As you know by now, Prince Harry and Meghan Markle, the Duke and Duchess of Sussex, welcomed their first-born son, Archie, on May 6, 2019. In a prior blog post, we discussed the US tax consequences (individual income tax, international informational, and Expatriation Tax) to Meghan Markle, a US citizen, of marrying a non-US citizen and British royal. We will now explore what it means (from a US tax perspective) for Meghan and baby Archie to receive specific financial support from the Royal Family Trust. It’s all related to US foreign non-grantor trust beneficiary rules.
For this article, we are making certain assumptions to illustrate several essential points. Those assumptions include:
- That the Duchess of Sussex is still a US citizen.
- That baby Archie is also a US citizen under INA 301(g) – born abroad in wedlock to a US citizen and an alien. (Note: we always advise that you seek the professional opinion of a US immigration attorney for these types questions).
- That (as indicated in the Panama Papers) Meghan and Archie are now beneficiaries of the Royal Family Trust, which is a foreign trust for US tax purposes.
- That in this day and time the trust pays the income tax on for the earnings in the trust and therefore, it is a “non-grantor” trust for US tax purposes.
US Tax Consequence #1
Foreign non-grantor trust taxation is one of the most complex and burdensome areas of the US tax code. If a trust accumulates income and fails to pay this income annually to beneficiaries, it will have undistributed net income (UNI). Should this income be distributed to Meghan and/or Archie in the future, it will be subject to the US “throwback tax rules,” as an “accumulation distribution.”
It is unlikely that any Royal Trusts will keep their financial statements based on US tax principles. Therefore 100% of any distributions to Meghan and Archie would be treated as distributions of UNI or accumulation distributions.
Generally, accumulation distributions are taxed at the highest marginal rates available (rather than at preferential long-term capital gains or qualified dividend rates). Furthermore, since the income was not paid out (and taxed by the US IRS) annually, the tax owed is also subject to many years’ worth of back interest charges. The longer the income has accumulated, the harsher the effect of the throwback taxes and associated interest charges.
US Tax Consequence #2
For each year that Meghan and/or Archie receives a distribution from a Royal Trust, they would be required to file IRS Form 3520 (one form per trust that issued a distribution). Failure to file the form can result in a $10,000 penalty or 35% of the gross value of the distributions received (whichever is higher).
US Tax Consequence #3
If Meghan were to expatriate from the US in the future, she would likely be considered a “covered expatriate” under IRC 877A. The IRS provides guidance for expatriation provisions. This guidance indicates that if Meghan were to receive a distribution from a foreign non-grantor trust, the distribution would be subject to a 30% withholding tax, similar to a US tax resident. Or at least this is the requirement that would be imposed on the foreign trustee. Meghan would then have to file a Form 1040NR to claim the withholding tax back from the US government (if all of the income is of foreign source).
Baby Archie may have a different outcome from Meghan. There is an exception to the US expatriation rules. Baby Archie qualifies for this exception if he is a citizen of the US and a citizen of another country (in this case the United Kingdom) at birth. And if he has not resided in the United States for more than ten years in the last 15-year period. Assuming this to be accurate, then unless baby Archie was to violate the 5-year compliance test under IRC 877A, he would not be a “covered expatriate.”
Therefore, if he renounces his US citizenship later, he would not be subject to the same withholding tax rules as his mother. It should be noted that US embassies and consulates will not let minors expatriate. So Archie would have to wait until he reaches the age of majority before taking this step.
The Importance of Exit Tax Planning
The foreign non-grantor trust issue presented in the context of Royal Baby Sussex serves as a reminder to US taxpayers about the various intricacies of the US Exit Tax rules. Are you an individual formally considering expatriating from the US, either by renouncing citizenship or giving up your long-term green card? If so, we advise that significant Exit Tax planning be undertaken to ensure proper outcomes. Please contact us. The Duchess of Sussex should have taken our advice to expatriate well before her marriage. This would allow her to avoid her annual US individual income tax and international informational reporting requirements. And also any long-term ramifications for future requirements for both her and her son.