The Foreign Trustee Trap!

Many of us have friends and family who live in other countries and are not U.S. citizens. You might trust them with your life, but you should not trust them to be your Successor Trustee. Even if they are the most honest people on earth, naming them can cause huge problems for your money and your family.

Suppose you pass away and your mom, who lives in Russia and is not a U.S. citizen, takes over your trust. Here are six reasons why this is a "trap":

1. The IRS Might Call Your Trust "Foreign"

The IRS uses a "Control Test" to decide if a trust is domestic or foreign. If a non-U.S. person makes the substantial decisions for the trust, it is no longer a "Domestic Trust." It becomes a Foreign Trust. When this happens, a "hidden" tax called a capital gains tax can be triggered. The IRS acts as if you sold all your property the moment the trust became foreign. While a house might be safe because its value "resets" when you die (this is called a step-up in basis), other items like annuities do not get that break. Your family could end up with a massive tax bill they never expected. Citations: IRC § 7701(a)(30)(E); IRC § 7701(a)(31)(B); IRC § 684; IRC § 1014; IRC § 691.

2. Massive Paperwork and Fines

Foreign trusts have to fill out very complicated forms, like IRS Form 3520 and Form 3520-A. If your trustee forgets to send them in or fills them out wrong, the IRS can charge huge penalties—often 35% of the entire trust’s value! Citations: IRC § 6048; IRC § 6677.

3. Banks Might Close Your Accounts

U.S. banks are very wary of "money laundering," which occurs when people try to hide money from the government. Because of strict banking laws, many banks will refuse to talk to a trustee who lives in a foreign country. Your mom might try to pay your final bills, only to find the bank has frozen the accounts because she doesn't have a U.S. address. Citations: 31 U.S.C. § 5311 (Bank Secrecy Act); 31 C.F.R. § 1010.230 (Beneficial Ownership/KYC).

4. The "Long Distance" Delay

Imagine your mom needs to sign a deed to sell your house so your kids can get their inheritance. She can’t just sign it at a local bank in Russia. She might have to travel to a U.S. Embassy or find a special official to verify her signature. This can take months and cost thousands of dollars in legal fees and travel costs. Being a Trustee is like being a general contractor for a house. You have to be there to check the work, sign the papers, and talk to the workers. If your "contractor" is in Russia, the project will take much longer and cost much more. Citations: 22 C.F.R. § 92.1 (Notarial services at U.S. Embassies).

5. It Is Harder for Your Family to Sue

If a trustee steals money or makes a mistake in the U.S., a judge can help the family find a solution. But if the trustee is in another country, U.S. judges usually do not have any power over them. Your family would have to hire a lawyer in Russia to try to get the money back, which is almost impossible for most people. Citations: Uniform Trust Code § 202 (Jurisdiction over trustee).

6. Extra Taxes on the Money Made

If a foreign person is in charge of a trust, the law says the trust is treated as a "foreign person" for tax purposes. This means that for every dollar of income the trust makes—like rent from a house or dividends from stocks—the bank or the tenant must automatically take 30% out and send it straight to the IRS. This is a mandatory withholding tax that applies to foreign entities, and it means much less money actually reaches your family. Citations: IRC § 1441; Treas. Reg. § 1.1441-1(c)(2); IRC § 7701(a)(31).

The Bottom Line: If you want your family to move on easily after you're gone, choose a trustee who lives in the United States. It will save your loved ones a lot of stress and a lot of tax money.