26 CFR 301.7701-7: Domestic vs. Foreign Trust Rules

The classification of a trust as either “domestic” or “foreign” is an important determination for U.S. federal tax purposes. This status dictates the trust’s tax obligations and reporting requirements. The governing rules are found in Treasury Regulation 26 CFR § 301.7701-7, which provides a two-part test to establish a trust’s residency. The distinction is not elective; a trust’s characteristics are measured against the specific criteria outlined in the regulation to determine its classification. This determination has significant financial consequences, impacting how the trust’s worldwide income is taxed by the Internal Revenue Service (IRS).

The Two-Part Test for Domestic Trust Status

For a trust to be classified as a domestic trust under U.S. tax law, it must satisfy two specific tests simultaneously: the “Court Test” and the “Control Test.” Both prongs of the test must be met for the trust to be considered a U.S. person for tax purposes. If a trust fails to meet even one of these tests, it is, by default, classified as a foreign trust.

This analysis is based on the terms of the trust instrument itself and the applicable laws governing its administration. The tests are designed to assess where the trust has its most significant connections. The Court Test looks at the judicial oversight of the trust, while the Control Test examines who holds the power over its important decisions.

The Court Test Explained

The Court Test focuses on the judicial supervision of the trust’s administration. To satisfy this test, a court within the United States must be able to exercise “primary supervision” over the administration of the trust. This means a U.S. court has, or would have, the authority to resolve most issues concerning the trust’s management. It is a test of authority, not whether a court has actually intervened.

The regulations provide a “safe harbor” provision that, if met, automatically satisfies the Court Test. A trust meets this safe harbor if three conditions are present: the trust instrument does not direct that the trust be administered outside the U.S.; the trust is, in fact, administered exclusively in the U.S.; and the trust is not subject to an “automatic migration” clause. An automatic migration clause is a provision that would cause the trust to move outside U.S. court supervision if a U.S. court attempts to assert jurisdiction.

For example, consider a trust created in the U.S. with a U.S. trustee and U.S. beneficiaries, administered solely within the country. If the trust document is silent on where it must be administered and contains no clause to move the trust to another country upon court action, it would satisfy the safe harbor and therefore pass the Court Test.

The Control Test Explained

The second requirement for a trust to be classified as domestic is the Control Test. This test requires that one or more “U.S. persons” have the authority to control all “substantial decisions” of the trust. For these purposes, a “U.S. person” includes a U.S. citizen or resident alien, a domestic partnership, a domestic corporation, and any estate or trust that is not foreign. The regulations provide a non-exclusive list of what constitutes “substantial decisions.” These decisions include:

• Determining whether to distribute income or principal
• The amount of any distributions
• The selection of a beneficiary
• The power to make investment decisions
• The authority to terminate the trust
• The power to compromise or contest claims
• The power to remove, add, or replace a trustee
• The decision to sue on behalf of the trust

“Control” means having the power, by vote or otherwise, to make all of the substantial decisions of the trust, with no other person having the power to veto any of those decisions. If a non-U.S. person has the authority to veto a substantial decision made by a U.S. trustee, the U.S. persons do not have control, and the test is failed. For instance, if a trust has two trustees, one a U.S. citizen and one a citizen of another country, and the trust instrument requires a majority vote to make investment decisions, the U.S. trustee does not have control. The foreign trustee holds a veto power, causing the trust to fail the Control Test.

The regulations do allow for a grace period in certain situations. If an inadvertent change, such as the death or resignation of a U.S. trustee, would cause the trust’s status to change, the trust has 12 months to make necessary corrections to avoid reclassification. This provision prevents an automatic change in status due to unforeseen events.

Tax and Reporting Consequences of Classification

A domestic trust is treated as a U.S. person for tax purposes and, much like a U.S. citizen, is subject to U.S. income tax on its worldwide income. These trusts report their income, deductions, and distributions on Form 1041, U.S. Income Tax Return for Estates and Trusts.

A foreign trust is treated as a nonresident alien for tax purposes. Its tax liability is limited to U.S.-source income and income effectively connected with a U.S. trade or business. For example, certain U.S.-source income like dividends paid to a foreign trust is subject to a flat 30% withholding tax, unless a tax treaty specifies a lower rate.

The reporting requirements for foreign trusts are substantially more complex. A U.S. person who creates a foreign trust or transfers money or property to one must file Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. A foreign trust with a U.S. owner is required to file Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner. Failure to file these forms can result in substantial penalties.