IRS Falls Short of Clearly Defining a Foreign Trust in New Rules

The IRS’s proposed regulations for foreign trusts, and receipt of large foreign gifts, aim to close perceived abuses associated with foreign trusts. They also introduce some new rules on reporting obligations when a foreign trust is domesticated or migrates to the US.

But without additional guidance, US taxpayers may face significant penalties for classifying a foreign structure incorrectly. Taxpayers with foreign structures that are similar to trusts should be afforded the same certainty that taxpayers with eligible business entities have concerning the tax classification of such an entity or arrangement.

The May proposal doesn’t clearly define a foreign trust. While Notice 97-34 was a significant improvement to the then-existing rules on the classification of a trust, there are still plenty of ambiguities.

For a trust to be treated as domestic, it must pass the control test, which requires that a US person have control over all substantial decisions of a trust. It also must pass the court test, which requires a US court have primary supervision over administration of the trust.

The regulations offer useful guidance in providing some safe harbors and bright-line tests to help determine whether a trust passes the court test. But the determination still requires a facts-and-circumstance analysis, and the determination isn’t always clear.

Let’s say, for example, a trust is established in the US with a US person serving as trustee, who then moves abroad where the trust administration takes place. It isn’t uncommon for tax practitioners to disagree over whether this trust is foreign or domestic, based on whether the trust passes the court test.

The answer depends on facts and circumstances. Why not resolve that ambiguity by providing additional guidance? One possibility would be to add a provision in the regulations that provides a trust will pass the court test if the trustee agrees to be subject to US court supervision, including if there is a dispute over a US tax or reporting matter. This would give the taxpayers clarification and certainty on how such trusts will be classified.

Taking that thought one step further, what about entities that aren’t US trusts but look like them? In the US, trusts are commonly used in estate planning. But many civil law countries don’t recognize trusts and often have enacted legislation providing for other planning type entities or arrangements to accomplish similar objectives as a trust.

Some of these structures, such as waqfs and fideicomisos, don’t exist in the US. Each structure must be analyzed under the laws of the US and the foreign country to determine how that structure will be treated for US tax purposes.

It may be difficult to determine how the foreign structure should be treated for US tax and reporting purposes without an extensive review and analysis. Determining how the structure will be classified for US purposes often requires interpreting foreign law and the structure’s formation and governing documents to decide whether the structure is an ordinary trust as defined under the Treasury regulations.

The governing documents may need to be translated into English, and advice likely will be required from counsel in the foreign country where the structure was formed regarding various legal and tax aspects of the structure. The analysis can be very expensive and time-consuming.

When such a determination is subjective, different conclusions can be reached by the taxpayer and the IRS. The guidance in this area consists of case law, a private letter ruling, and an advice memorandum by IRS counsel. While helpful, the guidance is fact-specific and doesn’t give the taxpayer certainty as to which entities should be classified as trusts.

Eligible entities such as limited liability companies and similar foreign entities may file an entity classification election on Form 8832, electing the entities tax treatment for US tax purposes.

The proposed regulations should include guidance that an entity or arrangement for which the primary purpose is to protect or conserve the property for the beneficiaries (who aren’t associates)—rather than to actively carry on business activities—may make an election to be classified as an ordinary trust for US tax purposes, similar to how an eligible business entity makes a check-the-box election.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Michelle Graham is partner in the private client and tax team at Withers in its San Diego office.

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