The Offshore Trust Loophole When tax havens are mentioned, most people think of foreign trusts. That's no accident. The trust is a staple of tax havens and offshore financial planning. Offshore trusts used to provide great tax and financial benefits to Americans, and they were very easy to set up. You simply paid a lawyer or banker $1,000 or so to set up a trust, then transferred assets to the trust. The income from the assets accumulated tax-free as long as it remained in the trust. Taxes were paid only when you or the trust's other beneficiaries had income distributed. Those days of big, easy tax savings are gone, but in the right situations, offshore trusts still can provide substantial tax benefits to those who know how to use them. These days, however, some of the biggest benefits of offshore trusts are the non tax benefits. To many Americans, these benefits are far more valuable than any potential tax savings. Non tax benefits of offshore trusts include the following: * The protection of assets from creditors * Privacy * Estate planning * International investing and diversification In this chapter we look at the many uses and benefits of offshore trusts. The trusting basics Trusts are rooted in antiquity. There were trusts in both Roman and Greek law. The Romans called it the fiducia, from which our word fiduciary is derived. Ancient Germanic and French law had a similar concept, and from the time of Mohammed the concept of the trust was a fundamental principle of Islamic law. The trust was probably the world's first tax shelter. In 16th- century England it took on tax shelter aspects that allowed citizens to avoid feudal taxes on property inheritances and transfers. After fighting the trust for a few decades, the Crown finally decided to give in, and the Statute of Uses became law. American lawyers frequently will mistakenly inform you that trusts only exist in common law countries. Not so. What they should be saying, if they had more understanding of comparative law, is that the IRS only recognizes common law trusts. (The fact that they do not recognize civil law trusts can sometimes have interesting tax planning aspects itself, if you have a tax lawyer sophisticated enough to explore the possibilities.) They used to be divided into two parts: countries that recognized common-law trusts and countries that didn't (whether or not they had their own civil law equivalent). Anglo-American or common-law-based legal systems-such as those of the United Kingdom, the United States, and most of the Caribbean tax havens that were once British colonies-recognized trusts. Countries with civil-law-based legal systems generally didn't recognize common-law trusts. But trusts have become such popular financial devices that many countries with civil-law-based legal systems have passed laws recognizing their own versions of the trust. Such countries include Liechtenstein, Monaco, Jersey, Guernsey. Panama, and in 1992, France. Jersey and Guernsey have ties to the United Kingdom, but are not common-law jurisdictions, as their unique laws are based on pre-conquest Norman law. The Liechtenstein law formally gives recognition to both common-law trusts and its own civil law trusts, but the IRS does not recognize a Liechtenstein trust as being a common- law trust, since they hold that only a common-law country (basically one of British historical ties) can have a common-law trust. A trust is basically a legal relationship between three or more parties. The grantor or settlor creates the trust. The trustee takes legal title to the trust property and manages it according to the terms of the trust agreement and the law of the country involved. The beneficiary receives money or property from the trust according to the terms of the trust agreement. Often, one person can have more than one role in this scheme. For example, you can create a trust that names you the trustee and a beneficiary. This is the standard "living trust" agreement that is used to avoid probate in the United States and that provides for a contingent beneficiary and substitute trustee upon your death. More often, when a trust is used to reduce taxes, the grantor, trustee, and beneficiary are different parties. There often is more than one beneficiary, and there is no legal limit to the number of beneficiaries a trust can have. A trust can be revocable or irrevocable. A revocable trust is one that the grantor can abolish or alter at any time. This gives the grantor more control of the assets, but it normally provides no tax benefits. An irrevocable trust is one that permits the grantor very few changes once the trust agreement is signed. An irrevocable trust is usually required if a trust is to be used as a tax-reduction device. Non tax advantages Although it is the world's first and longest-lasting tax shelter, the trust has a number of non-tax advantages. Many people have found that even when an offshore trust does not save them one dime in taxes, the non-tax advantages are very worthwhile. In fact, it is likely that many Americans who set up offshore trusts today do so more for these non-tax benefits than for any tax-planning reasons. Let's take a look at these non-tax advantages. Asset preservation and protection Wealthy Americans today have at least one financial foe they fear more than they do the tax man, and that is the lawyer. Many businessmen and professionals fear that the legal system is out of control, and it doesn't take much to convince a jury to give all your assets to a sympathetic plaintiff. One mistake, or even one unfortunate accident, can take away the fruits of a life's labors, and insurance companies often cannot or will not cover an entire claim. Because of this, many successful professionals and business owners are putting a higher priority on asset preservation than on tax avoidance. A foreign trust is one key to preserving assets from creditors. Herežs how it works. A trust agreement contains several important clauses. One clause allows you to replace the trustee whenever you want, which ensures that the trustee will manage the trust according to your instructions and the trust agreement. This can be a dangerous clause, however, if it is deemed to give you too much control over the trust, such as by transferring it to a person or company under your control. Prudent lawyers will draft a clause that limits your choice of trustee to a definition such as "a bank in the jurisdiction of the trust, with assets over $20 million, and in which the grantor does not hold more than 5% of the stock." The force majeure clause allows the situs, or location, of the trust to be changed at any time. A force majeure clause is often used in case a war or natural disaster makes it wise to change the country in which the trust is located. But it also is useful if laws change. If the host country changes its tax or privacy laws, you will be glad to have the force majeure clause to rely on. The country in which the trust and trustee are located should be one with strong financial privacy laws. The ideal countries for asset-preservation trusts are usually the tax haven countries such as Jersey, Channel Islands, and the Cook Islands, among others. Discuss your needs with a local lawyer and have him explain exactly how the trustee and the country's government will act in particular circumstances. In most of these countries, you'll find that the trustee does not have to divulge the assets held by the trust and does not have to turn over assets to U.S. creditors, unless they go through the host country's court system, which allows the trustee time to move the assets to another country. You generally want to transfer only cash and intangible assets (stocks, bonds, etc.) to the trust. Portable assets, such as gold coins or diamonds, also can be used. You do not want to transfer title to real estate or a business located in the United States. This does nothing to keep the assets away from U.S. creditors, and could make the trust subject to the jurisdiction of a U. S. court because it would be deemed to be doing business in the U. S. The trust will not affect your tax return. You likely will be the grantor. The beneficiaries likely will include your family members, but will not include yourself. The trustee will follow your instructions on how the trust assets should invested and disbursed. You will notice very little difference in the way things operate, unless you suddenly are faced with creditors who want your assets. You will have to disclose the trust on your federal tax return. But creditors must get a court to order you to reveal your tax return, and that takes time. If they do discover the trust's location and file a collection suit in that country, the laws of the country are likely to be hostile to the creditors, and the trustee can shift the trust and its assets to another country and another trustee. Then the creditors must begin the process all over again. Soon they probably will want to talk about settling the dispute. Asset-protection specialists believe that a variation of this is more effective than a straight foreign trust. They advise that you first form a limited partnership and name yourself the general partner. Then you transfer ownership of the partnership to an offshore trust created in an asset-protection country like the Isle of Man or the Cook Islands. The supporters of this arrangement argue that it renders legally improbable the chances that the assets owned by a limited partnership-trust combination could be reached by a court. You don't want to set up an arrangement like this without the aid of an attorney who has experience in this area. Privacy Unlike a corporate charter and bylaws, a trust agreement is not registered with any government authority, in most countries. (Some of the tax haven countries now have provisions for registering trusts, so you need to consider whether this is helpful or harmful to you.) The agreement is between you and the trustee, unless a dispute forces one of you to bring the trust agreement into court. Many trust beneficiaries have never seen the trust agreements. This gives trusts a distinct privacy advantage over corporations. In every country concerned, at least one person involved in organizing the corporation must be listed on the public record, along with the name and address of the corporation. In most countries the directors must be listed, but in a few tax haven countries that place a premium on financial privacy, often only the lawyer who did the paper work is listed, but that gives privacy invaders a starting point. With a trust, in most countries, nothing is required to be registered. The trust agreement and the parties involved are not required to be disclosed, and the information filed is not on the public record. In privacy-conscious countries, the trustee is allowed to reveal information about the trust only in very limited circumstances. Even in the United States, a trust provides more privacy than does any other form of ownership. An offshore trust multiplies your privacy. International investing and diversification Some of the world's top-performing mutual funds cannot accept U.S. shareholders. Many of the world's best-performing or highest-potential stocks and bonds cannot sell to U.S. investors. In general, foreign investments can't be sold in the United States unless they are registered with the Securities and Exchange Commission (SEC) and the state commissions. Since this is very expensive and also subjects the companies to U.S. securities laws, only a few foreign stocks, bonds, and mutual funds are registered in the United States. You can invest and diversify internationally through U.S.-based mutual funds. But if you prefer to make your own portfolio selection or know how to keep trading costs down, you donžt want to use a U.S. mutual fund. You could use a foreign trust. An offshore mutual fund that cannot accept money from a U.S. investor can accept money his investor's foreign trust. Your trustee handles the investments and paper work while you make the investment suggestions. This way, you can partake of the worldžs best investments without worrying about borders and conflicting laws. Some people prefer to have a portion of their investments physically outside the United States as part of a diversification program. You can do that through a foreign bank account, but the fees on many foreign bank accounts can be steep. Also, you might not have a full number of investment options. A foreign trust with a lawyer or trust company as trustee might be a better way to achieve international diversification. Many large trust companies charge a percentage of the trust's assets as an annual fee plus a percentage of the value of each transaction. Many smaller trust companies charge a fixed annual fee plus additional costs for time spent on transactions and other business. Since it takes just as long to wire $1 million as it does to wire $10,000, the fees ought to be given serious consideration. Offshore trust tax loopholes Offshore trusts still can be structured to generate tax advantages for some Americans. In most cases, but not all, an offshore trust makes sense if you have some of the non tax goals listed above in addition to tax-reduction goals. But there are a few remaining instances when the offshore trust is available purely for tax reduction. What you don't want When Congress decided to end the old-style fun and games that had been available through offshore trusts, Section 679 of the tax code was created. This section says that when four conditions are met, the grantor of the trust is taxed annually on all income and gains earned by the trust, even if they are not distributed to anyone. In other words, you put money or property in the trust, and all income earned by the trust is included in your gross income as though the trust never existed. If you are plan to use the trust for asset protection, privacy, or international diversification, this wonžt matter to you. These are the four factors that must be present for the grantor to be treated as owner of the offshore trust and taxed on its income: 1. A U.S. person transfers property (including money) to a trust. 2. The transfer to the trust is either directly or indirectly from this person. 3. The trust has a U.S. beneficiary. 4. The trust is foreign. Obviously, to get the maximum tax benefits, you do not want all four of these factors present. If you can eliminate just one of the factors, Section 679 no longer applies, and the grantor is not taxed on the income of the trust (at least not under this part of the tax code). Fortunately, there are ways to avoid taxes on the foreign trust. The major tax loophole Every year, many Americans receive tax-free income from offshore trusts. They comply fully with the U.S. tax code, and there is nothing the IRS can do about it. They get tax-free income by avoiding the first factor listed above: The offshore trust is not set up by a U.S. person. "U.S. person" is broadly defined in the tax code. It means a U.S. citizen or resident alien. It also means a U.S. partnership, corporation, estate, or trust. To qualify for this loophole, the grantor of the foreign trust must be a foreigner. Here's the typical case in which this loophole is used: An individual who is not a resident or citizen of the United States (a non resident, alien under the tax code) sets up a foreign trust. The beneficiary is a U.S. citizen or resident, probably the grantoržs child or grandchild. The grantor retains the power to change the beneficiary, revoke the trust, and control disposition of the trust property. The trust and all its assets are located outside the United States. Under this arrangement, the grantor is treated as owner of the trust and is taxed on all income the trust produces. (These are the regular U.S. tax rules on grantor trusts.) The U.S. beneficiaries are not taxed when they receive income from the trust, because the grantor is the owner and is responsible for the taxes. The grantor, however, is not a citizen or resident of the United States, so that country does not tax any of his income. He doesn't even file a U.S. tax return. The trust is located outside the United States and does not invest in U.S. assets. So the trust is not taxed by the United States or required to file a U.S. tax return. If the trust is located in a tax haven, there might be no income tax whatsoever. The IRS approved that result in Revenue Ruling 69-70, and the law remains the same today! In this situation, to maximize the tax benefits, the grantor should form a foreign corporation and transfer the assets to the corporation. Then the corporation should be a grantor of a foreign trust. The reason for this is that the trust will has foreign grantor only as long as the grantor is alive. After the grantor dies, all income received by the U.S. beneficiaries is taxable in the United States. To maximize the tax benefits for as long as possible, the trust should be created by a corporation, not an individual. A recent law tightened this loophole slightly. The law was designed to attack the following kind of situation: A foreign individual gives money to friends or relatives who then set up a trust with the foreign individual as beneficiary. The individual then moves to the United States. Normally, the individual is treated as a U.S. resident and is taxable in the United States on worldwide income. But since the individual is a U.S. beneficiary of a foreign grantor trust, all income from the trust is tax free in the United States. The new rules say that this is not a bona fide foreign grantor trust, so Revenue Ruling 69-70 does not apply. The trust income is generally taxable to the beneficiary. This change applies only when there is a U.S. beneficiary of a foreign trust who has previously transferred assets to a foreign person who then transfers them to a trust. However, the new law indicates that a gift of $10,000 or less of a present interest from the beneficiary to the settlor shall be disregarded. Tricks that can cause trouble -- and how to fix them Somebody shows you Revenue Ruling 69-70 and comes up with this variation: You set up a foreign corporation and transfer assets to the corporation. Then the corporation creates a foreign trust for the benefit of your children or grandchildren. It looks good. You have a foreign grantor of the foreign trust, so you get the same zero-tax results as provided by Revenue Ruling 69-70, right? Wrong. Look at the second factor listed above. The offshore trust rules apply to direct and indirect transfers to offshore trusts. Setting up an offshore corporation that in turn sets up an offshore trust is considered an indirect transfer from you to the trust. You fall under Section 679 and will be taxed on all income provided by the trust. There are numerous other U.S. tax problems that make this technique undesirable to use. Remember the first rule of offshore tax planning: All offshore tax schemes suggested by promoters should be reviewed by an experienced and objective international tax advisor who is paid by you. But the scheme is not totally off-base. With a few changes, it might work. If U.S. citizens do not control more than 50% of the foreign corporation voting power, then the foreign corporation might be considered a legitimate foreign grantor. This could make the income of the offshore trust completely tax-free again. But be careful with this approach. It has not been tested by the IRS or in the courts, and if it is to work, it must be set up very carefully. It still might be considered an indirect transfer from you to the trust. You need the advice of both a U.S. and a foreign attorney. Another scheme to avoid taxes involves an "accommodator" or "accommodating transferor." In this scheme, a shady foreign banker, lawyer, or promoter agrees to set up, or have his company set up, a foreign trust for you. He says that he is legitimately an alien, and that puts the trust outside the offshore trust rules. He'll write the trust agreement to your specifications. Then you can contribute assets to the trust, and the assets eventually find their way to your named beneficiaries, supposedly tax-free. The problem is that this arrangement is not likely to pass by the IRS or through the courts. The accommodation trustee will be treated as your agent, not as an independent, bona fide foreign grantor. You are likely to be treated as the grantor of the trust and taxed on its income. There have been many foreign trusts set up this way. They work only because the IRS has not located them yet. In the past few years there have been a number of tax fraud convictions of people using this approach -- the courts simply held that the trust was a sham, created for the purpose of tax fraud, and long prison sentences resulted. Unfortunately, many of these cases have involved people who purchased a trust package in all innocence from a promoter, who had meanwhile gone on to sell the same scheme dozens of times more. The operative word here is "sham." The courts will very quickly look right through all those cute technicalities that the promoter told you would work. Before you get into one of these schemes, close your mind to the individual trees, and look at the forest from the viewpoint of a judge and jury. There are innumerable variations of this scheme. These basic schemes are usually complicated by the use of a number of trusts and foreign corporations. The complications merely make it more difficult for the IRS to uncover the transactions. Another offshore trust loophole There is another way to avoid being taxed on the income earned by the offshore trust. Note the third factor in the list above. The offshore trust rules apply only when the trust has a U.S. beneficiary. If there is no U.S. beneficiary, the grantor is not taxed on the trust income. The easy way to take advantage of this loophole is to set up the trust to benefit someone who is not a U.S. citizen or resident. For example, if most of your family members are citizens and residents of another country, you can set up an offshore trust to benefit them. If you set it up properly, you will not be taxed on the trust's income. Another way to achieve this result is to have an offshore corporation be the beneficiary of the offshore trust. Under the tax code, an offshore corporation is not considered a U.S. beneficiary of the offshore trust unless 50% or more of the corporation's voting power is controlled by U.S. persons. So if a U.S. person is one of several persons you want to benefit from the trust, you can have the beneficiaries form an offshore corporation. Be sure the U.S. person does not own more than 50% of the voting stock. Under these conditions, you fall outside the offshore trust rules and are not taxed on the trust income. The income in the trust can accumulate tax-free. This is another area in which you have to beware of shady promoters with questionable schemes. A promoter might say that he can form an offshore corporation and hold more than 50% of the voting stock. Then the U.S. beneficiary you designate can buy the rest of the voting stock or nonvoting stock According to the promoter, that makes the corporation a non-U.S. beneficiary and gets you outside the offshore trust rules. Be very wary of this approach. The promoter looks like an accommodator in this arrangement. If the IRS uncovers it, however, it likely will conclude that the foreign owners of the corporation are really just agents for you. You would be considered the genuine owner of the corporation, and the trust -- in the eyes of the IRS -- would have a U.S. beneficiary. Yet another offshore trust loophole Because of this loophole, an offshore trust could be a key part of your estate plan. The offshore trust rules are avoided when the transfer to the trust is made reasonable by the death of the transferor; that is, under the terms of a will. In other words, if the offshore trust is set up under the terms of your will and if property is transferred to it under the terms of the will, the offshore trust rules are avoided. Neither your estate nor any other U.S. person can be taxed as grantor of the trust. This loophole allows income to accumulate tax-free in the foreign trust. The trust can invest anywhere in the world, including the United States, and pay little or no taxes, depending on where the investments are made and how they are structured. If your children do not need the income or assets of your estate right away, the offshore trust can make their eventual inheritance much larger than it otherwise would be. Does the loan loophole work? Here's a strategy that is commonly recommended by tax advisors: Suppose you set up an offshore trust with $500,000 in cash or liquid investments. You are subject to the grantor trust rules, so any income the trust generates from that property is taxable to you. But suppose the trust then uses that property as collateral to secure a $400,000 loan from a bank that has no relationship to you or the trust. The loan proceeds can be invested, and as long as the income from the investments exceeds the interest on the loan and other trust expenses, the trust profits and continues to grow. Here's the tricky part: The tax code says that as grantor of the offshore trust, you are taxed only on the income generated by the property you contribute to the trust. For example, if you and a foreigner jointly create and contribute to an offshore trust with U.S. beneficiaries, you are taxed only on the income generated by your contribution. A number of tax advisors believe the same principle applies to the loan. You do not contribute the loan proceeds, so you are not taxed on the income generated by the loan proceeds. If the property you contribute to the trust is invested in low-income, high-growth assets, you might not be taxed at all on the income from the trust at all. This is another strategy that has not passed the hurdles of IRS challenges and court review. If you use it, do so with great care and in conjunction with the advice of experienced international tax lawyers. You want to be careful not to set up what the IRS calls back-to-back loans. One example of a back-to-back loan is when your corporation or trust deposits money in a foreign bank. The bank then lends 80% of this money to the trust, corporation, or some other entity controlled by you. The IRS is likely to attempt to collapse these transactions and not treat the loan as a real loan. The offshore private lead trust The private lead trust (PLT) is a fairly sophisticated income and estate-tax planning device that should be considered by anyone with appreciated assets. The PLT works like this: You transfer the appreciated assets to a trust. The trust agreement provides that you be paid income from the trust for the remainder of your life, or for a specified number of years. The amount of the annual payment, which must fall within a range prescribed by the tax law, can be determined by you at the creation of the trust. The trust agreement also provides that when income payments to you cease, the trust assets belong to your named beneficiaries, probably your children or grandchildren. The lifetime estate- and gift-tax credit can be used to reduce or eliminate the gift tax due when the trust is created. Usually, a PLT is set up to pay you income for life and leave the remainder to charity. That gives you a deduction up front for the charitable contribution. The trust, however, does not have to include a charity. Suppose you set up a PLT in an offshore tax haven. The trust invests in assets that are designed to produce low income and high growth. When the trust earns capital gains or income, you use your own separate funds to pay the tax on the gain. That does not initially look like a good deal. But consider the alternative. Suppose you leave the assets in your name. Each year you will pay taxes on the gains and income, just as with the trust. But when you die, all the assets all be included in your estate. Unless you can make other provisions, your estate will pay taxes not only on the value of the assets you own today but also on the appreciation and income that are generated between today and the day you die. But if you transfer the assets to an offshore PLT, the appreciation is out of your estate. If you are in the top estate-tax bracket, you trade a 55% estate tax for an income tax of approximately 28%. In this case, you don't eliminate taxes. Instead, you trade a high tax for a much lower tax. You probably don't want to do this unless you have substantial assets and have considered other estate-tax reduction strategies. The offshore trust loophole summary Offshore trusts are extremely flexible financial and tax-planning devices. Though efforts have been made to eliminate their tax benefits to U.S. taxpayers, opportunities still remain. But offshore trust strategies are complicated and full of pitfalls, and there are many tax haven promoters out there who are trying to capture fees rather than generate solid tax plans. Venture into this area only with the help of an experienced international tax adviser who is unquestionably working for you. One more hurdle to clear Whether you are setting up a foreign trust, corporation, or other entity, there is one more hurdle you have to clear. That is the excise tax that is imposed on some transfers of property to foreign entities. This tax is imposed by Section 1491 of the tax code, with exceptions in Section 1492. The excise tax is imposed on transfers by a U.S. person or entity to a foreign corporation, partnership, estate, trust, or partnership. A 35% tax is imposed on the appreciation that is inherent in the property and is not recognized on the transfer. In other words, if you transfer appreciated property to a foreign corporation, trust, or partnership in what would normally be a tax-free transaction, you can turn the transaction into a taxable one and pay the regular capital-gains tax or you can pay the excise tax. Obviously, the easy way to avoid the excise tax is to transfer cash or non-appreciated property to the foreign entity. There also are exceptions for tax-free contributions to a foreign corporation under certain circumstances. Aside from these exceptions you have to choose between paying the capital-gains tax or paying the excise tax. A reliable source of help One of the best sources of help in setting up offshore trusts and corporations is an American certified accountant who has a large practice in Panama. Marc Harris holds a master's degree in business administration from Columbia University in New York, and completed the certified public accountancy examination at the age of 18. He is believed to be the youngest person in the U.S. to pass the examination. He opened his Panamanian firm in 1985, after being a consultant with the accounting firm of Ernst & Whinney. His services are highly recommended because he is able to create and administer offshore corporations and trusts with complete compliance with U.S. laws. Often an American client uses a tax-haven based advisor who knows the local laws but is not familiar with American tax law requirements and technicalities, and the client eventually gets into trouble, so Marc Harris has a unique ability to bridge the two worlds for his clients. Although based in Panama, he can create and administer corporations and trusts that are registered in all of the popular tax havens. For more information, please write to The Harris Organization, Attn: Traditional Client Services, Estafeta El Dorado, Apartado Postal 6-1097, Panama 6, Panama.