U.S.-Trusts in German-American Estate Planning

Trusts are a fundamental component of traditional estate planning in common law jurisdictions. Yet, they are virtually unknown in German Civil law. Following the introduction of regulations drafted to target tax avoidance in 1999, the German government enacted tax provisions applicable to transfers to certain trusts. This article describes the legal framework applicable to common law trusts and provides recommendations for the avoidance of tax traps associated with German tax law.

Trusts in German Civil Law

Trusts are virtually unknown in German Civil law and German land law does not allow for the transfer of assets located in Germany to a trust. However, such a transfer does not necessarily have to be without effect. For example, a testamentary trust may be interpreted as a German legal instrument which has similar effects. For example, it may be interpreted as durable execution of the estate (Dauertestamentsvollstreckung), subsequent heirship (Vor- und Nacherbschaft), life estate / usufruct (Nießbrauch) or a combination thereof.

Basic Principles of the German Inheritance and Gift Tax Act

The taxation of transfers of property on death (e.g. an estate/inheritance) or lifetime transfers without consideration (e.g. gifts) is codified in the Inheritance and Gift Tax Act (Erbschafts- und Schenkungsteuergesetz) - hereinafter ErbSt. Additionally, other German tax laws, such as the German General Fiscal Code (Abgabenordnung) - hereinafter AO - and the Valuation Act (Bewertungsgesetz)- hereinafter BewG - apply.

Nature and Calculation of the German Inheritance Tax

In contrast to U.S. federal estate tax law, German inheritance tax (Erbschaftsteuer) does not attach to the estate itself, but instead the acquisition of each beneficiary is taxed. Tax rate and tax free exemptions generally depend on the familial relationship between the deceased and the beneficiary. Tax free exemptions are granted per capita.

Estate Planning Consideration: If more than one family member lives in Germany, consider making distributions to each of them individually as the tax free amount is granted per capita.

The tax-free exemptions are granted for any “transfer” from the same person. 

Estate Planning Consideration: If the German resident beneficiary`s parents live in the U.S., ensure that each parent makes use of the tax-free exemption. As some trusts are considered "deemed legal entities" for inheritance and gift tax purposes, the use of trusts may allow to claim the exemption even more often. 

There is no generation skipping tax in Germany.

Estate Planning Consideration: If the German resident beneficiaries’ parents live in the U.S., ensure that each parent makes use of the tax-free exemption. As some trusts are considered "deemed legal entities" for inheritance and gift tax purposes, the use of one or more trusts may allow to claim the exemption more than one time.  

There is no generation skipping tax in Germany and each grandchild may receive € 200,000 gift tax/inheritance tax free within 10 years.

Estate Planning Consideration: If there is more than one generation living in Germany, consider skipping one generation.

For more information on the German inheritance tax please see our article “The German Inheritance Tax” and “The German Gift Tax”.

Tax Liability in Germany

Pursuant to § 2(1) ErbStG (unlimited tax liability) Germany taxes all worldwide transfers, if either the deceased or the transferee is a German tax resident (Inländer) at the time of the taxable event (in most cases the death).  For more information on the German inheritance tax please see our article “The German Inheritance Tax, Secion Taxable Transfers in Germany”.

Please note: The Germany-US Estate and Gift Tax Treaty may prevent Germany from taxing the transfer. See last chapter of the article. 

Trusts as Deemed Legal Entities for Inheritance and Gift Tax Purposes

Prior to 1999, transfers of assets to trusts were not taxed by the Inheritance Tax Act. Similar to German Civil Law, the German Inheritance and Gift Tax Act (ErbStG) did not recognize trusts as legal entities. the German government enacted tax provisions applicable to transfers to certain trusts. The law does not explicitly use the term "trust". Instead, it uses the term "foreign pool of assets with the purpose to bind assets (Vermögensmasse ausländischen Rechts, deren Zweck auf die Bindung von Vermögen gerichtet ist)".

All trusts that are not deemed to be legal entities under German tax law are referred to as “transparent trusts” hereinafter. Trusts that are considered to be a legal entity for inheritance and gift tax purposes are referred to as "non-transparent trust" or "opaque trusts". 

Taxation of Asset Transfers to Inter Vivos Trusts

Pursuant to § 7 Section 1 Lit. 8, Sentence 2 ErbStG, transfers of assets to a non-transparent inter vivos trust trigger German gift tax (Schenkungsteuer) if there is a nexus to Germany. There is a nexus to Germany, if either the grantor or the opaque trust is a  German tax resident (Inländer) at the time of the transfer. If only the beneficiary is a German tax-resident, no German gift tax is triggered by the mere fact of transferring the assets to a non-transparent trust.

Example: Grantor A, U.S. citizen, without a residence/fiscal domicile in Germany, transfers € 500,000 into an irrevocable living trust and does not retain any rights with respect to the trust assets. The Trustee is fiscally domiciled in the U.S. Despite the fact that the beneficiary resides in Germany, the transfer does not trigger German gift tax. 

If the transfer is taxable in Germany, the asset transfer is subject to least favorable tax class III, which provides for a minimal € 20.000 tax-free allowance and tax rates from 30% to 50%.

Example: Grantor A transfers € 500,000 to an irrevocable trust, which is managed by the trustee whose tax-residence (and fiscal domicile) is in Germany. Upon transfer of the assets to the trust, a tax base of € 480,000 would be found resulting in a tax assessment of € 144,000. Calculations: Taxes payable at transfer: Transfer to the Trust = Taxable acquisition of the trust: €500,000 Tax allowance under § 16 ErbStG: - €20,000 Tax Base: €480,000 Application of tax rate according to § 19 ErbStG (x 0.3) = Tax Due: € 144,000.

Taxation of the Transfer of Assets to a Trust upon Death of Grantor of Revocable Trust

If an opaque trust is created upon the death of the grantor (e.g. because a revocable trust becomes irrevocable and the successor trustee shall hold and administer the trust assets for the lifetime of a beneficiary) and there is a nexus to Germany, German inheritance tax is triggered. See § 3 Section 2 lit 2 ErbStG.

There is a nexus to Germany, if either the grantor or the opaque trust is a German tax resident (Inländer) at the time of the creation/funding of the trust. If only the beneficiary is a tax-resident of Germany, no German inheritance tax or gift tax is triggered by the mere fact of transferring the assets to the non-tax-transparent trust.

Estate Planning Consideration: This may be used to avoid the German inheritance tax if the beneficiary does not permanently live in Germany and considers to return to the U.S.

However, the Trust income may be attributed to a German resident beneficiary if the trust qualifies as a Foreign family pool of assets (Familien-Vermögensmasse ausländischen Rechts)

If the successor trustee of a revocable trust shall distribute the trust assets outright and free of trust to the beneficiaries, the trust is tax transparent and the interest of beneficiary may be subject to German inheritance tax. 

Example: Grantor A, U.S. citizen, without a tax residence in Germany, transfers € 500,000 into a revocable living trust and retains the right to revoke and amend the trust. Upon his death, the trust become irrevocable and German inheritance tax is triggered (for calculation of the tax see prior example).

Taxation of accumulated Trust Income 

Undistributed (accumulated) trust income may be attributable to a German resident beneficiary if the trust is a Foreign family pool of assets (Familien-Vermögensmasse ausländischen Rechts)

In our opinion, the provisions of the Germany-U.S. Income Tax Treaty preventing Germany to impose income tax on certain income sources are not affected by these rules. Consequently, income from U.S. real estate is not attributable to a German resident beneficiary of a U.S. trust. 

A credit on the German income tax may be available for U.S. income tax paid on trust income subject to the right of the U.S. under the Treaty to tax such income if paid directly to the beneficiary. Thus, if taxation occurred on trust level and the trust filed form 1041, U.S. income tax on certain sources of income may not qualify for a credit against the German income tax. 

A Credit on the U.S. income tax will most likely not be available if taxation occurs on trust level in the U.S. Thus, it may be advisable to claim the distribution deduction under IRC § 661 sec.

Gift Tax on Distributions during the Existence of the Trust

Pursuant to § 7 (1) Nr. 9, S 2 ErbStG Germany imposes gift tax on the transfer during the existence of a non-transparent trust to a intermediary beneficiary (Zwischenberechtigter)

In its decision dated 27th September 2012,  II R 45/10 the Federal Fiscal Court (Bundesfinanzhof) held that any person who receives trust distributions during the existence of a trust is such intermediary beneficiary.

However, in its decision dated July 3, 2019, II R 6/16 (affirmed: decision dated June 25, file no. II R 31/19) the Federal Fiscal Court held that distributions from a non-transparent trust can only be subject to German gift tax if the beneficiary has “rights to the assets and/or income of the trust independently of a distribution decision of the trustee.” The substantive decision states that an "abstract-general right to the distribution" or an "interest in the capital and/or income that cannot easily be withdrawn" may qualify as a “right” in this meaning. As a consequence, distributions from a trust may be not subject to German gift tax, if the trustee’s discretion is broad. 

German Income Tax on Trust Distributions

Distributed income of a trust that is a "foreign pool of assets" within the meaning of Sec. 1a KStG may be subject to German income tax under § 20 (1) No. 9 EStG (German Income Tax Act). 

According to the local tax court of Münster (ruling dated March 23, 2023 - 1 K 2478/21 E), the entire distributed amount is to be taxed  - regardless of whether it is (accumulated) income or principle of the trust and regardless of the nature of the distributed assets (money or other assets and only the value of the assets that were transferred to the trust can be deducted. Consequently, not only realized but also unrealized capital gains are taxed upon distribution. In our opinion distributed trust principle is not subject to German income tax. 

Distributions from a trust are not subject to taxation pursuant to Sec. 20 (1) No. 9 sentence 2 EStG to the extent that the income underlying the transfer has already been attributed pursuant to paragraph § 15  Abs. 1 AStG. See § 15 Abs. 11 AStG. Consequently, it is often advisable to distribute trust income during the term of the trust.

Taxation of Final Distribution (Dissolution of Trust)

The final distribution of trust assets to beneficiaries is subject to German gift tax under § 7 (1) Nr. 9 S. 2 ErbStG. The applicable tax class is determined by the familial relationship between the Grantor and the beneficiary. See § 15(2) Nr. 2 ErbStG. Any distribution from the trust within the 10 years preceding the final distribution is added to the taxable acquisition for the calculation of the tax. See § 14 ErbStG

Example: Grantor A transfers €500,000 to an irrevocable trust = opaque trust. Under the terms of the trust, the trustee shall distribute the income of the trust to the A`s son, B. Accordingly, the trustee distributes €100,000 in the 10 years preceeding the termination of the trust to B. Upon the termination of the trust, the trust assets are to be distributed B. Calculation of tax upon the termination of the trust: Final distribution (€500,000) + Distributions to B in the last 10 years (€100,000) = Total taxable acquisition: € 600,000. Tax base after deduction of tax allowance (€400,000) = € 200,000; Tax due (see tax table): € 22,000.

Impact of Germany-U.S. Estate and Gift Tax Treaty

The Germany-U.S. Estate and Gift Tax Treaty (hereinafter "Treaty") may have a significant impact on German-American estate planning with U.S. based trusts: 

Treaty does not preclude Germany from applying special Rules for Trusts

Pursuant to Art. 12 para 1 of the Treaty does not preclude Germany from applying its domestic tax rules governing the recognition of a taxable event, with respect to transfers of property to a trust.

Treaty does not preclude Germany from taxing Trust beneficiary`s whose "fiscal domicile" is in Germany

The Treaty does not preclude  Germany from taxing in accordance with its law distributions from a U.S. trust if the beneficiary`s fiscal domicile is in Germany at the time of the taxable event (e.g. trust distribution). See Art. 11 para 1 lit. b) of the Treaty. 

Treaty precludes Germany from imposing German Gift or Inheritance Tax on the Transfer to a U.S. Trust if Grantor`s Fiscal Domicile and the Trust`s Fiscal Domicile is in Germany

Treaty precludes Germany from imposing German gift or inheritance tax on the transfer to a U.S. trust if the grantor`s fiscal domicile and the opaque trust`s fiscal domicile is in Germany. See Art. 9 of the Treaty. 

Example: Grantor A is a U.S. citizen with a fiscal domicile in the U.S. transfers € 500,000 into an irrevocable trust managed by a U.S. corporate trustee, who holds the assets for a beneficiary with a fiscal domicile in Germany. As the grantor`s fiscal domicile is in the U.S., Germany may only tax the transfer if the trust is deemed a legal entity which is fiscally domiciled in Germany. As the trustee clearly has no fiscal domicile in Germany, Germany may not tax the transfer despite the fact that the beneficiary is a German tax resident.

Recommendations

  • If the Grantor has a fiscal domicile in Germany it is generally not advisable to create a trust that is deemed to be a legal entity under German tax law.
  • A person who has a fiscal domicile in Germany should not act as (sole) trustee if the trust is deemed to be a legal entity under German tax law.
  • If the Grantor`s fiscal domicile is in the U.S. and the beneficiary`s fiscal domicile is Germany, the creation of a discretionary trust may be advantageous as distributions from such trust may not be subject to German transfer taxes.
  • If the beneficiary may later move back to the U.S., a non-transparent trust may be advantageous.
  • If more than one family member lives in Germany, consider making distributions to each of them individually as the tax-free amount is granted per capita.
  • If there is more than one generation living in Germany, consider skipping one generation. There is no generation-skipping tax in Germany.
  • Do not transfer German assets to a trust. Trusts are not recognized by German civil law and any transfer to a trust may complicate estate administration.
  • If the beneficiaries are minors or there is any other reason to retain rights in the estate, use German legal instruments that are similar to a trust in replacement of a trust.
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