Cross-border estate planning

Estate planning for families with international ties requires careful consideration. When U.S. beneficiaries inherit or receive distributions from foreign trusts, they can face significant tax consequences. Without proper planning, the benefits of foreign structures can be undermined by complex U.S. tax rules, leading to unnecessary tax burdens and compliance challenges.

The International Wealth Strategist team at Merrill strives to help global families navigate the intricacies of U.S. tax regulations related to foreign trusts and cross-border estate planning. Below are key considerations and strategies to help mitigate potential tax pitfalls and ensure an efficient wealth transfer across borders.

Understanding U.S. taxation on foreign trusts

The United States employs a worldwide tax system, meaning U.S. persons (citizens, green card holders, and tax residents) are taxed on their global income. This includes distributions received from foreign trusts. The U.S. tax treatment of a trust depends on whether it is classified as a foreign grantor trust or a foreign non-grantor trust, with the latter posing significant tax challenges for U.S. beneficiaries.

Foreign grantor trusts: The foreign grantor is responsible for U.S. tax imposed on the trust’s income, if any. Beneficiaries typically do not incur U.S. federal income tax consequences in connection with distributions they receive from the trust.

Foreign non-grantor trusts: These trusts are treated as separate taxpayers for U.S. federal income tax purposes. U.S. beneficiaries may be subject to throwback tax rules, potentially leading to highly punitive tax rates and interest charges on accumulated income.

The throwback tax and its implications

One of the most significant concerns for U.S. beneficiaries of foreign non-grantor trusts is the throwback tax regime. If a trust accumulates income instead of distributing it annually, the undistributed net income (UNI) will generally be taxed at ordinary income tax rates when eventually distributed (even if the income was capital gain when it was realized). Additionally, an interest charge is applied to account for the deferral period, increasing the tax liability. To avoid these unfavorable outcomes, proactive planning is essential.

Addressing the Controlled Foreign Corporation (CFC) and Passive Foreign Investment Company (PFIC) rules

U.S. beneficiaries may become subject to anti-deferral tax regimes if they inherit interests in foreign corporations classified as CFCs or PFICs. These rules accelerate taxation on certain foreign income and impose complex reporting obligations.

CFC rules: A foreign corporation is considered a CFC if more than 50% of its stock (by vote or value) is owned by U.S. shareholders.  A U.S. shareholder is defined as a U.S. person who owns 10% or more (by vote or value) of the CFC’s stock. U.S. shareholders may be required to pay U.S. tax on their pro-rata share of the CFC’s earnings, even if no distributions are made.

PFIC rules: A Passive Foreign Investment Company (PFIC) is a foreign corporation where at least 75% of its income is passive (such as dividends or interest) or at least 50% of its assets generate passive income. U.S. beneficiaries of foreign trusts holding PFICs may face significant tax penalties and interest charges.

To mitigate exposure to these tax regimes, trusts should:

• Plan accordingly to minimize federal income tax implications for U.S. beneficiaries if there are offshore mutual funds.
• Structure ownership of foreign corporations carefully to prevent triggering CFC status for U.S. beneficiaries.

Reporting guidelines

Remember that U.S. persons¹ are subject to U.S. federal income tax on their worldwide income, which may include foreign wages, rents, capital gains, dividends, interest and pension income. Download Guidelines for reporting foreign income, gifts and assets for information on the various forms a U.S. person may need to file with the Internal Revenue Service (IRS) or the U.S. Department of the Treasury.

Looking ahead

Estate planning for cross-border families is about more than passing down wealth; it’s about reducing tax exposure that could have been mitigated with proper planning for both the foreign wealth creator and their U.S. beneficiaries. Understanding how foreign trusts, U.S. tax laws, and compliance obligations interact is essential to preserving wealth across generations.

Your Merrill private wealth advisor can connect you to a Merrill international wealth strategist to help you find the planning solution that works best for your family’s needs.