MORE IMMEDIATE USE OF THE OFFSHORE STRUCTURE
The FNGT is an excellent tool for long term planning. To the extent assets are not needed for the use of the Settlor they can be invested for distribution to his or her children, grandchildren, etc. at a future time. Until recently Settlors were able to make tax advantageous use of the FNGT Structure by borrowing money on arms-length terms. However the Small Business Job Protection Act of 1996 added IRC §643(i), which provides that a loan by a foreign trust directly or indirectly to a U.S. grantor or beneficiary is treated, except to the extent provided in regulations, as a distribution in the amount of the loan. The conference report to the 1996 Act states that regulations are expected to provide an exception from this treatment for loans with arms-length terms, and that consideration will be given to whether there is a reasonable expectation that a loan will be repaid. This provision applies to loans made after September 19, 1995.
Notice 97-34, 1997-25 IRB 22 states that a loan is excepted from distribution treatment under the above rule if it is in consideration for a "Qualified Obligation from the grantor, beneficiary or a related person. The IRS is expected to issue regulations. Until these regulations are issued, taxpayers must comply with Notice 97-34. An obligation is a qualified obligation only if (among other requirements): (i) it is written; (ii) doesn't exceed five years, (iii) the U.S. transferor reports the status of the obligation, including principal and interest payments, on Form 3520 for each year that the obligation is outstanding.
If, while the original obligation is outstanding, the U.S. transferor or a person related to the trust directly or indirectly obtains another obligation issued by the trust, or if the U.S. transferor directly or indirectly obtains another obligation issued by a person related to the trust, the original obligation will be deemed to have the maturity date of any such subsequent obligation in determining whether the term of the original obligation exceeds 5-years. In addition, a series of obligations issued by and repaid to the trust (or a person or entity related to the trust) will be treated as a single obligation if the transactions giving rise to the obligations are structured with a principal purpose to avoid the application of this provision.
If allowing assets to grow tax-free for his heirs is longer-term planning than the Settlor had in mind, there may be other methods to allow the Settlor to use the assets transferred. For example:
1. Loans from the IBC. All loans made directly or indirectly from trusts must comply with IRC §643(i) and the guidelines set forth in Notice 97-34 (see above).64
The IBC can loan the Settlor money, and secure the loan with a lien.65 If the interest payments are properly structured as portfolio interest, no withholding taxes will be payable when the interest is paid to the IBC. If the IBC is in a no-tax jurisdiction, no tax will be due.
If a creditor attempted to attach the Settlor’s assets, the creditor would not be able to do so in view of the prior lien in favor of the IBC "lender". U.C.C. should be used.
2. Mortgages. All loans made directly or indirectly from trusts must comply with IRC §643(i) and the guidelines set forth in Notice 97-34 (see above).66 The Settlor can borrow from the foreign structure secured by mortgages on his or her home or other real estate. The mortgage is a lien against the real estate (to the detriment of future creditors), the interest tax deductible by the Settlor,66 and tax and withholding free to the IBC.67 This device has almost no peer in its ability to deter a creditor from attachment of a Settlor's home and other real estate.
If a creditor obtained a judgment against the Settlor, the creditor would find that the Settlor has no equity in his real estate. The equity in his home and investment real estate has been encumbered via trust deeds to the IBC ("lender").
3. Factor. If the Settlor's business has receivables, they can be sold to the IBC on a discounted basis (known as factoring). Again, this planning must be on reasonable commercial terms. U.S. taxes are only due on the discounted amount received from the IBC. If and when the amount of the discount is received by IBC, this amount is received tax-free.
4. Consult. The Settlor may be able to consult with the IBC and receive a taxable consultation fee.68
5. Offshore Business. The IBC can conduct a business activity outside the U.S.
6. Sale at Fair Market Value. The IBC can purchase rapidly appreciating U.S. based assets at their current fair market value in exchange for an annuity. The future appreciation is offshore and not taxed.
7. Sale of Lois Los Angeles’ Corporation. The journey has been long and complex, but finally Lois Los Angeles understands. Whereas she can not hope (or can she---see the second part to this article) to be taxed exactly as Victor Vancouver, she can come close. She must set up an FNGT which in turn must set up an IBC. She must exchange her stock for a private annuity. The FNGT (as an NRA) can sell her stock tax-free. She will not be taxed immediately, the NRA's assets (like Victor's) will grow tax-free, however, unlike Victor, if she lives past the starting date of the annuity, the annuity payments will be taxed, and her children (unlike Victor's) will be taxed on distributable net income after her death. In addition if she would like to use the money (unlike Victor who has no restrictions) she must borrow it and she is subject to IRC §643(i).
By using an IBC to sell a Settlor’s domestic corporation, the tax savings to the Settlor and his family can be significant.
In the second part to this article we will see that the IRC §643(i) restrictions as well as DNI taxation can be eliminated.
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