Can a QTIP Trust Become Foreign and Subject 3520/3520-A

Can a QTIP Trust Become Foreign and Subject 3520/3520-A

Can a QTIP Trust Become Foreign and Subject 3520/3520-A?

The QTIP Trust ‘Qualified Terminable Interest Property’ is a trust instrument that is oftentimes used in situations in which a spouse has children from a prior marriage and wants to plan to leave assets to their children, while also providing for the current spouse. In order to plan to take care of the children from the first marriage to ultimately receive the assets, while also planning for the current spouse to receive an income stream when the first spouse passes, they can create a QTIP Trust.  While the QTIP trust begins as a US Trust, if the trust migrates and becomes a foreign trust — it can lead to a big tax and reporting headaches for all those involved.

Purpose of the QTIP Trust

The primary purpose of the QTIP tries to make sure that the surviving spouse — who is not the original spouse — receives a stream of income following the death of the other spouse while protecting the assets of the first spouse so he can direct them to his children and not have them diverted to the surviving spouse or her children.

Income Tax on Spousal Income

Since we are dealing with a trust, it is important to note that there are two different types of taxes. There is the estate tax based on the value of the assets relative to the exclusion amount (subject to portability and other issues) and then there is income tax on the income that is generated on behalf of the surviving spouse during her lifetime. While the surviving spouse pays income tax on the income received via the QTIP trust – the estate tax is postponed.

26 USC 2056

      • (7) Election with respect to life estate for surviving spouse

        • (A) In general

          • In the case of qualified terminable interest property—

            • (i)for purposes of subsection (a), such property shall be treated as passing to the surviving spouse, and

            • (ii)for purposes of paragraph (1)(A), no part of such property shall be treated as passing to any person other than the surviving spouse.

        • (B) Qualified terminable interest property defined For purposes of this paragraph—

          • (i) In general The term “qualified terminable interest property” means property

            • (I) which passes from the decedent,

            • (II) in which the surviving spouse has a qualifying income interest for life, and

            • (III) to which an election under this paragraph applies.

          • (ii) Qualifying income interest for life

            • The surviving spouse has a qualifying income interest for life if—

              • (I) the surviving spouse is entitled to all the income from the property, payable annually or at more frequent intervals, or has a usufruct interest for life in the property, and

              • (II) no person has a power to appoint any part of the property to any person other than the surviving spouse. Subclause (II) shall not apply to a power exercisable only at or after the death of the surviving spouse. To the extent provided in regulations, an annuity shall be treated in a manner similar to an income interest in property (regardless of whether the property from which the annuity is payable can be separately identified).

          • (iii) Property includes interest therein

            • The term “property” includes an interest in property.

          • (iv) Specific portion treated as separate prop­erty

            • A specific portion of property shall be treated as separate property.

          • (v) Election

            • An election under this paragraph with respect to any property shall be made by the executor on the return of tax imposed by section 2001. Such an election, once made, shall be irrevocable.

26 CFR § 20.2056(b)-7 – Election with respect to life estate for surviving spouse.

      • 20.2056(b)-7 Election with respect to life estate for surviving spouse.

        • (a) In general.

          • Subject to section 2056(d), a marital deduction is allowed under section 2056(b)(7) with respect to estates of decedents dying after December 31, 1981, for qualified terminable interest property as defined in paragraph (b) of this section. All of the property for which a deduction is allowed under this paragraph (a) is treated as passing to the surviving spouse (for purposes of § 20.2056(a)-1), and no part of the property is treated as passing to any person other than the surviving spouse (for purposes of § 20.2056(b)-1).

        • (b) Qualified terminable interest property

          • (1) In general. Section 2056(b)(7)(B)(i) provides the definition of qualified terminable interest property.

            • (i) Terminable interests described in section 2056(b)(1)(C) cannot qualify as qualified terminable interest property. Thus, if the decedent directs the executor to purchase a terminable interest with estate assets, the terminable interest acquired will not qualify as qualified terminable interest property.

            • (ii) For purposes of section 2056(b)(7)(B)(i), the term property generally means the entire interest in property (within the meaning of § 20.2056(b)-5(d)) or a specific portion of the entire interest (within the meaning of § 20.2056(b)-5(c)).

          • (2) Property for which an election may be made –

            • (i) In general.

              • The election may relate to all or any part of property that meets the requirements of section 2056(b)(7)(B)(i), provided that any partial election must be made with respect to a fractional or percentage share of the property so that the elective portion reflects its proportionate share of the increase or decrease in value of the entire property for purposes of applying sections 2044 or 2519. The fraction or percentage may be defined by formula.

Migration of Trust Can Cause Headaches

Typically, a QTIP trust will begin as a US domestic trust — but there are various scenarios that can occur that may result in the trust becoming a foreign trust. For example, if at any time during the life of the trust, it no longer satisfies either the court or the control test, the domestic trust may become a foreign trust. For example, if the surviving spouse is a Lawful Permanent Resident and decides to return to their country of citizenship and give up their US status, this could become a problem if in addition to moving outside of the United States and giving up US person status — they can appoint a new or additional trustee. If the beneficiary has any power to change the trustee and selects a foreign trustee, for example, because now they are a foreign person residing outside of the United States, this can impact whether the trust is still considered a domestic trust, since it may fail the control test. In addition, if there is any type of migration or flee clause verbiage in the trust — it can cause unnecessary problems.

Migration of Trust, Taxes, and Reporting

When a domestic trust migrates and becomes a foreign trust, many potential issues can happen. In the situation of a grantor trust, the grantor may become subject to the tax. If the trust is a non-grantor trust, it may incur a tax liability based on the fair market value of the assets that were migrated outside of the United States. Likewise, there can be additional tax headaches matters involving items such as the throwback rule. Moreover, there are various foreign trust reporting requirements for the trust now that it is a foreign trust — such as Form 3520 and 3520-A. The failure to file these forms may result in significant fines and penalties, and since they are assessable penalties it can be a big headache to try to fight the IRS to a bed or remove those penalties.

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