What is a Hybrid Trust?
Trusts in general are legal entities that combine aspects of corporations, contracts and a last will and testament. The settlor (founder or creator of the trust) signs a legal document appointing a trustee (administrator) and outlining the trustee’s powers, while reserving some powers for the settlor. The Trust document also stipulates who are the beneficiaries (the persons who should benefit from the trust property), including how and when they should benefit. The applicable statutes and case law determine the interpretation of what the Trust document says and fill any gaps when the document contains conflicting language or fails to cover essential terms. There are an infinite variety of Trusts and each Trust should be personalized according to the profile and objectives of the settlor and beneficiaries, and depending on the type of assets to be owned by the Trust. A Hybrid U.S. Trust, for example, is a type of Trust created pursuant to the law of one of the States without being considered a U.S. taxpayer.
Even though Trusts are like corporations in many respects, a Trust does not have to registered anywhere to exist. As such, a Trust can be kept totally private. In fact, certain Trust laws were designed specifically to protect the identity of the settlor and beneficiaries and require third parties to deal with the trustee directly. However, when dealing with third parties such as opening a bank account or selling real property, the existence of the Trust must be revealed to some extent. For persons in compliance with their home countries’ tax laws, a Hybrid Trust may not create any reporting requirements and may be exempt from tax information exchange. Depending on how the trust is structured and operated, FATCA may not require reporting by the settlor or beneficiaries of the Trust and CRS is inapplicable because the US is not a party to CRS.
A Hybrid Trust is a US trust that is not a US taxpayer. To achieve this dual classification under the tax law, the Trust documents must meet certain technical requirements and care must be taken in how the Trust is operated. A Hybrid Trust is basically taxed like a foreign individual: it is not taxed on income earned outside the US nor does it pay tax on interest and capital gains earned in the US. Assets held in a Hybrid Trust can also avoid the up to 40% estate tax when the settlor or beneficiaries pass away. Since the Trust is created using US law, the desired US tax benefits are more likely to be respected in the event of an audit or legal dispute, because the trust law and tax law coexist in the same country and have evolved in reference to each other.
Estate Planning Benefits
The most fundamental benefit of a Trust is to be a testamentary vehicle, because assets held by the Trust can be kept outside of court upon the death or incapacity of the settlor. In some cases, the Trust can shield the assets from claims against the settlor and/or beneficiaries. In fact, in the event of a divorce of death, the spouse or heirs might not have any right to the assets held by the Trust. Since the Trust is controlled by US law, it is backed up by some of the strongest, most sophisticated, flexible and predictable laws available. If necessary, the settlor’s wishes can be enforced in perhaps the most efficient and fairest courts on the planet.
Technical Considerations and Practical Consequences
With so many legal and tax considerations, designing a trust that can stand up to an IRS audit or pass muster in the courtroom requires a vast amount of knowledge and experience. Among other things, here are just some of the tax and legal issues that must be covered to create a proper Trust:
- Choosing among the various US jurisdictions: e.g. Delaware, Wyoming, Nevada, South Dakota, Florida, etc.
- Choosing the Trustee: Individual or Institutional? Settlor as Trustee? Family members?
- Revocable vs. Irrevocable? What powers if any will the Settlor reserve if irrevocable?
- Discretionary or Directed?
- How to deal with current or potential US beneficiaries?
- Who should be the Protector and what powers should they have?
- What will be the Trust’s FATCA classification? How will you complete the W-8 forms?
- How to stipulate in the Trust how things should be handled during the life and upon the death of the settlor in a way that it can be understood and administered by the Trustee and/or a judge in the event someone does not follow the wishes of the settlor
- When transitioning from an existing offshore trust, is it better to “domesticate” or “decant” to a Hybrid Trust?
- How will the tax profile of the Trust change upon the death of the settlor?
- Etc., etc., etc….
A US trust designed to have certain US tax characteristics should obviously be created by an independent and experienced, US tax and trust lawyer. Moreover, an independent attorney is the only person who can provide attorney-client privilege to some of the most intimate communications regarding your wealth ecosystem and family dynamic. None of the so-called “confidential” communications with financial advisors, accountants, or offshore company and trust providers, are protected by the attorney-client privilege. Nevertheless, the following professionals play an important role in the formation and maintenance of the Trust, because they cover essential issues beyond the US tax and legal ones:
- Local lawyers in the settlor/beneficiaries’ home country. Every country has rules regarding whether and how to report involvement with a Trust. Communications with these attorneys may be protected by attorney-clients privilege, depending on the country.
- Accountants. US accountants cannot partner with lawyers, draft legal documents, or provide attorney-client privilege. However, the assistance of an accountant with expertise in the subspecialty of international taxation of trusts is required to prepare tax reports in certain situations, such as when a Hybrid Trust wasn’t structured properly or upon the Trust becoming controlled by US persons.
- Corporate Formation/Trustee Service Providers. Most US jurisdictions require trustees to be licensed and few attorneys are willing to serve as trustee due to potential conflicts of interest. There is a competitive marketplace of businesses offering these services. Most will require the participation of an independent attorney in drafting the Trust, and all of them provide disclaimers that they do not provide US tax or legal advice.
- Financial Advisors. Private bankers and other trusted financial advisors are often the first to identify the need for a Trust to avoid paying unnecessary taxes or prevent the reduction in wealth resulting from a disorganized transfer from one generation to the next. After forming a Trust, the transfer of funds and/or opening of new bank accounts must be coordinated with the financial institution.
How do we create a Hybrid Trust?
Creating a Hybrid Trust that actually works is a four-step process: 1. First, we meet with the settlor in person, over the phone or Skype to carefully and confidentially review the technical considerations mentioned above and determine the optimal structure for each particular case. 2. Based on this conversation, we prepare a customized draft of the Trust that defines the relationship between the settlor, trustee and beneficiaries. We may have to go through multiple versions until the settlor is sure the stipulations reflect their desires, the relevant law and requirements of the trustee. 3. The settlor and trustee sign the trust document in a way that satisfies all the legal formalities, and 4. Transfer assets to the trust.
Contact us at 305-444-7662 or Ed@AristaLaw.com for a confidential consultation.