Increasingly we receive questions from Bermuda nationals as to the US taxation of distributions from a Bermuda trust to children or grandchildren of the Bermuda grantor who are US citizens. As this subject involves both tax and legal issues, I have asked Dina Kapur Sanna, a partner in the New York office of the US law firm of Day Pitney LLP to host the column for this month and her response follows.

Importance of US Tax Planning For Bermudians with US Children

Given the proximity of the US to Bermuda, it is not at all uncommon for Bermudian families to include one or more family members who are US persons. Tax planning opportunities exist for these families, especially with regard to the portion of the family wealth that is owned by the senior generation foreign (non-US) family members. Potential tax traps are also plentiful.

Whenever the term "foreign" is used, it is deemed to refer to the laws of a non-US jurisdiction.

US Income Tax

US persons are subject to income tax on worldwide income at rates that range from 15 percent (on long-term capital gains) to 35 percent (on ordinary income and short-term capital gains). Note: These rates are scheduled to increase to 20 percent and 39.6 percent respectively, in 2011.

Foreign persons are subject to income tax on certain types of US source "passive periodic" income and income effectively connected with a US trade or business. US source "passive periodic" income includes dividends paid by US corporations, rental income from US real property and gains on the sale of US real property, among other things, and the tax is collected by withholding at source.

Importantly, interest paid on US corporate and government bonds and on US bank deposits is usually exempted from tax to encourage foreigners to buy US debt.

A US person for income tax purposes includes (i) a US citizen, and (ii) a non-US citizen who either (a) holds a US green card or (b) meets the physical presence requirements of the substantial presence test of the US federal income tax laws, which requires presence for at least 31 days in the current calendar year and presence in that year and the two immediately preceding calendar years to equal a weighted aggregate of 183 days or more.

US Transfer Tax

US persons are subject to gift, estate and generation-skipping transfer tax on their worldwide assets at rates as high as 45 percent. The amount that can be transferred free of gift tax is $1 million and the amount that can be transferred free of estate and generation-skipping transfer tax is $3.5 million. Note: The estate tax is scheduled to be repealed in 2010 but just for one year. It is extremely likely that Congress will take some action in 2009 to undo the one-year repeal and keep the existing rates and exemptions through 2010 and beyond.

Foreign persons are subject to gift, estate and generation-skipping transfer taxation only on US-sitused assets. For estate tax and generation-skipping transfer tax purposes, US-sitused assets include US stocks, US real property and tangible personal property physically located in the United States.

The amount that can pass free of estate tax in a foreign person's estate is limited to $60,000. For gift tax purposes, only US real property and tangible personal property are considered US-sitused assets A US person for transfer tax purposes is (i) a citizen, and (ii) a non-US citizen whose primary residence, or domicile, is in the United States, based on the person's physical presence in the United States and intention to remain indefinitely.

Trusts

There are structuring opportunities for US beneficiaries through the use of so-called "grantor trusts," which are tax transparent entities.

If the person settling the trust is a foreign person and the trust is invested in non-US source income producing assets, during the foreign grantor's life neither the trust nor the grantor is subject to income tax. Likewise, distributions to US beneficiaries during the foreign grantor's life are free of tax and income accumulated by the trust during this time is not taxed when distributed to US beneficiaries after the grantor's death.

However, to be a foreign grantor trust, one of the following requirements must be met: (i) the foreign grantor must have power to revoke the trust and reinvest its assets in himself or herself either alone (without the consent of another person) or with the consent of a related or subordinate party who is subservient (within the meaning of the Internal Revenue Code (the "Code")) or (ii) the only amounts distributable from the trust (whether income or principal) during the foreign grantor's lifetime are to the grantor or his or her spouse. A foreign trust becomes a non-grantor trust on the death of the grantor - or at the outset, if one of the above requirements is not met. Distributions of income from a foreign non-grantor trust to a US beneficiary carry out taxable income.

Importantly, if a foreign non-grantor trust accumulates income and later distributes it to a US beneficiary, the distribution carries the following adverse US tax consequences: (i) all capital gains realised by the trust in prior years are taxable at ordinary income rates, (ii) an interest charge applies on the tax due on the accumulated income per annum from the date the income was originally earned and (iii) so-called "throwback rules" apply so that the income may be taxed at the beneficiary's tax bracket for the year in which it was earned.

The following example illustrates how the failure to seek US tax advice can lead to unintended dire consequences for the US family members:

Example

Father is a 70-year-old non-US citizen and resident of Bermuda. Son is a 33-year-old who holds a green card and is domiciled in the United States. Recently, Son's wife gave birth to Granddaughter, a US citizen. Father wishes to give $10 million to Son. Son has no present need for the money but wants to know that he can receive income or principal in the future, as necessary. Eventually, Son hopes to pass the money to Granddaughter.

Without planning: If Father gives Son $10 million, there will be no gift tax on the transfer. (However, Son must report receipt of the gift to the Internal Revenue Service and there is a penalty of 35% of the gift for failure to report.) Son will be liable for income taxes on all future income earned by the gifted assets and remaining assets will be taxable in his estate, as well as Granddaughter's estate, upon their respective deaths.

With planning: Instead of making an outright gift, Father puts $10 million in a properly structured foreign grantor trust for the benefit of Son. Son is a permissible beneficiary of both income and principal. Neither Father nor trust is subject to income tax, except 30 percent withholding on US source "passive periodic" income. Son can receive distributions during Father's lifetime on a tax-free basis, although he must report them to the Internal Revenue Service. The trust can incorporate generational tax planning aspects by continuing for the lives of Son and Granddaughter. These family members may receive income and principal of the trust as needed in the Trustee's discretion, and the assets that remain in the trust are not subject to estate tax on the death of Father, Son or Granddaughter.

After Father's death, the trust will become a foreign non-grantor trust, and distributions of accumulated income to Son or Granddaughter will have adverse income tax consequences. In this case, the following are some available options; these can be used in combination for various portions of the trust fund:

1. Migrate to United States: The Trustee could pay all current income (including capital gains) to Son or move the trust situs to the United States. In both cases, all income will be taxed currently, but the future accumulations problem will be avoided.

2. Accumulate and Pay Only to Non-US Beneficiaries: The Trustee can leave the trust offshore, accumulate the trust income free of income tax, and make distributions of accumulated income only to non-US beneficiaries. The Trustee could benefit US beneficiaries through loans or alternate means (e.g., co-invest in an operating business of the US beneficiaries, purchase tangibles and real estate for the US beneficiary to enjoy).

3. Consider Alternate Investments: The Trustee could invest the trust fund in alternate products such as annuities or variable life insurance products which can build up income inside the policy and avoid the interest charge on accumulations.

Pursuant to the requirements relating to practice before the Internal Revenue Service, any tax advice in this communication is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties imposed under the United States Internal Revenue Code, or (ii) promoting, marketing or recommending to another person any tax related manner.

The tax advice given by this column is, by necessity, general in nature. You should, of course, check with your own US tax consultant as to how specific transactions affect you since tax advice varies with individual circumstances.

James Paul Sabo, CPA, is the president of ETS Ltd., PO Box HM 1574, Hamilton HM GX, Bermuda. Questions should be sent to: jsabo@expatriatetaxservices.com