Tag: finance

IRC 677

Posted on by Peter Harper


To build upon our previous discussions on foreign grantor trusts, today’s topic concerns Section 677 of the Internal Revenue Code (IRC). Specifically, this section of the IRC discusses a foreign trust’s grantor’s ability to receive income from the trust. This topic is essential for anyone who owns assets in foreign trusts and is moving to the U.S. or facing a liquidity event. Furthermore, this topic is also necessary for those who wish to take steps to avoid having their trust activate a grantor trust status. 

IRC 677

What is IRC Section 677? Simply put, any rev. rul under it states that a grantor of a trust shall be recognized and treated in the role of the owner of any portion of a trust with an income that is distributed towards the grantor or their spouse, held, or has been accumulated for future distribution towards the grantor or their spouse. This also will apply to the payment of life insurance policies on the life of the grantor or their spouse.

Income for Benefit of Grantor

The grantor shall be recognized and treated as the owner if the income from the trust is or may, at the grantor’s discretion (or a nonadverse party), be:

  • Accumulated for future distribution towards the grantor or their spouse;
  • Distributed to the grantor or their spouse; or
  • Applied towards the life insurance payment on the life of the grantor or their spouse.

IRC Section 677 – General Rule

This section of the Internal Revenue Code and all rev. rul provides that the grantor of a trust will be granted ownership and taxation upon any portion of the trust whose income is at the discretion of the grantor, their spouse, or any nonadverse person without the consent or approval of an adverse party, either:

  • Accumulated for future distribution towards the grantor or their spouse
  • Distributed to the grantor or towards the grantor’s spouse
  • Applied to pay premiums on life insurance policies for the grantor or their spouse
  • Applied or distributed in order to support or put towards maintenance of beneficiaries whom the grantor or their spouse is legally obligated to support or maintain

Definitions Relevant to Section 677

Various definitions relevant to this section of the code are basic yet essential to explain.

What is Income?

For the purposes of this subpart, under any rev. rul under Internal Revenue Code 677, income refers to taxable income (and not fiduciary accounting income), such as ordinary income or capital gains income. 

Who is a Spouse?

For the purposes of this subpart, a person is considered the spouse of a grantor solely during the period of the marriage to the grantor. Therefore, if the grantor and the spouse divorce, the grantor would cease to be taxed as the trust’s owner for income distributions or accumulations that benefit the former spouse.

Who is an Adverse Party?

For the purposes of this subpart, an adverse party can be defined as someone who holds a substantial beneficial interest in the trust and would be negatively affected by the exercise (or lack of exercise) of the power the person possesses concerning the trust.

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What is a Grantor Trust?

According to the IRS, grantor trust status is activated when the grantor retains control over the trust’s income and assets. 

What Grantor Trusts Are Used For

There are various reasons for an individual to set up a grantor trust, but the five most common reasons are: 

  • Asset protection and wealth preservation;
  • Credit protection;
  • Avoiding probate;
  • Reduce or eliminate estate taxes and gift tax; and 
  • To gain any possible tax benefits or tax deferral benefits.

Who is the Grantor?

Also known as the owner, settlor, or trustor, it is a general rule that this person contributes property (such as real estate or estate planning), other funds, or even a trust instrument such as life insurance to the trust. According to the grantor trust reg, the property and the grantor’s funds become part of the trust corpus (in other words, the trust assets). It is crucial to note that a trust can have more than one grantor. If more than one taxpayer had funded a grantor trust, they will each be treated as a grantor in proportion to the cash or property’s value they transferred to the trust, according to the terms of the trust. 

The grantor is someone who retains the power to direct or control the trust’s income or assets, including estate planning under the trust. This is crucial to understand, especially when dealing with a foreign trust and the income tax treatment surrounding this trust instrument. Pulling from one of our previous articles, the grantor can also be any taxpayer who creates a trust and either directly or indirectly contributes a gratuitous transfer of property towards a trust. If someone creates or funds a trust on behalf of another, they are treated as the trust’s grantors. 

Income for Benefit of Grantor

The grantor shall be treated as owner if the income from their trust is or may, at the discretion of the grantor, be:

  • Distributed towards the grantor or to the grantor’s spouse, not in a fiduciary manner;
  • Accumulated for future distribution towards the grantor or their spouse; or
  • Applied towards the insurance policies’ payment on the life of the grantor or their spouse.
Constructive Distribution

Under Section 677, the grantor shall be recognized and treated in the role of the owner of any portion of a trust if they retain interest. And, without the approval/consent of an adverse party, the grantor can be enabled to have their income from the portion of the trust distributed to themselves at some time, either actually or constructively. The grantor shall also be treated as the owner if they have granted or retained any interest which might be distributed to the spouse (whether actually or constructively). Again, this action can be done without the approval or consent of an adverse party to enable their spouse to have the income from the portion at any time, even if it is not within the grantor’s lifetime. In this case, constructive distribution includes payment on behalf of the grantor or their spouse to another in obedience to their direction and payment of premiums upon life insurance policies on the grantor’s life or their spouse’s life.

Discharge of Legal Obligation of Grantor or His Spouse

The grantor shall be recognized and treated as owner of the trust if that trust income is or able to be applied towards the discharge of a legal obligation belonging to the grantor or the grantor’s spouse.  

Exception for Certain Discretionary Rights Affecting Income

A grantor should not be recognized or treated as the owner of a trust when a discretionary right can only impact the income’s beneficial enjoyment of a trust that is received after a period of time during which the grantor would not be recognized or treated as an owner if the power were a reversionary interest. 

Accumulation of Income

The grantor shall be recognized and treated as owner of a trust if any income has been accumulated for future distribution towards the grantor or their spouse without the consent of an adverse party. The grantor will be taxed in the current year, even if they must wait for an extended amount before accessing the accumulated income. Suppose that income is accumulated as a tax liability for future distribution towards the grantor or their spouse during any taxable year. In that case, the grantor shall be considered the owner for that taxable year.

Income Distributed to or on Behalf of the Grantor or Grantor’s Spouse

Section 677 applies when the grantor or their spouse is entitled to or can demand trust income. Further, it also applies when a nonadverse trustee has the discretion to distribute trust income to either the grantor or their spouse without the consent of an adverse party. Therefore, even the mere possibility that the grantor or their spouse will receive income is sufficient to trigger the application of Section 677. For income tax purposes, the grantor shall be taxed on all income that could be distributed, even if it is not distributed. 

Income Accumulated for Future Distribution to Grantor or Grantor’s Spouse

According to the grantor trust reg, a grantor is recognized and treated as owner of a trust whose income is or may be at the discretion of the grantor, their spouse, or a nonadverse party, currently accumulated for future distribution towards the grantor or their spouse, even without an adverse party’s consent. Therefore, this income would be taxable to the grantor in this scenario. 

Deferred Right to Distribution or Accumulations

Section 677 does not result in a grantor being taxed on a trust’s income when a discretionary power to apply the income of the trust for the grantor or their spouse’s benefit may occur only after a period of time that would not cause the grantor to be treated as an owner if the discretionary power were what is called a reversionary interest. 

Income Applied to Pay Premiums on Life Insurance Policies on the Life of the Grantor or Grantor’s Spouse

For income tax purposes, the grantor is taxed on any taxable income (and not fiduciary income) used to pay premiums on life insurance policies on the life of the grantor or their spouse. 

Income Applied or Distributed in Satisfaction of the Grantor’s or Grantor’s Spouse’s Legal

For possible income tax purposes, the income of a trust is not taxable to the grantor merely because trust income may be distributed or applied for the support or maintenance of a trust beneficiary whom the grantor or their spouse is legally obligated to support or maintain. The discretion of another person or the grantor acting as trustee must be applied in this scenario.

Obligation of Support for a Trust Beneficiary

With the statement above, however, any trust income distributed or used to satisfy the grantor’s or their spouse’s legal obligation of support for beneficiaries will cause the grantor to be taxed on such income. 

Divestiture of Powers Triggering Section 677

Suppose the grantor and/or their spouse have any interest in a trust that triggers the grantor trust status. In that case, they may be able to evade the application of Section 677 if they divest themselves of every interest that could cause the grantor to be taxed under Section 677. 

Taxable Portion Under Section 677

A grantor with only an income interest in the trust is taxed on ordinary items of income, and a grantor with only an interest in the trust’s principal is taxed on capital gains items.

Estate, Gift, and Generation Skipping Transfer Tax Implications of Section 677

The three most common transfer taxes under this section of the code (gift tax, estate tax, and generation skipping tax) under IRC 677 usually depend on the existing status of a person involved with the trust. For instance, the federal estate tax can be applied to the transfer of property or other kinds of items of income upon or following death. The gift tax also applies to transfers made only if a person is still living. Additionally, the generation skipping transfer tax is a supplemental tax on a transfer of a trust property or other items of income that skips a generation. However, intention and power under this section of the code over that transfer may impact if one of these taxes is imposed for your case. For example, a gift tax can only be imposed if complete dominion, including interest, over the gift, as the gift will be recognized as a trust property, thus triggering the gift tax.

How is an Irrevocable Grantor Trust Taxed?

An irrevocable trust can trigger grantor trust status if the trust fulfills any one of the following requirements as set out in Internal Revenue Code § 673-679:

  • The Grantor Maintains A Reversionary Interest
    • If a grantor holds a ‘reversionary interest’ within a trust greater than 5% of the trust income or principal, the trust may trigger the grantor trust status in terms of IRC § 673m.
  • The Grantor Has The Power To Control Beneficial Enjoyment
    • If a grantor can control the ‘beneficial enjoyment’ of trust assets or income, the trust may trigger the grantor trust status in terms of IRC § 674.
  • The Grantor Maintains Administrative Control
    • If the grantor can maintain administrative control over their trust that is able to be exercised for their own benefit, the trust may trigger the grantor trust status in IRC § 675.
  • The Grantor Maintains Revocation Powers
    • If the trust allows the grantor to revoke any portion of the trust, followed by reclaiming or taking back the trust assets, the trust may trigger the grantor trust status in terms of IRC § 676.
  • The Trust Distributes Income To The Grantor
    • If the trust distributes any income towards the grantor, the trust can, in terms of IRC § 677(a), trigger the grantor trust status.

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Is an ILIT a Grantor Trust?

An ILIT, also known at length as an irrevocable life insurance trust, is an optional irrevocable trust that contains provisions designed to facilitate the ownership over one or more life insurance policies. In other words, an ILIT is a trust designed primarily to hold life insurance. Because it is irrevocable, the grantor cannot change or terminate it. It is important to note that in this scenario, the ILIT is both the owner and beneficiary of the life insurance policy and that it insures the grantor’s life. But to answer the question in this section, an ILIT is not necessarily a grantor trust. For a trust to trigger grantor trust status, specific provisions or powers that can lead the grantor of the trust to be recognized and treated as the owner over the trust’s assets under reg have to be in place. An ILIT is also subject under Grantor Trust Rule §677(a)(3) if the income of the trust may be applied towards the premium payments on policies that insure the grantor’s life (or the grantor’s spouse’s life). Again, for income tax purposes, the grantor will need to report all income of the ILIT towards the grantor’s income tax return. That way, the ILIT will use the grantor’s Social Security number as its primary tax identification number. This grantor trust option is usually referred to as an Intentionally Defective Grantor Trust (IDGT”).

What Makes an Insurance Trust a Grantor Trust?

The grantor will be treated as the trust’s owner if its income is, or in the owner’s direction, distributed to the owner or the grantor’s spouse. It will also accumulate for any future distribution to the grantor or their spouse or to be applied to payment of insurance policies on either the life of the grantor or their spouse.

Can a Non-Grantor Trust Own Life Insurance?

Yes, for instance, through private placement life insurance or PPLI. PPLI provides the ability for a foreign non-grantor trust to make investments into assets deemed to generate U.S.-sourced income and avoid U.S. taxation to the non-grantor trust.

An increasingly utilized technique to either eliminate or reduce U.S. income taxation towards U.S.-sourced income-generating assets to the foreign non-grantor trust is all for the trust to be making those investments inside a U.S. tax-compliant PPLI contract.

Inside a PPLI transaction, the insurance company will become the underlying beneficial owner over the assets in exchange for a policy whose value is tied to the asset’s value as held by the insurance company. Therefore, the trust would have ownership over a U.S. tax-compliant life insurance policy that includes a tax deferral on the build-up of cash value. It will not own the income tax-generating U.S.-sourced income assets, as those assets would be considered to be owned by the insurance company.

If the U.S.-sourced income-generating assets are held until the insured’s death within a PPLI policy, the death benefit is tax-free by the trust. In effect, having the U.S.-sourced income-generating assets that are held along with the policy should permit all the growth within the assets to escape U.S. income taxation while also being held and then sold at the insured’s death as they are changed into a death benefit.

However, once the current taxable year’s distribution exceeds the trust’s distributable net income, it is treated under reg as being paid from prior years’ undistributed income (also known as an accumulation distribution). This throwback to an accumulated distribution is taxed at the highest income tax rate that would have been applied if the income had been distributed to the beneficiaries in the year it was received. To make matters worse, any accumulated long-term capital gain loses its favorable character and is taxed at the higher ordinary income tax rate for a higher total tax liability. Further, the beneficiaries are also subject to a non-deductible interest charge on the accumulation distribution based on how long the trust retained it.

 

Speak with one of our specialists to learn more about IRC 677 and how it can help your case.

Arin Vahanian

Peter Harper

Peter Harper on US Tax – American Kleptocracy

Posted on by Peter Harper

Asena Advisors is proud to present an episode of US Tax, the podcast for Australian accountants with US clients. CEO Peter Harper dives with host Heide Robson into how the United States has become the most popular offshore haven with illicit finances.

Transcript:

Peter Harper: As far as how did a lot of these island nations and tax havens get into trouble, it had nothing to do with their tax rules. Their tax rules in of themselves were completely fine. It was the way that they managed those tax rules in conjunction with their secretive banking practices to effectively hide and laundered by.

[introductory music plays]

Narrator: You’re listening to US Tax; the podcast for Australian accountants with US clients.

Heide Robson: Welcome to Update 33 of US Tax. This is Heide Robson. So now we are back to publishing content that is unique to this podcast here, US Tax. So this podcast, this episode was not published previously somewhere else.

Heide Robson: When I was talking with Peter Harper of Asena Advisors during the last three updates, I asked him about a book. The book is called American Kleptocracy by Casey Mitchell. The full title is American Kleptocracy: How the US Created the World’s Greatest Money Laundering Scheme in History. Amazon quotes the book, “An explosive investigation into how the United States of America built one of the largest illicit offshore finance systems in the world.”

Heide Robson: So I wanted to get Peter’s input on this. And at the time I (had) asked Peter about this book, neither Peter nor I had read it. In fact, the question was unplanned. I didn’t know I was going to ask Peter this (because) my mind sometimes goes off on a tangent. So neither Peter nor I had read the book and we don’t really discuss the book. What had triggered my question to Peter was the blurb on the back of the book. I had read the blurb and let’s just quickly read the beginning of the blurb. It’s quite long, so let’s just read the first one and a half paragraphs and skip some bits to make it shorter.

[transitional music plays]

Narrator: “For years, one country has acted as the greatest offshore haven in the world, attracting hundreds of billions of dollars in illicit finance (that has been) tied directly to corrupt regimes, extremist networks, and the worst the world has to offer. And this one country is the United States of America. American Kleptocracy examines just how the United States’ implosion into a center of global offshoring took place. How states such as Delaware and Nevada perfected the art of the anonymous shell company.”

Heide Robson: So that’s part of the blurb. So this is what triggered my question to Pete, and bear in mind that Peter hadn’t read the blurb. And my question to Peter is, “Do LLCs just help to hide assets, or do they also help to avoid tax? And if the latter, how does that work? How can you avoid tax using an LLC? Is that what this is about?”

[transitional music plays]

Heide Robson: Before we start, please let me just quickly play you the legal disclaimer that Peter Harper has recorded for you.

Peter Harper: So we talk about those complex questions. I want to caution listeners that each case that may come before them will be unique, and it is vital that they consult with someone that has US expertise in order to handle delicate matters. These topics are not simplistic and need experience and proficiency to tackle. So please reach out to us to address any issues that your clients may bring up with the diligence they deserve.

[transitional music plays]

Heide Robson: Here’s Peter’s answer:

Peter Harper: If you’re a conspiracy theorist, which, in every conspiracy theory, there is some truth. But this is the reality of what happened: the US went out with fat (finger) error, and through all this stuff that happened in Switzerland with UBS, and then in Asia with HSBC, you know, the offshore stuff, and applied these very draconian empirical financial laws.

Peter Harper: The US has gone around and set up all these mutual disclosure regimes around extracting information and information sharing, all that type of stuff. But its states, in itself, are not actually bound by those jurisdictions. And then, you’re quite right, the structure of the LLC is kind of hiding in plain sight, right? Because if you’re generating non-US sourced income and you’re a non-US owner, it’s not subject to US taxation.

Heide Robson: So you basically have three buckets: in the first one, you have EFTP. In the second one, you have ECI. And then in the third bucket, you have income that is neither EFTP nor ECI, and this third bucket does not get taxed in the US if you are not a resident of the US. And so you are referring to this third bucket that is not taxed in the US if it flies through an LLC.

Peter Harper: Yeah, correct. So this is the thing: when you think about a US LLC, and this took me a while to wrap my head around, I spent a lot of time thinking through this. I’m like, “Oh, well, you know, there’s automatically got to be this notion or presumption of a US LLC having a US trade or business,” because my first exposure to an LLC and a lot of people is they go, “Ah, it’s a partnership.” And that is true. When you add multiple people together in a US LLC like it is in Australia, there is this presumption when you have a partnership in Australia that it is two people in business with a view of profit, right, that creates this nexus sort of business. In the US, that’s conceptually true, but it’s not guaranteed. In the context of a single-member LLC, categorically, it’s really straightforward; if you don’t have US-sourced income, so (like) you don’t have a US tradeable business with effectively connected income and you’re not generating US FDAP income, there’s no US tax.

Heide Robson: To just kind of guess what structure they are aiming at, it would be a single-member LLC that is then held by a multilayer structure of international shell companies in tax havens. So you would have a single-member LLC that is held by a tiered structure of companies in tax havens. Most likely then, also, with not even a registered shareholder, but just holding certificates, so that it’s very difficult to work out who is actually owning these assets in the LLC, correct?

Peter Harper: Yeah, correct. So what then happened when all these tax havens got hit through the last round, again, the money always looks around the world. And obviously getting bank accounts and all that type of stuff is very different, right? Because you’ve got to go through and deal with anti-monetary (laundering), or AML, policies and all that type of stuff. But just that process of having a legal structure where you’re not concerned about getting access to US banking. And this is where a lot of the European nations and other countries have since kind of paid the heavy price. (And what) really pushed back at America is America’s willingness and desire to regulate the rest of the world, but its unwillingness to let the rest of the world regulate it, right? And I think when you’re the biggest economic gorilla in the room, you get to push a different agenda. But that is absolutely the truth when it comes to wealth structuring that’s driven by confidentiality today.

Heide Robson: So we identified how it might be structured, but the question is what income could actually flow through it. Because I think the main income that is in this third bucket where it’s neither EFTP nor ECI is when you have product businesses selling products from outside the US into the US. Because then you don’t have a US trade or business, you don’t have an FDAP, hence you are in this third bucket.

Heide Robson: But I think as a vehicle for major tax avoidance, I can’t see how it works. Because, for example, if you set up an LLC that is then held by a multi-tiered structure in tax havens and multiple tax havens scattered across the globe. If you have passive income running through that LLC, you have FDAP, hence it’s taxable in the US. Unless, of course, you’re aiming at capital gains, yes. So it would be mainly capital gains then because they would be-

Peter Harper: FDAP has still got to be coming from a US source. Really where, I think, this has gone, right, it should be very, very clear. This is something I can see how it resulted like this, but we’re not in the business of helping this stuff happen is… I think it’s really (that) a lot of this is driven by folks that have got money that may not have paid (the) proper tax. That may have some issues around how it was derived. And so the only way this kind of works as being a tax haven, it’s a tax haven in the sense that you can have non-U.S. sourced income flow into a US structure and flow out of a US structure.

Peter Harper: What the US gives these clients is (that) they give a really high level of confidentiality that they probably used to have in places such as Switzerland and in Hong Kong that they don’t enjoy anymore. And that’s really it. Because if you think about tax havens, if you really think about most tax havens as they used to exist for many, many years, there’s been really strong anti-avoidance provisions that have existed in most major city nations across the world. But so the ability to maintain substantial amounts of capital in offshore tax havens without attribution, you know, it’s not impossible, but it’s been extremely limited over the course of the last 10 to 20 years. So then the people that are storing money there are just… They’re doing it by being dishonest as far as compliant with the rules.

Peter Harper: So I think why a lot of people are saying, you know, they go (and) say, “Is [the] US a tax haven?” They’re thinking about it in the context where they’re saying, “Okay, you’ve got an LLC, you’ve got a foreign owner, you’ve got income coming into an LLC that’s foreign-sourced (and) that’s flowing back out to a foreign owner. Therefore there’s no US taxation.” Now Americans sometimes jam up and say, you know, “Tax haven.” I’m like, “Okay, well, Australia has a whole bunch of rules. They like to take the conduit, foreign income rules. You got foreign-sourced income flowing through a foreign holding company back out to a foreign owner. There’s no Australian tax.”

Peter Harper: So this notion that it’s really a tax haven automatically on its own, I think, just by virtue of the fact you’ve got income flowing out and not being taxed, that’s a bit of a rich statement. I think what is a fair statement is it is that coupled with the rules that each of these states has implemented around confidentiality. And to me, that’s a bigger issue. The confidentiality (and) the rules they have around confidentiality are more of an issue than the tax rules in of themselves. And some of these rules are not too dissimilar from places like the Cook Islands.

Heide Robson: Yes. Now I’m with you, Peter, because I couldn’t see the tax avoidance, because when you have FDAP, for example, you have withholding tax. Yes, the capital gains would not be taxed in the US and hence would be taxed probably nowhere if the whole structure is held in a tax haven. But I agree with you. It’s really the privacy rules that are around these LLCs by the different states who establish these LLCs. That’s really where you can then hide assets; it’s more about hiding assets than avoiding tax, correct?

Peter Harper: Yeah, correct. And I think, really, if you actually survey a lot of the most recent (years), particularly over the last 30 years, as far as how did a lot of these island nations and tax havens get into trouble. It had nothing to do with their tax rules. Their tax rules in of themselves were completely fine. It was the way that they managed those tax rules in conjunction with their secretive banking practices to effectively hide and launder money, right? And I think the concern with America is, “Hey, guys! You guys went around with a sledgehammer and smashed up the whole offshore tax world.” Right, which is fair enough. You think that’s bad guys doing bad things, anti-money laundering basics. But then at the same time, you’re happy with some of your really more Republican-in-nature states to say that, “Come and put your cash over here or your assets over here and no one can know about it.” It was just one of those things, I think that you know, a lot of people, particularly in Europe, feel that it was a very sort of unfair thing.

[transitional music plays]

Heide Robson: Welcome back. So the criticism leveled at US LLCs is not about tax evasion, because when you have assets in the US that earn US-sourced income, usually for FDAP, you pay tax in the US. Not you, but the LLC which holds those assets pay tax in the US.

Heide Robson: So LLCs in this web of illicit finance are not about evading tax, but are about hiding assets. So if you are a dictator or an oligarch or a corrupt official or a money launderer or a drug or illegal weapons dealer, in short, if you have assets that you shouldn’t have, then US LLCs allow you to hide those assets. So your LLC will still be paying tax in the US, but folks back home can’t see where your assets are. So when you look at offshore tax havens, LLCs, and the lot, distinguish between tax evasion and the hiding of assets, tax evasion has become a lot harder with FATCA, the U.S. Foreign Account Tax Compliance Act, and the Common Reporting Standard, CIS, (which is) the equivalent to FATCA for non-U.S. countries. So tax evasion has become a lot harder with FATCA and CIS, but you can still hide assets. And one way to do that is a US LLC.

Heide Robson: So that’s all for today. The next episode will come out soon. We don’t have a set schedule or rhythm for US Tax. It just would get too much to publish each week on Tax Talks, as well as US Tax. Apologies. So we just publish US updates here as they come.

Heide Robson: Thank you for listening. Bye for now and see you in the next update.

[closing music plays]

 

Got more questions? Speak with one of our consultants at Asena Advisors.

Peter Harper