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Asset Protection Benefits of a Foreign Non-Grantor Trust

A Foreign Non-Grantor Trust (FNGT) is the best form of asset protection or other home country benefits for non-resident aliens (NRA). A FNGT can be understood by examining its two parts: 1) foreign; and 2) non-grantor. The needs for NRAs and the taxation of FGNT depends on the type of trust: simple or complex. Each type of trust provides asset protection because distributions may not be subject to US income taxation. However, this does not make considerations for the tax compliance obligation in the foreign jurisdiction for the distributions made to the resident foreign beneficiaries. The potential of not being subject to US income taxation makes this trust ideal for NRAs with foreign beneficiaries. In contrast, a FNGT with US beneficiaries will be subject to US income taxation.

Firstly, a trust is foreign if it is not a US domestic trust. A trust is considered foreign when it does not meet the following two tests: 1) the control test; and 2) the court test. The control test questions whether US persons control substantial trust decisions. The court test questions whether US courts have jurisdiction over the trust administration.

Secondly, non-grantor is a tax concept that determines the level of tax exposure and the level of reporting requirement where there is a US connection. A US connection can be a US grantor, US beneficiary, US source income, or US situs assets. Also, non-grantor is a tax concept that it is an individual entity as such a taxpayer in its own right.

The taxation of a FNGT and/or its beneficiaries depends on whether the trust is simple or complex. A simple trust must distribute all its income currently and only distribute current income. The income of the trust cannot be paid to charity. Lastly, no distributions are made from the trust other than current income. Alternatively, a complex trust does not need to distribute all its income currently and it may distribute income or principal. A complex trust can have a charitable beneficiary. The distribution deduction is applicable to distributions made to foreign beneficiaries. For simple trusts, a distribution deduction is received for the current income it must pay to beneficiaries whether income was distributed. In contrast, for complex trusts, a distribution deduction is received for the current income it must pay to beneficiaries in addition to income actually distributed.

The FNGT addresses the needs of NRAs who seek political stability or property protection. Also, this structure assists to avoid blacklisting issues associated with several offshore trust jurisdictions. The FNGT protects assets because distributions of specified income may not be subject to US income taxation. For example, a foreign beneficiary may not be subject to US income tax for interest income or capital gains. The distribution of interest income to foreign beneficiaries is not subject to US income tax because the beneficiaries are NRAs. Additionally, the income is not subject to a withholding tax.

US sourced capital gains are not recognized by foreign beneficiaries and, thus, not subject to US income tax unless for US real property interest. The fiduciaries of the trust must withhold tax before the distribution is paid for certain US sourced income. A tax withholding is required for the following types of US sourced income: capital gains from US real property interest, distribution from publicly traded partnership, gains from intangible property (patents, copyrights, etc.) related to contingent payments, and gains from resources (timber, coal, domestic iron) with retained economic interest.

Although, foreign beneficiaries may not be subject for US income tax, this does not overlook the tax compliance obligations of the NRA’s foreign jurisdiction. The foreign jurisdiction may take an alternative position on the distributions made to foreign beneficiaries. It may potentially take the position that their resident beneficiary taxpayer is taxed for the all the income of the trust, not only the amount distributed.

The FNGT is suitable for NRAs with foreign beneficiaries and, thus, who are without any US beneficiaries. This trust is less desirable with US beneficiaries because it is potentially taxable to them. The tax implications for US beneficiaries are dependent on the level of income, and the level of trust gains generated that can be matched with the benefit received by the US person. For US tax purposes, a benefit may be an outright distribution, an income entitlement, and a loan.

A distribution may be cash or a species distribution of actual assets passing out of the trust. An income entitlement is a benefit regardless of the funds flowing the US persons. A loan is the most unexpected common benefit received by a US beneficiary from a FNGT. A loan can be considered a distribution if it does not meet requirements such as five-year repayment period as well as applicable interest rates. Undoubtedly, an interest free demand loan is considered a benefit received by a US person as the entire value of the loan received. When the benefit value is determined, then that value is matched against the US tax basis income and gains of the trust and the tax consequences assessed.

A US beneficiary may experience several issues regarding their benefit such as negative tax consequences, burdensome tax compliance, and administrative complexities. (Whitaker) For example, the treatment of undistributed net income (UNI) paid US beneficiaries is a major disadvantage of FNGT. US beneficiaries incur negative tax consequences for UNI, which is generally subject to US income tax. Here are the following negative tax consequences: 1) capital gains taxed as ordinary income; 2) interest charge on tax due; 3) application of “throwback” rules; and 4) extensive tax reporting.

Firstly, capital gains are treated as ordinary income and taxed up to 37% when the trust has realized capital gains from prior years that were considered a part of the distributable net income (DNI) of the trust. Secondly, the tax due on the UNI, by the beneficiary, includes an interest charge from the original date the income was earned in the trust. Thirdly, the “throwback” rules are applied to FNGT, which means income may be taxed at the tax bracket of the beneficiary for the years in which the income was accumulated. (Whitaker) Lastly, due to the extensive tax reporting require for US beneficiaries, this structure is more suitable for foreign families with foreign beneficiaries and not anticipating US beneficiaries. (Whitaker)

The aforementioned tax rules may lead to unexpectedly high tax rates for US beneficiaries. This necessitates extensive tax planning to ensure the most efficient taxation of the benefit received by the US person. Likewise, distribution planning may be helpful for making the distributions efficient for tax purposes. However, the FNGT is most desirable to NRAs with foreign beneficiaries due to the penal tax rules and regulations applied to US persons.

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