Today, you get to look over my shoulder to see how I think through “do I have a grantor trust with a foreign grantor?”

Why grantor trusts with foreign grantors are cool

The Code doesn’t like it when a foreign person is the grantor of a grantor trust. A grantor trust’s income is taxable to the grantor. If the grantor is a foreign person, only U.S. source income from a grantor trust is subject to income taxation.

As a result, grantor trusts are useful for multinational families with wealth that will benefit U.S. family members–income now, principal later when the older generation dies. By multinational family, I mean a family where some members (typically the older generation, with wealth) live outside the USA, and some (typically the younger generation, who will eventually inherit the wealth) live in the USA. 

With a grantor trust and a foreign grantor:

• We can postpone U.S. income taxation on the trust’s income for as long as possible – until the foreign grantor dies. If the U.S.-resident family member needs money in the meantime, it’s a tax-free gift rather than taxable income to the recipient.
• With a bit of effort (see Rev. Rule 84-139 and Rev. Rul. 2023-2 for the parameters) we can achieve basis step-up on the trust assets when the grantor dies, without exposing the assets to U.S. estate tax.

How do you know if you have a grantor trust with a foreign grantor?

When a client announces the existence of a trust created by a nonresident of the United States, how do you figure out whether it’s a grantor trust, and how do you identify the grantor?

This newsletter tells you what I do. I hope it’s useful.

First things first. I print the trust document and take notes on paper: a combination of notations in the margin of the trust document and notes on a notepad. But you do you. 

This is a slow process because, frankly, most trust documents are barely-intelligible crap. It takes a few hours of reading to marinate in the glory of this document before you start to see how cross-references work and notice logic gaps. Working on paper and taking notes with a pen helps slow my brain down to handwriting speed. 

I work through the trust document one step at a time. Let’s look at the steps.

Step 1. Identify the grantor(s)

Your first task is to identify the grantors. These are the people who get income allocation from grantor trusts.

Actually, that’s not quite true. Third party people can get grantor trust income allocated to them because of IRC Section 678. This is irrelevant for us, because of IRC Section 672(f)(1), (2). IRC Section 678 is an irrelevant factor for foreign persons and the grantor trust rules.

There are two things that make a person a grantor. You can find the full details in Reg. Section 1.671-2(e)(1).

• The person who created the trust is a grantor. This is easy. Look at the very first paragraph of the trust document and the signature blocks. That person is a grantor.
• The person who gives assets to the trust is a grantor. This just requires a bit of due diligence on your part.

Make sure the grantors are NOT U.S. citizens, U.S. residents, or domestic corporations. Reg. Section 1.672(f)-1(a)(1). 

Now you know you are dealing with what I will call a “foreign grantor”. Let’s move on to the trust. Is it a grantor trust?

Aside: “Grantor” vs. “settlor”

One final thing. The word “grantor” only has meaning for U.S. income tax purposes and no other purpose. Do not use “grantor” for any other reason. I find it useful to refer to the person who creates a trust and transfers assets to the trust as a “settlor.” This comes from the common usage outside the United States: a person “settles” assets into a trust. No, don’t ask me to explain it.

So I use “settlor” for the mechanical actions of creating a trust and funding it. I use “grantor” when I am analyzing the U.S. income tax consequences of that trust. I do NOT use the word “grantor” when I’m looking at the U.S. estate, gift, and generation-skipping transfer tax implications of the trust, because “grantor” is an income tax word, not a transfer tax word.

Step 2. Confirm the trust is a grantor trust

Next, you have to figure out whether the trust is a grantor trust. Rather than go through all of the possible triggers for grantor trust status (IRC Sections 673 through 679), I focus on only two.

If one of these two items causes the trust to be a grantor trust with a foreign grantor, we are finished: grantor trust status is assured. If neither of those items apply, the trust cannot be a grantor trust and is therefore “not a grantor trust” or as we like to colloquially call it, a nongrantor trust.

Grantor trusts must have U.S. citizens, residents, or domestic corporations as grantors. IRC Section 672(f)(1).

There are two relevant exceptions, found in IRC Section 672(f)(2).

• Trusts where the grantor can force the trust to return ownership of assets he/she gave to the trust. IRC Section 672(f)(2)(A)(i).
• Trusts where the grantor (or optionally the grantor’s spouse) is/are the sole lifetime beneficiaries. IRC Section 672(f)(2)(A)(ii).

Grantor as the sole lifetime beneficiary

This one is easy. It only requires finding and reading the definition of “beneficiary” in the trust document.

The rule

A trust can be a grantor trust with a foreign grantor if the beneficiary rules are written correctly–if:

“the only amounts distributable from such portion (whether income or corpus) during the lifetime of the grantor are amounts distributable to the grantor or the spouse of the grantor.”

IRC Section 672(f)(2)(A)(ii).

How to find it in the trust document

Somewhere, usually in the first two or three pages of the trust document, there will be a definition of the word “Beneficiary.” Either it will list the people who are beneficiaries, or it will cross-reference to an attached Exhibit.

What does it say? Does it say that the grantor (optionally adding the grantor’s spouse) is the exclusive beneficiary during his/her lifetime? If the answer is yes, then you have a grantor trust with a foreign grantor, relying on IRC Section 672(f)(2)(A)(ii).

You will not find this type of clause unless a U.S. tax lawyer was involved in the creation of this trust. Most of the time you will find a large, defined class of beneficiaries entitled to distributions of principal and income from the trust, probably including the grantor.

(Note: I am using the term “grantor” deliberately here to signal that I am considering the U.S. income tax consequences of the trust structure).

Grantor can revest assets in his/her own name

The second way a grantor trust can have a foreign grantor is if the grantor can “revest” assets in his/her own name. Usually this is phrased as if it means the trust is revocable. This is certainly part of it. But a grantor can “revest” assets in his/her own name by exercise of powers other than the power to revoke.

The rule

The specific rule that says a foreign person can be a grantor of a grantor trust when:

“the power to revest absolutely in the grantor title to the trust property to which such portion is attributable is exercisable solely by the grantor without the approval or consent of any other person or with the consent of a related or subordinate party who is subservient to the grantor[.]”

IRC Section 672(f)(2)(A)(i).

Simply put: can a foreign grantor take assets out of the trust without restraint? If so, then the trust is a grantor trust with a foreign grantor.

“Revest”

Notice the funky word “revest.” This means what the grantor put in, he/she can get out – without interference from other people. And it further means the portion of the trust that is attributable to a gratuitous transfer by the grantor – because a gratuitous transfer is the only way a grantor can become an owner of a portion of a trust for purposes of the grantor trust rules. 

Multiple types of powers that are included in the “power to revest”

The power to revest assets in the grantor’s name doesn’t say “revocable,” does it? The Regulations help us understand that the power to revest assets in the grantor’s name includes holding the power to revoke, as well as other powers.

“If the title to a portion of the trust will revest in the grantor upon the exercise of a power by the grantor or a nonadverse party, or both, the grantor is treated as the owner of that portion regardless of whether the power is a power to revoke, to terminate, to alter or amend, or to appoint.”

Reg. Section 1.676(a)-1, emphasis added. 

We don’t care, for purposes of this newsletter, WHO (aside from the grantor) holds the power. We just want to know what powers will work to cause the trust to be a grantor trust with a foreign grantor for the purposes of Section 672(f)(2)(A)(i).

How do you figure out whether a trust has one of these powers in it? Here is how I do it.

Look for explicit language

The first thing is to look for explicit language in the trust document. 

If you are lucky there will be a clause that explicitly says “this trust is irrevocable” or “this trust is revocable” and the clause will name the person (typically the “Settlor”) holding the power to revoke.

If that person is a grantor . . . bingo. A power to revoke held by the grantor is a power to revest assets in himself/herself. Reg. Section 1.676(a)-1. 

Your grantor (by assumption) is a foreign person, and your grantor holds the power to revest assets in his/her own name. Therefore the trust can be a grantor trust with a foreign grantor because of IRC Section 672(f)(2)(A)(i).

If the trust document is silent, look to governing law

What if the trust document says nothing about whether the trust is revocable or irrevocable? 

Some jurisdictions say that if a trust document is silent on the question of whether it is revocable or irrevocable, the answer is “revocable.” California law says this, by statute. Probate Code Section 15400. Other jurisdictions say that silence means the trust is irrevocable. New Zealand, I know from experience, is like that.

Find the paragraph in the trust that specifies the governing law of the trust. Find out what the default rule is in that jurisdiction.

You definitely need a lawyer in that jurisdiction to tell you the answer.

I have not looked at the whole world, but my gut feeling is that in most countries outside the United States you should assume a trust is by default irrevocable unless the trust document explicitly says otherwise. Still, the governing law might give you the answer you need to show the IRS that the grantor has the power to revoke the trust.

Even an irrevocable trust can give a grantor the power to revest assets

But even if the trust is irrevocable – either because it says so or the governing law says so – all is not lost.

Remember it’s not just the power to revoke that matters. Any power that the grantor holds that allows him/her to revest assets in his own name will satisfy the rule in IRC Section 672(f)(2)(A)(i) and make the trust a grantor trust with a foreign grantor.

Remember the list of powers given in Reg. Section 1.676(a)-1? The grantor’s “power to revoke, to terminate, to alter or amend, or to appoint” will all be treated as a power to revest assets.

Look at the power to appoint successor trustees

Remember that if a related/subordinate/subservient person is named as trustee of the trust – and the grantor is a beneficiary – then this is enough to engage the IRC Section 672(f)(2)(A)(i) rule that makes the grantor trust a grantor trust with respect to a foreign grantor.

Without any trust amendments, does the grantor have the power to remove and replace trustees? If the answer is yes, are there any restrictions on who may serve as a trustee?

If the grantor has the power to appoint a trustee, and there are no restrictions on who is qualified to act as trustee, then the grantor has a blank check to cash anytime he wants. He can appoint himself (or a related/subordinate/subservient person) as trustee and distribute assets to himself as a beneficiary. 

The mere fact that the grantor holds the power to appoint “the right kind of person” as trustee is enough. It’s sort of like constructive receipt: the grantor can do this, so we assume that the grantor has already done it. It is sufficient that the grantor can, at any time, with the stroke of a pen, revest assets in himself/herself.

Read the rules for removal of trustees and appointment of successor trustees in the trust document, then brainstorm. Can you imagine a way to put the grantor (or a related/subordinate/subservient person) in the position of trustee? If so, you can argue that the grantor has the power to revest assets in himself/herself within the meaning of IRC Section 672(f)(2)(A)(ii), and the trust will be a grantor trust with a foreign grantor.

Can you amend your way to grantor trust status?

An irrevocable trust is rarely completely locked in place. There is usually a way to amend it.

Read the trust document to find rules for how to amend the trust. You will probably see something that says the trustee has the power to amend the trust document. Sometimes there are limitations on what clauses can be amended. Sometimes consent of someone else (beneficiaries or a Protector) will be required.

Take the “this is how you amend the trust” clauses in the trust document and get creative. Can you see a pathway to multi-step amendments by which you end up with the grantor as a beneficiary and also holds trustee powers or can put a related/subordinate/subservient person in place?

If you can find a pathway, ask yourself whether you can look at the whole string of amendments as a self-executing chain of documents and actions that the grantor could trigger at any time. If so, analogizing to the idea of constructive receipt, we can say that the grantor has the power to revest assets in himself/herself at any time. 

If the only thing standing between the grantor and ownership of trust assets is drafting some trust amendments and signing them (or getting the consent of a related/subordinate/subservient person) then, to quote the villain in The Matrix, “No, Lieutenant, your men are already dead.” 

The thing is that foreign trusts typically have no analog to “related or subordinate” and “adverse or nonadverse” etc., as these are all U.S. grantor trust concepts. Thus you will frequently find wide-open abilities to amend the trust to put the “wrong” people in place as trustee (related/subordinate/subservient people) and achieve the grantor trust result you want.

Conclusion

There you go. That’s a roadmap of my trust analysis process when I’m attempting to understand a foreign trust – as it relates to grantor trust status, with the objective of making a foreign person the grantor of the trust within the meaning of IRC Section 672(f)(2)(A)(ii).