Can a foreign trust really lower your tax bill?

As an American, he knew he was required to pay tax on all the income he received in the US. But he believed that because the profits stayed inside his foreign corporation, he had no current US tax or reporting obligations.

That wasn’t true of course – the US taxes its citizens and residents on worldwide income from any source. And he needed to clean it up.

Fortunately, the IRS has several compliance procedures to help Americans on the wrong side of compliance. You can learn more about it here.

But mistakes like his are unfortunately not all that rare. We regularly come across cases like this.

And if you spend any length of time researching online experts talking about such things, or prompting AI to build an offshore solution for you, there’s a good chance you’ve gotten some bad advice too.

That bothers me for the obvious reasons that:

#1: It doesn’t have to be all that complicated.

#2: Most of these mistakes can be avoided in the first place.

And in fact, for our premium service, the Nestmann Inner Circle, I just released a briefing last week outlining five of the most common assumptions that lead to making mistakes. (Feel free to give the service a risk-free whirl if you’d like to have a look.)

But in today’s missive, I want to share one we see a fair bit…

Offshore trusts aka International Asset Protection Trusts aka Offshore Asset Protection Trusts, have their uses.

But in my mind, they are grossly oversold as a tool for the simple reason that what clients think they are buying – amazing asset protection with powerful tax benefits – isn’t actually true.

Yes, they do offer great asset protection if structured properly. But, for most US clients, they don’t provide any tax benefits.

Let’s quickly look at why that is.

To do so, we need to review the most relevant regulations around this topic – IRC Section 671-679.

(I’ll spare you the tedium of reviewing it here, but if you’re looking for a natural sleep aid, here are the relevant sections in all its glory.)

In short, these rules basically govern what defines a ‘grantor’ trust—meaning the person who set it up is treated as the owner for tax purposes.

For Americans setting up foreign trusts, the rules usually push them into grantor trust status. That means all gains are treated as if you earned them personally, and passed through to your personal tax return. No tax deferral or exemption at all.

But when someone promotes offshore trusts as a tax-saving strategy, they’re almost certainly talking about the non-grantor variety. And you’d be correct in assuming that the IRS is not a big fan of allowing US citizens to move assets into a structure that would deprive Uncle Sam of future revenue.

The rules are designed to drag the trust classification clearly into the “grantor” category should you try to do so.

So is there actually a way to get meaningful US tax savings with an offshore trust?

Yes, but you have to be willing to:

• Give up all control or influence over the assets permanently.

• In many cases, be willing to pay a tax on appreciated assets as if you had sold them as of the transfer date.

• Trust that a foreign trustee will manage it as you hope in the best interest of the beneficiaries, knowing that you won’t have the right to step in later.

Most clients aren’t comfortable with this, and so they don’t move forward.

Now please don’t get me wrong – an offshore trust can be a useful tool. But it needs to be presented with honesty.

If asset protection is the number one most important thing, it’s worth a look. If tax savings are your primary motivator, it’s worth looking at other options.

If you need some help with your planning and want to leverage our 40+ years of experience to do so, feel free to get in touch.