By Robert E. Bauman, JD

For most of the last decade the U.S. Internal Revenue Service’s target shooters have slapped a big red bull’s eye on one of the most venerable of all estate planning and asset protection devices—the trust, especially the best ones—trusts located in offshore jurisdictions. The eager IRS seems to presume guilt if one dares to go offshore for any financial activity, but especially if it involves what might be a “sham” trust.

Topping the IRS target list are “people selling fraudulent trusts that they claim will eliminate or reduce income or estate taxes.” The IRS warns both sellers and buyers of “fraudulent trusts” that they face fines and jail, and if intent is proven, “criminal prosecution for tax evasion.”

20 Year Battle Against Offshore Trusts

IRS saber rattling against trusts goes back to 1997 when that agency issued a warning to U.S. persons to shun what they described as “abusive trust arrangements...that are not permitted under federal tax laws.”

The warning came shortly after Congress clamped down on foreign trusts created by U.S. grantors. (A grantor, also called a settlor, is the person or entity that creates and funds a trust.) That law required, for the first time, extensive reporting of offshore trust “events” including creation, annual income and distributions to trust beneficiaries, as well as appointment of a U.S.-based “limited agent” to respond to IRS inquiries. Beneficiaries for the first time had to report income received from an offshore trust.  

The lure of supposedly tax-free income is a powerful one. But U.S. taxpayers can’t say they weren’t warned about these restrictions. Even before the IRS issued its threats, the American Bar Association and several state attorneys general issued similar warnings. The IRS only was restating established rules that good U.S. tax planners already follow.

As far back as 1976, Congress tried to restrict the ability of U.S. persons to form an offshore trust and obtain related tax benefits during their lifetime. In the interim, many schemes, some illegal, were developed to try to avoid the increasingly strict IRS rules. These now defunct schemes included:

• Creation of an offshore trust by a foreign national as both its grantor and beneficiary who later became a U.S. resident and reaped tax-free income from the trust. Now, any trust created within five years of a foreign citizen taking up U.S. permanent residence is treated as a U.S. “grantor trust” with all trust income attributed to the grantor and taxed annually as personal income.
• Loans by U.S. persons to offshore agents who would turn around and secretly finance a foreign trust. This was designed to make the trust fall under rules that permit U.S. persons to obtain tax-free income from certain trusts financed from outside the United States. Now, all trust loans must be “at arms length” with strict documentation and regular repayments. Failing that, the IRS treats the “loan” to a trust as reportable personal income. And anyone who claims they are receiving tax-free payments from a foreign trust they didn’t establish must document from whence comes the money. A trust established by a “secret agent” won’t pass muster.
• Converting a U.S. trust holding highly appreciated assets to a foreign trust. This tactic sought to avoid U.S. domestic capital gains and other taxes due when the transfer occurred. Now, capital gains taxes are imposed at the time of transfer.
• Using offshore trusts with various combinations of bogus offshore business entities alleged to allow the grantor/owner to avoid or defer U.S. income tax. International business companies (IBCs) established in the British Virgin Islands, the Cayman Islands or The Bahamas were popular for this purpose and made lots of money for their shady salesmen.

Is the Offshore Trust Dying?

The Sovereign Society and I, as an attorney, emphatically disagree that trusts are on the way out as an estate planning tool. There still is great utility in offshore trusts as asset protection devices and they certainly are worth the efforts required to create and maintain them. Trusts have been around since ancient Egypt and Rome. They have survived because of their unique and useful qualities and will endure, notwithstanding all the world’s eager tax collectors.

But the IRS anti-trust campaign has sown dissension among some professional offshore planners in America and elsewhere. In this sense, the IRS won ground because many planners now advise clients that establishing an offshore trust could trigger automatic IRS audits. That’s not really true, but for timid souls it’s scary.

These IRS initiatives are part of a wider global attack on legal tax avoidance. In past issues of TSI, we exposed the conspiracy by the U.S. and U.K. governments, the United Nations and the European Union to restrict asset havens globally to end “harmful tax competition” and promote “tax harmonization.”

In the forefront of these nefarious efforts has been the U.K. Labour government that forced changes in the laws of its overseas territories requiring them for the first time to enforce foreign tax claims. The jurisdictions affected include Anguilla, Bermuda, the Cayman Islands, the British Virgin Islands, the Turks and Caicos Islands, Gibraltar—and even constitutionally independent U.K. jurisdictions such as Jersey, Guernsey and the Isle of Man.

False Claims on Offshore Trusts Lead to Real Trouble

Beware of false claims of offshore trust tax savings. In truth, offshore trusts offer few tax savings during a U.S. grantor’s lifetime, but they do provide effective asset protection against civil creditors. In pursuing a properly configured offshore trust, a creditor has to bring his claim in a foreign court that is much less receptive to various “deep pocket” theories popular among U.S. contingency fee lawyers.

An offshore trust can also qualify as a “non-U.S. investor” avoiding regulations by the Securities & Exchange Commission that prohibit U.S. persons from purchasing many types of profitable offshore investments.

Under U.S. tax rules, during a grantor’s lifetime, he or she must pay tax on annual income generated by trust assets and investments. No honest professional trust advisor ever claims that an offshore trust can pay for a taxpayer’s personal, living, or educational expenses or make them into tax deductible items. Nor will they try to avoid tax liability by hiding either the true ownership of income and assets or the true substance of trust transactions.

For Americans, a domestic or offshore trust is “income tax neutral.” That’s because all trust income is treated as the U.S. grantor’s personal income, reportable annually on IRS Form 1040 and taxed accordingly. That the trust is “offshore” does not negate the U.S. grantor’s personal obligation to report trust income.

Even with these restrictions, a citizen of a foreign nation is free to create an offshore trust with U.S. citizens or residents as beneficiaries. Income received by U.S. beneficiaries from such trusts is tax-free. Thus, American citizens or residents can receive tax-free income from trusts established by wealthy relatives who themselves are neither U.S. citizens nor U.S. resident aliens. But the foreign grantor must not be acting as an agent or nominee for those U.S. beneficiaries.

As you might imagine, the IRS is highly suspicious of offshore trusts set up by foreign citizens who U.S. beneficiaries claim are such “loving relatives”—especially if your “loved one” turns out to be your offshore attorney.

Offshore Trusts Can “Disconnect” from U.S. Taxes

There is one legal method to cut U.S. taxes using an offshore trust formed by a U.S. grantor, but the generous grantor won’t be around to enjoy the fruits of this legal tax avoidance.

At your death, your estate must pay any U.S. estate tax on assets remaining in an existing offshore grantor trust. But when estate taxes are calculated, all exemptions, such as your lifetime estate tax exemption amount, can be applied to reduce overall estate value.

Assets you place in a foreign trust under the terms of a last will and testament are also counted once for estate tax purposes as part of your estate, but afterwards the trust and its assets may be free of most U.S. taxes.

Once estate taxes are paid, if the trust is structured properly, its assets will escape future U.S. taxation as they pass to succeeding generations. Only income distributed to U.S. beneficiaries will be subject to U.S. taxation. Taking advantage of these provisions requires careful planning and expert advice on structuring an estate.

In spite of the continuing IRS campaign against what they consider “abusive” trusts, there are good reasons why hundreds of thousands of people worldwide are grantors and/or beneficiaries of valid trusts. This most ancient of asset protection devices should not be abandoned simply to appease the likes of IRS bureaucrats

 

• Immunize your investments against downturns or bear markets...
• Access investments, unavailable in your home country, that offer safe   income and principal...
• Protect your wealth from personal injury, malpractice, environmental, or employee lawsuits...
• Save your loved ones' inheritance from claims and excessive estate taxes or government confiscation...
• And more...