In Metropolitan areas, such as the San Francisco Bay Area, it is common to have an estate planning client inquire about naming a foreign relative as Trustee or Co-Trustee.
Naming a Non-Resident Alien (“NRA”) relative as Trustee can cause the U.S. Trust to be re-characterized, for U.S. tax purposes, as a foreign trust due to the NRA’s exercise of substantial control of the Trustee powers.
If the goal is to maintain the Trust as a U.S. domiciled trust the requirements of Treas. Reg. Section 301.7701-7 of “court test” and “control test” must be satisfied.
For this test to be satisfied a court within the United States must be able to exercise primary supervision over the administration of the Trust. There is a safe harbor if the following three requirements are met:
- The trust instrument does not direct that the trust be administered outside the United States;
- The trust in fact is administered exclusively in the United States;
- The trust is not subject to an automatic migration provision described in Treas. Reg. Section 301.7701-7(c)(4)(ii).
This test requires that one or more U.S. persons have the authority to control all substantial decisions of the trust. Treas. Reg. Section 301.7701-7(d)(1)(ii).
“Control” means “the power, by vote or otherwise, to make all of the substantial decisions of the trust, with no other person having the power to veto any of the substantial decisions.”
Tax Impact of Foreign Trust Status
Depending on the circumstances, capital gain realization may be imposed on the transfer of property to the “now foreign trust”, i.e. forced sale treatment.
One Year Period to Cure Unintended Loss of U.S. Trust Status
If a U.S. Trust becomes a Foreign Trust due to the nomination of a NRA Trustee, the Trust has 12 months from the date of cessation of U.S. Trust status to reassert U.S. status by satisfying the aforementioned requirements of the “court test” and “control test”.
While it is not impossible to have a NRA relative act as Co-Trustee, the NRA relative should never be nominated as sole acting Trustee.
Even if a NRA relative is nominated as Co-Trustee, the Trust terms must make clear that any tie breaking decision is made by the U.S. Co-Trustee.