Contents
Nongrantor Trusts & Covered Expatriates
Covered Expatriates & Nongrantor Trusts
Covered Expatriates & Nongrantor Trust: When it comes to expatriation, U.S. Citizens and Long-Term Lawful Permanent Residents who are considered covered expatriates — they may be subject to an exit tax. In addition, when a covered expatriate has tax-deferred investments and deferred ineligible compensation (such as foreign retirement), there may also be additional deemed distributions (subject to exception and potential step-up basis).
One of the more complicated aspects of expatriation and exit tax is the ownership interest in a non-grantor trust.
Let’s review Nongrantor Trusts & Covered Expatriates for Exit Tax purposes.
What is a Non-Grantor Trust?
A Non-Grantor trust is simply a trust in which the owners of the assets is no longer in control of the trust assets. The grantor has relinquished dominion and/or control over the asset — as distinct from a grantor trust, in which the grantor generally can still exercise some control over the trust assets.
There are specific tax issues during (and post) expatriation involving Nongrantor Trusts & Covered Expatriates:
- Sale of trust property owned by the Covered Expatriate
- Distributions of property to the Covered Expatriate
- Distributions of money to the Covered Expatriate
- 8854 Election to preserve potential rights and avoid annual reporting
Non-Grantor Trust Expatriation Exit Tax Rule Basics
As Provided by Notice 2009-85 on the issue of Nongrantor Trusts & Covered Expatriates:
“Section 877A(c) provides that the mark-to-market regime does not apply to deferred compensation items, specified tax deferred accounts, and interests in a nongrantor trust of which the covered expatriate was a beneficiary on the day before the expatriation date.
If the covered expatriate is treated as the owner of any portion of a trust under the grantor trust rules (sections 671 through 679) on the day before the expatriation date, the assets held by that portion of the trust are subject to the mark-to-market regime (but see section 4 of this notice concerning coordination with section 684).
Section 877A(f) provides that in the case of any direct or indirect distribution of property to a covered expatriate from a nongrantor trust of which the covered expatriate was a beneficiary on the day before the expatriation date, the trustee must deduct and withhold from the distribution an amount equal to 30 percent of the taxable portion of the distribution.
If the fair market value of the property distributed exceeds its adjusted basis in the hands of the trust, gain shall be recognized to the trust as if the property had been sold by the trust and the proceeds distributed to the covered expatriate.
A covered expatriate must determine the fair market value of his or her beneficial interest in each trust, other than a nongrantor trust subject to section 877A(f), to the extent the trust would not constitute part of his or her gross estate, in accordance with the Federal gift tax valuation principles of section 2512 and the regulations thereunder without regard to any prohibitions or restrictions on such interest.
An interest in a life insurance policy will be valued in accordance with Treas. Reg. § 25.2512-6 as if the covered expatriate had made a gift of the policy on the day before the expatriation date.”
There are two main rules to consider involving Nongrantor Trusts & Covered Expatriates:
Ownership of Non-Grantor Trust
When a covered expatriate is considered an owner of a portion of the foreign nongrantor trust, the assets attributed to the covered expatriate is subject to the mark-to-market regime.
Distributions From Non-Grantor Trust
If the covered expatriate receives any distributions, those distributions are going to taxed at 30% with the administrator maintaining responsibility for withholding 30%.
In addition, distribution of property may result in tax as well.
Sure, it may be very difficult for the IRS to go after a foreign administrator of a foreign trust for enforcement, but technically those are the rules —
Section 7 (Notice 2009-85): Interests in Nongrantor Trusts
As provided by the IRS:
A. In general
The mark-to-market regime does not apply to any interest in a nongrantor trust.
For this purpose, section 877A(f)(3) provides that the term “nongrantor trust” means the portion of any trust, whether domestic or foreign, of which the covered expatriate is not considered the owner under subpart E of Part I of subchapter J, determined as of the day before the expatriation date.
Section 877A(f) provides that in the case of any direct or indirect distribution of property (including money) to a covered expatriate from a nongrantor trust of which the covered expatriate was a beneficiary on the day before the expatriation date, the trustee must deduct and withhold from the distribution an amount equal to 30 percent of the taxable portion of the distribution. Section 877A(f)(2) provides that the term “taxable portion” means, with respect to any distribution, the portion of the distribution that would have been includible in the covered expatriate’s gross income if the covered expatriate had continued to be subject to tax as a citizen or resident of the United States.
For purposes of determining whether a covered expatriate is a beneficiary of a nongrantor trust on the day before the expatriation date, a beneficiary is a person (a) who is entitled or permitted, under the terms of the trust instrument or applicable local law, to receive a direct or indirect distribution of trust income or corpus (including, for example, a distribution in discharge of an obligation of that person), (b) with the power to apply trust income or corpus for his or her own benefit, or (c) to whom the trust income or corpus could be paid if the trust or the current interests in the trust were then terminated.
If a trust that is a nongrantor trust immediately before the expatriation date subsequently becomes a grantor trust of which the covered expatriate is treated as the owner, directly or indirectly, then the conversion is deemed to be a taxable distribution under section 877A(f)(1) to the covered expatriate to the extent of the portion of the trust of which the covered expatriate is then treated as the owner.
Section 877A(f) does not apply to any distribution from a trust forming part of a plan an interest in which is treated as a deferred compensation item to which section 5 of this notice applies or part of a specified tax deferred account to which section 6 of this notice applies.
Section 877A(f)(1)(B) provides that if the fair market value of property distributed from a trust described in section 7.A of this notice exceeds its adjusted basis in the hands of the trust, gain must be recognized to the trust as if such property had been sold to the covered expatriate at its fair market value.
Example 20. On Date 1, Trustee of a complex, nongrantor trust, distributes a painting to A, a covered expatriate who was a beneficiary of the trust on the day before A’s expatriation date. The painting is a capital asset and has a basis of $100,000 and a fair market value of $400,000. The trust is a domestic trust that excludes gains from the sale or exchange of capital assets from its distributable net income (DNI) under section 643(a)(3). On Date 1, the trust is deemed to have recognized capital gain of $300,000 under section 877A(f)(1)(B). The trust must include the $300,000 of capital gain in its gross income and may not deduct that amount under section 661 in computing its taxable income under section 641. The trust is taxable on the $300,000 capital gain (reduced by the applicable exemption amount under section 642(b) and any applicable deductions) and is not required to deduct and withhold any amount pursuant to section 877A(f)(1)(A). A is not taxable on the $300,000 capital gain.
Example 21. The facts are the same as in Example 20 except that the trust is a foreign trust that includes capital gain in DNI pursuant to section 643(a)(6)(C). Although the trust must include the $300,000 of capital gain in its gross income, it may deduct that amount under section 661 in computing its taxable income under section 641. If A, now a nonresident alien, had continued to be subject to tax as a citizen or resident of the United States, the capital gain of $300,000 would have been includible in A’s gross income pursuant to section 662. Accordingly, the trust is required to deduct and withhold $90,000 (30 percent of $300,000) pursuant to section 877A(f)(1)(A).
Section 877A(f)(4)(A) provides that rules similar to the rules of section 877A(d)(6) shall apply. Thus, the tax that is imposed by section 877A(f) is imposed under section 871, but the payment is subject to withholding under section 877A(f)(1)(A) and not under section 1441. Any amount due under section 871 that is not paid by means of withholding must be reported on the income tax return filed by the covered expatriate for the relevant taxable year. In addition, rules similar to the rules of section 1461 through 1464 apply. Thus, the trustee, as the person required to deduct and withhold the tax, is liable for such tax as stated under section 1461. The covered expatriate must notify the trustee of his or her covered expatriate status by submitting Form W-8CE to the trustee on the earlier of (1) the day prior to the first distribution on or after the expatriation date or (2) 30 days after the expatriation date. For more information about Form W-8CE, see section 8 of this notice.
Section 877A(g)(1)(C) provides, in part, that in the case of any covered expatriate who is subject to tax as a citizen or resident of the United States for any period beginning after the expatriation date, such individual will not be treated as a covered expatriate during such period for purposes of the 30 percent withholding tax on the taxable portion of a distribution from a nongrantor trust. Thus, the taxable portion of the distribution would not be subject to tax under section 871, but would be subject to the tax imposed on distributions to a citizen or resident of the United States.
D. Interaction with treaties
Section 877A(f)(4)(B) provides that a covered expatriate shall be treated as having waived any right to claim any reduction under any treaty with the United States in withholding on any distribution to which section 877A(f)(1)(A) applies unless the covered expatriate agrees to such other treatment as the Secretary determines appropriate.
Until further guidance is issued, a covered expatriate may preserve his or her right to claim a treaty benefit with respect to a distribution to which section 877A(f)(1)(A) applies by electing on Form 8854 to be treated as having received the value of his or her interest in the trust as determined for purposes of section 877A, on the day before the expatriation date.
In order to make the election described in the previous paragraph, the covered expatriate must obtain a letter ruling from the IRS as to the value, if ascertainable, of his or her interest in the trust as of the day before the expatriation date by following the procedures set out in Revenue Procedure 2009-4, 2009-1 I.R.B. 118 (or any subsequent publication that replaces Revenue Procedure 2009-4).
Until the trustee receives a copy of the letter ruling from the covered expatriate and a certification signed under penalties of perjury that the tax due on the value of the interest in the trust has been paid to the IRS, the trustee must withhold as provided in section 877A(f)(1).
The amount of tax due on the value of the interest in the nongrantor trust as of the day before the expatriation date will be adjusted by the amount of any tax withheld on or after the expatriation date and prior to receipt of the letter ruling. The covered expatriate may not make the election if the IRS determines that his or her interest in the trust does not have an ascertainable value as of the day before the expatriation date.
If the covered expatriate provides the trustee with a copy of the letter ruling and a certification written under penalties of perjury that the tax due on the value of the interest in the trust has been paid to the IRS, then the tax imposed under section 877A(f) with respect to the trust will be deemed to have been fully satisfied.
Accordingly, no subsequent distribution from the trust to the covered expatriate will be subject to 30 percent withholding under section 877A(f)(1)(A), and the covered expatriate will not be precluded by section 877A(f)(4)(B) from claiming treaty benefits with respect to any distribution from the trust under the appropriate article of an applicable treaty.
Interest in a nongrantor trust. A covered expatriate with any interest in a nongrantor trust on the day before his or her expatriation date must file Form 8854 annually to certify that no distributions have been received or to report the distributions received.
However, if a covered expatriate makes an election on Form 8854 to be treated as having received the value of his or her entire interest in the trust as determined for purposes of section 877A (thereby preserving his or her right to claim a treaty benefit with respect to a distribution to which section 877A(f)(1)(A) applies), follows the procedure set forth in section 7.D of this notice for obtaining a letter ruling from the IRS, and pays the tax due, the covered expatriate will not be required to report subsequent distributions with respect to his or her interest in the trust on Form 8854.
The election, once made, cannot be revoked except with the consent of the Commissioner.”
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