What Makes a Trust Foreign or Domestic—And Why Does It Matter?
The United States is one of two countries in the world that imposes a tax on the worldwide income of its citizens. (The other is the East African country of Eritrea, which imposes a two percent tax on its citizens living abroad, far less than the top rate for U.S. income tax of 37 percent.)
Of course, trusts do not have citizenship like individuals, but trusts that are classified as domestic trusts for U.S. income tax purposes “suffer” the same fate: U.S. income tax is imposed on the worldwide income of the trust even if its income is earned from sources outside the United States or the Settlor and beneficiaries reside outside the United States.
So, what makes a trust a domestic trust and would it be better to avoid this classification? Paradoxically, a trust must meet two tests to be considered a domestic trust, and if it fails either of these tests, it will be classified as a foreign trust.
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