More than three years after FATCA was introduced it is perhaps surprising that “Accidental Americans” are still providing a steady stream of activity for private client lawyers and fiduciaries, as individuals continue to emerge who had not realised that they have US taxation or information filing obligations.
In some cases such people may not realise that if one or both of their parents qualifies as a US citizen who has spent a defined period of time in America before leaving, any subsequent children, whilst not born on US soil, will probably still qualify as US citizens – or maybe they are still holding a green card, whether valid or expired which they had all but forgotten about.
In another scenario, grandparents wishing to plan for the future can inadvertently fall foul of the US rules in settling a non US trust for the benefit of their non US grandchildren, one of whom subsequently becomes a US citizen (often through marriage or remaining in the US post education).
Any benefit subsequently bestowed on the US grandchild can have penal tax consequences if the assets have not been appropriately managed throughout the life of the trust or alternatively the appropriate planning has not been undertaken upon discovery of the US beneficiary.
If there is the possibility of an American citizen benefiting from the trust fund at any point in the future, the assets should be managed in a specific manner in order to avoid what are referred to as the throwback rules, a tax capped at 100 percent.
When such a situation arises it will be necessary to undertake some retrospective “cleaning up” to correct the position, potentially partly through filing and disclosure agreements. However, by far the most preferable and efficient preparation for such circumstances would be to maintain flexibility when creating the initial structure, otherwise it can become challenging and expensive to resolve at a later date.
Underlying all these issues is the fact that the US citizenship rules are highly complex. Americans are subject to global US income and transfer taxes regardless of residency, domicile or situs of the asset. Even foreign clients (non US citizens) may be subject to worldwide US income tax if they fall into the net of being US income tax resident, which does not necessarily require them to have been born in the US or even to be living there at the time of the planning. Accidental Americans can fall into a number of categories.
Perhaps the most obvious example will be where an individual is a US citizen through birth, in that one or both parents was a US citizen - meaning that at least one of them spent a prescriptive amount of time in the US before the birth, or the individual in question was born on US soil whether of US or non-US parents.
Alternatively, US citizenship may be acquired through naturalisation where a lawful permanent resident (“LPR”), otherwise known as a green card holder, has spent more than five years in the US or, if an LPR has spent three years or more in the US and is married to a US citizen.
Thirdly, a person may become a US citizen through derivation. Since 2001 this has applied to the child of an LPR where one or both parents have been naturalised and the parent and child are both resident in the US.
The importance of Know Your Client has never been more paramount, as some individuals may have no idea whatsoever that they are classified as a US citizen. It is estimated that 6.2 million US citizens live outside the US and an unknown number of those individuals will be unaware and undisclosed.
For advisors and trustees one way of future-proofing against Accidental Americans is introducing and maintaining flexible planning.
Whether establishing a structure at the outset or reviewing it once a US person has been discovered, the transient nature of 21st century high net worth families means that it makes sense to plan for the possibility of a future US touchpoint.
Flexible planning can allow US persons to benefit at a future point from an existing trust fund which has been sympathetically managed from the outset to ensure US tax efficiencies.
With the benefit of advanced planning (at the outset as well as pre-immigration planning) a structure can be established that will allow beneficiaries to benefit without falling foul of the US tax rules.
It is also necessary to be aware of the potential issues, such as investing into Passive Foreign Investment Companies, when choosing investment managers and reporting options.
The unexpected discovery of a US settlor, beneficiary or protector may have a greater impact than one might expect due to the way the US rules work in relation to foreign and domestic US trusts.
To determine whether a trust is classified as a foreign or domestic trust (resident for US income tax purposes) two tests must be satisfied: A court test, meaning that a court within the US must exercise primary supervision over the trust (this does not have to be exclusive) and a control test, where one or more US persons “control” all substantial decisions of the trust.
For the latter in particular it will be crucial to identify the citizenship of the principals with appointed authority within the trust instrument and more importantly any changes in the citizenships of those individuals, in order to avoid unexpected migrations.
The final point to note here is the potential filing consequences in the case of an Accidental American. There are many filling obligations for American tax payers such as FBAR, FATCA, beneficiary statements (Form 3520), ownership reporting for US controlled foreign corporations and PFIC filings.
Penalties for failure to file without reasonable cause can be substantial and as filing requirements grow this cannot be ignored, especially with the backdrop of FATCA and similar legislation compliant with the Automatic Exchange of Information initiative. As we work towards achieving global transparency, our tax residency has become a growing part of our identity.
For these reasons there is an argument for limiting the beneficiary class of the trust especially where there is the possibility of benefitting a US citizen at some point in the future. Whilst this will not change the specific tax requirements for administering the trust fund in a prescriptive manner it may help to manage the reporting in the short to mid term.
The unintended consequences of being an Accidental American cannot be underestimated. When undertaking any form of estate planning exercise where there is the possibility of beneficiaries becoming US tax payers or a US person being subsequently added to the beneficiary class thought should be given to this during the planning so that sufficient flexibility is built in from the outset.
In the event that the Accidental American is discovered retrospectively it’s possible for an adviser or trustee to undertaken a “clean up” which may mitigate the situation but is likely to be time-consuming for the advisor and costly for the individual concerned.
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