A family trust remains a popular vehicle for many to allow for the passing of wealth to the next generation. This is because it can provide flexibility, discretion and an element of control which is attractive to many.
For US citizens, residents’ trusts are often discussed in estate planning. They are an efficient vehicle to deal with often time consuming and costly probate processes in various states.
For transatlantic mobile families, the creator of a trust might be in one country and the beneficiaries in another. It is therefore very important to understand the rules applying to such arrangements.
Residence position of trusts - UK vs US
The UK and the US both consider trusts as separate taxable entities from those who create and those who can benefit from them. They therefore have rules which establish the tax residence position of the trust.
In the UK, the residence of the trust is determined by the residence of the trustees. A situation can arise where some of the trustees are resident in the UK and some outside the UK. So, the residence is determined by the domicile of the settlor.
From a US tax perspective, the residence of a trust is established by the Court and Control Tests. In order for a trust to be considered ‘US resident’, there are some conditions. It must be governed by the law of one of the states of the United States. Also, it must also be under the trusteeship of majority US persons.
Tax position in UK and US trusts
First, residency must be established, which means determining if a trust is ‘resident’ or ‘not resident’ under the rules of the US and/or the UK. Once this is complete, the tax position of both the trust itself and the beneficiaries can begin to be established. Provided that the trust is resident in either the US or the UK, one starts from the position that the trust is subject to tax. This will be on the income and gains of the trust as it arises and at the highest tax rate in both countries.
Payments to the beneficiary would then be essentially free from tax albeit that from a UK tax perspective. Distributions from income of the trust would be reported as such on the beneficiary’s tax return. These come with a credit for the 45 per cent tax already paid by the trustee, with the beneficiary receiving a refund if their personal marginal tax rate is lower than 45 per cent.
UK vs US differences in trusts
There are differences to be aware of in the UK. For example, when a trust is one whereby the beneficiary is absolutely entitled to the income. In that case, the beneficiaries’ trust income will be taxable. With potentially lower rates of tax payable by the trust, for which the beneficiary will get a credit. But the capital gains will still be taxable on the trust.
There are also specific rules regarding the treatment, where the person who created the trust is themselves a UK resident and they or their spouse or minor children are also a beneficiary of the trust. This may result in income and potentially gains being taxable on the settlor rather than the trustees.
In the case of the US, there are also specific rules about the person who funded the trust, known as the grantor. Particularly if they are a beneficiary of the trust or retain certain significant powers over the trust assets. This is by way of being a trustee or by the specific wording of the trust document. This can result again in the income and gains of the trust being taxable on the trustee.
There is the possibility under US tax rules that a distribution is made to a beneficiary from trust income. Transferring the tax liability for that income to the beneficiary, rather than it being taxable on the trustees, comes under what is known as a ‘distribution deduction’.
Trusts that are considered to be non-tax resident are taxed in both the UK and the US on certain income arising in that country, so may still have a reporting obligation.
Beneficiaries of UK vs US trusts
Both countries also have their own rules as to how they regard distributions to tax resident beneficiaries from non-resident trusts. In the UK, this can result in income and gains received by the trust over time being subject to tax on the beneficiary when they receive a distribution.
From a US perspective, beneficiaries receiving distributions from a non-resident trust are similarly subject to US income and capital gains tax. This is in respect of income and gains received by the trust over time.
Additionally, from a US tax perspective, if the income and gains of a non-resident trust [known as distributable net income or DNI] are not distributed within the calendar year or within 65 days of beginning of the new calendar year, they become undistributed net income [UNI].
When UNI is distributed to a beneficiary, it is taxed as ordinary income. This will be at their highest margin rate. Regardless of whether it is actually qualified dividend income or long-term capital gains that are received. An email extra interest charge also arises. This increases with the length of time that passes before the UNI is considered to be distributed.
Without careful planning, it’s very easy for inefficient tax situations to arise. For example, where the income and gains are taxed on the trust in one country. But the beneficiary is potentially being taxed on the income and gains of the trust in the other country. This can cause double taxation issues as it is a situation not well provided for in the double taxation agreement.
If you are considering setting up a family trust which involves people both in the UK and the US, it is important to carefully consider where the trust should be tax resident. It is imperative to ensure it is set up appropriately and there are several factors to consider in this decision, including the expected level of income and gains and expected distribution policy of the trust. Advice ought to be sought and heeded to be as tax efficient as possible.
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