Tax Haven Abuse: (Wyly Case) (Foreign Trust; U.S. Tax Issues)

The 8/1/06 Report: United States Senate (Permanent Subcommittee on Investigations/Committee on Homeland Security and Governmental Affairs), (Wyly Case) Foreign Trust Tax Issues (excerpted pages 136 – 139):

(a) Background on Trusts

Trusts are established for a variety of reasons, including by persons seeking to provide for the economic security of family members, manage their estates, or fund charitable works to benefit the public. A trust is created when one person, called the grantor or settlor, conveys a property interest to another person, called the trustee, to be held for the benefit of a party called the beneficiary.517 The grantor is the person who establishes the trust and typically contributes the trust assets. The trustee typically takes title to the assets and assumes a fiduciary obligation to exercise reasonable care over the property and to act solely in the interest of the beneficiary. The beneficiary can be a named individual, a charity, or a class of persons such as the grantor’s children. The grantor, in some circumstances, can also serve as the trustee or as one of the beneficiaries. The grantor can create a trust that is revocable or irrevocable. To establish the trust, the grantor, with the assistance of legal counsel, typically executes a written trust agreement identifying the trustee, the beneficiaries, the initial trust assets, and the terms of the trust.

Under U.S. trust law, grantors can retain significant control over assets conveyed to a trust. For example, the trust agreement can authorize the grantor to manage the trust assets or direct the trustee’s performance of certain duties, or require the trustee to obtain the grantor’s written consent prior to taking certain actions.518 Grantors can spend trust funds, replace the trustee, and reserve the right to revoke the trust altogether. Foreign jurisdictions afford grantors similar authority over trust assets. The Isle of Man, for example, which plays a key role in the Wyly case history, allows grantors to establish trusts giving the trustee wide discretion to invest and distribute trust assets. The grantor may then converse directly with the trustee or provide a “letter of wishes” with specific recommendations on how to administer the trust assets.

A trust agreement can also establish a “trust protector,” a person selected by the grantor with authority to oversee the trust assets and often with the power to replace the trustee. The Isle of Man permits trust protectors to interact with trustees on a daily basis, conveying information and recommendations from the grantor about how the trust assets should be handled, and to replace the trustees at will, including, for example, if a trustee declines to follow the protector’s recommendations.519 At the same time, trust law typically assigns final decisionmaking authority over trust assets to the trustee, requiring the trustee to act with due care and in the sole
interest of the trust beneficiaries.

U.S. tax treatment of trust property depends upon the amount of control the grantor retains over the trust. If the grantor places property in an irrevocable trust and gives up all control over the property and the trust, the trust is generally treated as a separate taxpayer and pays tax on the income from the property.520 When the trust distributes the income to the beneficiaries, it gets a deduction for the amount distributed, but the beneficiaries have to pay tax on the income, so that the income is taxed only once.521 On the other hand, if the grantor directly or indirectly keeps the power to revoke the trust or retains significant control over the trust or trust assets, the trust is considered a "grantor trust" and its income is generally attributed to the grantor for tax purposes.522 In some cases where a grantor has supposedly established an irrevocable, independent trust, but secretly retained control over the trusts assets, courts have ruled that the trust was a sham and attributed the trust assets and income to the grantor for tax purposes.523

Trusts formed in foreign jurisdictions originally operated under a different set of tax rules. Generally, foreign trusts were seen as foreign entities outside the normal reach of U.S. tax law, and foreign trust distributions to U.S. persons were generally untaxed. Over the years, some U.S. citizens began to take advantage of the tax status of these foreign trusts. For example, some U.S. persons formed foreign trusts in tax havens, named themselves as the grantor, named U.S. beneficiaries, and placed U.S. assets in those trusts. They claimed that the foreign trusts could then distribute the trust income to the U.S. beneficiaries tax free, and the trusts could accumulate capital gains tax free, unless and until any appreciated assets were brought back into the United States. Congress and the IRS responded with a series of laws and regulations designed to stop
what were seen as tax dodges unintended by the tax code. In 1976, for example, Congress declared that a foreign trust that was funded by a U.S. person and had U.S. beneficiaries was considered a U.S. grantor trust whose income had to be attributed to the U.S. person who transferred the assets.524

Some U.S. persons responded to these new limitations on foreign trusts by convincing a foreign person (rather than a U.S. person) to act as the grantor of the foreign trust and name U.S. beneficiaries. The U.S. person then transferred assets to this “foreign grantor trust” for later distribution to the U.S. beneficiaries tax free. In 1996, in effort to end this practice, Congress enacted legislation essentially requiring the U.S. beneficiaries to pay tax on any distributions from a foreign trust that was not already taxable to a U.S. grantor.525 In passing this law, however, Congress applied it only to assets transferred to foreign trusts after February 6, 1995; foreign trusts funded with assets prior to that date were allowed to continue operating under earlier rules permitting tax-free distributions to U.S. beneficiaries.526

The Wyly case history, which spans a thirteen-year period from 1992 to 2005, reflects this legal tug of war over foreign trusts. The Wylys created and funded some foreign trusts with U.S. grantors, such as the Bulldog and Pitkin Trusts, and other foreign trusts with foreign grantors, such as the Bessie and Tyler Trusts.527 Some of the Wyly-related offshore trust agreements appear to have been written with the express goal of avoiding U.S. tax rules applicable to foreign trusts with U.S. beneficiaries by naming, for example, only foreign charities as the immediate trust beneficiaries and barring any “U.S. person” from receiving trust assets until two years after the death of the grantor, Sam or Charles Wyly.528 The Wyly case history also illustrates the tensions between trust law, which often allows significant grantor control of trust assets, and U.S. tax and securities obligations which often turn on control issues. It illustrates further the tensions created by offshore secrecy laws that make it difficult to determine who really controls an offshore entity.

View complete report: Tax Haven Abuses: The Enablers, The Tools, & Secrecy