Income Tax Savings After the Grantor

A Model Offshore Trust falls under the grantor trust rule only during your (the Grantor’s) lifetime.

Afterwards the Trust (or the part of it you funded) becomes a foreigner for all U.S. tax purposes. As a foreigner, it generally is not subject to U.S. income tax on its investments (with certain easy-to-avoid exceptions explained below). Thus after your lifetime, the Trust can accumulate investment returns without triggering any U.S. income tax liability for anyone.

By becoming a foreigner when the Grantor dies, the Trust effectively disappears from the U.S. tax system. Neither the members of the Beneficiary Class nor the Protector will have any U.S. tax liability for the Trust’s income.

Only if the Trust engages in an active business in the U.S. (either on its own or through a partnership) or if the Trust invests in U.S. real estate, would the Trust be subject directly to U.S. tax and be required to file a U.S. tax return.

Otherwise, it is simply a foreigner — as foreign as a monk in Tibet. It can invest in anything anywhere outside the U.S. and not involve itself with the U.S. tax system. It also can invest in stocks, bonds and commodities in the U.S. without having to file a U.S. tax return.

U.S. Withholding on Foreign Investors

Upon the death of the Grantor, a Model Offshore Trust is treated under U.S. tax law as a non-resident alien, or foreigner.

The U.S. imposes withholding at a rate of 30% on “fixed or determinable income” earned in the U.S. by foreign investors — such as dividends on U.S. stocks, annuities paid by U.S. insurance companies, pensions paid by U.S. pension plans and interest earned on bonds issued by U.S. companies before July 19, 1984. Income earned in the U.S. and exempt from 30% withholding includes…

  • capital gains (on stocks, bonds, commodities or anything else other than real estate)
  • interest on most bonds
  • interest from bank certificates of deposit
  • interest on U.S. Treasury bills
  • life insurance benefits

Because the application of 30% withholding is somewhat narrow, and because tax-free investment opportunities outside the U.S. are so broad, it is fairly easy for the Trust to invest conservatively and profitably without incurring U.S. withholding. It is even practical to invest in the U.S. stock market without tax. For example, without losing a penny to 30% withholding, the Trust can invest in…

  • non-dividend-paying growth stocks
  • stock warrants
  • call options on stocks
  • convertible bonds

After the Grantor’s lifetime, the Trust also can invest tax free in U.S. mutual funds if it redeems before the fund pays a dividend.

NEXT: Limited Tax on Distributions

Some distributions are tax free to Beneficiaries.

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