT or its assets, a claim often will need to be filed in the country designated as the applicable law of the FILIT. The advantages of a FILIT include: 1) the ability to avoid the Rule against Perpetuities imposed by most states in the United States; 2) the ability to avoid the imposition of federal and state income taxes after the settlor's death; 3) the ability to avoid the exposure of the assets of the trust to the creditors of the settlor and/or beneficiaries; and 4) the ability to avoid the imposition of the generation-skipping transfer tax. Three additional advantages include: 1) increased investment options; 2) increased levels of privacy; and 3) avoidance of domestic state laws pertaining to property distribution or forced heirship.

[a] Avoiding The Rule Against Perpetuities
Certain foreign jurisdictions have not adopted the Rule against Perpetuities, as have, for example, the Cook Islands. Creating a FILIT under the laws of a foreign jurisdiction that has abolished the Rule against Perpetuities allows the settlor to extend the life of the trust in perpetuity. This permits the settlor to mandate certain controls over the assets held in the trust for as long as the settlor deems necessary. Also, a trust that is established as an exempt trust for generation-skipping transfer tax purposes can exist in perpetuity for the benefit of the settlor's family without ever being subject to generation-skipping transfer taxes.

Certain states in the United States also have abolished the Rule against Perpetuities. Therefore, the FILIT may not offer any advantage over an ILIT established in these particular states (e.g. South Dakota, Wisconsin, and Delaware) at least with respect to the Rule against Perpetuities. Even here, however, FILITs arguably may still offer an advantage in that some of the other jurisdictions appear to have less volatility in their law making. In other words, they may be less likely to revert to the Rule against Perpetuities.

[b] Imposition of Federal and State Income Taxes
A FILIT avoids paying U.S. income taxes on all its foreign source income. However, all other income is taxed to the trust in the same manner as a domestic trust. Therefore, a FILIT could avoid paying any U.S. income taxes by investing all its assets into foreign investments. The U.S. settlor could also avoid paying U.S. income taxes on the foreign income of the FILIT if the settlor were able to bypass all the grantor trust rules. This may be a difficult task, however, since a FILIT most typically purchases or maintains life insurance on the settlor's life (thereby becoming a grantor trust under Section 677(a)(3) of the Internal Revenue Code of 1986, as amended (the "Code")) or has U.S. beneficiaries (thereby being a foreign trust that is treated as a grantor trust under Section 679 of the Code). A "foreign trust," for purposes of Code Section 679 and other U.S. income tax laws, means any trust, unless: "(i) a court within the United States is able to exercise primary supervision over the administration of the trust, and (ii) one or more United States fiduciaries have the authority to control all substantial decisions of the trust."2

If a client settles a FILIT, and designates beneficiaries who are U.S. citizens or residents, then upon the client's death, these beneficiaries will be subject to U.S. income taxes on any distributions received by those beneficiaries (or any distributions that are required to be distributed to those beneficiaries during such year) to the extent of the distributable net income ("DNI") of the FILIT. This aspect of the FILIT, therefore, offers no advantage to the U.S. beneficiaries over a domestic ILIT. On the other hand, if the beneficiaries were non-resident aliens, and the DNI were solely comprised of foreign source income, then the beneficiaries would not be subject to U.S. income taxes.

[c] Exposure of Assets to Creditors of Beneficiaries
The FILIT offers advantages over the ILIT in that no state offers the same protection against creditors that can be found in certain foreign jurisdictions when it comes to accusations of fraudulent transfers or certain other methods available to creditors to gain access to the client's trust assets. U.S. laws can be more liberal with respect to creditor rights. It is not uncommon to find foreign jurisdictions that allow the settlor to retain certain veto powers over the trustee without losing the asset protection features of the trust. Self-settled trusts do not receive the same treatment in most states in the United States. On the other hand, domestic irrevocable trusts, such as the ILIT, created for other family members, will receive more asset protection. This assumes that the trust, such as the ILIT, is set up so that the settlor retains no strings to the assets contributed to the trust and the settlor has no beneficial interest in the trust, which is typically the case with an ILIT. Therefore, the FILIT may not provide sufficient additional protection to warrant setting up the FILIT as opposed to an ILIT. However, the FILIT should be considered if the following aspects of foreign trusts appeal to the client.

Fraudulent conveyance claims can be difficult to defend against under United States law. Certain foreign jurisdictions have more restrictive and definite fraudulent transfer laws as compared to the United States. For example, the Cook Islands has a two-year statute of limitations as to when a fraudulent conveyance action can be brought.3 Cook Islands law also requires a showing of fraudulent intent "beyond a reasonable doubt" before the creditor can be granted any relief.4 Further, once fraudulent intent is proven, Cook Islands law requires only that an amount sufficient to satisfy that particular creditor's claim be set aside.5 Each creditor must also separately prove his respective individual claim that there was a fraudulent intent in making the transfer (regardless of whether a different creditor previously proved a transfer of the debtor to be fraudulent). Finally, Cook Islands law does not presume fraud simply based on the settlor preserving certain rights in the trust.6 Therefore, in these respects, the FILIT may offer great advantages over the ILIT.

In a creditor's pursuit of a FILIT's assets, the creditor has additional hurdles to clear, such as hiring foreign counsel to establish a case in the foreign jurisdiction de novo of any U.S. lawsuit. The creditor would need to establish that the foreign court or tribunal has sufficient jurisdiction over the matter. The creditor may also need to demonstrate that a violation of foreign laws has taken place.

[d] Imposition of the Generation-Skipping Transfer Tax
Nothing in the Code or Treasury Regulations allows a U.S. person to avoid the generation-skipping transfer tax ("GSTT") in transferring assets for less than full consideration to a foreign trust. The U.S. person is still deemed as the "transferor" and the U.S. person's grandchildren are still considered to be the "skip persons."

A FILIT may be structured in such a way that funding the FILIT would not require the application of the GSTT exemption to a portion of the assets funding the FILIT and would not be subject to the GSTT. This is accomplished by having the settlor contribute some assets (and allocating GSTT exemption amounts to them) and then selling some assets to the FILIT in exchange for an installment note or an annuity of equal fair market value. The portion of assets sold to the FILIT will not require the allocation of any GSTT exemption amount to be exempt from the GSTT. The contributed assets would facilitate the repayment of the installment note or annuity. However, this part sale/part contribution of assets results in the FILIT eventually holding less funds because the FILIT's obligation to repay the settlor has the effect of removing GSTT exempt funds from the FILIT and placing them back into the settlor's estate. Therefore, in that sense, it is better for GSTT purposes to contribute funds to the FILIT with the adequate GSTT exemption amounts being allocated to those contributions, as opposed to selling assets to the FILIT.

[e] Increased investment options
FILITs allow a settlor to build a more dynamic investment portfolio due to the fact that U.S. securities laws are inapplicable towards a FILIT. Both the Securities Act of 1933 and the Securities Exchange Act of 1934 govern U.S. securities. The three basic purposes of these statutes are: 1) to require the disclosure of meaningful information about a security and its issuer so as to allow investors to make intelligent investment decisions; 2) to establish liability for those who make inadequate and erroneous disclosures of information; and 3) to require the registration of issuers, insiders, professional sellers of securities, securities exchanges, and other self-regulatory securities organizations. Due to the applicable law in a foreign jurisdiction, settlors of FILITs can avoid restrictive U.S. securities laws. FILITs therefore allow for a much larger selection of what would normally be unavailable foreign securities. As a result, the FILIT has a good chance to dramatically increase its overall portfolio by investing in unregulated non-U.S. securities.

[f] Increased level of privacy
A FILIT's settlor will receive an increased level of privacy as opposed to the settlor of an ILIT due to the fact that a FILIT is outside the jurisdiction of the United States legal system. One should be aware that despite its foreign jurisdiction, some Internal Revenue Service compliance requirements exist that must be satisfied by the FILIT or its settlor. Among these requirements include the filing of an IRS 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) under certain circumstances.7 Additionally, penalties may be assessed under certain circumstances if the requisite information pertaining to a FILIT is not provided to the Internal Revenue Service.8 Therefore, although the trust itself is outside the jurisdiction of the U.S. legal system, one should be aware that a FILIT will not be completely invisible to the IRS, despite the fact that the trust is governed by a foreign jurisdiction.

[g] Avoidance of domestic state laws pertaining to property distribution
Should the unfortunate situation arise where a family member of the settlor decides to institute legal proceedings against the FILIT, a court is more likely to rule that the foreign jurisdiction's laws apply as opposed to the family member's home state. This will force the family member to file a claim in the foreign jurisdiction in order to have a chance to break the FILIT. Settling one's FILIT in a foreign jurisdiction serves as a partial deterrent (dependent upon how much effort the relative is willing to put into challenging the trust) as it will create numerous additional expenses of retaining local counsel in the FILIT's home jurisdiction, travel costs to and from the litigation, and so on, and so forth.


[1] Planning Strategy Under Prior U.S. Tax Law
A pre-immigration trust (sometimes referred to as a "drop-off" trust) is simply a non-U.S. trust created by a non-resident alien individual who later becomes a U.S. person for U.S. tax purposes. Under prior U.S. laws, these trusts were excellent vehicles to avoid U.S. income taxes. This strategy called for the trust as a non-U.S. person to earn only non-U.S. source income, hence escaping any U.S. tax obligations. This type of trust also avoided the foreign grantor trust rule under Internal Revenue Code Section 679 because the trust was settled prior to the settlor becoming a U.S. person for U.S. tax purposes.

[2] Current U.S. Tax Law
In 1996 Congress passed the Small Business Job Protection Act. Under this Act, and with respect to transfers made after February 6, 1995, if a non-U.S. person becomes a U.S. person within five years after creating the foreign trust, then such person will be considered to have transferred the assets to the trust as of the date that person became a U.S. resident. This scenario results in the application of Code Section 679 and the grantor being subject to U.S. income taxes on the trust's income. This also triggers the filing requirements under Code Section 6048 with regard to the reporting of certain information in connection with these trusts. If Code Section 679 applies, then the trust is a grantor trust to the extent the grantor contributed funds to the trust. The amount that the grantor is considered to have contributed to the trust is the amount actually transferred by that person to the trust, plus any accumulated income that had not been distributed between the time the trust was created and the time that the person became a U.S. person.

[3] Current Planning Strategy
By avoiding being subject to the five-year rule, the grantor of the trust can avoid being taxed on the income generated by that trust, even after that settlor becomes a U.S. person. This provides a vehicle to avoid the payment of U.S. income taxes on the trust income. It should be noted, however, that if the non-U.S. person creates the trust at a time when he or she holds certain powers under other grantor trust rules (Code Sections 671 through 677) then this would cause the trust to be considered a grantor trust, and thereafter if that person relinquishes those powers (or if those powers are removed by trust amendment or otherwise), then the five-year waiting period will begin at this later date, not the date the trust was created.

Planning-wise, another way to avoid having Code Section 679 apply is to design the trust to avoid having any U.S. beneficiaries. Not only must the trust not have U.S. beneficiaries, but also the trust should be specifically prohibited from ever having any U.S. beneficiaries in the future. The mere fact that no distributions have been made to a U.S. person is not in itself sufficient to avoid Code Section 679.

[4] Examples
One example of this type of trust is set forth in Treasury Regulations Section
Example 1:

[a] On January 1, 2002, A, a nonresident alien individual, transfers property to a foreign trust. On January 1, 2006, A becomes a U.S. resident. A's residency starting date is January 1, 2006. A is treated as a U.S. transferor of the foreign trust, and is deemed to have transferred to the foreign trust on January 1, 2006 the amount of the original transfer, plus the undistributed net income of the trust attributable to the property originally transferred. A second example is set forth in the Treasury Regulations Section 1.679-5(c),

Example 2:

[b] On January 1, 2002, A, a nonresident alien individual, transfers property to a foreign trust, reserving the power to revoke the trust and revest the trust funds absolutely in A. A is treated as the owner of the trust under § 676. On January 1, 2008, A amends the trust to delete the reserved power to revoke the trust and revest the trust assets in A. A then ceases to be treated as the owner of the trust. On January 1, 2010, A becomes a resident of the United States. A is treated as having originally transferred the property to the foreign trust on January 1, 2008, and because this date is within five years of A's residency starting date, A is deemed to have made a transfer to the foreign trust on January 1, 2010, A's residency starting date. A is deemed to have transferred to the foreign trust on January 1, 2010, the property A actually transferred to the trust, and the undistributed net income of the trust attributable to the property deemed transferred.


There often arise situations where the use of multiple foreign trusts, or multiple entities to underlie one or more foreign trusts, may be advantageous from an integrated estate planning point of view.

[1] Multiple Partnerships and/or Limited Liability Companies
The primary integrated estate planning reason that clients create one of more limited partnerships ("LPs") or limited liability companies ("LLCs"), or a combination thereof, is to segregate "hot assets" from "cold assets."

[a] Hot Assets
"Hot assets" include assets that potentially create liability for their owner. Hot assets include commercial or residential real property, automobiles, boats, planes and general partner interests. For example, the owner of a commercial office building or apartment building could be sued by a tenant who trips and falls in the building. The owner of a general partner interest in a partnership could be sued for partnership liabilities, which could occur if the partnership engages in some type of business as opposed to simply owning investment assets. The owner of an automobile could be sued if the automobile were involved in an accident, and so on.

[b] Cold Assets
"Cold assets" are assets that do not generally create liability for their owner. Cold assets include brokerage accounts, cash, stocks and bonds, interests as a limited partner, and LLC interests. That is, few people will be sued because someone tripped and fell over a certificate of stock. Owners of limited partner interests, limited liability company interests and corporate stock should be protected from personal liability because a primary reason for each such entity is to protect the entity's owners from personal liability for the entity's debts and liabilities. That said, these interests can be said to be cold assets as well, except to the extent there is a risk that the entity's veil might be pierced.

[c] Protective Walls
By creating and funding separate entities, an IEPT client can not only protect the assets' equity from the client and what may befall him, but the assets can also be protected from each other. For example, assume that an IEPT structure has been created, the client has transferred securities and cash to the underlying LP, and the client now wants to transfer his ownership of a small apartment building to the LP. If a building tenant trips and injures herself, the owner will of course be sued. This means that if the LP is the owner, it will be sued and its other assets (the cash and securities) will be exposed; hence, the wisdom of creating a separate entity to underlie the IEPT (in this case, an LLC) to take ownership of the apartment building. In this manner, the IEPT acts very much as a holding company with multiple "subsidiaries."

There may be multiple LLCs underlying the IEPT, each owning one or more real properties or other hot assets. The number of such entities to be created should be the result of balancing cost and administration with the protection and other benefits achieved.
There can also be variations to this concept. For instance, an LLC could be owned by the LP or by another LLC instead of directly by the trust. Or, one could create an underlying, first-tier LLC (owned 99% by the IEPT) that in turn itself owns the 99% interest in another, second-tier LLC. The second-tier LLC could own hot assets. In this situation, the first-tier LLC acts as a further buffer between the LLC owning the hot assets and the IEPT, guarding against a piercing of the veil of the second-tier LLC. In these planning structures, there will still be a fair amount of flexibility if there is a planning reason for assets to later be moved from one entity to another. For instance, if in the above example the apartment building is generating income over and above its operating needs, and if there is a desire to further protect that excess income and/or otherwise invest it via the LP, a distribution can be made from the LLC to the trust, and the trust can contribute the funds to the LP. This transaction should be appropriately documented, of course, for purposes of each entity's records.

[2] Multiple Trusts
Situations exist where creating multiple trusts may make sense for a particular client. Some of the reasons for this are explained in more detail below, and include creating trusts with different terms and provisions; locating the trusts in different jurisdictions for additional asset protection; segregating into one of several trusts those risks that are associated with certain hot assets; and increasing planning options in the event a threat arises against the trust and its assets.

One approach is for the client to settle one or more additional trusts. Of course, if properly empowered and authorized, the IEPT itself may settle further trusts.
In either situation, care should be taken so that if any assets are to be transferred from one trust to the other, then no such transfer is a completed gift for gift tax purposes, if and to the extent this is not desired. Each trust should provide for certain limited powers in the hands of the client under Treasury Regulations Sections 25.2511-2(b) and (c) so that the transfers are not considered complete, and therefore subject to gift tax. Also, if the trustees of the first trust create the second trust, care should be taken that the perpetuities period of the second trust does not extend beyond the perpetuities period applicable to the first trust.
Further trusts may of course be created in connection with the estate planning component of the overall IEP, such as children's trusts, ILITs, charitable remainder trusts ("CRTs"), grantor retained annuity trusts ("GRATs") and grantor retained unitrusts ("GRUTs"). Instead of the client creating and funding these trusts himself, the trustees can generally do this. In this way, protected funds can be used to create a CRT, GRAT, ILIT, or other completed gift trust. This would avoid having to distribute any assets to the client before creating the second trust, which could then subject them to any creditor threat that might arise during that period or any applicable statute of limitations period that would follow a new transfer by the client.
A client may also want the additional protection afforded by having trusts created in more than one jurisdiction. Consider the dilemma for a client's future potential creditor if that creditor is faced not only with an IEP structure, but one in which one trust has been created in, say, Nevis, and funded with certain assets, and another trust has been created in the Cook Islands and funded with other assets. If the battle does in fact progress to the courts of an offshore jurisdiction, the creditor is now faced with having to move against assets under the control of different trustees, under different laws, hire counsel in two separate locations, and to prove his case, more than likely de novo, in two separate jurisdictions. The assets themselves may not even be located in either of these jurisdictions.
Multiple trusts can be usefully employed to further segregate risks associated with hot assets. If a trust owns an asset that itself carries any potential liability, creating a separate trust can create a wall between the potential liability associated with that asset and other assets. Also, if the veil of an underlying entity is pierced, the risk would be isolated to the assets of that separate trust.
The trusts may have different terms and provisions. The trusts can have different trustees, different protectors, different applicable laws, different beneficiaries, and even different estate planning dispositive provisions. The settlor might be a beneficiary of one trust but not of the other. There is great flexibility in this regard.


[1] IDITs in General
An IDIT is an irrevocable trust that is also considered a "grantor trust" for income tax purposes pursuant to Code Sections 671-679. It is "defective" only in the sense that it has not been drafted to avoid being categorized as a grantor trust. Since it is a grantor trust, the grantors or settlors of the trust will be responsible for paying any income tax on the taxable income generated by the IDIT's assets. By paying the income tax, the grantor is in effect making additional transfers to the IDITs that are free of the gift tax. This further reduces the grantor's taxable estate. At the same time, this increases the value of the IDIT, because it grows free of any tax burden.

[2] Income Taxation of a Grantor Trust
Under the grantor trust rules, the grantor typically pays the income tax on the income of the trust. In years past, practitioners often went to great lengths to avoid grantor trust status. However, there are many planning reasons for drafting an irrevocable trust so that it is classified as a grantor trust for income tax purposes. Hence, the term "intentionally defective grantor trust."

One potential disadvantage with an IDIT is that the grantor's marginal income tax rate will likely be higher than the beneficiaries' tax rates. Therefore, in years when substantial trust distributions are made to beneficiaries, a higher combined income tax may be incurred than if the trust and its beneficiaries were taxable under a non-grantor trust arrangement. However, this possible increase in income tax is generally outweighed by the estate tax savings that result from the grantor paying the income tax attributable to the IDIT's assets.
The grantor trust classification only determines who pays the income tax on the assets owned by the irrevocable trust. It does not alter any of the estate or gift tax rules.

[3] How an IDIT Reduces the Taxable Estate
An IDIT reduces one's taxable estate in the following manner. The grantor reports the IDIT's income. The grantor pays income tax on such amount, and therefore, the assets in the IDIT grow free of the income tax burden. The grantor's estate is reduced by the amount of income tax paid. In essence, the payment of the IDIT's income tax by the grantor can be considered as an additional gift by the grantor to the IDIT, free of any transfer tax implications.

[4] Potential Gift Tax Consequences of Paying the Trust's Tax?
Might there be some gift tax consequences to the grantor paying the trust's taxes? If the income tax paid by the grantor is in substance an additional indirect transfer to the trust or possibly a gift, is it subject to the gift tax? This question will next be analyzed from the position of both the IRS and the practitioner.

Originally, the Internal Revenue Service (the "Service") took the position that income tax paid by the grantor on the IDIT's earnings was a taxable gift by the grantor if the IDIT that was otherwise obligated to pay such tax had no requirement to reimburse the grantor for his tax payment.9 But the Service did not cite any authority for its position. Further, the trusts created under these PLRs required the trustees to pay the grantor's income tax. This was important in that the grantor paid an obligation that was otherwise required to be paid by the trustee. As a result, the Service deemed the payment as a contribution by the grantor to the trust, followed by the trustee's payment of the tax.
Almost all practitioners have taken the opposite view, because there is no donative intent or a voluntary transfer to the trust when, under the Code, a grantor has no choice but to pay the tax of another under the grantor trust fiction. For gift tax purposes, a gift requires a gratuitous voluntary transfer. A tax, even if paid by the donor, is a forced extraction from the government. The discharge of a liability when someone is personally responsible is not a gift.10 A change in position appears to have been made by the IRS. PLR 9543049 amended PLR 9444033, eliminating the gift tax issue but not stating why the Service did so.

[5] Common Methods to Create an Intentionally Defective Grantor Trust
There are two common methods to create an IDIT. The first is the power to substitute assets of equivalent value. If the grantor has the power to reacquire trust property by substituting property of equivalent value, the trust will be classified as a grantor trust for tax purposes and all income of the trust will be taxable to the grantor.11 The second method includes the power to lend to the grantor without adequate interest or security. If either the grantor or a non-adverse party has a specific power to make a loan to the grantor without adequate interest or without adequate security, the grantor will be treated as the owner of the entire trust.12

[6] Ability to Toggle Off Grantor Trust Tax Classification
A planning issue to be addressed is how grantor trust status can be changed to non-grantor trust status, if and when desired. An issue to be discussed in this regard is the circumstance of the client not having income or assets with which to pay the phantom tax liability. For example, assume a client created a grantor trust and funded it with $1,000,000 when he was 55 years old. The client lived well past his life expectancy and he is now 85 years old. After 30 years, based on an 8% return on investment and no distributions, the net worth of the IDIT is now $9.3 million. Assume that the client has now gifted away most of his assets. If, in that year, the income of the trust is 10% of its value, or $930,000, the client may well not have the funds to pay the $186,000 in income tax. Certain planning techniques have been employed to terminate the trust's classification as a grantor trust, thus relieving the grantor of any further income tax liability.

One power that could be granted is known as a "specific release power." The aforementioned power of the grantor to substitute property of equivalent value for trust property (which was used to achieve grantor trust status) could be modified by additional language stating: "The grantor may release this power at anytime by providing written notice to the trustees." Another power that may be included is known as a "general release of power." Many times a trust will have a general provision that allows any person to release a power.
A grantor trust may also have what is known as a "toggle switch." What if the grantor renounces a power (so that the trust ends its grantor trust status), but later decides that it would be advantageous if the trust were once again taxable as a grantor trust? Could the trustees, for example, be given a power in the trust document to reinstate a previously renounced power, so that the trust would once again become a grantor trust? That is, would it be advisable or permissible to provide the trustees with such broad powers as to make the grantor trust classification similar to a toggle switch: one minute it is on, the next minute it is off.
Currently, this is a relatively new idea and little has been written on the subject. In fact, most of what is available is on estate planning news groups through the internet. Some of these practitioners believe that such broad powers would risk pulling the trust assets back into the grantor's estate, due to (for instance) his indirect power over trust assets through the collusion or agency of the trustee.
There may be a safer alternative. Given that the trustees can be given the power to change the applicable law of the trust, the planner should consider a design whereby a trust's domestic, non-grantor trust status can be changed to grantor trust status via a change in applicable law to that of a foreign country.
In general, the grantor trust rules were enacted to tax a grantor on the income of a trust where it appeared that the grantor or his spouse had retained certain interests in the assets, or where the grantor or a non-adverse party had too broad of control over beneficial interests in the trust. However, Code Section 679 is an exception to this rule. Under this section, the grantor is treated as the owner of a trust merely because he makes a transfer to a "foreign trust" that has a U.S. beneficiary.
The following three requirements need to be met for a foreign trust to be classified as a grantor trust under Code Section 679: 1) A U.S. person; 2) transfers property to a foreign trust; and 3) there is a U.S. beneficiary.
Therefore, toggling the grantor trust status by the use of changing the applicable law to a foreign jurisdiction is a viable option. As necessary, the trust can be "re-domesticated to the U.S." to once again make it a non-grantor trust.


Under Code Section 679, during the lifetime of the grantor of a foreign trust, the grantor will be subject to a tax on the trust's income if: a) a U.S. person; b) transfers property to a foreign trust; and c) the trust has one or more U.S. beneficiaries. At the death of the grantor, however, these rules will no longer apply. It will no longer be a grantor trust. If the trust at that time is or becomes a "foreign trust" for tax purposes, it can avoid U.S. taxation of its income, even though it has U.S. beneficiaries. This can be achieved by having its assets invested primarily in investments that do not generate U.S. source income or income effectively connected with a U.S. trade or business.

[1] Advantages of Using a Non-Grantor Trust That Is Foreign for U.S. Tax Purposes
There are number of advantages to using a non-grantor trust that is foreign for U.S. tax purposes. First, the trustees will be able to administer the trust so that its income will not be subject to U.S. taxation in the year the income is earned. To accomplish this goal, investments will generally be made outside of the U.S., preferably in jurisdictions with low or no income taxation. However, if the trust owns any shares of a controlled foreign corporation, a foreign personal holding company, or a passive foreign investment company, the beneficiaries may be subject to tax even if no distributions are made.

Next, because income accumulated in the trust will avoid U.S. taxation until actually distributed to a beneficiary, the value of the trust's assets will compound at a faster rate. Therefore, the trust estate will grow larger more quickly.
Another advantage is that if the trustees retain the trust income for an extended number of years, allowing the trust's value to grow at a faster pace, the income generated from those assets can grow to substantially larger amounts than would have otherwise been the case.
A fourth advantage is that if the trustees then begin making distributions to beneficiaries in later years, they can shelter all or a portion of such distributions from any interest charges that might otherwise apply for federal tax purposes. Distributions that do not exceed trust income in the year of distribution are not subject to the interest charge. For example, if trust income is accumulated for the first 20 years and distributions begin in year 21, the foreign trust's assets may have grown to a substantial amount compared to the domestic trust's assets. Therefore, its annual income may also be substantially higher. In that case, sizeable distributions can be made that are not subject to the interest charges because they do not exceed the trust's current year income.
Another advantage is that the trustees can purchase assets abroad for the use and benefit of the beneficiaries, such as artwork, a home, or a vacation residence. The beneficiaries, and younger-generation beneficiaries, would be able to use the foreign assets without such being considered a taxable distribution of the assets.
Finally, there is the mandatory distributions exception. If a foreign trust requires that distributions of a fixed amount of money (or of specific property) be made to a beneficiary as described in Code Section 663(a)(1), it may be possible to make such distributions without even subjecting the beneficiary to tax (and without subjecting the distribution to any interest charge).13 For example, if a trust required a distribution to a child of a fixed amount when the child attains the age of 25, and of another amount at the age of 30, it is possible that such distributions from a foreign trust could avoid U.S. taxation altogether. The distributions can be greater than the amount of the current year's income but still escape taxation under the "throwback rules," discussed below.

[2] Disadvantages of Using a Trust That Is Foreign for U.S. Tax Purposes
As may be expected, there are disadvantages of using a trust that is foreign for U.S. tax purposes. First, distributions of income that avoided taxation in earlier years, because they were allowed to accumulate in the trust, may be subject to a non-deductible, compounding interest charge (based on the floating federal rate on tax underpayments) when finally distributed to a beneficiary. This "throwback" rule applies to distributions in excess of the foreign trust's current trust accounting income.14 The result can be that the longer the income is accumulated, the higher the "effective" tax rate will be when it is finally distributed. Unless there is a very high rate of return, this can subject distributions of accumulated income (as opposed to current income) to after-tax results that are less advantageous to beneficiaries than they would have been under a domestic trust arrangement. The foreign trust might, however, be an effective vehicle, even in this situation, for riskier, but potentially higher-yield, investments. Please note the exception to the throwback rule mentioned above, however, for certain mandatory distributions.

Second, for foreign trusts that must terminate in whole or in part at some time (for example, due to an applicable rule against perpetuities or a beneficiary attaining a designated age) and that do not have any foreign beneficiaries to whom distributions might be made, the non-deductible, compounding interest charge must eventually come into play. A final disadvantage of using a trust that is foreign for U.S. tax purposes is that a distribution of accumulated capital gains from the foreign trust will not retain its character as capital gain. It will instead be treated as ordinary income.15


[1] Non-Grantor Trusts
Generally, a non-grantor trust is an irrevocable trust where there was a completed gift by the settlor when such trust was funded, the grantor is not a beneficiary of the trust, and the grantor did not retain "certain" miscellaneous powers over the trust (i.e., such as the power to borrow the corpus or income of the trust without adequate security or the power to substitute trust property with property of equal value). The technical definition of a non-grantor trust is any trust that is not a grantor trust.

Under subchapter J of the Code, the income of a non-grantor trust is taxed either to the trust, to the beneficiary, or part to the trust and part to the beneficiary. Generally, to the extent the income is accumulated by a non-grantor trust, it is taxed to the trust. To the extent the income is distributed to the beneficiary, the beneficiary instead of the non-grantor trust pays the tax on such income.

[2] Grantor Trusts-Code Sections 671-679
The standard "garden variety" living, loving, or revocable trust (all three in general being synonyms for the same type of trust) is a grantor trust. Also, generally an IEPT is intentionally designed to be tax neutral and is therefore a grantor trust.

With regard to the income taxation of a grantor trust, all taxable income and credits of the portion of the trust of which such person is deemed to be an owner is included in such persons income as if the trust did not exist.16 In the case of most grantor trusts as well as in the case of an IEPT, all the income, deductions, and credits of the trust will be taxable to the grantor.
The technical definition of a grantor trust includes when the settlor of a trust holds certain strings or powers over a trust, it will be classified for income tax purposes as a grantor trust. The following powers or strings result in a trust being classified as a grantor trust for income tax purposes: 1) reversionary interest;17 2) power to control beneficial enjoyment;18 3) power to deal for less than adequate and full consideration;19 4) power to borrow the corpus or income of the trust without adequate interest or security;20 5) borrowing of any portion of trust fund without adequate interest or security;21 6) power to direct voting of a corporation which is owned by the trust;22 7) power to control investment of the trust funds;23 8) power to substitute trust property with property of equal value;24 9) power held by the grantor, a non-adverse person, or both to revest trust property in the grantor;25 10) power held by grantor, non-adverse party, or both to distribute or accumulate for future distribution income of the trust to either the grantor or the grantor's spouse;26 11) person as other than a grantor treated as a substantial owner;27 and 12) foreign trusts having one or more U.S. beneficiaries.28

[3] Foreign Trusts
Why do we care whether a trust is classified as a foreign trust for tax purposes? First, in order for a corporation to qualify as an S corporation for tax purposes, no shareholder may be a non-resident alien.29 A non-resident alien means a foreign shareholder. Next, a foreign trust has substantially greater reporting requirements than a domestic trust. Third, under Code Section 684(a), except for a grantor trust, gain in the amount of the difference between the fair market value of the assets and their adjusted basis is recognized when property is transferred by a U.S. person to a foreign trust. Fourth, when a U.S. grantor (i.e., settlor) is a beneficiary of an offshore IEPT, it is always classified as a grantor trust under Code Section 673 and usually classified as a grantor trust under both Code Sections 676 and 677, as noted above.

Next, if a transferor does not report a contribution, or a beneficiary does not report a distribution from a foreign trust, under Code Section 6048, a 35% penalty computed on the fair market value of the property transferred is imposed. Finally, with regard to reporting requirements, a U.S. person that makes any payments to a foreign trust will be required to withhold a U.S. tax on the payment. There is a 30% withholding for certain U.S. source income that is not effectively connected with the conduct of a trade or business within the United States.30 There may also be a 10% withholding requirement if the foreign trust sells an interest in U.S. real property.31 Also, if a foreign trust owns an interest in a partnership, and the partnership has income that is effectively connected with the conduct of a U.S. trade or business, there will be withholding at the partnership level of the trust's allocable share of such income.32
The Small Business Job Protection Act of 1996 changed the definition of a "foreign trust" for federal tax purposes by creating a two factor "bright line" test. Under the bright line test, in order for a trust to be classified as a "domestic trust" for tax purposes, both the (1) court test and (2) the control test must be satisfied.33
Under the court test, a court within the United States must be able to exercise primary supervision over the administration of the trust.34 The primary supervision over the administration of the trust may be exercised concurrently by both a U.S. court and a foreign court.35 However, an automatic migration provision within the trust (i.e., an automatic flee clause) that states the trust would migrate from the U.S. if a U.S. court attempts to assert jurisdiction, would prevent a U.S. court from exercising primary supervision over the administration of the trust.36
Under the control test, one or more U.S. persons must have the authority to control all substantial decisions of the trust.37 U.S. persons are not considered to control all substantial decisions of the trust if there is an automatic migration provision that provides that "an attempt by any governmental agency or creditor to collect information from or assert a claim against the trust would cause one or more substantial decisions of the trust to no longer be controlled by United States persons."38

[4] Reporting Requirements for an IEPT

[a] Domestic Trusts For Tax Purposes
If an offshore IEPT is classified as a domestic trust for tax purposes by virtue of it complying with both prongs of the bright line test, it is required to file a Form 1041, U.S. Income Tax Return For Estates and Trusts. A trust that has its situs or any of its assets located outside the United States is required to file Form 1041.39 An offshore IEPT has as its situs a foreign jurisdiction. Therefore, irrespective of the fact that an offshore IEPT is classified as a domestic trust under Code Section 7701(a)(30)(E), the offshore IEPT must file a Form 1041.

[b] Foreign Trust For Tax Purposes
If an offshore IEPT is classified as a "foreign trust" for tax purposes, the filing requirements are much more burdensome. Both Forms 3520 and 3520-A are required to be filed annually.

Form 3520 is entitled "Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts." This form documents annual reports of transfers "to" and distributions "from" a foreign trust. All distributions to a U.S. beneficiary from a foreign trust to a beneficiary must be reported by the U.S. beneficiary on Form 3520. Unless properly extended, Form 3520 is due by April 15th or the extended due date of the taxpayer's income tax return. The penalty for failing to timely file such tax return is 35% of the fair market value of the assets transferred.
Form 3520-A is entitled "Annual Information Return of Foreign Trust with a U.S. Owner." This form is due on the 15th of March unless properly extended. The penalty for failing to properly file Form 3520-A is 5% of the trust fund.
To the extent the offshore IEPT has any U.S. beneficiaries, the trust must provide each U.S. beneficiary with a "beneficiary information statement." In simple terms, this is the beneficiaries share of all items of income and deduction of the trust.
An IEPT may appoint a U.S. agent for tax purposes. The designation of a domestic agent, in writing, for the trust is required. The agent must be available to accept service of process, give testimony concerning the trust, and allow for the examination of trust records for the purpose of determining the amount of tax due and owing.
Form 926 is entitled "Return By a U.S. Transferor of Property to a Foreign Corporation. All transfers to a foreign trust are required to be reported on Form 3520, and therefore, Form 926 is not required to be filed. Prior to the issuance of regulations under Code Section 684, some practitioners thought that gain might be imposed on the death of the U.S. grantor, because the foreign trust would no longer qualify under the Code Section 684(b) exception. However, the regulations under Code Section 684 specifically allow for a step up in basis under Code Section 1014.
There may be a requirement to file other tax forms. The first form to consider is Form 709, entitled "United States Gift (and Generation-Skipping Transfer) Tax Return." As noted above, a transfer to an IEPT is typically structured as an incomplete gift under Treasury Regulation § 25.2511-2(b). Because it is an incomplete gift, there is no gift tax due. However, irrespective of the fact that it is an incomplete gift, pursuant to Treasury Regulation § 25.6019-3, a gift tax return must be filed.
TD F 90-22.1 is the "Report of Foreign Bank and Financial Accounts." Any person or entity controlled by a U.S. person that has a foreign bank or brokerage account is required to file a Form TD F 90-22.1.
FSA-153 is a form consisting of a U.S. Department of Agriculture Foreign Investment Disclosure Act Report. Irrespective of whether the offshore IEPT is classified as a domestic or foreign trust for tax purposes, it must file this report if the offshore IEPT or the domestic partnership that is owned primarily by the offshore IEPT owns any agricultural property.
Other forms to consider include Form 1065, a U.S. Return of Partnership Income and Form 1120-F, U.S. Income Tax Return of a Foreign Corporation.
Form 5471 is entitled "Information Return of U.S. Persons With Respect to Certain Foreign Corporations." Generally, any person who owns a ten percent or more interest in a foreign corporation must file this return. Form 5472 is entitled "Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business." When a foreign person or entity owns twenty-five percent or more of a U.S. corporation, then Form 5472 must be filed.
Finally, a Foreign Partnership Information Return may be required to be filed. Specifically, Treasury Regulation 1.6038-3(a)(3) requires a Form 8865 to be filed by a ten percent or more owner of a foreign partnership.

[5] Estate And Gift Tax Consequences Of An Offshore IEPT

[a] Gift Tax: Incomplete Gift For Gift Tax Purposes
Gifts to most IEPTs are purposefully drafted to be incomplete gifts. Under Treasury Regulation § 25.2511-2(c), a gift is incomplete to the extent the donor is given the power to change the interests of beneficiaries. Therefore, the settlor of an IEPT is usually given the power to alter beneficiaries' interests in the trust.

[b] Estate Tax
Upon the settlor's death, all of the property owned by an IEPT will typically be included in the settlor's estate. Transfers with a retained life estate can be found within Code Section 2036. Under Code Section 2036(a), if the settlor retains the use, possession or enjoyment of, or the right to the income from, property that was transferred to the trust, the property is included in the settlor's estate.

Revocable transfers are governed by Code Section 2038. Any retained power to alter, amend, revoke, or terminate the trust results in the entire trust being included in the settlor's estate. A power to revoke includes the power of a settlor to remove a trustee (who has the power to revoke) and appoint himself as a trustee with the same power.40 Similarly, the Code Section 2038 regulations indicate that Code Section 2038 powers include the ability to alter the timing of enjoyment. In this case of a typical offshore IEPT, the settlor is also the protector of the structure.

[c] Continuation of Gift Tax
The gift tax including the annual exclusion ($11,000 per donee during 2003) and the rate structure of the Economic Growth and Tax Relief Reconciliation Act of 2001 will remain intact for the one year period of estate tax repeal (pursuant to the substantive provisions of the bill) and thereafter (pursuant to the sunset clause). However, effective for gifts made and estates of decedents dying after December 31, 2009, except as provided in regulations, all transfers to trusts other than certain "grantor" trusts will be treated as taxable gifts under Code Section 2503. Although the current gift tax rate structure is retained for 2010, the rate on transfers over the $1 million exemption in that year will effectively be a flat 35% (the highest income tax rate).

[d] Rates and Exemptions
Prior to full repeal, rates will reduce and exemptions will increase in accordance with the following table, effective for estates of decedents dying and gifts and generation-skipping transfers made after December 31, 2001:

Year Estate and GST Deathtime Transfer Tax Exemption Gift Tax Exemption Highest Estate and Gift Tax Rates Carryover Basis Exemption State Death Tax Credit Other
2002 $1 million* $1 million 50% N/A 25% reduction (from present law amounts) 5% surcharge repealed on transfers in excess of $10,000,000 but not exceeding $17,184,000
2003 $1 million* $1 million 49% N/A 50% reduction  
2004 $1.5 million $1 million 48% N/A 75% reduction Sec. 2057** repealed
2005 $1.5 million $1 million 47% N/A Repealed (Replaced with deduction)  
2006 $2 million $1 million 46% N/A    
2007 $2 million $1 million 45% N/A    
2008 $2 million $1 million 45% N/A    
2009 $3.5 million $1 million 45% N/A    
2010 N/A (estate and GST taxes repealed) $1 million Top individ. rate (gift tax only) $1.3 million, + $3 million marital (indexed for inflation)   Distributions after 2020 and terminations after 2009 of QDOTs*** no longer subject to estate tax

* GST Exemption remains indexed for inflation above the current $1.12 million prior to 2004
** Qualified Family-Owned Business Exclusion
***Qualified Domestic Trusts

[e] Carryover Basis Rules
Upon full repeal of the estate tax in 2010, the current system, which provides a basis step-up to fair market value at death, will be replaced with a carryover basis system in which assets retain the basis inherited from the decedent. Each decedent will, however, be allowed a $1.3 million exemption from carryover basis (which may be increased by the amount of the decedent's built-in losses and unused loss carryovers). The decedent's executor may allocate that exemption among assets owned by the decedent at death. An additional $3 million exemption may be allocated to qualified marital deduction property inherited from a spouse. The estate of a nonresident alien will be allowed a $60,000 aggregate basis increase. No allocation of basis can increase the basis in property in excess of its fair market value on the date of the decedent's death.

[f] Required Returns
Under Code Sections 6018 and 6019, estate and gift tax returns will be required after repeal for the one year post-repeal, pre-sunset period covered by the bill. Estate tax returns (to be filed with the decedent's last income tax return or by a later date prescribed by the Treasury) will be required for "large transfers"- basically any transfer of property (other than cash) with a value in excess of $1.3 million. Information required on the return-generally including a description of the property, its basis, holding period and fair market value-must be furnished to the IRS and (within 30 days of filing with the IRS) to the beneficiaries of property acquired from a decedent. Information required on yearly gift tax returns (which will be filed in accordance with existing rules) must also be furnished to donees within 30 days of filing with the IRS. The penalty for failure to file an estate tax return required under Section 6018 will be $10,000, and the penalty for failure to furnish the required information to beneficiaries or donees will be $50 for each such failure.

1 The author wishes to extend his thanks and gratitude to John R. Garland, principal, Engel Reiman & Lockwood pc, and Eric R. Kaplan, associate, Engel Reiman & Lockwood pc, for their contributions to this article.
2 I.R.C. §§ 7701(a)(30) and 7701(a)(31).
3 Cook Islands International Trusts Act of 1984 §13B(3)(a).
4 Cook Islands International Trusts Act of 1984 §13B(1).
5 Cook Islands International Trusts Act of 1984 §13B(6).
6 Cook Islands International Trusts Act of 1984 §13B(5)(b).
7 I.R.C. §6048.
8 I.R.C. §6677.
9 See PLR 9444033.
10 See, for example, Treas. Reg. § 25.2511-1(d).
11 I.R.C. § 675(4)(C).
12 I.R.C. § 675(2).
13 Treas. Reg. §1.665(b)-1A.
14 I.R.C. § 665(b).
15 I.R.C. § 643(a)(6)(c).
16 I.R.C. § 671.
17 I.R.C. § 673(a).
18 I.R.C. § 674(a).
19 I.R.C. § 675(1).
20 I.R.C. § 675(2).
21 I.R.C. § 675(3).
22 I.R.C. § 675(4)(A).
23 I.R.C. § 675(4)(B).
24 I.R.C. § 675(4)(C).
25 I.R.C. § 676(a).
26 I.R.C. § 677(a).
27 I.R.C. § 678.
28 I.R.C. § 679.
29 I.R.C. § 1361(b)(1)(C).
30 I.R.C. § 1441.
31 I.R.C. § 1445.
32 I.R.C. § 1446.
33 I.R.C. § 7701(a)(30(E).
34 I.R.C. § 7701(a)(30)(E)(i).
35 Treas. Reg. § 301.7701-7(c)(4)(I)(D).
36 Treas. Reg. § 301.7701-7(c)(4)(ii).
37 I.R.C. § 7701(a)(30)(E)(ii).
38 Treas. Reg. § 301.7701-7(d)(3).
39 Treas. Reg. § 1.671-4(b)(1) and Treas. Reg. § 1.671-4(b)(6)(ii).
40 Treas. Reg. § 20.2038-1(a)(3).

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