Foreign Trusts: What They Are, How They Work, and Why They Matter
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Contents
- What is a Foreign Trust?
- How Do Foreign Trusts Work?
- Why Consider a Foreign Trust?
- 1. Ownership of Foreign Real Estate
- 2. Enhanced Asset Protection
- 3. Privacy and Confidentiality
- 4. Investment Flexibility
- 5. Estate Planning Benefits
- Popular Jurisdictions for Foreign Trusts
- Foreign Trust Tax Classification
- US Tax Reporting Requirements for Foreign Trusts
- Foreign Trust Structures
- Common Foreign Trust Mistakes to Avoid
- Is a Foreign Trust Right for You?
- Setting Up a Foreign Trust
- The Cost of a Foreign Trust
- Foreign Trusts vs. Domestic Asset Protection Trusts
- Common Questions About Foreign Trusts
- The Future of Foreign Trusts
- Our Approach to Foreign Trusts
- Diversification is Key
- From Awareness to Action: Let’s Build Your Plan
You’ve worked hard to build your wealth. But if you’re like many successful Americans, proactively taking steps to protect that wealth might not always be the most urgent priority. It’s easy to assume you’ll “get to it later” when you’re focused on building a career, growing a business, or managing investments.
Yet the hard truth is this: without proper safeguards, even decades of work can unravel in an instant. Lawsuits, creditors, legal challenges, or changing regulations can place everything you’ve earned at risk.
That’s why more individuals and families are looking beyond US borders to secure their assets. Foreign trusts – especially foreign asset protection trusts – are a proven tool for those seeking stronger asset protection and peace of mind. And they’re flexible, too, able to hold foreign real estate, private company shares, stock portfolios, and more.
This guide breaks down foreign trusts – what they do for you, how they’re taxed, and practical considerations you need to know. If you’re worried about protecting your wealth, you’ll find straightforward answers here.
What is a Foreign Trust?
A foreign trust is any trust that isn’t considered domestic under US tax law. The IRS defines a domestic trust as one that meets two specific tests:
- The Court Test: A US court must be able to exercise primary supervision over the trust’s administration.
- The Control Test: One or more US persons must have the authority to control all substantial decisions of the trust.
If a trust fails either test, it’s classified as a foreign trust. If your trust is governed by laws outside the US, or if control over important trust decisions sits with non-US persons, you’re dealing with a foreign trust.
Factors that may cause a trust to be foreign include:
- Having a foreign trustee with decision-making authority.
- Including an “escape clause” allowing the trust to migrate if a US court attempts to assert jurisdiction. (In some circles, this is known as a “bridge trust”.)
- Requiring trust administration to occur outside the US.
- Having foreign co-trustees with veto power over important decisions.
- Specifying that the trust is governed by foreign law.
How Do Foreign Trusts Work?
Like any trust, a foreign trust involves three key parties:
- The Grantor (also called the settlor): Creates the trust and transfers assets into it.
- The Trustee: Manages the trust and handles distributions.
- The Beneficiaries: Receive distributions from the trust.
Foreign trusts operate under the laws of the jurisdiction where they’re established. A trust in the Cayman Islands, for instance, is subject to Cayman Islands law, not US law.
The mechanics include:
- Asset Transfer: The grantor transfers assets to the foreign trust, giving up legal ownership.
- Trust Management: A foreign trustee manages the assets according to the trust document.
- Distribution Standards: The trust document specifies when and how beneficiaries receive distributions.
- Protector Provisions: Many foreign trusts include a “trust protector” who oversees the trustee.
- Jurisdictional Change Provisions, or “Flee Clauses”: Provisions allowing the trust to change jurisdictions if necessary.
The specific structure depends on the jurisdiction chosen and the goals of the grantor.
Why Consider a Foreign Trust?
1. Ownership of Foreign Real Estate
Many clients choose to place foreign real estate—such as vacation homes, rental properties, or land—into a foreign trust. This can help safeguard the property from US lawsuits, simplify estate transfer across generations, and generally help protect against political or economic risks in the US.
2. Enhanced Asset Protection
The main benefit of a foreign trust is the additional protection it provides for assets.
When a creditor realizes assets are held in a properly structured foreign trust, they may be more likely to negotiate a smaller settlement than pursue a lengthy international legal battle – but don’t be surprised if they still make the attempt.
Foreign trusts can protect assets from:
- Commercial creditor claims.
- Forced inheritance claims when owning property in countries that have such rules.
- Civil judgments.
- Professional liability claims.
- Business risks.
Important: Most countries honor the enforcement of criminal cases. A foreign trust generally won’t shield assets from criminal penalties.
Properly structured foreign trusts provide superior asset protection through:
- Jurisdictional Barriers: US courts can’t just reach into other countries. Creditors would need to start a whole new case overseas, hire foreign lawyers, and spend way more money. Jurisdictions like the Cook Islands and Nevis are known for their strong asset protection laws.
- Favorable Local Laws: Some countries have rules that shield trusts from outside claims. They basically say, “Nope, we don’t care about your US judgment.” That said, some foreign jurisdictions are more favorable to trust protection than others—so choosing your location strategically is important.
- Burden of Proof: In many foreign spots, it’s on the creditor to prove you were trying to hide assets. That’s often harder than in the US. Some places set the bar very high – almost like a criminal case standard.
- Short Time Limits: Many offshore places give creditors a tiny window to challenge transfers. The US might give them 4-6 years, but some foreign spots only allow 1-2 years.
- No Recognition of US Judgments: Some places just don’t accept US court rulings. Period. Creditors would have to start over from scratch under local rules.
Note, “properly structured” foreign trusts. You’ll save yourself from expensive headaches when you take the time to set things up the right way, the first time, and this is something we can help you with.
3. Privacy and Confidentiality
Many offshore places keep your financial affairs more private than the US. While certain details of US trusts may become public during lawsuits, foreign trusts usually stay private.
4. Investment Flexibility
Foreign trusts can give you access to investments you can’t get in the US, like international stocks, overseas real estate, and foreign currencies.
In fact, one practical – and often requested – use of a foreign trust is to hold international real estate. Real estate assets located outside the US can be difficult for US creditors to reach, especially when held within a well-structured foreign trust. It can be a very useful way to divide risk between your domestic assets and your international assets.
Owning foreign property through a trust can provide not only asset protection but also privacy and estate planning benefits. Popular real estate markets for this purpose include countries with stable governments, strong property rights, and investor-friendly regulations.
5. Estate Planning Benefits
For families with international connections, foreign trusts offer more flexibility when planning estates, especially when family members live in different countries.
Popular Jurisdictions for Foreign Trusts
Technically, because a “foreign trust” is any trust not under US jurisdiction, any country that include trusts in their law – mostly British Commonwealth countries past and present – will let you set up a foreign trust.
But when we speak of these things, we’re specifically talking about a few specific places that have “beefed up” their trust law to make them very unattractive to creditors.
In that view, there are only a few stand out jurisdictions:
- Cook Islands: Strong asset protection jurisdiction.
- Nevis: Strong asset protection with relatively low costs.
- Belize: One of the strongest asset protection laws on record. However, rarely recommended thanks to a poor reputation in the international community. This makes it very hard to access banking services.
- New Zealand: Although nowhere near as useful for asset protection as the above options, a foreign trust in New Zealand can be a very useful tool for clients with assets in many countries.
When selecting a jurisdiction, consider the legal system, political stability, financial infrastructure, asset protection laws, language, and reputation. For assistance in setting up and placing the most cost-efficient foreign trust structure, feel free to get in touch.
Foreign Trust Tax Classification
For US tax purposes, foreign trusts fall into two categories:
#1: Foreign Grantor Trusts
A trust where the US grantor maintains certain controls over the trust or its assets. Most foreign trusts created by US persons with US beneficiaries fall into this category.
The grantor reports and pays taxes on the trust’s income on their personal tax return.
#2: Foreign Non-Grantor Trusts
A trust where the grantor has given up control of the transferred assets. These trusts are taxed as separate entities (the trust itself is responsible for paying taxes on the income it generates, rather than the grantor).
In theory, this means a US taxpayer could put assets into the trust and not be taxed anymore on their gain. In practice, the rules are so onerous, there’s only one situation we’re aware of where it would make sense.
(If tax planning is the goal, there are better options with fewer complications.)
You might be thinking, “Well, I don’t need the money and want to give it to my kids. Can’t I just put assets in, grow them tax deferred, and let them benefit from it down the line?”
Unfortunately, the answer is no.
US beneficiaries receiving distributions face complex tax rules, including the “throwback tax” on accumulated income – a punitive tax applied to distributions of income that were earned but not distributed in prior years.
The key to avoiding the throwback tax is to ensure that distributions are made regularly and in accordance with US tax regulations.
This is just one example of the rules that make foreign trusts unsuitable for tax planning. They can be very useful; just not to avoid taxes.
US Tax Reporting Requirements for Foreign Trusts
Foreign trusts require significant reporting. Key forms include:
Form 3520
Filed when creating or transferring assets to a foreign trust, receiving distributions, or being treated as an owner. Penalties for non-filing can reach 35% of the asset value.
This form must be filed annually by US persons who:
- Transfer property to a foreign trust.
- Receive distributions from a foreign trust.
- Are treated as owners of a foreign trust.
- Receive certain large gifts from foreign persons.
Form 3520 is due with the taxpayer’s annual income tax return, including extensions.
Form 3520-A
Annual information return filed by the trust or US owner. Due March 15th, with extensions available. Non-filing penalties can be 5% of trust assets.
This form provides information about:
- Trust income and expenses.
- Trust assets and liabilities.
- Distributions to US beneficiaries.
- Changes in trust terms or trustees.
If the foreign trust fails to file Form 3520-A, the US owner must file a substitute Form 3520-A to avoid penalties.
Additional Reporting
May include:
- FinCEN Form 114 (FBAR) for foreign accounts exceeding $10,000 at any point in time in the calendar year.
- Form 8938 for specified foreign financial assets.
- Form 1040 Schedule B, Part III, to disclose foreign accounts and trusts.
Detailed records must be maintained for all trust activities, as the IRS can request these at any time.
Foreign Trust Structures
Effective foreign trusts often incorporate these elements:
Trust Protector
An individual with limited powers to oversee the trustee, typically able to remove trustees, veto decisions, or approve changes.
Underlying Companies
A foreign trust may hold a membership interest in an international LLC or shares in an International Business Corporation (IBC), which in turn owns foreign real estate. This layering provides extra insulation against claims and adds an administrative buffer between the grantor and the property.
Avoiding "Sham" Trust Status
To prevent courts from disregarding the trust, it should:
- Be properly funded.
- Have a legitimate purpose beyond asset protection.
- Function as a real trust with active management.
- Maintain proper separation between grantor and trust assets.
- Follow all required formalities.
Common Foreign Trust Mistakes to Avoid
Mistakes in the world of estate planning can rapidly devolve into expensive snowballs. Getting things right the first time is key to successful asset transfers and compliance with the IRS.
Here are some common mistakes to avoid when establishing a foreign trust – and how working with honest and experienced professionals can help you navigate these complex issues:
- Setting Up a Trust in the Wrong Jurisdiction: Not all jurisdictions offer the same benefits. What works well for one situation might be inappropriate for another.
- Failing to Structure Foreign Real Estate Ownership Properly: Foreign real estate can create complex reporting and legal issues if not correctly placed into the trust structure. Local property ownership laws and tax treaties must be considered. We see this one a lot.
- Poor Trustee Selection: Choose trustees with experience, strong reputations, and deep understanding of relevant laws. A trustee without proper experience or resources can undermine the entire structure.
- Overlooking Reporting Requirements: Remember that penalties can reach 35% of trust assets. The IRS takes foreign trust reporting very seriously.
- Setting Up a Trust Too Late: After claims arise, transfers may be considered fraudulent. Timing is critical – asset protection planning works best when done well in advance of any potential claims. As we say to clients, “when the sun is shining, before any clouds on the horizon.”
- Keeping Too Much Control: This can cause courts to disregard the trust. Effective asset protection requires giving up some control, which many grantors find difficult.
- Ignoring US Tax Implications: Foreign trusts don’t provide inherent tax advantages for US persons. In fact, they can create tax complexities that must be carefully managed. However, the trust can own assets that do provide tax advantages, like a Private Placement Life Insurance (PPLI) policy. Again, though, careful planning is needed.
- Using Cookie-Cutter Documents: Custom drafting is essential for your specific situation. Generic trust documents often fail to address jurisdiction-specific requirements or individual circumstances.
- Underfunding the Trust: A trust with minimal assets may appear to be set up solely for asset protection purposes, which can undermine its effectiveness.
Is a Foreign Trust Right for You?
Foreign trusts typically make sense for:
- High-net-worth individuals with significant assets to protect.
- People with international business interests or family connections.
- Those in high-liability professions (doctors, business owners, real estate developers).
- Those concerned about future liability risks.
Consider these questions:
- How significant is your liability risk?
- Can you afford the setup and maintenance costs?
- Do you have legitimate international connections?
- Are you comfortable giving up direct control of your assets?
- Can you handle the compliance burden?
- Do you have the professional guidance needed?
For most Americans with modest assets, simpler domestic asset protection strategies often provide a better cost-benefit ratio.
Setting Up a Foreign Trust
The process typically involves:
- Consulting with experienced professionals who understand both US and international trust law.
- Selecting the right jurisdiction based on your specific needs and goals.
- Choosing a professional trustee established outside the United States.
- Drafting comprehensive trust documents tailored to your situation.
- Funding the trust with appropriate assets.
- Filing required US tax forms, including Form 3520 for the initial funding.
- Maintaining ongoing compliance with all reporting requirements.
This usually takes one to three months and requires working with the right team – like the professionals we partner with here at Nestmann, including:
- International trust attorneys.
- Tax advisors familiar with foreign trust reporting.
- Professional trustees in the selected jurisdiction.
The setup process should be thorough and deliberate. Cutting corners during establishment can compromise the trust’s effectiveness and create problems later.
The Cost of a Foreign Trust
Foreign trusts aren’t inexpensive. Setting up a foreign trust could cost several thousand dollars, and there are ongoing maintenance costs as well.
Given these costs, foreign trusts usually make economic sense only when you have substantial assets to protect – thresholds vary based on estate complexity, but they typically start with at least $5 million for standard cases.
If a client is in a high-risk profession (medical professional, professional real estate investor, entrepreneur etc), or there is a large number of foreign assets, we may recommend a foreign trust with a lower minimum. But that’s case by case.
But for most Americans with modest assets, simpler domestic asset protection strategies might be more appropriate and cost-effective.
Foreign Trusts vs. Domestic Asset Protection Trusts
Some US states offer irrevocable Domestic Asset Protection Trusts (DAPTs).
To compare:
Foreign Trusts:
- Stronger asset protection.
- Higher costs.
- More complex administration.
- Extensive reporting requirements.
- Greater privacy.
- Less vulnerable to US judgments.
Domestic Asset Protection Trusts:
- Less robust protection.
- Lower costs.
- Simpler administration.
- Standard reporting.
- Limited privacy.
DAPTs are available in states like Nevada, Alaska, and Delaware. Each state has different rules regarding creditor protection, statute of limitations, and exceptions for certain types of creditors.
The key advantage of DAPTs is simplicity – they’re easier to establish and maintain. However, they have a significant weakness: the Full Faith and Credit Clause of the US Constitution requires states to honor judgments from other states. This means a judgment from a non-DAPT state could potentially be enforced against assets in a DAPT state.
Example: Someone living in California couldn’t set up a DAPT in Nevada to hold Californian property and hope to gain any asset protection. A California court would simply disregard the structure and Nevada would have to honor that decision.
Again, there are ways to address this, but it doesn’t come straight out of the box.
Common Questions About Foreign Trusts
Are foreign trusts legal?
Yes, when properly structured and reported. Foreign trusts are legitimate legal structures recognized under US tax law.
Can they avoid US taxes?
No. US persons must report worldwide income regardless of source. Foreign trusts can create tax complexities but don’t provide tax advantages for US persons, unless the trust owns assets or policies that do.
Will they protect from all creditors?
They provide strong but not absolute protection. No asset protection strategy is foolproof, but properly structured foreign trusts create significant barriers for potential creditors.
Can the grantor be trustee?
No. Independent trustees are essential for asset protection. Having the grantor serve as trustee would defeat much of the trust’s protective purpose.
What assets can be placed in a foreign trust?
Most types of assets, though some (like real estate) require additional specialized planning. Cash, investments, intellectual property, business interests, and personal property can all be held in foreign trusts.
It’s worth noting that foreign real estate is a common and valuable trust asset. When owned directly by individuals, foreign property can expose them to local risks, taxation, and lack of privacy. A foreign trust can provide enhanced confidentiality, shield the property from US judgments, and streamline management and inheritance of property across borders.
Can grantors access their money?
Yes, but with limitations. Typically, the grantor would be a discretionary beneficiary, meaning the trustee has discretion to make distributions. Having unlimited access would undermine asset protection benefits.
The Future of Foreign Trusts
Despite increased scrutiny and reporting requirements, foreign trusts remain valuable asset protection tools when properly structured.
Trends shaping their future include:
- Growing international transparency requirements through initiatives like the Common Reporting Standard (CRS) and FATCA.
- Evolution of offshore jurisdictions to balance privacy with compliance.
- Technological changes, including digital assets and blockchain applications.
- Changing needs of globally mobile clients with international ties.
These developments don’t make foreign trusts obsolete, but they do require careful planning and meticulous compliance.
Our Approach to Foreign Trusts
We’ve helped clients establish legitimate, compliant foreign trusts since 1984, focusing on:
- Understanding specific client needs and whether a foreign trust is appropriate.
- Custom-designing appropriate structures that provide maximum legal protection.
- Ensuring full compliance with all US reporting requirements.
- Providing ongoing support as laws and circumstances change.
Diversification is Key
The most dangerous number in wealth protection is one – one jurisdiction, one currency, one asset class. Most Americans have all their assets exposed to one economy and legal system.
Foreign trusts are one tool in a comprehensive wealth protection strategy. Whether or not a foreign trust is right for you, diversification across jurisdictions, asset classes, and legal structures is essential for true wealth protection.
The question is not whether to protect your wealth, but how. If you’re ready to take control of your financial future and explore strategies that go beyond traditional wealth management, feel free to get in touch.
From Awareness to Action: Let’s Build Your Plan
For those with substantial assets at risk, particularly entrepreneurs, professionals in high-liability fields, or those with international connections, a properly structured foreign trust can provide peace of mind.
In today’s uncertain environment, traditional wealth protection strategies may not be sufficient. Those who have worked hard to build wealth deserve a plan to protect it.
Talk to a Nestmann Associate today about developing a comprehensive wealth protection plan that may include a foreign trust or other international strategies tailored to your specific needs.
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We have 40+ years experience helping Americans move, live and invest internationally…
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We have 40+ years experience helping Americans move, live and invest internationally…
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