Members of the Beneficiary Class who receive benefits from a Model Offshore Trust may be subject to U.S. income tax on all, part or none of what they receive — depending on how and when they receive it, as explained below.
During your lifetime, while the Trust is still covered by the grantor trust rule, there is no U.S. income tax on any distribution to you or other member of the Beneficiary Class.
Distributions during your lifetime are income tax free because, under the grantor trust rule, the Trust Fund you established is treated as being owned by you. Thus when you receive a distribution, you are seen under the income tax rules as merely moving money from one pocket to another.
When any other member of the Beneficiary Class receives a distribution, he is seen as receiving a gift from you, not taxable income.
Later Distributions to Model Offshore Trust Beneficiaries
After your lifetime, when the Trust has become a foreigner for U.S. tax purposes, the income tax treatment of distributions is more complicated.
A distribution received by a Beneficiary who is a U.S. taxpayer will be taxable to the extent it comes from income the Trust recognized after your death. Any other distribution — whether paid out of the Trust’s original capital or out of income recognized during your lifetime — is income tax free for the recipient.
Thus, even though the Trust itself won’t be subject to U.S. tax on its investment income, there still will be a reason to defer recognition of taxable income — so that a larger portion of distributions to Beneficiaries in the U.S. will be income tax free. (A number of technical provisions in U.S. tax rules make it easier for the Trust to defer recognition of taxable income after the Grantor’s lifetime than during the Grantor’s lifetime.)
No U.S. income tax is due on distributions to a Beneficiary who is neither a U.S. citizen nor a U.S. resident.
The Trust Fund can be used in other ways, in addition to outright distributions, to benefit members of the Beneficiary Class without attracting income tax. For example, the Trust can invest in a business owned or being started by a Beneficiary. Or the Trust can lend money to a Beneficiary (at a reasonable rate of interest as determined by statute). Other transactions can be arranged with the Trust to provide cash to Beneficiaries without attracting tax.
Tax Savings For Beneficiaries
In many business and investment transactions, it is possible to shift tax advantages from one party to the other — for example, by making corresponding changes in price and interest rates, by structuring a transaction as a purchase or as a lease or by characterizing an investment as debt or equity. Potential tax advantages frequently become a subject of bargaining: the party who receives the tax advantages should expect to give up something in return.
Beneficiaries who deal with the Trust after your lifetime can have the good without the bad. Since the Trust will then be a foreigner and not generally subject to U.S. income tax, it will have little use for income tax advantages. Thus it can conveniently enter into transactions structured for the Beneficiary’s tax planning advantage.
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