US tax liability for beneficiary of UK bypass trust

Question

In the UK, discretionary will trusts (DWT) often were, and to some extent still are, used to ensure that married couples could take advantage of both spouses' nil-rate-band (i.e. estate tax exemption in US parlance) with regard to UK inheritance tax (which is really an estate tax). When the first spouse dies, the trust is set up with (say) the second spouse and their children as beneficiaries, and with the second spouse together with their lawyer as trustees. Then when the second spouse dies, two separate things pass to the children: (1) access to the trust assets and (2) the second spouse's estate, including whatever the second spouse inherited from the first outside of the trust. The intention of the DWT was to be a mechanism of allowing money to be inherited, in a way that's fairer under UK tax law than it would be without the trust. (Since first posting this question I've discovered that this mechanism is called a "bypass trust" and that people do or have done it in the US as well as the UK.)

Now, what happens if the children are US tax payers? The US does not tax foreign inheritances, and the DWT is intended to be a mechanism for inheriting. But presumably the DWT must also be classed as a "foreign trust" and those words immediately ring all sorts of alarm bells and flash all kinds of red lights at the IRS—because foreign trusts (presumably of a different kind) are frequently used for tax avoidance. So, the interwebs warn that foreign trusts come with complicated reporting requirements and (possibly) heavy US income-tax liability.

Under what circumstances would a US person receive penalties or a heavy tax bill from the IRS after becoming the primary beneficiary of a UK discretionary will trust? And which strategy leads to less liability: to wind up and liquidate the trust as soon as possible, or to keep it in existence?

Answer 1

So, the interwebs warn that foreign trusts come with complicated reporting requirements and (possibly) heavy US income-tax liability.

Correct. Check forms 3520 and 3520A and the instructions. Then hire a good EA/CPA to explain to you what you've read.

Under what circumstances would a US person receive penalties or a heavy tax bill from the IRS after becoming the primary beneficiary of a UK discretionary will trust?

Any. In fact "primary" has nothing to do with it.

And which strategy leads to less liability: to wind up and liquidate the trust as soon as possible, or to keep it in existence?

This is a question for a competent tax adviser familiar with the tax laws of both the countries and the tax treaty between them.

If you think that a by-pass trust may be useful for you, you can most definitely afford such an adviser. Free advice on the internet in this case may cost much more than what you paid for it, and these heavy costs can be avoid by talking to a specialist in the field.'

You should also check with a lawyer the legal benefits of using a trust vs. liquidating it and distributing the proceeds and decide whether the benefits are worth the extra pain and costs wrt the IRS reporting and the US taxes.