We are taking a break from The Ultimate Tax Guide this week and next week to answer, in two parts, a question I received from a reader. We’ll get back to our 37 Tax Insights in a couple of weeks when we will start discussing foreign tax credits. The issue we will be discussing today and next week relates to the foreign taxation for Swiss resident beneficiaries of US trusts. The person who asked the question lives in Switzerland, and since this a situation that regularly impacts my clients, I am addressing the key points today.
As with every tax issue that we discuss, my goal is to give you a framework to think about them. If you are an immigrant in the USA or an American living in a foreign country that is not Switzerland, you can apply this framework to your situation to try to understand how trust distributions may impact you.
Stay safe and take good care of one another. Un abrazo y buena onda,
I am a beneficiary of a US trust and live in Switzerland. Now what? – Part I
You are a US citizen, and you live in Switzerland. You just learned that you have been named beneficiary of a US trust. Congratulations!
You are happy to be entitled to trust distributions, but you are also worried about the consequences. What are the US and Swiss implications? You wonder….
Let’s start from the beginning.
What is a trust?
A trust is a legal vehicle by which a party, the grantor, appoints a second party, the trustee, to manage assets held in trust for the benefit of a third party, the beneficiary.
Grantors set up trusts to ensure that their assets are managed in a certain manner during their lifetime and after their death. The trust document specifies how the grantor wants the assets to be managed and distributed by the trustee to the trust beneficiaries.
Trusts are widely used in the USA as estate planning instruments. Trusts avoid probate, protect the privacy of the grantor and beneficiaries, and can also help avoid estate taxes.
What are the most commons situations by which US citizens living in Switzerland become beneficiaries of US trusts?
The most common scenario usually involves a Revocable Living Trust. A Revocable Living Trust is when a grantor (usually mom, dad or both parents) set up a trust and name themselves trustees and beneficiaries during their lifetime. During the lifetime of the parents, the trust is disregarded, and the assets and income are treated as if they were still owned directly by the parents. The parents, as grantors, usually retain the ability to modify the terms of the trust if they wish to.
When they pass away, the trust becomes irrevocable, the successor trustee is appointed, and the contingent beneficiaries (usually the children) become the primary beneficiaries. It is typically at this point that US citizen children, usually adult children, living in Switzerland, are informed that they is now the beneficiaries of a US trust.
What are the US tax consequences of being beneficiaries of a US trust?
US beneficiaries of a US trust are typically responsible for income tax on any income that they receive from the trust as a distribution. They do not pay any tax on distributions of trust corpus.
What is trust income?
Trust income is generally interest, dividends, rents, royalties or gains on the sales of appreciated trust assets.
What is trust corpus?
Trust corpus are the assets that were initially contributed to the trust by the grantors.
How do US beneficiaries know if a trust distribution is from income or corpus?
Trust beneficiaries receive a tax form, called Form K-1, that specifies the breakdown of the trust distribution into various different categories such as interest, ordinary and qualified dividends, rental income, long and short-term capital gains, distributions from corpus, etc.
The breakdown shown in the Form K-1 is used to prepare the beneficiary’s US income tax return, Form 1040, where the beneficiary reports the different amounts and types of income.
What are the Swiss tax consequences of being the beneficiary of a US trust?
Unlike the USA, Switzerland doesn’t have its own trust law.
On March 13 2019, the Swiss parliament voted in favor of an initiative that requires the Swiss Federal Council to provide for Swiss trust law. The Federal Council has two years to draft a legislative proposal, which is expected early next year, by March 2021.
In the meantime, as a signatory of the Hague Trusts Convention, Switzerland will generally recognize foreign trusts. A US trust is a foreign trust from a Swiss perspective; therefore, Switzerland will generally recognize a US trust as a foreign trust.
What does this mean for the Swiss resident beneficiaries of the US trust?
The Swiss beneficiaries of a US trust can be liable for Swiss taxation with respect to trust assets, trust income or trust distributions if they are residents of Switzerland when the trust is settled or when a distribution from the trust is received.
The taxation will depend on the type of trust involved.
Administrative Swiss tax guidelines distinguish between revocable and irrevocable trusts. Irrevocable trusts are further classified between discretionary or fixed interest trusts.
How do you know what kind of trust you are dealing with?
A tax ruling from the competent Swiss Tax Authority is usually needed to determine the classification of a foreign trust. Yep, you will likely need to go to your Swiss tax authority and ask for a ruling.
What is a Swiss tax ruling?
A Swiss tax ruling is binding determination issued by Switzerland’s tax administration on the tax treatment of a planned or existing tax-relevant situation. Either the taxpayer or the taxpayer’s representative can request the tax ruling. The goal of the tax ruling is to ensure the correct assessment of the facts in question. In this case, the tax-relevant situation is the trust. The tax ruling will determine the treatment that it will receive by the tax authorities and the reporting requirements and resulting taxation to the Swiss trust beneficiary.
Let’s go back now to the example of the Swiss resident adult children who are now the beneficiaries of their deceased parents’ irrevocable U.S. trust. In most cases, the Swiss tax authorities will agree with the characterization of such a trust as being irrevocable from a Swiss perspective. The grantors are deceased and they can no longer modify the terms of the trust.
The second step that the tax authorities will take is to evaluate the terms of the trust, usually by reviewing the trust document, and determine if it will be viewed as a discretionary or fixed interest trust from a Swiss perspective.
We will pick up at this stage in CBP No. 32 to discuss what the Swiss tax authorities take into consideration to make their determination and the consequences, for the U.S. beneficiary, of this decision.
Before signing off, the usual disclaimer: this is not legal tax advice intended for anyone in particular. This is general information to help you understand how to think about things. Do not rely on this information to draw any conclusions about your situation and trust. If you do so, understand that you are doing it at your own risk and that you may reach the wrong conclusion. If you have questions about your situation, you should seek personalized guidance from the competent Swiss tax authorities or from your trusted tax advisor.
Until next week.