The new WikiLeaks style disclosures and “revelations” about offshore and domestic “secret trust” arrangements will reveal a great many legitimate and perfectly legal family planning arrangements that are commonly established for non-tax purposes by U.S. and non-U.S. taxpayers.
The Asset Protection Trust
It is perfectly legal and the right of any U.S. taxpayer to establish an irrevocable trust in an offshore jurisdiction that can offer legal arrangements that are not available or considered to be as reliable in the United States.
For example, in Private Letter Ruling 200944002, which was issued to a taxpayer requesting specific tax guidance on the contemplated transfer to an Alaska Asset Protection Trust, the individual wanted to place assets in an irrevocable trust as a gift using part of his/her estate tax exemption so that the assets placed under the trust, and future income and growth thereon, could be held for family members without being subject to federal estate tax in the same way that such trusts are established commonly in the home-state where the grantor/contributor lives.
In this situation, Alaska was one of the few states in 2009 that permitted irrevocable trusts to be established that could benefit the grantor/contributor without permitting his/her creditors to reach into the trust. If the creditors of a contributor to a trust can reach into the trust, and the trustee can make distributions for that contributor, then the estate tax law considers the trust to be owned by the contributor, and to therefore be taxable upon the contributor’s death.
The 2009 Private Letter Ruling taught us that the IRS understands that a contributor could make a gift to an irrevocable trust that would benefit him/her if and when needed, but could still be off the table for creditor protection purposes.
Full Faith and Credit Clause
This would work fine for an individual who resides in Alaska and sets up this kind of trust, but the creditor protection rules are not so clear when an individual residing in a state that does not recognize asset protection trusts (such as New York, California, or Florida) sets up an Alaska trust for this purpose. The reason that this is not clear is because the Full Faith and Credit Clause of the U.S. Constitution generally indicates that a court in one state has to give “full credit” and follow the judgment of a court in another state, unless it is clearly erroneous.
As the result of this, nobody can be certain whether the law of Florida or Alaska should apply if a Floridian establishes an asset protection trust in Alaska, and is later sued by another Floridian over an incident that happens in Florida. There is support for the proposition that Alaska law should still apply to determine whether a creditor could reach into the Alaska trust, but we have no test case that has gone to the appellate level on this.
The Offshore Trust
For this reason, it is safest for U.S. taxpayers who do this kind of conventional planning to use a trust company that is situated in an offshore jurisdiction, such as Nevis, Belize, or the Cook Islands, which have special legislation to help assure that individuals from anywhere in the world can establish a trust there and not have creditors who later arise reach into the trust.
Offshore trusts are “disregarded” for income tax purposes under Internal Revenue Code Section 684, which basically results in all the income from the trust being considered income of the grantor or grantors, and thus reportable and taxable on the Form 1040, Individual Income Tax Return. This results in a situation where there is no income tax savings or cost, other than compliance with the appropriate reporting and the normal income tax rules that would generally apply.
In addition to tax planning purposes, any U.S. citizen has the right to set-up a financial structure that will exclude creditors that do not exist and are not expected at the time the structure is established, and some states allow such structures to be established even after a creditor has arrived on the scene.
Just as almost every state has a law that protects a number of categories of assets from creditors, U.S. persons have the right to use offshore laws by establishing offshore trusts, and this has been the case for decades, if not centuries.
It should therefore come as no surprise that a great many well-advised U.S. individuals have established and maintained offshore trusts and similar structures, and that the vast majority of these structures are completely income tax compliant.
In particular, the tax law requires extensive disclosure of offshore trust assets and activities to the IRS, and there are significant penalties for failure to disclose. You can read about this by looking at IRS Form 3520, IRS Form 3520-A, and Treasury Department FinCEN Form 114 (FBAR Form) and reading the instructions thereto.
Sometimes, the trusteeship under such trusts established by U.S. taxpayers will consist of a foreign trust company and a domestic trust company that act as co-trustees, to avoid having to file as a foreign trust. Under these “hybrid-trusts”, the trust agreement provides that the U.S. based co-trustee will have control of the trust assets and decision-making and that U.S. law will apply to the trust, unless or until the U.S. trustee resigns. This avoids the need to file a Form 3520, 3520A, or FBAR when properly drafted, implemented, and operated. This is all permitted under IRC section 7701(a)(30)(E), which defines a “foreign trust” and outlines what the Treasury Regulation refers to as the “control test” and the “court test” for determining if a trust is a foreign trust.
Privacy in Estate Planning
Because of the above, it is painful to see a presumption or assumption that individuals and families who have formed and maintained offshore trusts or trusts in domestic jurisdictions are for some reason breaking the law, or acting illicitly. It is particularly painful to see that reputable trust companies that our law firm and other law firms have worked with for a number of decades are having their records and client matters disclosed indiscriminately as if they are routinely engaged in some kind of financial or tax fraud, which is certainly not the case based on what we have seen and experienced over the last 30 years.
International bankers and trust companies are well aware of how important it is to operate ethically and accurately, and to safeguard the confidentiality of client information, except for governmental disclosures and required reporting under the many laws they must navigate and with which they must comply.
Regulatory Compliance
As for non-U.S. individuals and families who have placed their assets in international trusts, which now commonly include trusts in Nevada and South Dakota, the vast majority of those arrangements are also U.S. tax compliant and required to be compliant in the country of the grantor/contributor’s origin.
It is generally against the U.S. law for an American professional to participate in breaking the law of a foreign country. There is nothing wrong, however, in assisting a foreign individual in establishing a trust or trusts that may be immune from being reached by creditors, or forming and operating trusts that may take appropriate advantage of foreign tax laws that enable trusts formed outside of the jurisdiction of where the owner resides to facilitate avoidance or deferral of income taxes.
For example, many foreign countries have tax laws which basically provide that only income from within the foreign country is taxable, and that income from outside the foreign country that is owned under special trusts will not be taxable unless or until it is brought back into the country in which the grantor/contributor resides.
In fact, such trusts were commonly used by U.S. citizens until the early-1960’s, when the United States began passing legislation regulating U.S. taxpayers from engaging in such strategies, partially as a result of the efforts of President John F. Kennedy, who’s family used such trusts for tax avoidance and other purposes before he became president.
Now U.S. companies can still engage in similar strategies with respect to foreign income that is earned under structures whereby a foreign corporation known as a “blocker” is not subject to tax in the country where it is formed, so that the income is not taxed until it is brought into the United States.
Transparency vs. Harassment
The journalists that have found and are disclosing sensitive and confidential information about a great many individuals and families throughout the world may be acting nobly and with good intent to expose tax fraud and crime, which undoubtedly exists to some extent in the international realm, but at the same time they are disrupting private families and lives that are in complete compliance with all U.S. and international laws, and are being exposed to possible financial, and even personal harm as a result of assumptions and innuendos that may be completely incorrect and uncalled for.
This will cause more U.S. taxpayers to use smaller trust companies, law firms, or other individuals or entities that provide foreign trustee services in order to make it less likely that they will be subject to mass public exposure of this nature.
In some cases it is not unusual for foreign individuals and families to put assets under a trust that will not be accessible to the government of the country where they live for fear of inappropriate or illegal retribution/seizure. In fact, a provision under a trust agreement that indicates a governmental overturn of the jurisdiction where the trustee is located is called a “Cuba Clause”.
U.S. citizens can continue to use appropriately formed, funded, and reported offshore trusts for legitimate estate tax planning and creditor protection purposes when the circumstances are right. Unfortunately, they risk having their personal information exposed to the general public in circumstances such as these, and being subjected to unnecessary criticism or ridicule as a result there of.