By Cynthia Wu

Setting up a trust can be an excellent strategy for Non-Resident Aliens (NRAs) to manage and protect their assets, considering future uncertainties for beneficiaries, such as divorce, bankruptcy, substance abuse issues, or lawsuits. When an NRA establishes an irrevocable trust that holds an LLC, which in turn owns various assets like real estate, stocks, or membership interests, the tax implications can vary significantly. Here’s a detailed look at how this strategy works, focusing on tax implications.

IRC § 7701(a)(30): Defines a domestic trust as any trust where:

• A court within the United States is able to exercise primary supervision over the administration of the trust.
• One or more U.S. persons have the authority to control all substantial decisions of the trust.

Taxation of Worldwide Income:

• IRC § 641: Trusts (including domestic trusts) are taxed similarly to individuals. This includes income from both U.S. and foreign sources.
• Reg. § 1.641(b)-1: Confirms that the taxable income of a trust includes all items of gross income, regardless of whether such items are from sources within or outside the United States.
• Even if the grantor is an NRA, if the trust qualifies as a domestic trust under these definitions, it is taxed on its worldwide income, including income from non-U.S. sources.

California Tax Law

• California Revenue and Taxation Code § 17742: A resident trust is taxed on all of its income if the fiduciary is a California resident or the trust is administered in California. This includes income from both U.S. and non-U.S. sources.
• Source of Corpus: If the corpus of the trust consists of non-U.S. situs assets, the income generated by those assets is still subject to U.S. taxation for a domestic trust.

Income Tax:

• Trust Taxation:The NRA grantor does not report the income of the irrevocable non-grantor trust. Instead, the trust itself is responsible for paying taxes on its income.

1. Taxation on Trust When it Exists

IRC § 1(e) – Ordinary Income Tax Rates for Trusts:

• Trusts are subject to progressive income tax rates, similar to individual taxpayers, but with different brackets.
• The highest marginal tax rate for trusts is 37%, which applies to income above a relatively low threshold (e.g., $13,450 for 2024).

IRC § 1411 – Net Investment Income Tax (NIIT):

• The NIIT imposes an additional 3.8% tax on net investment income, which includes passive income such as dividends, interest, and capital gains from investments.
• For the NIIT to apply, the trust’s adjusted gross income (AGI) must exceed the threshold amount (e.g., $12,950 for 2024).

Example Scenarios:

Scenario 1: Trust Holding US Stocks

• Dividend Income:Dividends received from US stocks held by the LLC are considered net investment income.
• Taxation:Dividends are taxed at the trust’s ordinary income tax rates, up to 37%, plus an additional 3.8% NIIT if passive.
  • Example:If the trust receives $50,000 in dividends, the initial tax due at 37% is $18,500. An additional NIIT of 3.8% on $50,000 results in $1,900. Total federal tax liability: $20,400.
  • State Tax (California):Assuming a state tax rate of 13.3%, the state tax on $50,000 is $6,650. Total federal and state tax liability: $27,050.

Scenario 2: Trust Holding US Real Estate

• Rental Income:If the trust owns real estate via an LLC, rental income is taxed at ordinary income tax rates.
• Taxation:Rental income is subject to a maximum rate of 37% plus an additional 3.8% NIIT if passive.
  • Example:If the rental income is $100,000, taxed at 37%, the tax due is $37,000. An additional NIIT of 3.8% results in $3,800. Total federal tax liability: $40,800.
  • State Tax (California):Assuming a state tax rate of 13.3%, the state tax on $100,000 is $13,300. Total federal and state tax liability: $54,100.

Scenario 3: Trust Holding Foreign Stocks

• Dividend Income:Dividends received from foreign stocks may be subject to foreign withholding taxes, but for US tax purposes, they are still included in net investment income.
• Taxation:Dividends are taxed at the trust’s ordinary income tax rates, plus an additional 3.8% NIIT if passive.
  • Example:If the trust receives $50,000 in dividends from foreign stocks, with a foreign withholding tax of 10%, the US tax due at 37% is on the gross amount ($50,000), resulting in $18,500. An additional NIIT of 3.8% on $50,000 results in $1,900. Total federal tax liability: $20,400, minus any foreign tax credit for the withholding tax.
  • State Tax (California):Assuming a state tax rate of 13.3%, the state tax on $50,000 is $6,650. Total federal and state tax liability: $27,050.

Scenario 4: Trust Holding LLC Membership Interests

• Capital Gains:Gains from the sale of LLC membership interests are taxed at long-term capital gains rates if held for more than one year.
• Taxation:Long-term capital gains are taxed at a maximum rate of 20%, plus an additional 3.8% NIIT if the gains are passive.
  • Example:If the trust realizes $200,000 in long-term capital gains from the sale of LLC interests, the tax due at 20% is $40,000. An additional NIIT of 3.8% on $200,000 results in $7,600. Total federal tax liability: $47,600.
  • State Tax (California):Assuming a state tax rate of 13.3%, the state tax on $200,000 is $26,600. Total federal and state tax liability: $74,200.

2. Tax Consequences of Trust Termination and Distribution

During Grantor’s Lifetime:

Gift Tax:

• Initial Funding:Under IRC § 2501(a)(2) and IRC § 2511, gifts of non-US situs assets by an NRA are generally not subject to US gift tax. Therefore, the initial funding of the irrevocable non-grantor trust with non-US situs assets does not trigger gift tax.
  • Example:An NRA grantor funds the trust with $1 million in foreign stocks. Since the assets are non-US situs, no US gift tax applies at the time of funding.

Upon Termination of Trust:

Income Distribution:

• Distributed income is taxed to the beneficiary at their individual tax rates.
  • Example:If the trust distributes $100,000 of income to the daughter, who is a US resident, she will report this income on her personal tax return. If her federal income tax rate is 24%, she will owe $24,000 in federal taxes. California state tax at 13.3% would add an additional $13,300. Total tax liability: $37,300.

Corpus Distribution:

• Distribution of the remaining corpus upon termination does not trigger additional income tax, provided all income has been distributed and taxed accordingly.
  • Example:If the trust terminates and distributes $1,000,000 in LLC interests to the daughter, there is no additional federal or state tax on the distribution of corpus, assuming all previously generated income was taxed when earned and distributed. The daughter receives the LLC interests without further immediate tax implications.

Estate tax:

Complete Gift:

Definition: A complete gift is one where the grantor fully relinquishes control over the assets, and the transfer is irrevocable.

Estate Tax Consequences:

• Exclusion from Grantor’s Estate:Assets transferred to an irrevocable trust as a complete gift are not included in the grantor’s estate for estate tax purposes. This means the value of these assets will not be subject to estate tax upon the grantor’s death.
• Gift Tax Consideration:The transfer of assets may be subject to gift tax at the time of the gift, but once transferred, these assets are removed from the grantor’s taxable estate.
• Step-Up in Basis:Beneficiaries typically do not receive a step-up in basis for these assets, which means they may incur higher capital gains taxes if they sell the assets.

Incomplete Gift:

Definition: An incomplete gift is one where the grantor retains some level of control or interest over the transferred assets, making the transfer not fully irrevocable.

Estate Tax Consequences:

• Inclusion in Grantor’s Estate:Assets in an irrevocable trust that are considered incomplete gifts remain part of the grantor’s taxable estate. As a result, their value is included in the estate and subject to estate tax upon the grantor’s death.
• No Immediate Gift Tax:Since the gift is not complete, it typically does not trigger gift tax at the time of transfer. However, the assets’ value is still included in the grantor’s estate for estate tax purposes.
• Step-Up in Basis:Beneficiaries may receive a step-up in basis for these assets, potentially reducing capital gains taxes if they sell the assets after the grantor’s death.

Summary

• Complete Gifts:Remove assets from the grantor’s estate, avoiding estate tax but potentially incurring gift tax at the time of transfer and no step-up in basis for beneficiaries.
• Incomplete Gifts:Keep assets in the grantor’s estate, avoiding immediate gift tax but subjecting the assets to estate tax upon death, with the potential benefit of a step-up in basis for beneficiaries.

Conclusion:

Creating a domestic irrevocable non-grantor trust funded by an NRA with non-US situs assets, such as through an LLC, can have favorable tax implications. Proper structuring is essential to ensure compliance with US and state tax laws and optimize tax efficiency. Consulting with tax professionals is crucial to navigate the complexities and avoid adverse tax consequences.

Relevant IRC Sections and Treasury Regulations

• IRC § 7701(a)(30): Definition of Domestic Trust
• IRC § 7701(a)(31): Definition of Foreign Trust
• IRC § 871(a): Tax on Nonresident Alien Individuals
• IRC § 1(e): Tax rates on estates and trusts
• IRC § 1411: Net Investment Income Tax
• IRC § 1(h): Capital gains tax rates
• IRC § 1014: Basis of property acquired from a decedent
• IRC § 661: Deduction for trust distributions
• IRC § 301.7701-3: Classification of certain business entities