Lewis Saret authored the following column, published in CCH Taxes - The Tax Magazine, The Estate Planner: Estate Planning During 2012 (March 2012). The full column may be downloaded by clicking the following link: Saret_MAG_03-12.pdf
]]>Lewis Saret authored the first in a series of columns, published in CCH Taxes - The Tax Magazine, The Estate Planner: Retirement Benefits in the Context of Estate Planning--Part I: Minimum Required Distributions. The full column may be downloaded by clicking the following link: Saret_MAG_11-11.pdf
]]>Published in
The Washington, D.C. Estate Planning Council
Estate Planning Newsletter
Issue No. 43, Fall-Winter 2005
By
Lewis D. Solomon
Theodore Rinehard Professor of Business Law
The George Washington University Law School
And
Lewis J. Saret
Moore & Bruce, LLP
We are all familiar with testamentary devices such as Wills and Trusts. However, few are familiar with ethical wills, which deal with our clients' values. While clients come to advisors primarily to help them transfer property between generations, many also are concerned about the legacy they leave to their loved ones in the form of the values passed on, the meaning of their lives and the love they feel for their family members. These clients feel the need to address this concern, but do not know where to turn. We have found that such clients are not only receptive to learning about ethical wills, but in fact grateful. By exposing clients to ethical wills, you will satisfy your clients' needs, earn their gratitude and feel increased professional satisfaction.
Ethical wills are really not wills at all. They are a very personal form of communication, often in the form of a letter but sometimes in other forms, such as video or audio recordings, from individuals to their loved ones telling the recipient what they would say if they were alive. Authors of ethical wills often intend for their ethical wills to share their values, important life lessons, wisdom and/or family history with loved ones. They also often use ethical wills to express their love and affection, and sometimes to ask for forgiveness.
The first ethical will is generally attributed to Jacob, in Genesis, chapter 49, when Jacob gathers his sons around him to tell them how to live. This is an example of an oral ethical will. Other examples include the New Testament, where Jesus gives his parting blessings and advice to his loyal followers, and Hamlet, where Polonius gives such sage advice to his son, Laertes, as "Give every man your ear, but few thy voice... (and) This above all: to thine own self be true."
While still rare when compared to legal wills, the interest in ethical wills has significantly increased in recent years. We believe this reflects several factors, including an aging population coming to grips with its own mortality, increasing affluence in our society which allows for greater self-reflection and a general societal shift over the past thirty years to more conservative values.
Among other possible things, ethical wills may do the following:
Ethical wills also have significant incidental benefits. Writing an ethical will forces the author to articulate his or her values. This is extremely beneficial where the author desires to implement an overall plan to transfer values along with human and intellectual capital between generations, which is sometimes referred to as a values based estate plan. To illustrate, articulating the senior family members' values greatly facilitates the creation of a family mission statement, implementation of enhanced family rituals, creation of incentive trusts and a more formal structure for family philanthropy, each of which may be included in such a plan.
In addition, the self-reflection implicit in the preparation of an ethical will may also cause authors to re-examine their lives and in some cases cause them to change the direction of their lives to one more aligned with their personal values and objectives.
As authors gain greater identification with their values and beliefs, they may wish to share the thoughts and words expressed in their ethical wills with other family members during lifetime rather than after or near death. Under the right circumstances, this can bring family members closer together and greatly enhance the education of younger family members.
While an ethical will can benefit anyone, certain types of clients tend to be more interested in them than others. One such group consists of parents with young or newborn children. The birth of a child begins a thought process, which sooner or later causes new parents to focus on who will raise their child if something happens to them. A named guardian is only a substitute, often a poor to fair substitute at best, for the real parent. An ethical will may give new parents some degree of comfort that their child will learn and understand their values.
Another such group consists of terminal patients. Terminal illness forces an individual to come to grips with his or her own mortality. One common result of this is a desire to find meaning in one's life. An ethical will may help in this situation.
Ethical wills are often important to individuals with a strong religious affinity as such individuals typically want their children to understand their religious beliefs. An ethical will may assist with this effort by articulating and explaining the author's religious beliefs and why they are important to the author.
Owners of family businesses may also be attracted to the concept of an ethical will. Family businesses often serve as the glue that binds a family together. In such cases, this results in a focus on the values and other characteristics of the family itself, which distinguish that family from other families. In such an environment, ethical wills not only are greatly appreciated, but also often assist with family business succession issues and multi-generational family plans.
Finally, other life changes that may prompt an interest in ethical wills include the following:
Each ethical will is a unique, highly personal document. Having said this, many ethical wills follow a similar organizational structure. Individuals who want to write an ethical will may use the following outline as a guide. Specifically, they may pick and choose those headings that are important to them and ignore those which are not.
We firmly believe that ethical wills add substantial value to the estate planning process for clients. They are a beautiful gift from the author to the recipient of the ethical will. In many cases, they convert a horrible chore to a labor of love. For estate planners, suggesting an ethical will may result in a closer bond with clients, greater client satisfaction and increased personal and professional satisfaction from helping clients transfer values and wisdom between generations.
Books
Barry K. Baines, Ethical Wills: Putting Your Values on Paper (2002).
Barry K. Baines, The Ethical Will Writing Guide Workbook (2001).
Jack Riemer & Nathaniel Stampfer, So That Your Values Life On - Ethical Wills and How to Prepare Them (2003)
Web Sites
]]>By
Lewis J. Saret, Esq.
Moore & Bruce, LLP
Many people give to charity without much thought. Often they give because that's what their parents taught them to do, or it feels good - the right thing to do. However, there is an additional, excellent, reason why families should consider giving to charity. Namely, when families give to charity in an organized way (often referred to as family philanthropy), charitable giving can be a very effective parenting tool with significant benefits for the family.
For example, parents may use family philanthropy to teach their children how to manage financial assets. Schools don't teach children how to manage money, and parents often do a very poor job of this, resulting in young adults with no clue about how to manage their money. This is particularly true for first generation affluent parents. Such parents learned to manage money because they had to, their parents were not wealthy and they had a burning desire to achieve financial security. In contrast, their children grow up affluent and don't have to worry about money. Therefore, they don't learn the same financial skills their parents did. Family philanthropy works particularly well in these situations.
But, you ask, how can giving away your money teach your children how to keep and grow their money. There are various ways to do this, but a popular method is to create an informal investment advisory committee for family charitable vehicles, such as family foundations or donor advised funds. Families then place children on such committees, beginning when their children become teenagers, with an adult retaining ultimate investment authority. When this is part of a family philanthropic plan designed to develop and nurture the entire family's passion for its philanthropic initiatives, these teenagers who would otherwise not care about money management will typically care enough to learn such financial concepts. They will do this because they understand that money management directly impacts the amount the family will make available to give to charitable causes that they care about. Once learned, these skills are directly transferable to the child's personal financial assets as he/she matures and accumulates wealth, as well as to any family assets that such child may inherit in the future.
Families may also form informal charitable grant committees, often involving children as young as age six and grandparents, which provide additional benefits. The grant committee holds annual or other periodic meetings at which children present their grant proposals. The requirements for these proposals are tied to the child's age and maturity. For example, for older children more written material about the grant recipient, including more due diligence such as site visits may be required. Each child makes an oral presentation advocating his or her grant proposal, about which he/she will feel passionate. Following the presentation, the parents, grandparents, and other children and grandchildren should, with great care and love, critique the request and vote on the application. Naturally, comments should be tied to the child's age. As you can see, such activity provides an excellent opportunity to teach children public speaking, writing, problem solving and decision making skills. In addition, it teaches family members how to work together as a family.
Finally, by engaging children in family philanthropy, parents can pass on core values to their children and grandchildren. This includes core values such as generosity, volunteerism, and individuality, but goes far beyond this. Such values may include promoting rights of women and minorities, helping the underprivileged, and promoting environmental conservation and faith-based values including those related to Judaism. Often, when families begin to engage in family philanthropy, they begin by determining what their core values really are. There are various exercises that can help families articulate their core values. In the author's experience, this often yields unexpected and pleasantly surprising results. Because these exercises typically involve the entire family, they promote a family dialogue that might not have occurred otherwise, and can lead families down roads providing great fulfillment and bonding for all family members. Ultimately, this can also result in a greater family cohesion, which results from a sense of higher purpose and cooperative effort.
]]>1) Introduction.
Historically, foreign trusts have been very useful tools for sophisticated estate planners. However, they have also been the focus of great suspicion and scrutiny by the IRS. Before 1976, properly designed foreign trusts created in low tax jurisdictions provided significant income tax deferral and, in some cases, complete income tax avoidance, even where both the grantor and current trust beneficiaries were US persons.
However, over the years, Congress has repeatedly attempted to discourage the use of foreign trusts by US individuals by passing legislation that has gradually reduced the tax benefits accruing from such trusts. Such legislation has included the following:
· Revenue Act of 1962.[1]
· Tax Reform Act of 1976.[2]
· Revenue Reconciliation Act of 1990.[3]
· The Small Business Job Protection Act of 1996.[4]
· Taxpayer Relief Act of 1997.
Because of the aforementioned legislative changes, the tax and other benefits flowing from foreign trusts to US persons have been greatly eroded. Notwithstanding this, foreign trusts continue to be very useful in certain circumstances.[5]
2) What constitutes a foreign trust?[6]
a) Importance of classification of trust as "foreign" or "domestic."
i) Generally. Classification of a trust as "foreign" or "domestic" has significant tax consequences.
ii) Domestic trusts. Domestic trusts are both:
(1) Treated as US persons, and
(2) Are subject to tax on worldwide income.
iii) Foreign trusts. Foreign trusts are both:
(1) Treated as nonresident aliens ("NRAs"), and
(2) Are subject to tax only on US source income or income effectively connected with a US trade or business.[7]
iv) Other effects of classification. Classification of trust also impacts:
(1) Whether a grantor will be treated as the owner of the trust for income tax purposes under the grantor trust rules.
(2) Whether gain must be recognized upon transfers to the trust.
(3) The application of certain withholding provisions.
b) What makes a trust a "foreign trust?"
i) Generally.
(1) A different set of rules applies to determine whether a trust constitutes a foreign trust, as opposed to a domestic trust, depending on whether the amendments enacted as part of the Small Business Job Creation Act of 1996 (the "1996 Act") apply to the trust. The 1996 Act generally applies to tax years beginning after December 31, 1996, and at the trustee's election to tax years ending after August 20,1996.
(2) Before the enactment of the 1996 Act, a subjective analysis was required to determine whether the US treated a trust as domestic or foreign for US tax purposes. The 1996 Act changed the classification scheme to one that determines a trust's nationality based on a set of objective criteria.
(3) Note. The situs of a trust for tax years beginning before January 1, 1997 may be relevant, among other things, because that situs may determine the character of accumulated trust income that will be taxed when ultimately distributed to a US beneficiary.
ii) Definition of foreign trust before the 1996 Act.
(1) Statutory
Rule - IRC § 7701(a)(31). For
tax years beginning before January 1, 1997, IRC § 7701(a)(31) provided that a
foreign trust was one "the income of which, from sources without the United
States which is not effectively connected with the conduct of a trade or
business within the United States, is not includible in gross income under
subtitle A."
(2) Application
of the Rule.
(a) Essentially,
the pre-1996 Act version of IRC § 7701(a)(31) provided for a subjective
analysis of whether the trust was more comparable to a resident or a
nonresident alien individual.[8]
(b) Generally,
the pre-1996 Act version of IRC § 7701(a)(31), by itself, provided no guidance
as to how to determine whether a trust would be classified as domestic or
foreign.
(c)
Judicial and administrative authority partially
filled the void left by the pre-1996 Act version of IRC § 7701(a)(31) by
providing for a test that required a weighing of a trust's foreign contacts
against its US contacts.[9]
(d) The
cases and rulings provided that the following six major factors in were to be
considered determining the situs and nationality of a trust:
(i)
The country under whose laws the trust was created.
(ii) The
situs of the trust's corpus.
(iii)
The nationality and residence of the trustee.
(iv) The
situs of the trust administration.
(v)
The nationality and residence of the grantor.
(vi) The
nationality and residence of the beneficiaries.
(e) Where
the various indicia were inconsistent, this test was extremely difficult to
apply.
(f)
Courts and the IRS tended to place more weight on
the following factors:
(i)
The situs of the trust's corpus.
(ii) The
nationality and residence of the trustee.
(iii)
The situs of the trust administration.[10]
iii) Current
(i.e., Post-1996 Act).
(1) Generally.
(a) General
Rule. For tax years
beginning after December 31, 1996, a trust is a US trust if both:
(i)
A court within the US is able to exercise primary
supervision over the trust's administration ("Court Test"); and
(ii) One
or more US persons have authority to control all substantial decisions of the
trust ("Control Test").[11]
1.
Note 1.
A trust that does not satisfy both of these tests will constitute a foreign
trust.[12]
2. Note 2. For purposes of the foreign trust definition:
a. A trust is a US person on any day that the trust meets both the court test and the control test.
b. A domestic trust means a trust that constitutes a US person.
c. A foreign trust means any trust other than a domestic trust.[13]
d. Treasury regulations apply the terms of the trust instrument and applicable law to determine whether the court test and the control test are met.[14]
(b) Background
- Rationale for enactment of the post-1996 Act Rule.
(i) Congress's primary objective was clearly to provide an objective test, rather than the prior subjective test.[15]
(ii) In addition, it appears that one of the principal objectives for the post-1996 definition of foreign trusts was to level the competitive playing field for trust administration business between US and foreign institutions. The pre-1997 rule effectively acted as an incentive for a foreign person to avoid using a US financial institution as trustee because of the significant risk that this would cause the trust to be taxed as a US domestic trust. Under the post-1996 Act rule, a foreign person can easily use a US financial institution without creating a domestic trust.[16]
(c)
Effective Date. The post-1996 Act rule applies to tax
years beginning after December 31, 1996, and at the lection of the trustee, to
tax years ending after August 20, 1996.
(d) Example
1. Ms.
Havisham, a US citizen who resides in Maryland, creates a trust for her
children, all of whom are US citizens. She names the Dickens Trust Company, a
Delaware corporation, and her brother, Pip, a Bermuda citizen and resident, as
co-trustees. The trust instrument (a) gives Pip the right to determine the ages
at which each child receives its share of the trust fund, and (b) directs that
the trust funds be maintained in the US in the custody of the Dickens Trust
Company, and that Maryland law governs the trust's administration. Here, the
trust will be treated as a foreign trust because a foreign person will possess
control over a substantial trust decision.
(2) Court
test.
(a) Generally. The court test is
one of the two tests that a trust must satisfy in order to be classified as a
domestic trust.
(b) General
Rule. To
satisfy the court test, a court within the US must be able to exercise primary
supervision over the trust's administration.[17]
(c) Safe Harbor. Under Treasury Regulations, a trust satisfies the court test if:
(i) The trust instrument does not direct that the trust be administered outside of the US;
(ii) The trust in fact is administered exclusively in the US; and
(iii) The trust is not subject to an automatic migration provision described in Treas. Reg. § 301.7701-7(c)(4)(ii).
(d) Example 2.[18] Charles creates a trust for the equal benefit of his two children, Biddy and Pip, called the Dickens Trust. The trust instrument provides that DC, a Virginia corporation, is the trustee of the Dickens Trust. DC administers the trust exclusively in Virginia and the trust instrument is silent as to where the Dickens Trust is to be administered. In addition, the Dickens Trust is not subject to an automatic migration provision. Here, the Dickens Trust satisfies the court test.
(e) Definitions. The following definitions apply for purposes of the court test:
(i) Court.[19] "Court" means any federal, state, or local court.
(ii) The United States.[20] "United States" is used in a geographical sense. Thus, for court test purposes, the United States includes only the States and the District of Columbia.
1. Caution. A court within a territory or possession of the United States (e.g., Puerto Rico) or within a foreign country is not a court within the United States.
(iii) Is able to exercise.[21] "Is able to exercise" means that a court has or would have the authority under applicable law to render orders or judgments resolving issues concerning administration of the trust.
(iv) Primary supervision.[22] "Primary supervision" means that a court has or would have the authority to determine substantially all issues regarding the administration of the entire trust. Note that a court may have primary supervision under this definition notwithstanding the fact that another court has jurisdiction over a trustee, a beneficiary, or trust property.
(v) Administration.[23] "Administration" of the trust means the carrying out of the duties imposed by the terms of the trust instrument and applicable law, including maintaining the books and records of the trust, filing tax returns, managing and investing the assets of the trust, defending the trust from suits by creditors, and determining the amount and timing of distributions.
(f) Bright line rules for satisfying or failing the Court Test. Treasury regulations provide the following bright line rules for determining when a trust will satisfy or fail the court test, which are not intended to be an exclusive list:[24]
(i) Uniform Probate Code.[25] A trust satisfies the court test if an authorized fiduciary registers the trust in a court within the US pursuant to a state statute containing provisions substantially similar to Uniform Probate Code, Article VII, Trust Administration.
(ii) Testamentary trust.[26] A testamentary trust created by a will probated within the US (other than ancillary probate) will satisfy the court test if all fiduciaries of the trust have been qualified as trustees by a court within the US.
(iii) Inter vivos trust.[27] For inter vivos trusts, if the fiduciaries and/or beneficiaries take steps with a court within the US that cause the trust's administration to be subject to the primary supervision of such court, the trust will satisfy the court test.
(iv) A US court and a foreign court are able to exercise primary supervision over the administration of the trust.[28] If both a US court and a foreign court can exercise primary supervision over the trust's administration, the trust satisfies the court test.
(g) Automatic migration (i.e., flight) provisions.[29] A court within the US is not considered to have primary supervision over a trust's administration if the trust instrument provides that a US court's attempt to assert jurisdiction or otherwise supervise the trust's administration, directly or indirectly, will cause the trust to migrate from the US. Such provisions are commonly referred to as "flight provisions," "migration provisions," and "duress provisions." This rule will not apply, however, if the trust instrument provides that the trust will migrate from the US only in the case of foreign invasion of the US or widespread confiscation or nationalization of property in the US.
(h) Example 3.[30] Oliver, a US citizen, creates a trust for the equal benefit of his two children, both of whom are US citizens. The trust instrument provides that the Dickens Trust Company, a US corporation will serve as trustee and the trust shall be administered in Bermuda. The Dickens Trust Company maintains a branch office in Bermuda with personnel authorized to act as trustees there. The trust instrument provides that Maryland law governs the trust. Assume that under Bermuda law, a Bermuda court may exercise primary supervision over the trust's administration. Pursuant to the trust instrument, a Bermuda court applies the Maryland law to the trust. However, under the terms of the trust instrument, the trust is administered in Bermuda, and no court within the US is able to exercise primary supervision over its administration. Here, the trust fails to satisfy the court test. Therefore, it constitutes a foreign trust.
(i) Example 4.[31] Estelle, a US citizen, creates a trust for her own benefit and the benefit of her spouse, Pip, a US citizen. The trust instrument provides that the trust is to be administered in Maryland, by Copperfield Corporation, a Maryland corporation. The trust instrument further provides that if a creditor sues the trustee in a US court, the trust will automatically migrate from Maryland to Gibraltar, a foreign country, so that no US court will have jurisdiction over the trust. Here, a court within the US is unable to exercise primary supervision over the trust's administration because of the flight provisions. Therefore, the trust fails to satisfy the court test from the time of its creation and constitutes a foreign trust.
(3) Control
Test.
(a) Generally. The control test
is one of the two tests that a trust must satisfy in order to be classified as
a domestic trust.
(b) General
Rule. To
satisfy the control test:
(i)
One or more US persons
(ii) Must
have authority to control
(iii)
All substantial decisions of the trust.[32]
(c)
Definitions.
(i) US person. The term "United States person" means a US person within the meaning of IRC § 7701(a)(30).[33] For example, a domestic corporation is a US person, regardless of whether its shareholders are US persons.[34]
1. Note. The control test, as originally enacted in the Small Business Job Protection Act of 1996, required that one or more "US fiduciaries" have the authority to control all substantial decisions of the trust in order for the trust to be treated as a domestic trust.[35] Treasury regulations use the term "persons" as defined in IRC § 7701(a)(30), which includes US citizens and residents, and domestic corporations and partnerships.[36] As a technical correction to the Small Business Job Protection Act of 1996, the Taxpayer Relief Act of 1997 substituted the term "US persons" for "US fiduciaries."[37]
(ii) Substantial decisions.
1. Definition under Treasury Regulations. Treasury regulations define "substantial decisions" as non-ministerial decisions that persons are authorized or required to make under the terms of the trust instrument and applicable law.[38]
2. Ministerial decisions. Ministerial decisions, which do not constitute "substantial decisions," include decisions regarding details such as the bookkeeping, the collection of rents, and the execution of investment decisions.[39]
3. Non-exclusive list of substantial decisions.[40] Treasury regulations provide the following non-exclusive list of substantial decisions:
a. Whether and when to distribute income or corpus;
b. The amount of any distributions;
c. The selection of a beneficiary;
d. Whether a receipt is allocable to income or principal;
e. Whether to terminate the trust;
f. Whether to compromise, arbitrate, or abandon claims of the trust;
g. Whether to sue on behalf of the trust or to defend suits against the trust;
h. Whether to remove, add, or replace a trustee;
i. Whether to appoint a successor trustee to succeed a trustee who has died, resigned, or otherwise ceased to act as a trustee, even if the power to make such a decision is not accompanied by an unrestricted power to remove a trustee, unless the power to make such a decision is limited such that it cannot be exercised in a manner that would change the trust's residency from foreign to domestic, or vice versa; and
j. Investment decisions
i. Note. With respect to investment decisions, if a US person hires an investment advisor for the trust, investment decisions made by the investment advisor will be considered substantial decisions controlled by the US person if the US person can terminate the investment advisor's power to make investment decisions at will.
(iii) Control.[41]
1. Treasury regulations define "control" as having the power, by vote or otherwise, to make all of the substantial decisions of the trust, with no other person having the power to veto any substantial decisions.
2. In order to determine if US persons have control, it is necessary to consider ALL persons who have authority to make substantial decisions of the trust, not only the trust fiduciaries.
3. Note. A trust can have a foreign fiduciary and still be a domestic trust, if the foreign fiduciary can be outvoted by domestic fiduciaries. For example, if the trust has one foreign trustee, two domestic trustees, and the trust instrument provides for a majority vote for trustee decisions, the trust satisfies the control test as a domestic trust.[42]
(d) Safe
harbor for certain employee benefit trusts and investment trusts. Certain
employee benefit trusts will be deemed to satisfy the control test as long as
US fiduciaries control all of the substantial decisions to be md to benefit a US person, but
the law applicable to the trust may require payments or accumulations of income
or corpus to/for the benefit of a US person (by judicial reformation or
otherwise), all potential benefits that could be provided to a US person
pursuant to the law must be taken into account, unless the US transferor
demonstrates to IRS satisfaction that the law is not reasonably expected to be
applied or invoked under the facts and circumstances; and
c.
If the parties to the
trust ignore the trust instrument's terms, or if it is reasonably expected that
they will do so, all benefits that have been, or are reasonably expected to be,
provided to a US person must be considered.
(iv)
Attribution Rules.
1.
For IRC § 679
purposes, an amount is treated as paid or accumulated to or for the benefit of
a US person if the amount is paid to or accumulated for the benefit of:
a.
A controlled foreign
corporation.
Therefore, transfers
by will of US decedents to a foreign nongrantor trust will generally not
trigger gain recognition under IRC § 684 because the foreign nongrantor trust
will take a stepped up basis under IRC § 1014.
(2)
Exception to
General Rule.
(a)
Some commentators
argue that there may be IRC § 684 gain recognition upon deaths of US
transferors to foreign trusts, which occur in 2010. The argument in favor of
this result is as follows:[115]
(i) Until the US person's death, such person is treated as the owner of the property for US income tax purposes under IRC § 671.
(ii) The US grantor's death terminates the trust's grantor trust status.
[129]
2.
Beneficiaries.
a.
Beneficiaries of a complex FNGT must include in
their gross income all income that the trust is required to distribute and all
income actually distributed to the beneficiaries pursuant to the trust
instrument.[130]
b.
Each beneficiary must include in his gross income
an amount equal to his pro rata share of the trust's DNI.[131]
c.
Distributions that exceed the FNGT's DNI are
treated either as nontaxable distributions of principal or as distributions of
accumulated income from prior years, which are taxable under the throwback rule
(discussed below).[132]
b)
Tax at the FNGT level.
i)
Generally. Unlike the gross
income of domestic trusts, which includes the domestic trust's worldwide gross
income, the gross income of an FNGT, for purposes of taxation imposed on the
trust (as opposed to tax imposed on the trust beneficiaries), consists only of:
(1) Non-trade/business
US source gross income. Gross
income derived from sources within the US that is not effectively connected
with the conduct of a trade or business within the US; and
(2) Trade/business
within US. Gross
income that is effectively connected with the conduct of a trade or business
within the US.[133]
(a) Note. FNGTs generally are not subject to US income taxation on undistributed foreign source income because of a lack of a nexus between the US and the FNGT for income tax purposes. However, foreign source income of an FNGT that is distributed to US beneficiaries may be taxed to such beneficiaries.[134]
ii) Imposition of US income tax - generally.
(1) Income earned by a foreign nongrantor trust ("FNGT"), which as mentioned above is taxed as an NRA, will generally fall into one of two taxing regimes. For FNGTs "engaged in a trade or business" in the US, the US taxes the net income that is "effectively connected" with the conduct of such trade or business in the same manner as net income earned by a US resident.[135] In contrast, fixed or determinable annual or periodical gains, profits, and income from US sources (commonly referred to as "FDAP" income), which an FNGT earns is typically taxed on a gross basis at a flat 30 percent rate.[136] In other words, the IRC taxes trade or business income on a net basis at graduated rates. In contrast, the IRC taxes non-business income on a gross basis, without the benefit of deductions, at a flat rate of thirty percent.<%his would allow the FNGT to be able to deduct expenses associated with its US real property rental activity, rather than to pay a flat 30 percent tax on a gross basis.
iv) Taxation of FNGT Not Engaged in US Trade or Business - FDAP Income.
(1) Generally.
(a) IRC §§ 871 and 881 tax NRAs, and therefore, FNGTs, at a flat 30 percent tax on several types of nonbusiness income. The tax is imposed at a flat 30 percent rate without any deductions or other allowances for costs incurred in producing the income and is typically collected through withholding.[156] This tax applies to interest, dividends, rents, royalties and other "fixed or determinable annual or periodical" income ("FDAP" income) if such income is: (1) includible in income; (2) from US sources; and (3) not effectively connected in the conduct of a US trade or business.
(b) FDAP income from sources outside the US is generally not taxable when received by an FNGT. FDAP income from sources within the US that is effectively connected with the conduct of a US trade or business is taxed in the manner described above.
(c)[162] In addition, the tax cannot exceed the amount of the payment less any part of the payment that represents expressly stated interest.[163]
(ii) OID taxed on a payment is not taxed subsequently on the sale or exchange of the OID obligation.[164] Upon disposition of an OID obligation, all untaxed OID accruing during the time the obligation was held by the FNGT is taxed, even if the accrued amount exceeds the gain on disposition.
(b) Portfolio Interest. Portfolio interest on certain types of obligations, which is paid to an FNGT, is not subject to the 30 percent tax.[165]
(c) Interest on Bank Deposits. Interest received by FNGTs or foreign corporations on deposits with banks, savings institutions or insurance companies are exempt from tax if they are not effectively connected with the recipient's US trade or business.[166]
(3) Gain
on Sale of Capital Asset. If
an FNGT is not engaged in the conduct of a US trade or business, then the
FNGT's US source non-real estate capital gains will not be subject to US
federal income tax. This results
because (1) FNGTs are taxed as NRAs not present in the US at any time,[167]
and (2) in order for the capital gains of an NRA (which an FNGT is treated as)
to be subject to US federal income tax, the NRA must be physically present in
the US for at least 183 days.[168]
(a) Note. An FNGT's US
capital gains will be subject to US income tax at the beneficiary level if the
FNGT distributes them to a US beneficiary.
v) Source
Rules.
(1) Generally. An
FNGT is subject to income tax on income from US sources, including both US
source passive income (i.e., FDAP)[169]
and income that is effectively connected with the conduct of a trade or
business in the US.[170] Because
FNGTs are taxed only on income from US sources, it is critical to know the
source of the FNGT's income.
(2) In very general terms, the IRC statutorily
provides the following source rules:
(a) Interest. Interest
is generally sourced by reference to the payer's residence. Therefore, interest from US borrowers;
except for interest from US bank deposits (unless effectively connected with a
US trade or business) and portfolio interest, is treated as US source income.[171]
(b) Dividends. Dividends
paid by a US corporation are US source income. If a foreign corporation is engaged in a US trade or
business, a portion of any dividend payment may be treated as US source income. Specifically, if 25 percent or more of
the foreign corporation's gross income for the three preceding years is US
business income, the portion of the dividend attributable to the corporation's
US business income will be treated as US source income.[172]
(c) Personal service income. Income from the performance of personal services
in the US is US source income, subject to the de minimis exception, discussed
above.[173]
(d) Rental income. Rental income from property located in the US
is US source income.[174]
(e) Royalty income. Royalty
income generated in the US is US source income.[175]
(f)(i) The deduction for losses allowed by IRC §§ 165(c)(3) if the loss occurred with respect to property located in the US;
(ii) The deduction for charitable contributions allowed by IRC § 170; and
(iii) The deduction for personal exemptions allowed by IRC § 151.[181]
(2) Distributions
to beneficiaries. In
addition to the foregoing, distributions to beneficiaries made by either a simple
trust[182]
or a complex trust[183] are
deductible. However, this merely
shifts the taxability for such amounts from the trust to the beneficiaries.
ii) Deductions related to other income. No deductions are permitted against US source fixed or determinable annual or periodic income, except to the extent such income is effectively connected to a US trade or business.
iii) Foreign Tax Credit. A FNGT engaged in a trade or business within the US that pays foreign income, war profits or excess profits taxes on income that is effectively connected with such trade or business may, subject to certain limitations, credit the foreign tax against its US income tax liability.[184] Alternatively, it may deduct such taxes.[185]
d)
Applicable tax rates.
i) Income effectively connected with a US trade or business. For FNGTs "engaged in a trade or business" in the US, the US taxes the net income that is "effectively connected" with the conduct of such trade or business in the same manner as net income earned by a US resident.[186] In other words, this type of income is subject to the normal tax rates applicable to trusts under IRC § 1(e).[187]
ii)
FDAP income. In
contrast to income effectively connected with a trade or business, fixed or
determinable annual or periodical gains, profits, and income from US sources,
which an FNGT earns is typically taxed on a gross basis at a flat 30 percent
rate.[188] In other words, the IRC taxes trade or
business income on a net basis at graduated rates. In contrast,
the IRC taxes non-business income on a gross basis, without the benefit
of deductions, at a flat rate of thirty percent.
(1) Caution. The 15 percent maximum tax rate applicable to dividend income does not apply to income received by FNGTs.
e) Withholding.[189] FNGTs are subject to withholding, which are set forth in very detailed and extensive treasury regulations, and which are too extensive to cover in detail in this outline. However, it is important for practitioners to be aware that these rules exist.
4)
Tax treatment of beneficiaries of FNGTs.
a)
Generally. As
noted above, FNGT income may be entirely taxable to the FNGT, the FNGT's
beneficiaries, or partly to each. Under IRC §§ 651 and 661, trusts may deduct
amounts properly paid or credited to beneficiaries. Therefore, trusts are
treated as conduits to the extent of distributed income, and as separate
taxable entities to the extent of undistributed income. Because DNI is so critical to the
tax consequences of distributions to FNGT beneficiaries, this outline next
discusses DNI.
b)
Distributable Net Income ("DNI").
i)
Simple versus complex trusts.
(1) Simple
trust.
(a) Definition. A FNGT will
constitute a "simple" trust if it satisfies all of the following
requirements:
(i)
all income must be distributed currently.
(ii) no
amounts may be paid, permanently set aside for, or used for a charitable
beneficiary.
(iii)
no distributions are made other than of current
income (i.e., no distributions of accumulated income or corpus).[190]
(b) Tax
treatment. All
of a simple FNGT's income will be taxed to the beneficiaries. In turn the FNGT
will receive a deduction for its current income, which it must pay to the
beneficiaries, regardless of whether such income is actually distributed or
not.[191]
The amounts that the beneficiaries must include in their gross income, along
with the trust's deduction, are both limited by the trust's DNI.[192]
(2) Complex
trust.
(a) Definition. A FNGT will
constitute a "complex" trust if any of the following are true:
(i)
It is not required to distribute all of its income
currently.
(ii) it
distributes accumulated income or principal
(iii)
or it has a charitable beneficiary.[193]
(b) Tax
treatment.
(i)
Trust. A
complex FNGT receives a deduction for that portion of its current income that
it must distribute plus that portion of its current income that the trustee
actually distributes to the beneficiaries pursuant to the trust instrument.[194]
The trust's deduction is limited to the amount of its DNI.[195]
(ii) Beneficiaries.
1.
Beneficiaries of a complex FNGT must include in
their gross income all income that the trust is required to distribute plus all
income actually distributed to the beneficiaries pursuant to the trust
instrument.[196]
2.
Each beneficiary must include in its gross income
an amount equal to his pro rata share of the trust's DNI.[197]
3.
Distributions that exceed the FNGT's DNI are
treated either as nontaxable distributions of principal or as distributions of
income accumulated from prior years, which are taxable under the throwback
rule, which is discussed later in this outline.[198]
ii)
Computation of DNI.
(1) Generally. A
trust's DNI generally equals its taxable income computed with the following modifications:
(a) There
is no deduction for distributions to beneficiaries.
(b) There
is no personal exemption deduction.
(c)
The trust's taxable income is increased by any
tax-exempt income (net of allocable expenses).[199]
(2) Modifications
to DNI for FNGT. The
DNI of a FNGT is calculated in the same manner as for a domestic trust, with
the following modifications:
(a) Worldwide
income.
(i)
A FNGT's DNI begins with its worldwide taxable
income, including both US and foreign source income, without any distribution
deduction or personal exemption, and increased by net tax-exempt income, as
with a domestic trust.[200]
(ii) The
FNGT's DNI specifically includes gross income from sources outside the US,
reduced by disbursements allocable to such income that would have been
deductible were it not for the IRC § 265(a)(1) limitation, which disallows
certain deductions with respect to tax-exempt income.[201]
(iii)
The FNGT's DNI also includes US source gross
income, determined without regard to IRC § 894, which otherwise extends to
taxpayers the benefits of an US income tax treaties.[202] In other words, income that is exempt
from tax by treaty must nevertheless be taken into account in computing the
FNGT's DNI.[203]
(iv) The
two foregoing adjustments are reduced proportionately to the extent that the
FNGT is allowed a deduction for charitable distributions or set asides.[204]
(b) Capital
gains. Unlike
domestic trusts, for which DNI generally does not include capital gains, the
DNI of FNGTs includes capital gains, regardless of whether they are allocated
to income or to corpus under either the governing law or instrument, and
regardless of whether they are currently distributed.[205]
Capital losses reduce such capital gains to the extent that they do not exceed
capital gains.[206] If a FNGT
recognizes both capital gains and ordinary income in one tax year, then
distributions to US beneficiaries will include a proportionate share of both
ordinary income and capital gains, based on the relative inclusion of both in
the FNGT's DNI.
c)
Taxation of current distributions.
i)
Generally. FNGT
beneficiaries are taxed on the trust's income to the extent such income is
either distributed or required to be distributed.[207]
However, the exact US income tax treatment of income distributed to FNGT
beneficiaries depends on the following:
(1) Whether
the distribution is of current income (i.e.,. DNI) or accumulated income
(i.e., UNI).
(2) Whether
the beneficiary is a US or foreign person.
(3) Whether
the FNGT's income is from within the US or from outside the US.
ii)
Distributions to US beneficiaries.
(1) Generally. US
beneficiaries of FNGTs must include the following in their gross income:
(a) From simple trusts: The amount of any trust income required to be distributed to such beneficiary in the year in question, regardless of whether such income is actually distributed, but limited to the extent of that beneficiary's share of the trust's DNI for that year;[208]
(b) From complex trusts: Both:
(i) The amount of any trust income required to be distributed to such beneficiary in the year in question, regardless of whether such income is actually distributed, but limited to the extent of that beneficiary's share of the trust's DNI for the year;[209] and
(ii) Any
other amount (1) required to be distributed to such beneficiary, regardless of
whether such amount is actually distribute, or (2) that is properly and
actually distributed to such beneficiary, to the extent of such beneficiary's
share of the trust's DNI for the year in question.[210]
(2) Determining
the beneficiaries' share of DNI.
(a) Simple trusts.
(i) If the amount of income required to be distributed currently to beneficiaries exceeds the FNGT's DNI, each beneficiary includes in his gross income his proportionate share of such DNI.
(ii) Example 18. Adam, a beneficiary of Simple FNGT, a simple trust, is to receive two-thirds of the trust income. Bob is to receive one-third. The income required to be distributed currently is $99,000. Here, Adam will receive $66,000 and Bob will receive $33,000. However, if the DNI is only $90,000, Adam will include two-thirds ($60,000) of the DNI in his gross income, and Bob will include one-third ($30,000) in his gross income.
(b) Complex trusts.[211]
(i) Generally. The IRC breaks income from complex trusts into two (2) groups (or tiers) of income. However, the amount of income that can be taxed to a beneficiary is limited to the trust's DNI.
(ii) DNI > Tier 1 income. If the entire amount of income in tier 1 (i.e., income required to be distributed currently) is less than the trust's DNI, then the entire amount of the trust's income is taxable to the trust's beneficiaries.
(iii) DNI < Tier 1 income. If the entire amount of income in tier 1 is more than DNI, then each beneficiary is taxable only to the extent of his proportionate share of DNI.
(iv) Tier 2 distributions. Tier 2 distributions (i.e., other amounts properly paid, credited or required to be distributed to beneficiaries for the tax year) are taxed to beneficiaries only if the trust's DNI exceeds distributions falling into tier 1. If DNI exceeds distributions falling into tier 1, distributions are taxable to a beneficiary to the extent that they do not exceed his proportionate share of the trust's DNI after reduction for amounts required to be distributed currently.
(3) Tax character of income. The tax character of distributions that a beneficiary receives in a year proportionately reflects the character of the trust's income for that year.[212] If the trust agreement or local law requires the trust to allocate particular types of trust income to particular beneficiaries, then the character of distributions to such beneficiaries will reflect that allocation if it has economic significance independent of the tax consequences.[213]
(4) Credit for US income tax withheld at source.
(a) FNGT beneficiaries may claim a credit against their US income tax for US income taxes withheld at the source on US source income paid to the FNGT (e.g., withholding on FDAP income or FIRPTA withholding).[214]
(b) The withholding tax is treated as if it were paid by the beneficiary.
(c) Note. To claim the credit, however, the beneficiary must report as his income from the trust the sum of the tax withheld in addition to the amount actually distributed to him.[215]
(5) Credit for foreign taxes paid by FNGT.
(a) Although most FNGTs are established in a low/no tax jurisdictions, the FNGT may nevertheless incur foreign taxes or it may be established in a foreign country that does impose taxes upon the trust.
(b) If an FNGT pays foreign taxes, its US beneficiaries who receive income distributions on which such taxes have been paid may elect to take a credit for the share of foreign taxes attributable to their share of the income.[216] Alternatively, such beneficiaries may deduct such taxes as an itemized deduction.[217]
(c) To claim the credit, however, it appears that the beneficiary must report as his income from the trust the sum of the foreign taxes paid in addition to the amount actually distributed to him.[218]
iii) Distributions
to NRA beneficiaries.
(1) Foreign
source income. NRA
beneficiaries of FNGTs are generally not subject to US income tax on an FNGT's
foreign source income. This results because there is no US nexus on which to
tax such income to the foreign beneficiary.
(2) US
source income.
(a) NRA
beneficiaries of FNGTs are subject to US income tax on such FNGT's US source
income. Generally, such beneficiaries are liable for US income taxes on the
lesser of (1) the income the FNGT actually distributes or is required to distribute,
or (2) the FNGT's DNI.
(b) The
character of the FNGT's US income (i.e., as either effectively connected
with a US trade or business, or as FDAP income) establishes the beneficiary's
US tax liability in the same manner that it establishes the FNGT's tax
liability on undistributed income.[219]
(3) Withholding. As
a practical matter, most of an NRA's US tax liability stemming from an FNGT
with US source income may be paid in the form of withholding.[220]
d)
Taxation of Accumulation Distributions.
i)
Generally.
(1) If
an FNGT makes distributions that exceed its DNI in any particular year, the US
beneficiaries receiving such distributions must apply the throwback rule, which
may subject such distributions to both taxation and an interest charge.
(2) Generally,
the IRC allocates a foreign trust's income for income tax purposes each year
between the trust and the trust beneficiaries by means of its DNI.[221]
To the extent that DNI is either actually distributed or required to be
distributed, (a) the trust deducts such DNI from its taxable income,[222]
and (b) the beneficiaries are taxed on such DNI.[223]
(3) If
a trust does not distribute all of its DNI in any year, the amount of its DNI
that it does not distribute becomes "undistributed net income" ("UNI"),[224]
to which the throwback rule may apply in a future year. [In other words, UNI is
the excess of the amount available from DNI for distribution to trust
beneficiaries over the amount that the trust actually distributes to such
beneficiaries.] In any year that
the trust makes a distribution to its beneficiaries that exceeds its DNI for
such year, if it has UNI from prior year(s), the IRC will treat the trust as
making an "accumulation distribution." As noted above, the IRC then applies the
throwback rule, which may subject such distributions to both taxation and an
interest charge.
(4) The
throwback rule is designed to impose on trust beneficiaries approximately the
same income taxes that would have been imposed had the trust distributed all of
its income on a current basis.
(5) Application
of the throwback rule involves the following concepts:
(a) The
mechanics of the throwback rule.
(b) Definition
of "accumulation distribution."
(c)
Definition of "undistributed net income" ("UNI").
(d) Computation
of the interest charge imposed on accumulation distributions from foreign trusts.
(e) Application
of the character rule.
ii)
Throwback rule mechanics.
(1) Step
1 - Determine number of preceding tax years of trust to which distribution
attributable.
(a) Determine
the number of preceding taxable years of the trust to which the distribution is
attributable. The years to which the distribution is attributed are the
earliest years of the trust in which the trust had UNI.[225]
These are the actual years in which the income was accumulated based on the
trust records.
(b) Caution. If the trust's
records are insufficient to establish which years have UNI, the accumulation
distribution will be allocated to the earliest year that the trust was in
existence.[226]
(c)
If the amount of the trust's UNI in one of the
accumulation years is less than 25 percent of the average annual accumulation,
(i.e., the total accumulation distribution divided by the number of
years of accumulation) that year is disregarded in determining the number of
years in which the distribution has been accumulated. However, amounts
accumulated in any such disregarded year still are considered part of the total
accumulation distribution.[227]
(d) Example 19-A. Chandler creates
the Chandler trust, an FNGT, in 2000.
In 2004, the Chandler trust distributes $35,000 to its beneficiary,
Marlowe, when it has DNI of $10,000.
The Chandler trust had the following amounts of UNI: 2000 - $8,000; 2001
- $10,000; 2002 - $7,000, and 2003 - $18,000. Here, the accumulation distribution would be attributed to
three years (i.e., 2000, 2001, and 2002).
(2) Step
2 - Determine beneficiary's average years.
(a) Determine
the beneficiary's average years. This is determined by examining the
beneficiary's taxable income for the five immediately preceding tax years and
then ignoring the high and low years.
(b) Example
19-B. Marlow has the following amounts of taxable income in the five years
preceding the 2004 accumulation distribution:
(i)
2003. $100,000.
(ii) 2002. $10,000.
(iii)
2001. $75,000.
(iv) 2000. $75,000.
(v)
1999. $65,000.
Here, Marlowe's average years are 2001, 2000, and 1999.
(3) Step
3 - Determine the average annual accumulation.
(a) Determine
the average annual accumulation, which is calculated by dividing the total
accumulation distribution (including any taxes that the trust paid on the such
amounts) by the number of years in which such accumulation distribution was
accumulated.
(b) Note
- the number of years in which the accumulation distribution was accumulated
was determined in step 1.
(c)
Example 19-C. Here, the average annual accumulation
equals $8,333.33. This amount is calculated by dividing the total accumulation distribution
of $25,000 by the number of years in which that accumulation distribution was
accumulated, which was three.
(4) Step
4 - Add average annual accumulation to beneficiary's average years.
(a) The
average annual accumulation, calculated in Step 3, is added to each of the
beneficiary's (three) average years, determined in Step 2.
(b) Example
19-D.
Here, this step would yield the following adjusted amounts of taxable income
for Marlowe:
(i)
2001. $83,333.
(ii) 2000. $83,333.
(iii)
1999. $73,333.
(5) Step
5 - Compute the average additional tax.
(a) Compute
and average the increase in the beneficiary's tax caused by the addition of the
average annual accumulation in each of the beneficiary's average years.[228]
If the beneficiary is an NRA during some or all of the applicable years, this should
be reflected by a change in the additional tax in such years.
(b) Example
19-E. Assume
that this step yields the following increase in Marlowe's tax for each of his
average years:
(i)
2001. $2,531.
(ii) 2000. $2,573.
(iii)
1999. $2,573.
This yields an average increase in tax of $2,559.
(6) Step
6 - Calculate the partial tax on the accumulation distribution.
(a) Determine
the partial tax on the accumulation distribution by multiplying the average
additional tax (computed in Step 5) by the number of years of accumulation.[229]
(b) Example
19-F. Here,
ignoring the credit for taxes paid on the distribution, the partial tax would
be $7,677, which equals $2,559 (average additional tax) multiplied by 3 (number
of years of accumulation).
(7) Step
7 - Subtract credit for the taxes paid on the UNI being distributed.
(a) Subtract
from the partial tax, determined in Step 6, a credit for the taxes paid on the
UNI by the trust.[230]
(b) Note. Because the
beneficiary is given a credit for the taxes paid by the FNGT, the accumulation
distribution must be grossed up to reflect such taxes. In other words, such
taxes must be added to the accumulation distribution.
(c)
Note. If
a beneficiary receives accumulation distributions from more than two trusts,
he/she can only subtract a credit for the taxes paid by the first two trusts. Taxes by any additional trusts are
ignored for purposes of this step.[231]
(d) Example
19-G. Assume
that the Chandler Trust paid $2,000 of tax on the UNI that it distributes to
Marlowe as part of the accumulation distribution. Here, the partial tax is reduced
by $2,000.
iii) Character
Rule.
(1) Generally. Under
IRC § 667, the IRC taxes accumulation distributions that FNGT beneficiaries
receive as ordinary income, regardless of the character of the income that the
trust itself receives, with certain exceptions.[232]
(2) Exceptions.
(a) Tax-exempt
income. This
rule does not apply to tax-exempt income, which does retain its character in
the hands of the beneficiary in the form of an accumulation distribution.[233]
(b) NRAs. Accumulation
distributions that an FNGT makes to NRA beneficiaries retain the character of
such income as recognized by the trust.[234]
(3) Capital
gains. Since
capital gains are included in DNI, if they are not distributed currently, but
instead are distributed to a US beneficiary as part of an accumulation
distribution, such capital gains will be taxed at ordinary income tax rates
when the US beneficiary receives them.
(4) Elimination
of character rule is not limited as to types of character of income to which it
applies. The
elimination of character rule does not limit the character of income to which
it applies. Therefore, among
other things, it results in the following types of implications:
(a) Foreign
tax credit. Because
a US beneficiary of an FNGT cannot treat any part of the foreign income
included in an accumulation as foreign income, such beneficiary loses the
benefits of the foreign tax credit.
(b) Passive
activity income. If
passive activity income is included in an accumulation distribution, the
beneficiary cannot use such income to offset passive activity losses.
(c)
Tax preference items. If tax preference items are included
in an accumulation distribution, the beneficiary does not have to take such
items into account for alternative minimum tax purposes.
iv)
Interest charge.
(1) Generally.
(a) IRC
§ 668 imposes a nondeductible "interest" charge on an FNGT beneficiary's tax,
which the IRC imposes on accumulation distributions from the FNGT.[235]
(b) The
IRC imposes the interest charge in addition to any other tax liabilities of the
beneficiary of such FNGT.
(c)
The interest charge is imposed on the amount of
additional tax imposed on the beneficiary because of the accumulation
distribution, but after reduction for any credit for any taxes that the FNGT
paid on such distributed income.
(2) Pre-1996
interest charge. Under
pre-1996 law, the interest rate was a simple 6 percent per year rate.
(3) Post-1995
interest charge. The
1996 Act changed the interest rule. Under rules enacted by the 1996 Act, the
following rules apply:
(a) Simple
interest accrues at the rate of 6 percent through December 31, 1995.[236]
(b) Compound
interest accrues, beginning January 1, 1996, using the monthly underpayment
rate.[237]
This compound rate also applies to the total simple interest that accrues for
pre-1996 periods.
(c)
The accumulation distribution is allocated
proportionately to prior trust years in which the trust has UNI (as opposed to
the earliest of such years), and is treated as reducing UNI from prior years
proportionately from each year.[238]
(4) Limit
on interest charge.
(a) IRC
§ 668(b) provides that the interest charge, when added to the federal tax imposed
on the accumulation distribution (i.e., under the throwback rules
described above), cannot exceed the amount of the accumulation distribution
itself.
(b) To
illustrate, if you arrived at an additional tax of $70 and an interest charge
of $50 on an accumulated distribution of $100, the interest charge would be
limited to $30, and after taxes and the interest charge, you would be left with
$0 (i.e., rather than being worse off by $20).
(5) Not
deductible. The
IRC § 668 interest charge is not deductible.[239]
v)
Planning to avoid throwback rule and interest
charge. Commentators
have suggested the following methods of avoiding taxation of accumulation
distributions under the throwback rules.
(1) Specific
gifts.[240] Distributions
in satisfaction of a gift of a specific sum of money or of specific property
described in IRC § 663(a)(1) do not constitute an accumulation distribution.
Therefore, such distributions will not trigger the throwback rules. For
this purpose, a specific sum of money or of specific property described in IRC
§ 663(a)(1) is an amount that the trust instrument requires to be paid to a
beneficiary as a gift of a specific sum of money or of specific property and
which is actually paid to such beneficiary all at once or in no more than three
installments.[241]
(2) Distributions
in kind.[242] FNGT
trustees can distribute appreciated securities in kind, but not claim a
distribution deduction for the value distributed that exceeds the FNGT's
adjusted basis.[243] This
defers the tax until the US beneficiary recognizes the capital gain and,
therefore, will distribute greater value to the beneficiary without exceeding
DNI.
(3) Use
of holding company.[244] If
an FNGT holds investments through a holding company, the trust will have not
DNI (and therefore no UNI) until the holding company pays dividends to the
FNGT. This allows the trust to accumulate income at the holding company level
and ensure that all distributions to FNGT beneficiaries constitute current
distributions.
(a) Caution. This strategy
runs the risk of running afoul of the following tax regimes, each of which has
negative tax consequences:
(i) Passive foreign investment company, which subjects US beneficiaries to the PFIC tax.[245]
(ii) Foreign personal holding company.[246]
(iii) Controlled foreign corporation.[247]
(4) Investment in high yield securities.[248] Because the throwback rules only apply to accumulation distributions after the current year's DNI is exhausted, one effective way to avoid the throwback rule is to change the FNGT's investment mix in years that distributions are desired to increase DNI. If DNI equals or exceeds the contemplated distribution, there should be no accumulation distribution.
e) Loans to US beneficiaries treated as distributions.
i) Generally. IRC § 643(i) provides that, if a foreign trust loans cash or marketable securities directly or indirectly to any US grantor or beneficiary, or any US person who is related to such grantor or beneficiary, then the amount of such loan is treated as a distribution by that trust to such grantor or beneficiary.
ii) Definitions and special rules. For purposes of this rule, the following definitions and special rules apply.
(1) Cash. Cash includes foreign currencies and cash equivalents.[249]
(2) Related person. For purposes of this rule, a person is related to another person if the relationship between them would cause a loss disallowance under IRC § 267 (but applying IRC § 267(c)(4) as if the family of an individual includes the spouses of the members of the family) or IRC § 707(b).[250]
(3) Trust not treated as simple trust. A trust that is treated as making a distribution under this rule is treated as a complex trust.[251]
(4) Subsequent transactions regarding loan principal. IRC § 643(i)(3) provides that this rule applies, then "any subsequent transaction between the trust and the original borrower regarding the principal of the loan (by way of complete or partial repayment, satisfaction, cancellation, discharge, or otherwise) shall be disregarded for purposes of this title."
iii) Note re loans of marketable securities. As noted above, under IRC § 643(e), unless the trustee elects otherwise, the amount of a distribution other than cash is the lesser of (a) the trust's basis in the distributed property or (b) its fair market value. Therefore, it appears that if an FNGT trust lends marketable securities with a fair market value that exceeds its basis, the deemed distribution under this rule will be the amount of the basis unless the trustee elects to recognize gain on the distribution.
f) Intermediary rule - distributions through intermediaries.
i) General Rule. The IRC treats a US person (i.e., recipient) who receives property from another person (i.e., an intermediary) who received such property from a foreign trust as having received the property directly from such trust if the property the recipient receives was derived directly/indirectly from such foreign trust.[252]
ii) Exception for grantors. This rule does not apply if the person from whom the recipient receives the property is the grantor of the foreign trust.
iii) Treasury regulations - limit rule to tax avoidance transactions. Treasury regulations only apply this intermediary rule if the transaction in question has a principal purpose of avoiding US tax. (Note, the IRC itself does not make tax avoidance a prerequisite to application of the intermediary rule).[253]
iv) Tax avoidance purpose. Treasury regulations deem tax avoidance motivation to exist for purposes of the intermediary rule if all the following requirements are satisfied:[254]
(1) Relationship. The US recipient is related[255] to a grantor of the foreign trust, or has another relationship with a grantor that establishes a reasonable basis to or conclude that the grantor would make a gratuitous transfer to such recipient;
(2) Time frame. The US recipient receives from the intermediary, within the period beginning twenty-four months before and ending twenty-four months after the intermediary receives the property from the foreign trust, either:
(a) The property the intermediary received from the foreign trust;
(b) Proceeds from such property; or
(c) Property in substitution for such property; and
(3) Lack of alternate explanation. The US recipient cannot prove to IRS satisfaction that:
(a) The intermediary has a relationship with the US recipient that establishes a reasonable basis to conclude that the intermediary would make a gratuitous transfer to such recipient;
(b) The intermediary acted independently of the grantor and the trustee of the foreign trust;
(c) The intermediary is not an agent of the US recipient under generally applicable United States agency principles; and
(d) The US recipient timely complied with the reporting requirements of IRC § 6039F (notice of large gifts from foreign persons, which is filed on Form 3520), if applicable, if the intermediary is a foreign person.
v) Exceptions. The intermediary rule does not apply in the following cases.
(1) Non-gratuitous transfers. The intermediary rule does not apply to the extent that either the transfer from the foreign trust to the intermediary or the transfer from the intermediary to the US recipient does not constitute a gratuitous transfer within the meaning of § 1.671-2(e)(2).[256]
(2) Grantor as intermediary. The intermediary rule does not apply if the intermediary is the grantor of the portion of the trust from which the transferred property that is derived.[257]
vi)
Effect of application of intermediary rule.
(1) General rule. If the intermediary rule applies, then:
(a) The intermediary is treated as an agent of the foreign trust.
(b) The property is treated as transferred to the US recipient in the year the property is transferred, or made available, by the intermediary to the US recipient (as opposed to when the trust transfers the property to the intermediary).
(c) The fair market value of the property transferred is determined as of the date of the transfer by the intermediary to the US recipient.
(2) Alternative treatment. If the IRS determines, or if the taxpayer can prove to IRS satisfaction, that the intermediary is the US recipient's agent (rather than the foreign trust's agent), then:
(a) The IRS will treat the property as transferred to the US recipient in the year the foreign trust transfers the property to the intermediary.
(b) The fair market value of the property transferred will be determined on the transfer date from the foreign trust to the intermediary.[258]
(3) Intermediary's taxation. If the intermediary rule applies to cause the property to be treated as transferred directly by the foreign trust to a US recipient, the intermediary does not take into account such property's fair market value in computing his/her gross income.[259]
vii) De minimis rule. The intermediary rule does not apply if, during the US recipient's tax year, the aggregate fair market value of all property transferred to such person from all foreign trusts either directly or through one or more intermediaries does not exceed $10,000.
viii) Related parties. For purposes of the intermediary rule, a United States recipient is treated as related to a foreign trust grantor trust if the US recipient and the grantor are related for purposes of IRC § 643(i)(2)(B), with the following modifications:
(1) For purposes of applying IRC § 267 (other than IRC § 267(f)) and IRC § 707(b)(1), "at least 10 percent" is used instead of "more than 50 percent" each place it appears; and
(2) The principles of IRC § 267(b)(10), using "at least 10 percent" instead of "more than 50 percent," apply to determine whether two corporations are related.
5) Tax treatment of US beneficiaries of foreign grantor trusts ("FGTs").
a) Background.
i) Prior to the 1996 Act, trusts created by non-US persons were subject to the "grantor trust" rules to the same extent as trusts created by US persons. As a result, the grantor trust rules shifted such a trust's income, for virtually all US income tax purposes, from the trust to its non-US grantor.
ii) Where a foreign person was treated as the owner of the income because of the grantor trust rule, then (i) the foreign grantor-owner was taxed on such income only under the limited rules for taxing NRA individuals and foreign corporations; and (ii) distributions from the trust to US beneficiaries were treated as gifts from the foreign grantor-owner. Such gifts generally were not taxable to the US beneficiary as income.[260] Gift tax would frequently not be imposed (e.g., where the subject matter of the gift was situated outside the US).
iii) Today, IRC § 672(f) generally denies grantor trust status to trusts with non-US grantors.
b)
General rule - no grantor status for foreign
grantors.
i) IRC § 672(f)(1) provides that the grantor trust rules apply only to the extent that they cause an amount to be currently taken into account (directly or through one or more entities) in computing the income of a US citizen/resident or a domestic corporation. Accordingly, they apply to the extent that any part of a trust, upon application of the grantor trust rules without regard to IRC § 672(f), is treated as owned by a US citizen or resident, or domestic corporation.
ii) The grantor trust rules specifically do not apply to any part of a trust to the extent that, upon application of the grantor trust rules without regard to IRC § 672(f), that part would be treated as owned by a non-US citizen or resident, or a foreign corporation.
iii) Any portion of the trust that is not treated as owned by a grantor or another person is treated as a nongrantor trust.
iv) For purposes of this rule, the determination of the part of a trust treated as owned by the grantor or other person is made based on the trust terms, application of the grantor trust rules, and IRC § 671 and the regulations thereunder.[261]
v) Example 20.[262]
(1) Chandler, an NRA, funds an irrevocable domestic trust, DTrust, for the benefit of his son, Marlowe, a US citizen, with X Corporation stock. Chandler's brother, Raymond, also a US citizen, contributes Y Corporation stock to the Dtrust for Marlowe's benefit. Chandler has a reversionary interest within the meaning of IRC § 673 in the X stock, which would cause him to be treated as the owner of the X stock upon application of the grantor trust rules without regard to IRC § 672(f). Raymond has a reversionary interest within the meaning of IRC § 673 in the Y stock that would cause Raymond to be treated as the owner of the Y stock upon application of the grantor trust rules without regard to IRC § 672(f). The trustee has discretion to accumulate or currently distribute income of DTrust to Marlowe.
(2) Here, because Chandler is an NRA, the grantor trust rules (ignoring IRC § 672(f)) would not cause the portion of the trust consisting of the X stock to be treated as owned by a US citizen/resident. Therefore, Chandler is not treated as an owner of the portion of the trust consisting of the X stock under the grantor trust rules. However, because Raymond is a US citizen, the foregoing rule does not apply to him, and he is treated as the owner of the portion of the trust consisting of the Y stock under the grantor trust rules.
c)
Exceptions to the General Rule.
i) Certain revocable trusts.
(1) The IRC § 672(f) foreign nongrantor trust rule does not apply to any part of a trust if the grantor retains the power to revest[263] absolutely in him/herself title to such part, and such power is exercisable solely by the grantor without the approval or consent of any other person.[264]
(a) This exception is satisfied if, in the event of the grantor's incapacity, this power is exercisable by a guardian or other person who has unrestricted authority to exercise such power on the grantor's behalf.[265]
(b) This exception is also satisfied if the grantor can exercise such power only with the approval of a related or subordinate party who is subservient to the grantor.[266]
(2) Grandfather rule for certain revocable trusts in existence on September 19, 1995. The IRC § 672(f) foreign nongrantor trust rule does not apply to any part of a trust that was treated as owned by the grantor under IRC § 676 (revocable trusts) on September 19, 1995, if it would continue to be so treated thereafter. However, this exception does not apply to any portion of the trust attributable to gratuitous transfers to the trust after September 19, 1995. This exception also is subject to certain rules relating to separate accounting for gratuitous transfers to the trust after September 19, 1995, under Treas. Reg. § 1.672(f)-3(d).[267]
(3) Example 21.[268] Dashiell, a foreign person, creates and funds a revocable trust, Hammett Trust, for the benefit of his children, who are resident aliens. The trustee is a foreign bank, Maltese Bank, which is owned and controlled by Dashiell and Nick, who is Dashiell's brother. The power to revoke the Hammett Trust and revest absolutely in Dashiell title to the trust property is exercisable by Dashiell, but only with the approval or consent of Maltese Bank. The trust instrument contains no standard that Maltese Bank must apply in determining whether to approve or consent to the revocation of the Hammett Trust. There are no facts that would suggest that Maltese Bank is not subservient to Dashiell. Therefore, the revocable trust exception applies to the Hammett Trust.
(4) Example 22.[269] Assume the same facts as in Example 21, except that Dashiell dies. After Dashiell's death, Nick has the power to withdraw the assets of the Hammett Trust, but only with the approval of Maltese Bank. There are no facts that would suggest that Maltese Bank is not subservient to Nick. However, the revocable trust exception is no longer applicable, because Nick is not a grantor of Hammett Trust.
(5) Example 23.[270] Assume the same facts as in Example 21, except that neither Dashiell nor any member of Dashiell's family has any substantial ownership interest or other connection with Maltese Bank. Dashiell can remove and replace Maltese Bank at any time for any reason. Although Dashiell can replace Maltese Bank with a related or subordinate party if Maltese Bank refuses to approve or consent to Dashiell's decision to revest the trust property in himself, Maltese Bank is not a related or subordinate party. Therefore, the revocable trust exception does not apply.
ii) Trusts that can distribute only to the grantor or grantor's spouse.
(1) In general. The IRC § 672(f) foreign nongrantor trust rule does not apply to a trust of which, at all times during the grantor's lifetime the only amounts distributable from such trust are amounts distributable to the grantor or the grantor's spouse.[271] For purposes of this exception, payments of amounts that are not gratuitous transfers do not constitute amounts that are distributable.
(a) Note. This exception may also apply to only part of a trust.[272]
(2) Amounts distributable in discharge of legal obligations.
(a) Generally. A trust will not fail this exception solely because amounts are distributable from the trust to discharge a legal obligation of the grantor or the grantor's spouse. For this purpose, an obligation is considered a "legal obligation" if it is enforceable under the local law of the jurisdiction where the grantor or his/her spouse resides.[273]
(b) Obligations to related parties.
(i) Generally. For purposes of this exception, obligations to related persons do not constitute legal obligations unless they are either:
1. Contracted bona fide and for adequate and full consideration in money or money's worth; or
2. The related person is legally separated from the grantor under a decree of divorce or separate maintenance; or
3. The obligation is to support an individual who both: (a) would be treated as the grantor's (or his spouse's) dependent under IRC § 152(a)(1)-(9) (without regard to the requirement that over half of the individual's support be received from the grantor or the spouse of the grantor); and (b) is either permanently and totally disabled, or less than 19 years old.[274]
iii) Compensatory trusts. The IRC § 672(f) foreign nongrantor trust rule does not apply to a certain compensatory trusts. Specifically, treasury regulations provide that it does not apply to any part of
(1) A nonexempt employees' trust described in IRC § 402(b), including a trust created on behalf of a self-employed individual;
(2) A trust, including a trust created on behalf of a self-employed individual, that would be a nonexempt employees' trust described in IRC § 402(b) but for the fact that the trust's assets are not set aside from the claims of creditors of the actual or deemed transferor within the meaning of Treas. Reg. § 1.83-3(e); and
(3) Any additional category of trust that the Commissioner may designate in revenue procedures, notices, or other guidance published in the Internal Revenue Bulletin.
d) Recharacterization of certain purported gifts. IRC § 672(f)(4) provides that direct or indirect transfers from a partnership or foreign corporation that are treated as gifts by the transferee may be recharacterized in the manner that the Treasury Department deems appropriate to prevent the avoidance of the IRC § 672(f) rules. The preamble to the proposed regulations under IRC § 672(f)(4) indicated that this provision was intended as a backstop to IRC § 672(f) and was intended to "prevent taxpayers from avoiding the general rule of section 672(f) by using a partnership or foreign corporation as a substitute for a trust."[275]
e) Trusts created by certain foreign corporations.
i) IRC § 672(f)(3) and the regulations thereunder provide that the IRC § 672(f) foreign nongrantor trust rule does not apply to controlled foreign corporations ("CFC"), passive foreign investment companies ("PFICs"), or foreign personal holding companies ("FPHCs"). This prevents CFCs, PFICs, and FPHCs from using foreign trusts to avoid US tax.
ii) Note. Although IRC § 672(f)(3) treats CFCs, PFICs and FPHCs as domestic corporations for grantor trust rule purposes, IRC § 674(f)(4) (discussed above) gives the IRS authority to recharacterize purported gifts to US persons that are made directly or indirectly from foreign corporations. The regulations treat gifts to US persons that are made from a trust funded by a foreign corporation as if made indirectly by such corporation if that incurs more US tax.
f) Recharacterizing beneficiary as grantor of inbound trust.
i) Generally. If a foreign person is treated as owning part of a trust, any US beneficiary of such trust is treated as grantor to the extent he directly/indirectly transferred property[276] to such foreign person in excess of transfers to the US beneficiary from the foreign person.[277] This rule applies without regard to whether such beneficiary was a US beneficiary at the time of any transfer.[278]
ii) Exception. This recharacterization rule does not apply to the extent the US beneficiary can prove to IRS satisfaction that his/her transfer to the foreign person was wholly unrelated to any transaction involving the trust.
iii) Example 24. Dashiell, an NRA, contributes property to the Maltese Corporation, a foreign corporation that is wholly owned by Dashiell. Maltese Corporation creates a foreign trust, Maltese Trust, for the benefit of Dashiell and his children. Maltese Trust is revocable by Maltese Corporation without the approval or consent of any other person. Maltese Corporation funds Maltese Trust with the property received from Dashiell. Dashiell and his family move to the US. Under the recharacterization rule of IRC § 672(f)(5), Dashiell is treated as a grantor of Maltese Trust.
(1) Note. Dashiell may also be treated as an owner of Maltese Trust under IRC § 679(a)(4).
iv) Example 25. Nick, a US citizen, makes a gratuitous transfer of $1 million to his aunt, Nora, an NRA. Nora creates a foreign trust, the Charles Trust, for the benefit of Nick and his children. Charles Trust is revocable by Nora without the approval or consent of any other person. Nora funds the Charles Trust with the property that she received from Nick. Under the recharacterization rule of IRC § 672(f)(5), Nick is treated as a grantor of the Charles Trust.
(1) Note. Nick also would be treated as an owner of the Charles trust as a result of IRC § 679.
g) Pre-immigration trusts.
i) Generally. If an NRA becomes a US person and has a
residency starting date within five years after transferring property to a
foreign trust (the "Original Transfer"), the IRC treats him as having
transferred to the trust on the residency starting date an amount equal to the
portion of the trust attributable to the property he transferred in the
Original Transfer.[279]
ii) Cessation of application of grantor trust rules. If an NRA who is treated as owning any part of a trust under the grantor trust rules, subsequently ceases to be so treated, he/she is treated as making the original transfer to the foreign trust immediately before the trust ceases to be treated as owned by him/her.
iii) Treatment of undistributed income. For purposes of the pre-immigration trust rules, the property deemed transferred to the foreign trust on the residency starting date includes undistributed net income, as defined in IRC § 665(a), attributable to the property deemed transferred. However, undistributed net income for periods before the individual's residency starting date is taken into account only for purposes of determining the amount of the property deemed transferred. In other words, an NRA who immigrates to the US within five years of creating a foreign trust is deemed to have transferred to the trust both (a) the amounts previously transferred, plus (b) the undistributed income and appreciation in the assets held by the trust and attributable to the original transfers, on the date that the NRA becomes a US resident.
6) Reporting requirements.
a) Form 3520: Annual return to report transactions with foreign trusts and receipt of certain foreign gifts.
b) Form 3520-A: Annual information return of foreign trust with US owner.
c) Form 1040 NR: US nonresident alien income tax return.
d) Form 4970: Tax on accumulation distributions of trusts.
e) Form TD F 90-22.1: Report of foreign bank and financial accounts.
f) FIRPTA reports.
[1] P.L. 87-834, § 7, 87th Cong. 2d Sess. (1962).
[2] P.L. 94-455, 94th Cong., 2d Sess., 90 Stat. 1928 (1976).
[3] P.L. 101-508, § 11343.
[4] P. L. 104-188, 110 Stat. 1755 (1996).
[5] See discussion below of the continuing uses of foreign trusts. See also Charles M. Bruce, et al., Asset Protection, Privacy & AML Compliance: Foreign Trusts - Continuing Uses, ___ Taxes ___ (Sept. 2004).
[6] Classification of an entity as a foreign trust requires that it first be classified as a "trust" and, then, that it be treated as a "foreign" entity. This outline only addresses the second issue. See Howard Zaritsky, US Tax'n of Foreign Estates, Trusts and Beneficiaries, 854-2nd Tax Mgmt. Portfolio III.A-B (2002), for a discussion of what characteristics an entity must possess to be treated as a "trust" for tax purposes.
[7] IRC § 641(b); Treas. Reg. § 301.7701-7(a)(3).
[8] Rev. Rul. 60-181, 1960-1 C.B. 257, citing B.W. Jones Trust v. Commissioner, 46 B.T.A. 531 (1942), aff'd, 132 F.2d 914 (4th Cir. 1943).
[9] See, e.g., Maximov v. United States, 373 US 49 (1963); B. W. Jones Trust v.
Commissioner, 132 F.2d 914 (4th Cir., 1943); First National City Bank v.
Internal Revenue Service, 271 F.2d 616 (2d Cir., 1959), cert. denied, 361
US 948 (1960); Rev. Rul. 60-181, 1960-1 C.B. 257.
[10] See,
e.g., Maximov v. United States, 373 US 49 (1963) (Supreme Court held that
trust created under Connecticut law, which was administered in the US by a US
trustee for the benefit of foreign beneficiaries was a domestic trust); B. W. Jones Trust v. Commissioner, 132
F.2d 914 (4th Cir., 1943) (Fourth Circuit held that trust created by a foreign
grantor for the benefit of foreign beneficiaries, which was governed by foreign
law, but whose corpus consisted primarily of US securities held in a safe
deposit box in New York, where three trustees were foreign and one was US, was
a US trust); Rev. Rul. 60-181, 1960-1 C.B. 257 (IRS ruled that testamentary
trust created under laws of a foreign country, with corpus consisting primarily
of US securities, with a US trustee, was a domestic trust).
[11] IRC § 7701(a)(30)(E), (31)(B); Treas. Reg. § 301.7701-7(a)(1).
[12] IRC § 7701(a)(31).
[13] Treas. Reg. § 301.7701-7(a)(2).
[14] Treas. Reg. § 301.7701-7(b).
[15] Treasury Department, General Explanation of the Administration's Revenue Proposals 25 (Feb. 7, 1995). See also IRS Notice 96-65, 1996 C.B. 232.
[16] Treasury Department, General Explanation of the Administration's Revenue Proposals 25 (Feb. 7, 1995). See also IRS Notice 96-65, 1996 C.B. 232.
[17] IRC § 7701(a)(30)(E), (31)(B).
[18] Treas. Reg. § 301.7701-7(c)(2).
[19] Treas. Reg. § 301.7701-7(c)(3)(i).
[20] Treas. Reg. § 301.7701-7(c)(3)(ii).
[21] Treas. Reg. § 301.7701-7(c)(3)(iii).
[22] Treas. Reg. § 301.7701-7(c)(3)(iv).
[23] Treas. Reg. § 301.7701-7(c)(3)(v).
[24] Treas. Reg. § 301.7701-7(c)(4)(i).
[25] Treas. Reg. § 301.7701-7(c)(4)(i)(A).
[26] Treas. Reg. § 301.7701-7(c)(4)(i)(B).
[27] Treas. Reg. § 301.7701-7(c)(4)(i)(C).
[28] Treas. Reg. § 301.7701-7(c)(4)(i)(D).
[29] Treas. Reg. § 301.7701-7(c)(4)(ii).
[30] Treas. Reg. § 301.7701-7(c)(5), Example 1.
[31] Treas. Reg. § 301.7701-7(c)(5), Example 2.
[32] IRC § 7701(a)(30)(E), (31)(B); Treas. Reg. § 301.7701-7(a)(1).
[33] IRC § 7701(a)(30) provides "that the term "United States person" means -
(A) a citizen or resident of the United States
(B) a domestic partnership,
(C) a domestic corporation,
(D) any estate (other than a foreign estate, within the meaning of paragraph (31), and
(E) any trust if -
(i) a court within the United States is able to exercise primary supervision over the administration of the trust, and
(ii) one or more United States persons have the authority to control all substantial decisions of the trust.
[34] Treas. Reg. § 301.7701-7(d)(1)(i).
[35] Small Business Job Protection Act of 1996, Pub. L. No. 104-188, § 1907(a)(1).
[36] Treas. Reg. § 301.7701-7(d)(1)(i).
[37] Taxpayer Relief Act of 1997, Pub. L. No. 105-34, § 1601(i)(3)(A).
[38] Treas. Reg. § 301.7701-7(d)(1)(ii).
[39] Treas. Reg. § 301.7701-7(d)(1)(ii).
[40] Treas. Reg. § 301.7701-7(d)(1)(ii).
[41] Treas. Reg. § 301.7701-7(d)(1)(iii).
[42] Treas. Reg. § 301.7701-7(d)(1)(v), Example 2.
[43] Treas. Reg. § 301.7701-7(d)(1)(iv).
[44] Treas. Reg. § 301.7701-7(d)(1)(v), Example 1.
[45] Treas. Reg. § 301.7701-7(d)(1)(v), Example 2.
[46] Treas. Reg. § 301.7701-7(d)(1)(v), Example 3.
[47] Treas. Reg. § 301.7701-7(d)(1)(v), Example 4.
[48] Treas. Reg. § 301.7701-7(d)(2)(i).
[49] Treas. Reg. § 301.7701-7(d)(2)(i).
[50] Treas. Reg. § 301.7701-7(d)(2)(i).
[51] Treas. Reg. § 301.7701-7(d)(2)(ii).
[52] Treas. Reg. § 301.7701-7(d)(3).
[53] P.L. No. 105-34, 111 Stat. 788 (1997) § 1161.
[54] The final regulations supersede Notice 98-25, 1998-18 I.R.B. 11, which provided guidance as to the application of § 1161 of the Taxpayer Relief Act of 1997.
[55] Treas. Reg. § 301.7701-7(f).
[56] IRC § 6048(a)(3)(A)(i).
[57] IRC § 6677(a)
[58] For
this purpose, the term "US person" means a United States person as defined in
IRC § 7701(a)(30), and includes an NRA individual who elects under IRC §
6013(g) to be treated as a US resident.
Treas. Reg. § 1.684-1(b)(1).
[59] Treas. Reg. § 1.684-1(a)(1).
[60] Treas. Reg. § 1.684-1(a)(1).
[61] Treas. Reg. § 1.684-1(a)(2).
[62] Treas. Reg. § 1.684-1(a)(2).
[63] Treas. Reg. § 1.684-2.
[64] Treas. Reg. § 1.684-2(d).
[65] Treas. Reg. § 1.684-3(a).
[66] Treas. Reg. § 1.684-2(e).
[67] Treas. Reg. § 1.684-3(b).
[68] Treas. Reg. § 1.684-3(c).
[69] Treas. Reg. § 1.684-3(g), Example 2.
[70] Treas. Reg. § 1.684-3(g), Example 3.
[71] Treas. Reg. § 1.684-3(d).
[72] Treas. Reg. § 1.684-4.
[73] Treas. Reg. § 1.684-4(c).
[74] IRC § 671.
[75] IRC § 673.
[76] IRC § 674.
[77] IRC § 675.
[78] IRC § 676.
[79] IRC § 677.
[80] IRC § 679.
[81] Rev. Rul. 69-70, 1969-1 C.B.182.
[82] The term US person means a US person as defined in IRC §7701(a)(30), an NRA individual who elects under IRC § 6013(g) to be treated as a US resident, and an individual who is a dual resident taxpayer within the meaning of Treas. Reg. § 301.7701(b)-7(a).
[83] Treas. Reg. § 1.679-1(a).
[84] Treas. Reg. § 1.679-1(b).
[85] Treas. Reg. § 1.679-1(b).
[86] Treas. Reg. § 1.679-2(a)(1).
[87] Treas. Reg. § 1.679-2(a)(2).
[88] Treas. Reg. § 1.679-2(a)(2).
[89] Treas. Reg. § 1.679-2(a)(3).
[90] Treas. Reg. § 1.679-2(a)(3).
[91] Treas. Reg. § 1.679-2(b)(1).
[92] Treas. Reg. § 1.679-2(b)(2).
[93] Treas. Reg. § 1.679-2(c)(1).
[94] See IRC § 665(a).
[95] Treas. Reg. § 1.679-2(c)(1).
[96] Treas. Reg. § 1.679-2(c)(1).
[97] Treas. Reg. § 1.679-3(a).
[98] Treas. Reg. § 1.679-3(b)(2).
[99] Treas. Reg. § 1.679-3(b)(1).
[100] Treas. Reg. § 1.679-3(c).
[101] Treas. Reg. § 1.679-3(d).
[102] Treas. Reg. § 1.679-3(e).
[103] Treas. Reg. § 1.679-3(e).
[104] Treas. Reg. § 1.679-3(f).
[105] IRC § 679(a)(2)(A); Treas. Reg. § 1.679-4(a)(1).
[106] Treas. Reg. § 1.679-4(a)(2).
[107] Treas. Reg. § 1.679-4(a)(3).
[108] IRC § 679(a)(2)(B); Treas. Reg. § 1.679-4(a)(4).
[109] Treas. Reg. § 1.679-4(b).
[110] IRC § 679(a)(3)(A)(i).
[111] Treas. Reg. § 1.679-4(d).
[112] Treas. Reg. § 1.679-4(d).
[113] See Henry Christensen, III, International Estate Planning § 4.04[1] (2002);
[114] Treas. Reg. § 1.684-3(c).
[115] See Ellen K. Harrison, et al., US Tax'n of Foreign Trusts, Trusts With Non-US Grantors and Their US Beneficiaries, in Sophisticated Estate Planning Techniques (ALI-ABA Course No. SJ016 Sept. 2003).
[116] See also Madorin v. Commissioner, 84 T.C. 667 (1985); Rev Rul. 77-402, 1977-2 C.B. 222.
[117] Treas. Reg. § 1.684-2(e), Example 2.
[118] See Ellen K. Harrison, et al., US Tax'n of Foreign Trusts, Trusts With Non-US Grantors and Their US Beneficiaries, in Sophisticated Estate Planning Techniques (ALI-ABA Course No. SJ016 Sept. 2003).
[119] Treas. Reg. § 1.679-6(a).
[120] Treas. Reg. § 1.679-6(c).
[121] Treas. Reg. § 1.684-4.
[122] Treas. Reg. § 1.684-4(c).
[123] IRC § 672(f).
[124] IRC § 651(a); Treas. Reg. § 1.651(a)-1.
[125] IRC §§ 651(a), 652.
[126] IRC §§ 651(b), 652(a).
[127] IRC § 661(a)Treas. Reg. § 1.661(a)-1.
[128] IRC § 661(a); Treas. Reg. § 1.661(a)-1.
[129] IRC § 661(a).
[130] IRC § 662(a).
[131] IRC § 662(a)(2).
[132] IRC §§ 662(a)(2), 665-668.
[133] IRC §§ 641(b), 872(a).
[134] Howard Zaritsky, US Tax'n of Foreign Estates, Trusts and Beneficiaries, 854-2nd Tax Mgmt. Portfolio V.C.2. (2002),
[135] IRC § 871(b).
[136] IRC § 871(a).
[137] IRC § 871(b).
[138] Christenson, International Estate Planning, § 4.06 (2002).
[139] For a detailed discussion of court decisions and rulings regarding whether an NRA is engaged in a trade or business within the US, see 156 TM, Foreign Corporations - US Income Taxation. See also Garelik, What Constitutes Doing Business Within the United States by a Non-Resident Alien Individual or a Foreign Corporation, 18 Tax L. Rev. 423 (1963).
[140] US v. Balanovski, 236 F.2d 298 (2d Cir. 1956), cert. denied, 352 US 968 (1957), reh'g denied, 352 US 1019 (1957); Spermacet Whaling & Shipping Co. v. Commissioner, 30 T.C. 618 (1958), aff'd, 281 F.2d 646 (6th Cir. 1960).
[141] Continental Trading, Inc. v. Commissioner, T.C. Memo. 1957-164, aff'd, 265 F.2d 40 (9th Cir. 1959), cert. denied, 361 US 827 (1959).
[142] Spermacet Whaling & Shipping Co. v. Commissioner, 30 T.C. 618 (1958), aff'd, 281 F.2d 646 (6th Cir. 1960); Consolidated Premium Iron Ores, Ltd. v. Commissioner, 28 T.C. 127 (1957); Continental Trading, Inc. v. Commissioner, T.C. Memo. 1957-164, aff'd, 265 F.2d 40 (9th Cir. 1959), cert. denied, 361 US 827 (1959); Lewenhaupt v. Commissioner, 20 T.C. 151 (1953), aff'd, 221 F.2d 227 (9th Cir. 1955).
[143] De Amodio v. Commissioner, 34 T.C. 894 (1960), aff'd, 299 F.2d 623 (3rd Cir. 1962).
[144] Lewenhaupt v. Commissioner, 20 T.C. 151 (1953), aff'd, 221 F.2d 227 (9th Cir. 1955); De Amodio v. Commissioner, 34 T.C. 894 (1960), aff'd, 299 F.2d 623 (3rd Cir. 1962); Reiner v. US, 222 F.2d 770 (7th Cir. 1955).
[145] IRC § 864(b); Treas. Reg. § 1.864-2(a).
[146] IRC § 864(b)(2)(A)(i).
[147] Treas. Reg. § 1.864-2(c)(2)(i)(C).
[148]
For
a detailed discussion of foreign partners and partnerships, see 910 T.M., Foreign
Partnerships and Partners.
[149] IRC § 875(a); Treas. Reg. § 1.875-1.
[150] Treas. Reg. § 1.875-1.
[151] IRC § 897.
[152] IRC § 1445.
[153] Pub. L.No. 96-499, 96th Cong. 2d Sess. (Dec. 5, 1980).
[154] IRC § 864(c)(6).
[155] IRC § 864(c)(7).
[156] For a complete discussion of the withholding rules, see Charles M. Bruce, New US Withholding Tax Rules: A Practical Guide (2002).
[157] Rev. Rul. 80-222, 1980-2 C.B. 211.
[158] IRC § 871(a)(1)(A); Treas. Reg. § 1.871-7(b).
[159] Treas. Reg. § 1.1441-2(a)(2).
[160] Trust of Welsh v. Commissioner, 16 T.C. 1398 (1951), aff'd, 194 F.2d 708 (3d Cir. 1952), cert. denied, 344 US 821 (1952).
[161] IRC § 871(a)(1)(C).
[162] IRC § 871(a)(1)(C).
[163] IRC §§ 871(a)(1), 881(a)(3)(B).
[164] IRC §§ 871(a)(1)(C)(ii), 881(a)(3)(B).
[165] IRC § 871(h)(1).
[166] IRC §§ 871(i), 881(d).
[167] IRC § 641(b).
[168] IRC § 871(a)(2); Treas. Reg. § 1.871-7(c).
[169] IRC § 871(a)(1).
[170]
IRC
§§ 871-872. For a detailed discussion of the source of income rules, see 905
TM, Source of Income Rules.
[171] IRC §§ 861(a)(1), 871(h)-(i).
[172] IRC § 861(a)(2)(A)-(B).
[173] IRC § 861(a)(3).
[174] IRC § 861(a)(4).
[175] IRC § 861(a)(4).
[176] IRC §§ 861(a)(5), 897(c).
[177] IRC § 865(a).
[178] IRC § 865(a), (b), (e).
[179] IRC § 865(c)(1)(A).
[180] IRC § 873(a).
[181] IRC § 873(b).
[182] IRC § 651.
[183] IRC § 661.
[184] IRC § 901(b)(4), 906(a).
[185] IRC § 164(a)(3).
[186] IRC § 871(b).
[187] IRC § 871(b).
[188] IRC § 871(a).
[189] For a complete discussion of the withholding rules, see Charles M. Bruce, New US Withholding Tax Rules: A Practical Guide (2002).
[190] IRC § 651(a); Treas. Reg. § 1.651(a)-1.
[191] IRC §§ 651(a), 652.
[192] IRC §§ 651(b)(652(a).
[193] IRC § 661(a)Treas. Reg. § 1.661(a)-1.
[194] IRC § 661(a); Treas. Reg. § 1.661(a)-1.
[195] IRC § 661(a).
[196] IRC § 662(a).
[197] IRC § 662(a)(2).
[198] IRC §§ 662(a)(2), 665-668.
[199] IRC § 643(a).
[200] IRC § 643(a)(6), (a)(5).
[201] IRC § 643(a)(6)(A).
[202] IRC § 643(a)(6)(B).
[203] Treas. Reg. § 1.643(a)-6(a).(3)(i).
[204] Treas. Reg. § 1.643(a)-5(b).
[205] IRC § 643(a)(6)(C); Treas. Reg. § 1.643(a)-6(a)(3)(iii).
[206] Treas. Reg. § 1.643(a)-6(a)(3)(ii).
[207] IRC §§ 652(a), 662(a); Treas. Reg. § 1.652(a)-1.
[208] IRC § 651.
[209] IRC § 662(a)(1).
[210] IRC § 662(a)(2).
[211] IRC § 662.
[212] IRC §§ 652(b), 662(b).
[213] IRC §§ 652(b), 662(b); Treas. Reg. § 1.652(b)-2(a); Treas. Reg. § 1.662(b)-1.
[214] Treas. Reg. § 1.1462-1(b).
[215] IRC § 1462; Treas. Reg. §§ 1.1441-3(f), 1.1462-1(b).
[216] IRC §§ 901, 666, 667.
[217] IRC § 164(a)(3).
[218] See Howard Zaritsky, US Tax'n of Foreign Estates, Trusts and Beneficiaries, 854-2nd Tax Mgmt. Portfolio V.D.1. (2002),
[219] See Isidro Martin-Montis Trust v. Commissioner, 75 TC 381 (1980), acq. 1981-2 C.B. 21, acq. 1981-2 C.B. 21; Rev Rul. 81-244, 1981-2 C.B. 151, amplified by Rev. Rul. 86-76, 1986-1 C.B. 284).
[220] For a complete discussion of the withholding rules, see Charles M. Bruce, New US Withholding Tax Rules: A Practical Guide (2002).
[221] IRC § 643.
[222] IRC §§ 651, 661.
[223] IRC §§ 652, 662.
[224] IRC § 665.
[225] IRC § 666(a).
[226] IRC § 666(d).
[227] IRC § 667(b)(3).
[228] IRC § 667(b)(1)(D).
[229] IRC § 667(b)(1).
[230] IRC §§ 666, 667.
[231] IRC § 667(c)(1).
[232] IRC §§ 667(a), 662(a)(2).
[233] IRC §§ 667(a), 662(b).
[234] IRC § 667(e).
[235] IRC § 668.
[236] IRC § 668(a)(6).
[237] IRC § 668(a).
[238] IRC § 668(a)(5).
[239] IRC § 668(c).
[240] Howard Zaritsky, US Tax'n of Foreign Estates, Trusts and Beneficiaries, 854-2nd Tax Mgmt. Portfolio V.E.2.e. (2002); Ellen K. Harrison, et al., US Tax'n of Foreign Trusts, Trusts With Non-US Grantors and Their US Beneficiaries, in Sophisticated Estate Planning Techniques (ALI-ABA Course No. SJ016 Sept. 2003).
[241] IRC § 663(a)(1).
[242] See Henry Christensen, III, International Estate Planning § 4.09[5][b] (2002).
[243] IRC § 643(e).
[244] See Henry Christensen, III, International Estate Planning § 4.09[5][a] (2002).
[245] IRC §§ 1291-1298.
[246] IRC §§ 551-558.
[247] IRC §§ 951-964.
[248] See Henry Christensen, III, International Estate Planning § 4.09[5][b] (2002).
[249] IRC § 643(i)2)(A).
[250] IRC § 643(i)(2)(B).
[251] IRC § 643(i)(2)(C).
[252] IRC § 643(h).
[253] Treas. Reg. § 1.643(h)-1(a)(1).
[254] Treas. Reg. § 1.643(h)-1(a)(2).
[255] For this purpose, "related" means related within the meaning of Treas. Reg. § 1.643(h)-1(e).
[256] Treas. Reg. § 1.643(h)-1(b)(1).
[257]
IRC
§ 643(h); Treas. Reg. § 1.643(h)-1(b)(1).
[258] Treas. Reg. § 1.643(h)-1(c)(2).
[259] Treas. Reg. § 1.643(h)-1(c)(3).
[260] Rev. Rul. 69-70, 1969-1 C.B. 182.
[261] Treas. Reg. § 1.672(f)-1(a)(2).
[262] Treas. Reg. § 1.672(f)-1(b).
[263] For purposes of this rule, the grantor is treated as having a power to revest for a taxable year of the trust only if the grantor has such power for a total of 183 or more days during the taxable year of the trust. If the first or last taxable year of the trust (including the year of the grantor's death) is less than 183 days, the grantor is treated as having a power to revest for purposes of paragraph (a)(1) of this section if the grantor has such power for each day of the first or last taxable year, as the case may be. Treas. Reg. § 1.672(f)-3(a)(2).
[264] Treas. Reg. § 1.672(f)-3(a)(1).
[265] Treas. Reg. § 1.672(f)-3(a)(1).
[266] Treas. Reg. § 1.672(f)-3(a)(1).
[267] Treas. Reg. § 1.672(f)-3(a)(3).
[268] Treas. Reg. § 1.672(f)-3(a)(4), Example 1.
[269] Treas. Reg. § 1.672(f)-3(a)(4), Example 2.
[270] Treas. Reg. § 1.672(f)-3(a)(4), Example 3.
[271] Treas. Reg. § 1.672(f)-3(b).
[272] Treas. Reg. § 1.672(f)-3(b).
[273] Treas. Reg. § 1.672(f)-3(b)(2)(i).
[274] Treas. Reg. § 1.672(f)-3(b)(2).
[275] Preamble to Prop. Treas. Reg. § 1.672(f)-4, 62 Fed. Reg. 30,785, 30.788 (June 5, 1997), referring to Staff of the Joint Committee on Taxation, 104th Cong., 2d Sess., "General Explanation of the Tax Legislation Enacted in the 104th Congress," at 271 (1996) (Committee Print).
[276] For purposes of this rule, the term property includes cash, and a transfer of property does not include a transfer that is not a gratuitous transfer (within the meaning of Treas. Reg. § 1.671-2(e)(2)). In addition, a gift is not taken into account to the extent such gift would not be characterized as a taxable gift under IRC § 2503(b). Treas. Reg. § 1.672(f)-5.
[277] Treas. Reg. § 1.672(f)-5.
[278] Treas. Reg. § 1.672(f)-5.
[279] IRC § 679(a)(4); Treas. Reg. § 1.679-5(a).
By Lewis J. Saret[1]
1)
Introduction.
The world that we live in, as well as the world economy, is becoming increasingly global. To illustrate, an estimated four to ten million US nationals live abroad.[2] In this increasingly global environment, there are an increasing number of migratory families and other nonresident aliens who have substantial contacts with the US.
These individuals include foreign executives moving to the US to run US companies or US subsidiaries of foreign companies, wealthy aliens who acquire homes in the US for retirement or vacation purposes, and young aliens with substantial wealth. They also include migratory families or family members, what the media once called "jet setters," who have homes and substantial assets in various parts of the world, including the US, and who constantly move from one locale to another. Many of these individuals come from countries with very different tax systems than ours. They typically would be shocked to learn that their contacts with the US may cause them to be treated as US resident aliens for tax purposes, thereby subjecting them to US income taxation on their worldwide income, and US estate and gift taxation on their worldwide assets.
The US also continues to be one of the most desirable destination countries for immigrating families and individuals. Despite the September 11 terrorist attacks, the US continues to have the most stable political system in the world, and it remains one of the safest countries to live in. It also has one of the highest standards of living in the world, and it remains the sole "superpower" today.
In addition, the character of individuals immigrating into the US today differs from the historical character of immigrants into the US. Today, many immigrants come to the US with substantial assets and either a high level of income, or a high probability of receiving a high level of future income. This is in stark contrast to the huddled masses that once immigrated to the US.
Based on the foregoing, we believe that international issues in estate and tax planning, which have always been important, will become even more important as time goes by. This is also the clear historical trend. In this regard, estate and tax planners can provide substantial tax and estate planning benefits to such individuals, frequently, by using very simple techniques.
2)
Federal estate and gift taxation of nonresident
aliens ("NRAs")
a) Generally.
NRAs are subject to federal
estate taxes at the same rates applicable to US citizens and residents - but
only on assets situated in the US at the time of their deaths.[3]
They are subject to federal gift taxes only with respect to transfers (by trust
or otherwise) of real or tangible property (but generally not intangible
property) situated in the US, after taking into consideration the annual gift
tax exclusion, which is currently $11,000 per year, per donee.[4]
b) Who is an NRA?
i) Generally / Significance of issue.
If an individual is a US citizen or resident alien, the US subjects that
individual to US estate and gift taxation on his/her worldwide assets. In
contrast, if an individual is an NRA, then: (a) the US subjects him/her to US
estate and gift taxation only on assets situated in the US; and (b) with proper
planning, that person may avoid virtually all US estate and gift tax.
To be an NRA, an individual must be neither a US citizen, nor a
US resident.
ii) Citizenship.
Citizenship is generally an objective factual issue. Most individuals
know, with a high level of confidence, whether they are US citizens. In cases of doubt, it is prudent for
tax practitioners to consult with immigration lawyers.
Occasionally, individuals may mistakenly believe that they have lost their US citizenship for US tax purposes by the commission of certain acts. However, not only must a person commit one of the several acts set out by statute, but he/she must do so voluntarily and with the intent to surrender his/her US nationality.[5] Therefore, when presented with a client who was once a citizen, the practitioner must carefully review that client's citizenship status.
If client is in fact a US citizen, then he/she is subject to estate and gift taxation on his/her worldwide assets, just as any other citizen would be, regardless of the location of his/her residence or domicile. Example 1 illustrates the situation where an estate planner is most likely to encounter this type of situation.
Example 1. Carl,
a US citizen and resident, retains Edith Estate-Planner to prepare his estate
plan. In the course of the initial
client interview, Edith asks Carl if he expects to inherit any substantial
wealth. Edith learns that Carl expects to inherit several million dollars from
his father, Frank, who lives in Switzerland, where Frank has lived for the past
fifty years. Upon further inquiry, Edith learns that Frank was born in the US
and holds a US passport, even though he has not stepped foot in the US for more
than forty years. Edith also learns that Frank has just assumed that he is not
a US citizen for US tax purposes, since he does not live in the US. More
precisely, because frank has intended to remain outside the US for his
remaining life, he has not even thought about whether he is a US citizen for
tax purposes, and has just assumed that he is not treated as a US citizen for
US tax purposes. Therefore, Frank has not filed any US income or other tax
returns for the past fifty years.
Caution. The
facts illustrated by Example 1, which are more common than one would expect,
raise significant and serious tax issues.
Estate planners must tread very carefully in such situations because, in
certain circumstances, they may inadvertently both (1) expose themselves to
civil and criminal tax liability, and (2) expose their clients to additional
civil and criminal tax liability.
A full discussion of the issues raised by such situations exceeds the
scope of this article. However, in
such cases estate planners, unless they are familiar with these issues, should
immediately contact tax counsel who has previously dealt with these issues.
(1) Special treatment for citizens/residents of US
possessions.
The IRC treats US citizens and residents of US possessions differently in certain respects than other US citizens and residents for estate and gift tax purposes. Specifically, the IRC treats US citizens as NRAs for estate and gift tax purposes if both:
· They acquire US citizenship solely by
reason of their (a) being a citizen of such US possession, or (b) birth or
residence within such possession, and
· They are both a citizen and resident of such
possession at their death or at the time of the gift in question.[6]
If this context, if a US citizen acquires citizenship by birth in one
possession and dies in a different possession, he/she is also treated as NRA.[7] In addition, where a US citizen
acquires citizenship by virtue of his/her parent's residence in one possession
and then dies in a different possession, he/she is also treated as NRA.[8]
Example 2. Paul is born in Texas. When Paul is two years old, his parents
move to Puerto Rico, where Paul lives until his death, at the age of 43. Here, this special rule does not apply,
and Paul is treated as any other citizen for estate tax purposes.
Example 3. Same facts as Example 2, except that Paul is
born in Puerto Rico, and his parents move to Texas when Paul is two years
old. When Paul is 40 years old, he
moves to Puerto Rico, where he dies three years later. Here, Paul is treated as an NRA for
estate tax purposes.
iii) Residence.
(1) Domicile is test.
For estate tax purposes, a nonresident decedent is a decedent who, at
the time of his death, had his domicile outside the US.[9]
Consistent with the above discussion, the term "United States" means only the
fifty states and the District of Columbia. It does not include US possessions.
Caution. Many
accountants and attorneys mistakenly confuse the estate and gift tax residence
test with the US income tax residence test. The estate and gift tax residence
test differs from the income tax residence test. Consequently, an individual can be a resident for income tax
purposes but not for transfer tax purposes, and vice versa.
(2) Domicile Defined.
Treasury regulations provide that a person acquires a domicile in a place by living there, even for a brief period of time, with no definite intention of later removing therefrom. Residence without the requisite intention to remain indefinitely will not suffice to constitute domicile, nor will intention to change domicile effect such a change unless accompanied by actual removal.[10]
Whether a person is domiciled in the US is a fact issue. Proof of the required intent to remain depends on all of the relevant facts and circumstances. Relevant factors include the following:[11]
· Immigration status of the individual.
Note. The US issues two types of visas, immigrant and nonimmigrant visas. Most non-immigrant visas limit visa-holders to a specified time period during which they may remain in the US. All other things being equal, holding a non-immigrant visa would seem to indicate nonresident status, since such a visa does not allow the holder to legally remain in the US. However, this is not always the case.[12] Conversely, all other things being equal, if a person holds an immigrant visa, this would seem to indicate intent to remain in the US indefinitely. Having said this, a green card holder is not necessarily an ipso facto resident. Again however, a green card would appear to be strong evidence of residence.[13]
· Presence within the US, including duration of stay in the US and elsewhere, the frequency and nature of travel, etc.
· Nature, extent, and reasons for temporary absence from the foreign home.
· Individual's own statements, including statements made to immigration authorities, and contained within legal documents (e.g., wills, deeds, divorce petitions, etc.).[14]
· The size, cost, location, and nature of the individual's home or other dwelling places, and whether such home is owned or rented.[15]
· Marital status and residence of individual's family. To illustrate, if a person moves his/her family to the US and places his/her children in US schools, this would indicate an intent to remain in the US.[16]
· Situs of clothing and personal belongings.
· Participation in community activities.[17] To illustrate, if an individual becomes active within the community within which he lives in the US by joining a Rotary or Lions club, this would seem to indicate an intent to remain in the US indefinitely. On the other hand, if a foreign business executive joins a private social club for business entertainment purposes, this would appear to be irrelevant with respect to the executive's intent concerning establishing a new domicile in the US.
· Phone listing, US driver's license, and auto registration.
· US bank accounts and investments.
· Participation in US business ventures.[18]
· Payment of taxes.
· Voting.
· Return ticket.
· Registration.
· Stationary.
· Mail.
Example 4.[19]
Facts. D
was an illegal alien who entered the US in 1959. Two years later, D's wife illegally immigrated into the US.
D remained in the US until his death, in 1978. Between 1959 and 1978, D
purchased a home in the US, and remained there until his death. He was a member of several local clubs
and an active participant in the community. In 1964 and in 1972, D purchased rental real property in his
native country, which he rented out.
At his death, D's estate took the position that D was an NRA, and
therefore, that the real property located in D's native country was not
includible in his federal gross estate.
Ruling. The IRS ruled that an illegal alien who lived
in the US for 19 years with his family, purchased a residence, and established
strong community ties was domiciled in the US at his death. Therefore, his
taxable estate is subject to the estate tax imposed by IRC § 2001, including
estate tax on the real property located in D's native country.
Example 5.[20]
Facts. D,
a citizen of a foreign country, was an employee of an international
organization at his death. In 1965, D entered and remained in the US with a
"G-4" visa. A "G-4" visa is a non-immigrant visa granted to employees of
international organizations. After arrival, D formed the intent to remain in
the US indefinitely, and the intent persisted until D's death in 1978.
Ruling. At
date of death, D was a US resident. Therefore, the transfer of D's taxable
estate, both situated inside and outside the US, is subject to federal estate
tax under IRC § 2001.
c) Gross Estate And Situs Rules.
i) Generally.
The issue of situs is extremely important because only an NRA's US situs
property is subject to estate, gift, and GST tax.[21]
The appropriate analysis is as follows:
·
Determine
the gross estate of the NRA.
·
Determine
if any treaties apply. This is
because treaties may modify the situs rules applicable to an NRA's property. As
of the date of this article, countries with which the US has estate tax
treaties include the following:
Ø Australia,
Ø Austria
Ø Denmark
Ø Finland
Ø France
Ø Germany
Ø Greece
Ø Ireland
Ø Italy
Ø Japan
Ø Netherlands
Ø Norway
Ø South Africa
Ø Sweden
Ø Switzerland
Ø United Kingdom
·
Determine
the situs of the NRA's property, under an applicable treaty, if one applies, or
under the situs rules, discussed below.
ii) Real Property.
Real property is deemed to have its situs in the place where it is
located.[22]
The issue occasionally arises as to what constitutes real property. Because neither the IRC nor treasury
regulations define "real property," either an applicable treaty or the law of
the jurisdiction governs the issue of what property constitutes real or
personal property.[23] To illustrate, generally, real property
includes land, buildings, improvement and fixtures, growing crops,[24]
timber cutting rights,[25]
and mineral rights.[26] Conversely, real property generally
does not include leasehold interests, unless the lease term is sufficiently
long,[27]
and security interests such as mortgages.[28]
Planning Pointer. NRAs acquiring real property may do so through
a non-US company. This will
effectively convert US real property into non-US intangible personal property
for federal estate tax purposes.[29]
This analysis assumes, of course, that the non-US company is a valid and bona
fide corporation, with all proper corporate formalities maintained.[30] In this regard, NRAs who already own US real property can also effectively convert US
real property into non-US intangible personal property for federal estate tax
purposes. However, there may be FIRPTA issues in doing this. A common structure for this purpose is
to have US real property owned by a US company, which in turn is owned by a
foreign holding company.
Caution regarding Earnings Stripping Rule. When using a foreign holding company that owns a US subsidiary to hold US real property, practitioners should examine carefully any debt that the US company uses to finance the acquisition of the real estate. Specifically, there is an issue of whether such debt triggers the IRC § 163(j) earnings-stripping rule.
As a general matter, the earnings stripping rule applies to a corporation for tax years where (a) its ratio of debt to equity at the close of the tax year exceeds 1.5 to 1, and (b) it has excess interest expense for the year.[31] Generally, "excess interest expense" would be the amount by which the US subsidiary's "net interest expense" exceeds 50 percent of its adjusted taxable income.[32]
To the extent the earnings
stripping rule applies to a US subsidiary for a taxable year, "disqualified
interest" paid or accrued during such tax year would be nondeductible, except
to the extent that such interest exceeds the US subsidiary's excess interest
expense. For this purpose, disqualified
interest includes (1) interest payable to a related person not subject to US
tax on such interest; (2) interest payable to an unrelated person under an
obligation guaranteed by a related person that is either tax-exempt or a
foreign person; or (3) interest paid or accrued by a taxable real estate
investment trust ("REIT) subsidiary to the REIT.[33]
It should be noted that this issue, earnings stripping, is a favorite one for IRS international examiners. The issue is usually "picked up" as a result of the US company, filing its Form 5472, Information Return of 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade of Business, disclosing the fact that it is more than 25 percent owned by a foreign person and that there is a related-party transaction.
Finally, advisors should note
that the earnings stripping issue is not limited to US real estate holding
companies. It can crop up for many
types of US subsidiaries of foreign parents.
Caution regarding use of debt
to reduce value of real property. Sometimes
NRAs get creative and try to reduce the value of US real property, particularly
US homes, by encumbering such property with a mortgage. This strategy is problematic in that
for it to succeed, the mortgage must be non-recourse debt, secured solely by
the real property. Unless this is
the case, the mortgage will not reduce the value of the real property house for
purposes of inclusion in the NRA's gross estate. Instead, such mortgage would constitute a deduction for US
estate tax purposes. More
important, as discussed below, it would be only partially deductible.
Specifically, the mortgage would be allocated to the US gross estate, for
deduction purposes, in proportion to the US gross estate over the worldwide
gross estate. In other words, the
mortgage would be multiplied by a fraction, the numerator of which would be
assets includable in the NRA's US estate, and the denominator would be the
NRA's worldwide assets, even though the entire mortgage relates to US assets.[34]
iii) Tangible Personal Property.
The situs of tangible personal property is determined by its physical
location at the time of death or gift.[35] However, items of personal property
accompanying an NRA who dies while temporarily visiting the US are not
includible in his/her gross estate.[36]
One type of tangible personal property that is particularly problematic
is art. This is because art is portable and highly valuable. It is not unusual for an NRA to loan
art to a US museum or to send art to the US to be cleaned or sold. Under the general situs rule for
tangible personal property, if an NRA who has loaned property to a US museum
dies during the period of such loan, that NRA would be subject to estate tax on
such art. Because this is
obviously unfair, the IRC provides an exception for this type of
situation. Specifically, works of
art owned by an NRA decedent are not included in the NRA's estate if such art
was:
·
Imported
in the US solely for exhibition purposes;
·
Loaned
for exhibition purposes to a public gallery or museum, no part of the net
earnings of which inures to the benefit of any private shareholder or
individual; and
·
At the
time of the NRA decedent's death, on exhibition, or en route to or from
exhibition, in such a public gallery or museum.[37]
Caution. If
an NRA sends artwork to the US to be cleaned or sold, and dies in the interim,
such artwork will be subject to US estate taxation.
Planning Pointer. In the facts of private letter ruling
199922038, an NRA loaned 31 works of art to a US museum, which rotated its art
so that all 31 works of art were generally not on display continuously. The
museum stored those pieces not on current display. The IRS ruled that none of the 31 works of art, including
any in storage, would be subject to US estate tax if the NRA died during the
loan period. It reasoned that the
entire collection was "on exhibition for purposes of section 2105(c) even
though only part of the collection will actually be on display to the public at
any given time on a rotating basis." Based on this rationale, an NRA could
enter into a similar arrangement with a museum, loaning several pieces to such
museum, and requiring the museum to clean or restore such art as a condition of
the loan. Such arrangements with
museums are common.
Currency or cash. Currency or cash that an NRA owns is not
considered to constitute a debt obligation or intangible property. Currency or
cash owned by an NRA, which is located in the US (e.g., in a safe
deposit box) constitutes tangible personal property subject to US estate tax.[38]
Personal property of diplomatic personnel. Personal
property of diplomatic personnel in the US is not includible in the NRA's gross
estate if such property is used in the conduct of such NRA's official mission
and is reasonably required for such purpose.[39]
iv) Shares Of Stock Of A Corporation.
US tax law deems shares of stock issued by a US corporation that are beneficially owned (or deemed beneficially owned) by an NRA at his death to be situated in the US.[40] In contrast, US tax law deems shares of stock issued by a foreign corporation that are beneficially owned (or deemed beneficially owned) by an NRA to be situated outside the US.[41]
The location of the stock
certificates, evidencing ownership of stock, is completely irrelevant for
federal estate tax purposes.The decedent's
tangible property situated in the US; i) Gift Tax. The US imposes a gift tax on donors, not the donee.[109] In addition, a donee's citizenship or
residence is irrelevant for federal gift tax purposes. Therefore, NRAs can make
unlimited gifts to US persons without any liability for US gift tax if the
property gifted has a situs located outside of the US.[110] As an incidental note, the IRC's estate tax provisions for NRAs are
contained within a separate subchapter (i.e., Subchapter B, Estates of
Nonresidents Not Citizens, of Chapter 11, Estate Tax). In contrast, the IRC's gift tax
provisions for NRAs are not contained in a separate subchapter. Instead, they
consist of specific provisions within Chapter 12, Gift Tax. i) %Text" style="margin-bottom: 6pt; line-height: 150%;">[55]
IRC
§ 871(h). [56]
IRC
§ 2105(b)(3). [57]
IRC
§ 2105(b)(3). [58]
IRC
§ 871(h)(4). [59]
IRC
§§ 2104, 861(a)(1)(A). [60]
Treas.
Reg. § 20.2104-1(a)(7).
Charles M. Bruce and Lewis
J. Saret[1] The form for reporting foreign bank and similar accounts has always
been a little tricky, but because of a little known implication of the new
Patriot Act and greatly increased enforcement attention, this form has become
dangerous. The requirement for filing this form arises from the Bank Secrecy Act
("BSA"), first enacted in 1970, amended, in order to add a number of
anti-money-laundering provisions, in 1992, and amended most recently in October
2001 by the Patriot Act.[2] The BSA, in general, authorizes the
Secretary of the Treasury to promulgate regulations requiring financial
institutions and other persons to keep records and file reports that he
determines will have a high degree of usefulness in criminal, tax, regulatory,
intelligence, and counter-terrorism matters, and to implement counter-money
laundering programs and compliance procedures. Section 5314 of the BSA specifically authorizes the
Secretary to require residents or citizens of the U.S., or a person in and
doing business in the United States, to keep records and/or file reports
concerning transactions with a foreign financial agency. "This provision reflected congressional
concern that foreign financial institutions located in jurisdictions with
strict bank secrecy laws were being used to violate or evade domestic criminal,
tax, and regulatory requirements."[3] Pursuant to this
provision, the Treasury Department promulgated regulations[4]
stating: Each
person subject to the jurisdiction of the United States (except a foreign
subsidiary of a U.S. person) having a financial interest in, or signature or
other authority over, a bank, securities or other financial account in a
foreign country shall report such relationship to the Commissioner of the
Internal Revenue for each year in which such relationship exists, and shall
provide such information as shall be specified in a reporting form. ...[5] The form
referenced is TD F 90-22.1 (Report of Foreign Bank and Financial Accounts,
sometimes referred to as the Foreign Bank Accounts Report or FBAR). (The most recent version of this form,
dated July 2000) is available in the Internal Revenue Service website.) The
Secretary of the Treasury delegated the authority to administer this
requirement to the Director of the Financial Crimes Enforcement Network
("FinCEN") FinCEN is a bureau of
the Treasury Department, alongside other bureaus and services, such as the
Internal Revenue Service ("IRS"). FinCEN is responsible for
the U.S. Government's domestic and international anti-money laundering
efforts. Among other things, it
engages in information collection, data analysis, dissemination of analytical
products, and technological assistance.
This bureau is overseen by the Under Secretary of Enforcement, who reports to the Secretary of
the Treasury through the Deputy Secretary. Both FinCEN and
its sister organization, the IRS, have responsibilities and roles with respect
to the FBAR. The FBAR is an information
return or report that is filed with the IRS Detroit Computing Center and input
into the BSA financial database, which is jointly administered by Detroit
Computing Center and FinCEN. After
FBARs are posted--presumably by hand--to the BSA financial database, the forms
are available to FinCEN analysts, law enforcement, and appropriate regulatory
authorities for use, among other things, in tracking flows of money.[6] For example, with proper authorization
from supervisors, a revenue agent or international examiner can obtain access
to this information. Pursuant to
Treasury Directive 15-41 (12/1/92), the Secretary of the Treasury delegated to
the IRS the authority to investigate possible violations of 31 U.S.C. § 5314
and federal regulation §103.24.
The IRS examines for compliance with the FBAR requirements. The IRS/Criminal Investigation Division
("CI") reviews failures to file identified by the IRS examination staff
(revenue agents and international examiners, for example) for possible criminal
investigation. CI forwards cases
that it recommends for prosecution through the IRS Office of Chief Counsel
(which conducts its own independent review) to the Department of Justice, which
has the final say on whether to initiate a criminal prosecution. More recently,
FinCEN delegated its enforcement authority for the FBAR to the IRS, to increase
enforcement with respect to FBARs.
Such authority includes the authority to collect civil penalties, to
investigate possible civil violations of these provisions, to employ the
summons power of subpart F of part 103, and to take any other action reasonably
necessary for the enforcement of such provisions, including the pursuit of
injunctions.[7] It will be noted
that the FBAR is not a tax return, as such, and is not attached to a taxpayer's
Individual Federal Income Tax Return (Form 1040). It follows that the information appearing on a FBAR is
not subject to the stringent disclosure restrictions of IRC § 6103 (relating to
confidentiality and disclosure of returns and return information). Thus, information contained in this
form can be shared with other agencies of the Federal Government. In addition, "[t]he information
collected may also be provided to appropriate state, local, and foreign law
enforcement and regulatory personnel in the performance of their official
duties."[8] What is not widely appreciated is that
a private litigant may request and may well be given access to this information
in a lawsuit. For example, a
spouse might seek discovery of this information in the course of an action for
divorce or separate maintenance.
If the form has been filed, the information, one can anticipate, will be
made available pursuant to a court order.
If it has not been filed, but should have, the other spouse can be
liable for all the very serious penalties described herein. If the other spouse says that he or she
has not filed the form because there are no foreign bank accounts, and the
requesting spouse doubts this is true, a court presumably could order the other
spouse to request a copy of any and all filings with the IRS Detroit Computing
Center. Cases that CI
declines to investigate as a criminal matter may be reviewed further by the IRS
for possible civil enforcement action.
If a taxpayer refuses to pay the penalty, the matter can be referred to
the Department of Justice to institute a penalty action in which both liability
and the amount of penalty must be litigated. Complying with the statutory and regulatory requirement to report
foreign financial accounts is a two-part process. Form 1040 Schedule B, Part III, instructs a taxpayer to
indicate an interest in a financial account in a foreign country by checking
"Yes" or "No" in the appropriate box. Form 1040 then refers the taxpayer to
Form 90-22.1, which provides that it should be used to report a financial
interest in or authority over bank accounts, securities accounts, or other
financial accounts in a foreign country. The instructions for Form 1040, Schedule B, provide
that the taxpayer must check "Yes" if he/she owns more that 50% of the stock of
any corporation (U.S. or foreign) that owns one or more foreign bank accounts
or at any time during the year the
taxpayer had any interest in or signature or other authority over a financial
account in a foreign country (such as a bank account, securities account, or
other financial account). Among
the exceptions noted in these instructions the only one of general application
is the one stating that if the combined value of the accounts was $10,0000 or
less during the whole year, the "Yes" box need not be checked. If the account is denominated in a
foreign currency, the value of the foreign currency is converted into US
dollars using the "official" exchange rate at the end of the year; "official"
in the case of freely traded currencies probably means interbank or market rate
of exchange.[9] The deadline for filing a FBAR is June 30 of the year following the
calendar year during which the threshold requirements are met (see
discussion below). While the number of FBAR filings has been steadily increasing--from
116,600 in 1991 to 177,151 in 2001, the Treasury Department believes that many
persons that should file are failing to do so. It
is difficult to determine with any accuracy how many taxpayers are failing to
file required FBARs in any calendar year.
Extrapolating from the limited information available concerning the
number of foreign bank and credit card accounts held by United States citizens,
the IRS estimates that there may be as many as 1 million U.S. taxpayers who
have signature authority or control over a foreign bank account and may be
required to file FBARs. Thus, the approximate rate
of compliance with the FBAR filing requirements based on this information could
be less than 20 percent.[10] In the past, criminal and civil prosecutions under these provisions
have been few and far between.
Between 1996 and 1998, only nine indictments were filed charging failure
to comply with section 5314. In
the following two years, no one appears to have been charged. The Customs Service reports only three
convictions since 1995.[11] This picture may be slightly distorted
since it is the case that IRS agents will sometimes raise the issue with
taxpayers and use a failure to file a FBAR as a means of obtaining a favorable
settlement of the tax case. Also,
the issue might be raised in a different form, for example, as a charge of
willfully subscribing false tax returns in violation of Internal Revenue Code §
7206(l) for failing to "check the box" on Schedule B of Form 1040. While in the past the FBAR has had a relatively low profile, it is
receiving and undoubtedly will continue to receive much greater attention. The government's focus on foreign bank accounts is clear. The past year and a half alone has
witnessed the following developments: · Enactment of the Patriot
Act, which
makes it easier for the Treasury Department to obtain foreign bank account
information and puts the foreign bank somewhat at risk of losing its ability to
maintain a correspondent account with a U.S. bank.[12] See discussion at
"Caution--Danger Ahead", below. · The Treasury Department
Report to Congress concerning FBAR reporting, as mandated by the Patriot Act, which
stated among other things that the only way to improve FBAR filing compliance
among those individuals who are aware of the FBAR involves "a series of highly
publicized criminal actions against intentional violators to raise the cost of
being an FBAR scofflaw. Ideally,
such cases would be brought not only as adjuncts to other types of criminal
conduct such as tax evasion and bankruptcy fraud, but also as stand-alone
cases."[13] · The implementation of the
IRS Voluntary Compliance Initiative Program, which offered taxpayers with unreported
foreign bank accounts an opportunity to avoid many otherwise applicable
penalties.[14] · The ongoing IRS John Doe
summons investigations, where the IRS has issued a series of summonses to obtain information
about US citizens holding payment cards tied to foreign bank accounts. This investigation has produced numerous
cases being referred to the Criminal Investigation Division of the IRS.[15] On the other hand, the FBAR,
which is a short, two-page form, is deceptively simple. Its concise format hides several latent
issues. More critically, the FBAR
filing requirements' broad applicability combined with the association in the
minds of most practitioners and lay people of the FBAR with so-called "tax
cheats," who use unreported foreign bank accounts to commit tax fraud, causes
many people to fail to understand that they must file an FBAR. Each US person with a financial interest in or signature or other
authority over any financial account in a foreign country must file an FBAR if
the aggregate value of all such accounts exceed $10,000 at any time during the
calendar year. The FBAR must be
filed on or before the June 30 after the calendar year in which the
relationship existed. The FBAR is required in addition to the reporting
obligations with respect to foreign accounts on Form 1040, Schedule B.[16] Certain people do not have to file an FBAR. These include officers or employees of
certain banks and large publicly traded corporations with signature/other
authority over foreign financial accounts maintained by that bank or large
corporation, where they have no personal financial interest in the account, and
they have been advised in writing by the corporation's chief financial officer
that the corporation has filed a current FBAR, which includes such account. To illustrate, E, a General Motors executive, based
in London, with signature authority over a GM bank account in London in which E
has no personal financial interest, and who otherwise satisfies the
requirements of the exception, does not have to file an FBAR. In contrast, F,
an executive in London under exactly the same circumstances but employed by a
non-publicly traded company, must file an FBAR. For FBAR purposes, a person has a "financial interest" in a foreign
financial account if he is the owner of record or has legal title, regardless
of whether that account is maintained for his own benefit or for the benefit of
others, including non-U.S. persons.
For joint accounts, each owner has a financial interest in that account. In addition, a U.S. person has a
financial interest in a foreign financial account where the owner of record is
any of the following: A "financial account" includes any bank, securities, securities
derivatives or other financial instruments accounts. Such accounts generally also "encompass any accounts in
which the assets are held in a commingled fund, and the account holder holds an
equity interest in the fund." But
there are many gray areas. To illustrate, if a U.S. person places $1 million
cash into a safe deposit box in Switzerland, does this constitute a financial
interest in a foreign account, which triggers the FBAR filing
requirements? As with many other
FBAR issues, no authoritative guidance answers this issue. However, it appears
that in the safe deposit box context, application of the FBAR requirements
depends on the precise nature of the arrangement between the bank and the safe
deposit box holder. For example,
if the holder gives the bank the right to access more than $10,000 of cash in a
safe deposit box in order to secure a credit card issued by that bank, then it
appears that the holder may be required to file an FBAR. The rationale for this
is that this arrangement is substantively no different than if the holder
deposited such cash into a checking or other financial account with the bank,
which would trigger the FBAR filing requirements. To illustrate a different situation, if a U.S. person creates
a grantor trust, which in turn owns a foreign financial account valued at more
than of $10,000, does the U.S. person need to file an FBAR? Here, it appears that the U.S. person
must file an FBAR if he is treated as the grantor of the trust under the
grantor trust rules.[18] To determine
whether the $10,000 filing threshold has been surpassed, "account valuation" is
defined as "the largest amount of currency and nonmonetary assets that appear
on any quarterly or more frequent account statements issued for the applicable
year." If periodic account
statements are not issued, the maximum account asset value is the largest
amount of currency and non-monetary assets in the account at any time during
the year. For this purpose, filers
must convert foreign currency by using the year-end official exchange or
conversion rate. The value of
stock, securities or other non-monetary assets is the fair market value at
year-end, or at withdrawal from the account, if earlier. Each account must be valued separately
in accordance with the foregoing rules.
The $10,000 filing threshold is an aggregate threshold; that is, it
applies if the aggregate value of all foreign financial accounts held by
the person in question exceeds $10,000 at any time during the calendar year. A person has "signature authority" over an account if he can control
the disposition of money or other property in that account by delivery of a
document containing his signature, or his signature along with that of one or
more other persons, to the bank or other person with whom the account is
maintained. A person has "other
authority" if that person can exercise comparable power over an account by
direct communication to the bank or other person with whom the account is
maintained, either orally or by some other means. This definition occasionally
has counterintuitive results. For example, it is clear that an individual who
establishes a foreign bank account and receives a credit card secured by that
account has the requisite signature authority to trigger the FBAR filing
requirements. On the other hand,
if a German entrepreneur gives his US resident daughter a credit card issued to
his German closely held company by a German bank, does the daughter now have to
file an FBAR? If the credit card
is secured by the German bank account the answer is yes. This results even though the daughter
is certainly not the type of person the FBAR is directed at. On the other hand, if the credit card
is unsecured, similar to most credit cards issued in the US, then it appears
the daughter need not file an FBAR. A US person, for FBAR purposes, includes US citizens and residents,
domestic partnerships, domestic corporations, and domestic estates or
trusts. This definition catches
several types of people unawares.
To illustrate, each of the following individuals must file an FBAR, even
though they may not realize this: · A US citizen studying
overseas who opens up a bank account at a foreign bank for convenience, which
had over $10,000 at any time during the year. · A child of a foreign
entrepreneur who attends college in the US, who has a foreign bank account from
childhood on, worth more than $10,000, will become subject to the FBAR
requirements if that child ultimately becomes a US resident or if it obtains an
immigrant visa permitting him/her to reside in the U.S. on a permanent basis (i.e.,
a "green card"). · A US citizen marries a Dutch
citizen who is temporarily stationed in the US. If the US citizen, along with
his new spouse, returns to Denmark, retains US citizenship, and opens a
financial account (e.g., a brokerage account) in the Denmark, he or she must
file an FBAR if the account value exceeds $10,000 at any time during the year. · A US citizen or resident is
temporarily stationed in Mexico by his employer. The individual opens a bank account in Mexico, and maintains
a nominal amount in that account throughout the year. At year-end, the employer gives the individual a $15,000
bonus, which he deposits in his bank account in Mexico. · A so-called "accidental
American" has an account outside the U.S.
An "accidental American" is someone who was born in the U.S. of foreign
parents. For example, a couple
give birth to a daughter while studying in the U.S. The daughter is a U.S. citizen, even though she, together
with her parents, live in Switzerland, and she has never returned to the U.S.
after leaving at a very early age.
This individual should file an FBAR for all foreign accounts. Each of the foregoing situations is common. In each situation, frequently, the individuals do not
realize that they must file an FBAR, and that they are subject to both civil
and criminal penalties for failing to do so. Moreover, often the accountants, attorneys, financial
planners, and other professionals who advise such individuals do not think
about the FBAR, thus exposing them to malpractice liability. What about the FBAR itself?
Is it difficult to complete?
No, the FBAR itself is very easy to complete. It requires taxpayers to provide the following information: If the filer has a "financial interest" in more than twenty‑five
foreign bank accounts, information for the accounts need not be provided but
must be made available to the Treasury Department upon request. If the filer
has an interest in fewer than twenty‑five accounts, the information listed
above must be provided for each account What happens if someone fails to file an FBAR? What is his or her liability exposure?
Failure to file a FBAR or filing a false FBAR may trigger criminal
penalties. The base penalty is a
maximum fine of $250,000, a maximum term of imprisonment of five years, or
both. The alternative penalty,
which is a fine of not more than $500,000, or imprisonment of not more than ten
years, or both, applies if the defendant violates any other U.S. law or if the violation
was part of a pattern of any illegal activity involving more than $100,000 in a
twelve‑month period. In addition,
the false‑statement statute, 18 USC § 1001, may be violated if a false form is
filed. For this purpose, a
separate criminal violation will occur for each FBAR not filed or falsely
filed. Because Form 1040, Schedule B outlines the FBAR reporting requirement,
willfulness may not be exceptionally difficult for the government to prove. In addition to criminal penalties, failure to file a FBAR or filing of
a false FBAR may also trigger civil penalties. To illustrate, an individual who willfully violates the FBAR
reporting requirement can be fined either $25,000 or an amount equal to the
balance in the account at the time of violation (not to exceed $100,000),
whichever is greater. Although not entirely clear, it appears that if multiple
accounts exist, the fine would be a minimum of $25,000 per account, even if
multiple accounts should have been reported on the same form. The requirement
to file an FBAR falls within the anti-money laundering programs instituted by
the U.S. Government; section 5314, in fact, sits in the U.S. Code just a few
sections away from a number of new provisions added by the Patriot Act. Under section 5318 of Title 31
(Compliance, Exemptions, And Summons Authority) of Section II (Records And
Reports On Monetary Instruments Transactions), of Chapter 53 (Monetary
Transactions, which Chapter also deals with money laundering and related
crimes), the Secretary of the Treasury or the Attorney General[19]
may issue a summons or subpoena to any foreign bank that maintains a
correspondent account in the United States and request records related to such
correspondent account, including records maintained outside of the United
States relating to the deposit of funds into the foreign bank. "Correspondent account" is defined in
new section 5318A (Special Measures For Jurisdictions, Financial Institutions,
Or International Transactions Of Primary Money Laundering Concern) as "an
account established to receive deposits from, make payments on behalf of a
foreign financial institution, or handle other financial transactions related
to such institution." Service and
acceptance of service are streamlined by new provisions that, in effect,
require the foreign bank to appoint an authorized agent for receipt of legal
process for records regarding the correspondent account. (The U.S. bank that is operating the
account will require this. The
U.S. bank is referred to by the statute as a "covered financial
institution.") If a foreign bank
fails to comply with a summons or subpoena issued under these new provisions,
the covered financial institution, upon notification by the Secretary of the
Treasury or the Attorney General, can be forced to terminate (shut down) the
correspondent account or itself face severe penalties. While a FBAR is
clearly not the only "predicate" to institution of these summons or subpoena
procedures, it is one, and the requirement to file an accurate report is an
easy one to point to. Foreign
banks will want to take note of the connection between Patriot Act summons and
subpoenas and FBARs. They may wish
to provide reminders to customers that the rules of countries, such as the
United States, may require them, the customers, to report "foreign" accounts,
and that information regarding the account may become the subject of a summons
or subpoena directed at the bank.
The bank may wish to notify its customers that it will comply with such
formal requests and to obtain the customers' consent in advance. So far as summons and subpoenas based
on a FBAR or failure to file a correct and complete FBAR, these thoughts are,
in general, only relevant to U.S. persons, that is, U.S. citizens, U.S.
residents, U.S. partnerships, U.S. corporations, U.S. trusts, and U.S. estates.[20]
Affected individuals should know that these new mechanisms make it much easier
for the U.S. Government to look at foreign accounts. The Patriot Act and newer generation mutual legal assistance treaties
are obviously designed to make it easier for the U.S. Government to obtain
admissible evidence of undisclosed foreign accounts. Prosecutors, it is believed, will be urged to take a second
look when deciding whether to charge a FBAR failure to file. Also, it should be noted that the Senate version of the Jobs and Growth
Tax Relief Reconciliation Act of 2003 (P.L. 108-27) would have added an
additional $5,000 civil penalty that, if enacted, would have allowed the IRS to
impose such penalty on any person who failed to properly file an FBAR, without
regard to willfulness.[21] This change would make it considerably
easier for a prosecutor to charge the violation. Although this provision did not make it into the final
version of the Act, such proposals have a way of recurring until they are
enacted. The FBAR form almost certainly will be changed in many important
respects in the very near future.
In its Report to Congress dated April 26, 2002, the Treasury Department
stated that FinCEN would take responsibility for updating this form and the
accompanying instructions. The
target date for doing so was set at December 31, 2002. One suspects that the delay is due in
part to work on Patriot Act and other regulations, the contents of which will
bear on this form. The Foreign Bank Accounts Form has never been something to sneeze at,
as it is a crime to violate the underlying rules. It is undoubtedly true, however, that individuals and their
advisers have too often not given this form the attention it deserves. In light of the Treasury Department's
and IRS's new focus on these provisions, born in large measure from the events
of "911" and the drive to prevent money-laundering, and the new Patriot Act
provisions, TD F 90-22.1 must be treated with a great deal more respect. If in doubt, the answer should be to
file the forms; there is no indication that the fact that one files triggers an
audit. To do otherwise is
dangerous. † Copyright © Moore & Bruce, LLP,
2003. All rights reserved. [1]
Charles M. Bruce is a partner in the law firm Moore & Bruce, LLP and is
based in Washington, D.C. and London. Lewis J. Saret is Of Counsel with the firm and is
based in Washington, D.C.
The portions of this article dealing with the background of TD F 90-22.1
draws heavily from the Treasury Department Report to Congress dated April 26,
2002, cited at footnote 3, below.
Readers' comments and corrections would be greatly appreciated. Please send these to
administrator@mooreandbruce.com.
Updates and additional information relating to this subject are posted
at http://www.mooreandburce.com. [2] 1 Titles 1 and II of Public Law 91-508, as amended,
codified at 12 U.S.C. 1829b, 12 U.S.C. 1951-1959, and 31 U.S.C. 5311-5330. [3] U.S. Treasury Department,
REPORT TO CONGRESS IN ACCORDANCE WITH §361(b) OF THE USA PATRIOT ACT SUBMITTED
BY THE SECRETARY OF THE TREASURY APRIL 26, 2002, p. 3 [hereinafter "TREASURY
REPORT"]. This report is required
to be made each year, but the one due April 26, 2003 has not been filed as of
June 1, 2003. [4]
31 CFR Part 103 (2002). [5]
31 CFR 103.24 (2002). [6]
In the last several years it has become more common, it appears, for the IRS
Detroit Computing Center to send requests for missing information to
individuals who have filed a FBAR. [7]
Financial Crimes Enforcement Network; Delegation of Enforcement Authority
Regarding the Foreign Bank Account Report Requirements, 68 Fed. Reg. 26,489
(May 16, 2003) (to be codified at 31 C.F.R. § 103.56(g)). [8]
Privacy Act Notification on the face of TD F Form 90-22.1 (Rev. 7/00). [9]
With the precipitous rise in the value of the Euro, many Euro-denominated
accounts, which were opened with an initial deposit of say 8,000-9,000 dollars
that were then converted into Euros, will have drifted above the reporting
threshold. [10]
TREASURY REPORT at p. 6. [11]
TREASURY REPORT at p. 8. [12]
Almost all foreign banks that need to receive or make payments in dollars
maintain a correspondent account with a U.S. bank, typically a large bank
located in New York. Today,
dollars are dealt with electronically through the DTC system, and access to
this system is through the large banks that have usually one DTC account. [13]
TREASURY REPORT at p. 11. [14]
Rev. Proc. 2003-11, 2003-4 I.R.B. 311. [15]
See Early Information Reveals Strong Response to Offshore Initiative, IRS
Says, 2003 TNT 85-17 (May 1, 2003). [16]
There is not a great deal of authority bearing on the "backfiling" of FBARs
voluntarily or even after notice from the IRS or FinCEN. In the case of nonfilers who are
"catching up" with their filing of income tax returns, the authors recommend
that they also "backfile" FBARs.
The recent Voluntary Compliance Initiative Program requires, among other
things, the backfiling of FBARs. [17]
Tying reporting requirements to a percentage of profits or current income can cause
difficulties, as the individual concerned may not know the total amount of
profits or current income. In some
cases another filing might help him/her, as is the case with beneficiaries of
foreign trusts that may receive statements from the foreign trust showing the
necessary figures. [18]
This point can be argued either way.
The argument for the proposition that filing is required is based not on
section 671 of the Internal Revenue Code but on the BSA provisions. [19]
Apparently this authority does not run to a grand jury. This is a technical problem that may be
fixed by legislation or otherwise. [20]
The regulations promulgated under 31 U.S.C. 5314 speak in terms of "[e]ach
person subject to the jurisdiction of the United States (except a foreign
subsidiary of a U.S. person) having a financial interest in, or signature or
other authority over, a bank, securities or other financial account in a
foreign country...." The
instructions to the FBAR form, however, refer to "United States person" and
define that term as a citizen or resident of the U.S., a domestic partnership,
a domestic corporation, or a domestic estate or trust. The Internal Revenue Code contains a
definition of "United States person" that is similar but not identical to the
FBAR-related definitions, and clearly the FBAR rules are not simply
cross-referencing the tax law definition.
For example, a Delaware trust that "flunks" the test in I.R.C. section
7701(a)(30)(E) is not a United States person for tax purposes but may be for
FBAR reporting purposes. Also,
there is no clarity as to the definition of a "domestic estate." Is the estate of a U.S. citizen who
lived the last 40 years of his life in Europe, which estate is administered
outside the U.S., a domestic estate?
What if the decedent was not a U.S. citizen or resident but the estate
owns commercial real estate in the U.S.?
This last estate probably is a "foreign estate" under the income tax
rules in I.R.C. section 7701(a)(31).
It is this type of confusion that needs to be dispelled. [21]
See Ratzlaff v. United States, 510 U.S. 135 (1994), involving a
different part of the BSA. Amnesty or Not? The April 15th deadline to participate in the
IRS's Voluntary Compliance Initiative has come and gone. Now what? At the beginning of this year, the IRS initiated a program,
effective January 14, 2003 and ending three months later, on April 15, 2003,
permitting US taxpayers, who have used offshore accounts and other financial
arrangements to avoid reporting or to underreport taxable income, to come
forward, report the income and avoid many of the otherwise applicable civil and
criminal penalties and related costs. According to published reports, Pamela Olson, Treasury
Assistant Secretary for Tax Policy, has stated that the voluntary compliance
initiative will constitute an important source of information for the Treasury
Department, which is continuing its efforts to improve and expand the US's
broad network of bilateral tax treaties and tax information exchange
agreements. Also, according to Ms.
Olson, better tax information exchange relationships will permit the IRS to
obtain the information it needs from other countries so it can pursue taxpayers
attempting to hide income offshore to avoid their tax obligations. The US recently expanded its network of tax information
exchange agreement with offshore financial jurisdictions and now has agreements
with Antigua, Bahamas, BVI, Cayman Islands, Guernsey, Jersey, Isle of Man and
the Netherlands Antilles. It can
be assumed that the IRS will exchange information with these countries, as well
as others within its extensive network of tax treaties, including the United
Kingdom, France and Germany. Acting IRS Commissioner, Robert Wenzel, in testimony before
a Senate appropriations subcommittee, has indicated that the IRS has received a
good response to the initiative, and has received several promising leads on
promoters of offshore arrangements. The program was aimed at taxable years 1999 to 2002. Years prior to 1999, in certain
circumstances, may not be subject to scrutiny, but taxpayers nonetheless will
have to provide information about their involvement in offshore financial
arrangements during these years. The interest and penalties imposed depended on the amount of
the unpaid tax liability, the years involved, whether a return was inaccurate
or if a return should have been filed and was not. By way of example, a taxpayer who understated his income to
avoid $100,000 in taxes in 1999 would wind up paying $149,319. This includes the tax liability plus
$29,319 in interest and an additional accuracy-related penalty of $20,000. If a taxpayer did not step forward, his tax liability
generally would include the civil fraud penalty of $75,000, and therefore
higher interest of $42,758. The
total amount due would be $217,758, without considering probable additional
civil penalties for failure to file certain information returns. Also, without coming forward, the
taxpayer must worry about possible criminal penalties. Not an amnesty:
Although loosely referred to as an offer of tax amnesty, this was a
misnomer, as taxes were not wholly or partially forgiven. Instead, if the taxpayer met the
requirements of the program, the IRS agreed not to impose a number of civil and
criminal penalties. The taxpayer
will have to pay the tax and, in appropriate circumstances, certain delinquency
and accuracy-related penalties. If
the Foreign Bank and Financial Accounts Report (Treasury Form 90-22.1) also was
not filed, the civil and criminal penalties associated with this failure would
also be dropped. Those who participated in the program were required to give
complete information about how they were introduced to the account or
arrangement, information about any promoter or other person involved, etc. There are really two groups of persons affected by the Offshore
Voluntary Compliance Initiative (the "Initiative"), the term the IRS uses for
this program: One, US taxpayers
that have used offshore arrangements and, therefore, have some exposure. Two, non-US persons-advisors, banks,
trust companies, investment management firms, and other persons that might be
characterized by the IRS as "promoters." Individual taxpayers: In regard to individuals, they were required to assess the
"opportunity" rapidly.
Were they eligible? What was
the possibility of being drawn into the program but learning later that there
are hidden detriments? What
happens if the individual is not able to make full payment of taxes and
penalties due? The taxpayer must fully pay the tax liabilities and interest
or make "other financial arrangements" that are acceptable to the
IRS. What these arrangements are
and the negotiation of the details will now be very important. If some type of workout is called for,
it will be necessary to carefully prepare the necessary financial statements. In this regard, the IRS has stated
that, although the Initiative requires taxpayers to
fully pay their tax liabilities, including applicable penalties and interest
for all years involved, as well all other unpaid, previously assessed
liabilities, it is possible to request other payment arrangements acceptable to
the IRS. However, the IRS also indicates that the burden will be on the
taxpayer to establish inability to pay, based on full disclosure of all assets
and income sources, domestic and offshore under the taxpayer's control. For those who made the initial filing, called a written
request to participate, they have approximately five months (150 calendar days)
within which to submit a number of items including: ·
Copies of previously filed original and amended
federal income tax returns for tax periods ending after December 31, 1998; ·
Copies of any powers of attorney granted by the
taxpayer with respect to the subject tax years; ·
Descriptions of offshore payment cards and
foreign and domestic accounts of any kind (including the name and address of
the bank or financial institution, the account number, and the date the account
was opened), and descriptions of foreign assets in which the taxpayer has or
had any ownership or beneficial interest or that are or were controlled by the
taxpayer (i.e., the taxpayer has or had the practical ability to direct
or influence the financial transactions or affairs of an account or entity, or
the use or disposition of an asset, whether this ability was exercised directly
or indirectly through a nominee, agent, power of attorney, letter of
directions, letter of wishes, or any other device whatsoever) at any time after
December 31, 1998; ·
Descriptions of entities of any kind (including
corporations, partnerships, trusts, and estates) and any nominees through which
the taxpayer exercised control over foreign funds, assets, or investments at
any time after December 31, 1998; ·
Descriptions of the source of any foreign funds,
assets, or investments owned or controlled by the taxpayer at any time after
December 31, 1998; ·
All related promotional materials, transactional
materials, and other related correspondence and documentation received
subsequent to the date the taxpayer submits the request to participate in the
Program (such materials received prior to submitting a request will have been
supplied with the request); ·
Complete and accurate amended or delinquent
original federal income tax returns of the taxpayer for all tax years ending
after December 31, 1998, which are supported by an explanation of previously
unreported income or incorrectly claimed deductions or credits (whether or not
related to offshore payment cards or offshore financial arrangements); ·
Complete and accurate amended or delinquent
original information returns required by sections 6035, 6038, 6038A, 6038B,
6038C, 6039F, 6046, 6046A, and 6048 for which the taxpayer requests relief from
penalties; and ·
Complete and accurate Foreign Bank Account
Reports for tax years ending after December 31, 1998. Taxpayers and their advisors will be hard pressed to pull
together these materials in this short period. It remains be seen whether requests for extensions of time
will be granted. Also, as with all exercises involving the filing of late
returns, there will be a large number of "judgment calls" including
how to handle the section 911 earned income exclusion and foreign tax credit
issues. There
will be issues as to what to do with respect to non-US tax authorities, and
State tax authorities, which may be owed returns and taxes as well. Obviously, information provided to the
US can be exchanged by the US with State and other countries' tax
authorities. In the case of
States, the IRS has announced that 10 states have indicated they will grant
special consideration to individuals who apply to the Initiative. According to the IRS, if individuals
amend their state returns and pay all tax, penalties, and interest by October
15, they can avoid prosecution by these states. The states participating are
California, Idaho, Louisiana, Maryland, Nebraska, New Jersey, New York, North
Carolina, Utah and Vermont. The IRS has indicated that additional states are
expected to announce they will offer similar treatment to applicants of the
Initiative. An additional issue is whether, where taxpayers are denied
eligibility for participation in the Initiative, the IRS will admissions made
in requests to participate in the program to prosecute them. Here, the IRS has
stated that information about a taxpayer requesting participation in the Initiative
is legally admissible in subsequent criminal proceedings. At the end of the process, the taxpayer and the IRS will
enter into a closing agreement, which like all such agreements entails a number
of legal issues. The exact wording
of that agreement should be constructed with great care. There will be issues that arise in
connection with joint returns, especially where one spouse was not aware of the
activities of the other spouse.
There will be special issues where the taxpayer is a trust or an estate. Unusual issues can arise where the foreign trustee bears
obligations to other beneficiaries.
For example, to what degree should a trustee cooperate where one US
beneficiary wishes to participate but this has implications for other US and
non-US beneficiaries? Also, the
trust, acting through the trustee, may be required to join in the filings. What indemnifications should the
trustee obtain? Offshore promoters: While at first blush it seems this program was aimed at
taxpayers who used offshore accounts, credit cards paid against those accounts,
foreign corporations, foreign trusts, and the like, to avoid US taxes, in no
small measure the program is designed to enable the IRS to proceed "with a
vengeance" against promoters and facilitators of these schemes. The wording of various announcements
and explanations makes clear that the IRS intends to use every means available
to it to attack these persons. For the advisors, banks, trust companies, investment
management firms, and the like who may be thrown into the category -- rightly or wrongly -- of "promoters," they will
want to anticipate the IRS's next steps.
They probably should not wait until they receive, for example, a request
for information or writ issued by their "home country" tax authority
at the behest of the IRS pursuant to an applicable tax information exchange
agreement. Filing Amended Returns Versus Filing Under The Initiative. The IRS has clearly tried to steer taxpayers to use the
Initiative, rather than quietly file amended tax returns, reflecting offshore
accounts and other arrangements.
In this regard, the IRS is
currently screening all amended returns against newly developed criteria to
identify taxpayers who tried to circumvent the Initiative, and it has stated
that it will audit amended returns identified during this screening process. What is the IRS's next step? We believe that the next step will be for the IRS to pursue
US taxpayers who had these arrangements and did not come forward, as well as
promoters, wherever they are located.
We think that the IRS will be looking to make examples of some
people. Concerning non-US firms,
such firms run the risk of aiding and abetting a tax fraud, among other
possible things. Lewis J. Saret is a lawyer, who is Of Counsel with the
Washington and London law firm Moore & Bruce, LLP (www.mooreandbruce.com). He may be reached by e-mail at:
lsaret@mooreandbruce.comBackground
Important Developments
Who Must File an FBAR?
Key Definitions
What information is required?
Criminal and Civil Penalty
Exposure
Caution--Danger Ahead
Conclusion
By Lewis J. Saret
The Voluntary Compliance Initiative
What's Next?