§318 Grantor Trust Attribution | Foreign Trust Tax Lawyer & Attorney

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In previous articles, I discussed the §318 downstream and upstream attribution rules; in that context, I also mentioned that there were special rules concerning grantor trusts and tax-exempt employee trusts. This article will cover the special §318 grantor trust attribution rules.

§318 Grantor Trust Attribution: Definition of Grantor Trust

A grantor trust is any trust which, under the IRC §§671–677 and 679, is taxed as if owned in whole or in part by the trust’s creator. This means that the grantor (or “settlor”) must include all items of income, deduction, and credit which are attributable to that portion of the trust property of which he is deemed the owner.

§318 Grantor Trust Attribution: Downstream and Upstream Attribution to Grantors

The grantor trusts are subject to both, upstream and downstream attribution of stocks. Under §318(a)(2)(B)(ii) (downstream attribution), the grantor constructively owns all stocks owned directly or indirectly by the trust. Under §318(a)(3)(B)(ii), the trust constructively owns all stocks owned by the grantor.

§318 Grantor Trust Attribution: Interaction With Other §318 Attribution Rules

Surprisingly, there is no IRS guidance on how the special §318 grantor trust rules interact with other §318 trust attribution rules. At first, it appears that other constructive ownership rules would apply only to beneficiaries of a trust other than the grantor.

This, however, is not at all certain; an opposite conclusion can be reached that the Congress intended the exclusive application of its special grantor trust attribution rules. Hence, in some situations, it would not be a frivolous position for a taxpayer to state that the grantor trust rules of §318 replace all other §318 trust attribution rules with respect to grantor trusts.

§318 Grantor Trust Attribution: Illustration

Let’s illustrate the operation of the §318 grantor trust attribution rules with an example. Here are the hypothetical facts: G, an individual, creates Trust T; under §676, he is treated as owner of Trust T because he reserved the right to revoke the trust; there are two beneficiaries, A and B (nephews of G), who have a 50% vested interest in T. X, a C-corporation, has issued 100 shares and divided them equally (i.e. 25 shares each) between four shareholders, G, X, A and B. The issue is determination of ownership of X shares under the §318 trust attribution rules.

Let’s begin with G. He actually owns 25 shares and is deemed to own all shares owned by the grantor trust T. In other words, G owns a total of 50 shares.

T actually owns 25 shares and constructively owns all of G’s 25 shares. Its further ownership of X’s shares will depend on whether the general §318 downstream trust attribution rules supplement the §318 grantor trust rules. If they do, then T would be deemed a constructive owner of another 50 shares of X stock held by A and B – i.e. T will be deemed to a 100% owner of X. If, however, the special §318 grantor trust rules replace the other grantor trust attribution rules, then T’s ownership will stay at 50 shares total.

Similarly, if the grantor trust rules supplement other trust attribution rules, then A and B each will be deemed to own 50% of X through their 50% beneficiary interest in T. If the grantor trust rules overrule all other §318 trust attribution rules, then there will be no attribution of T’s stock to the beneficiaries and vice-versa.

A final note on this example. A and B would not be deemed to own any of G’s shares due to §318(a)(5)(C) prohibition on re-attribution of G’s stocks to the beneficiaries because these stocks were already attributed to the trust.

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§318 Upstream Trust Attribution | US Foreign Trust Tax Lawyer & Attorney

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In a previous article, I discussed the Internal Revenue Code (“IRC”) §318 downstream trust attribution rules. Today, I would like to focus on the §318 upstream trust attribution rules.

§318 Upstream Trust Attribution: Downstream vs. Upstream

There are two types of §318 trust attribution: downstream and upstream. In a previous article, I already covered the downstream attribution rules which attribute the ownership of corporate stocks owned by a trust to its beneficiaries. The upstream attribution rules are exactly the opposite: they attribute the ownership of corporate stocks owned by beneficiaries to the trust. This article focuses just on the upstream attribution.

§318 Upstream Trust Attribution: Main Rule

Under §318(a)(3)(B)(i), all corporate shares owned directly or indirectly by a beneficiary of a trust are considered owned by the trust, unless the beneficiary’s interest is a remote contingent interest. Notice that the proportionality rule does not apply to upstream trust attribution under §318.

For example: if trust T owns 25 shares of X, a C-corporation, and A owns another 25 shares of X, as long as A has a beneficiary interest in T which is not a remote contingent interest, then T will constructively own all of A’s shares of X – i.e. T will own 50 shares of X.

§318 Upstream Trust Attribution: Contingent Interest

If a beneficiary’s interest in a trust is both, remote and contingent, then there is no attribution of stock ownership from the beneficiary to the trust. Hence, the key issue with respect to upstream trust attribution is classification of a beneficiary’s interest in the trust – is it a remote contingent interest or not? Let’s first define what a contingent interest is and then discuss when such an interest is considered remote.

A contingent interest is defined as interest that is not vested. This means that the beneficiary has no present right to trust property and has no present interest in a property with respect to future enjoyment of the trust property. In other words, this interest can only be activated by an occurrence of an intervening event.

§318 Upstream Trust Attribution: Remote Contingent Interest

A contingent interest is remote if “under the maximum exercise of discretion by the trustee in favor of such beneficiary, the value of such interest, computed actuarially, is 5 percent or less of the value of the trust property.” §318(a)(3)(B)(i).

Let’s use an example to demonstrate how this rule works. The fact scenario is as follows: trust T owns 40 shares in X, a C-corporation; A, an individual beneficiary, has a contingent (not vested) remainder in the trust which has a value computed actuarially equal to 3% of the value of the trust property; A also owns the remaining 60 shares of X (X issued a total of 100 shares).

In this situation, A’s beneficiary’s interest is contingent because it is not vested and it is remote because its value is less than 5% of the value of the trust property. Hence, no shares of X are attributed from A to T, because A has a remote contingent interest.

It should be noted that T’s shares in X are still attributed to A under the §318 downstream attribution rules; hence, A would constructively own 1.2 shares of X.

§318 Upstream Trust Attribution: Special Situations

I wish to conclude this article with a discussion of two special situations.

First, if beneficiaries are entitled to trust corpus, this is a vested interest. This is case even if the life tenant in the trust’s property has the right to exercise power of appointment in favor of others. Of course, if such right is actually exercised in favor of others, then the beneficiary will lose its vested interest in the trust.

Second, if a beneficiary interest is conditioned upon surviving a life interest, it is considered a contingent beneficiary interest. For example, in Rev. Rul. 76-213, the IRS stated that a beneficiary had a contingent interest, because his remainder interest in the trust would terminate if the beneficiary predeceased the life tenant.

§318 Upstream Trust Attribution: Grantor Trusts and Employee Trusts

While it is beyond the scope of this article to describe them in detail, there are special rules that apply to the attribution of stock from grantor trusts and employee trusts. I will discuss these rules in more detail in future articles.

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The complexity and importance of US international tax law (in which §318 constructive ownership rules play an important role) makes it extremely risky for US taxpayers to operate without assistance from an experienced international tax lawyer.

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US Information Returns: Introduction | International Tax Lawyer Minnesota

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In this article, I would like to introduce the readers to the concept of US information returns; I will also explore the differences between US information returns and US tax returns.

US Information Returns: Two Types of Returns

The US tax system is a self-assessment system where taxpayers must file certain forms or returns developed by the IRS in order to report information required by the Internal Revenue Code and the Treasury Regulations. The Internal Revenue Code specifies the due date for these returns.

There are two primary types of returns: tax returns and information returns. A tax return is a form that a taxpayer uses to compute the tax that he owes to the IRS. A tax return requires the taxpayer to set forth the relevant information and amounts for this computation.

On the other hand, the IRS requires US taxpayers to file information returns in order to obtain information on transactions and payments to taxpayers that may affect the information reflected on tax returns. In other words, the IRS uses information returns not to compute the tax liability, but to obtain information (or verification of information) to make sure that the tax returns were properly filed.

US Information Returns: Hybrid Returns

This ideal distinction between the two types of returns is often not preserved. Instead, there are many hybrid returns which possess the features of both, tax returns and information returns. For example, Part III of Form 1040 Schedule B is an information return which forms part of the overall tax return (i.e. Form 1040). Similarly, Form 8621 is a US international information return that is a hybrid return for the reporting of ownership of PFICs and calculation of PFIC tax at the same time.

US Information Returns: Domestic vs. International

The information returns are subdivided into two categories: domestic and international. The domestic information returns are usually filed by third parties with respect to US-source income or income under the supervision of a domestic financial institution. For example, US brokers provide Forms 1099-INT to report US-source interest income and foreign interest income that the taxpayer earned by investing through a domestic financial institution.

It should be mentioned that, due to the implementation of FATCA (Foreign Account Tax Compliance Act), some foreign subsidiaries of US banks also began to issue Forms 1099 to US taxpayers with respect to foreign income from their foreign accounts. The most prominent example is Citibank. However, this is a tiny minority of foreign financial institutions at this point.

On the other hand, international information returns primarily report information concerning foreign assets, foreign income and foreign transactions; there are even information returns concerning foreign owners of US businesses. Usually, these returns are filed not by third parties, but by taxpayers directly – individuals, businesses, trusts and estates. For example, Form 5471 is an international tax return which US taxpayers must file to report their ownership of a foreign corporation, its financial statements and its certain transactions.

US Information Returns: High Civil Penalties

One of the most distinguishing characteristics of information returns are high noncompliance civil penalties. This is very different from tax returns.

The tax return civil penalties are calculate based on a taxpayer’s unpaid income tax liability. The worst case scenario is a civil fraud penalty of 75% of unpaid tax liability. This is followed by negligence, failure-to-file and accuracy penalties.

The noncompliance penalties for information returns, however, do not depend on whether there was ever any tax liability connected with the failure to file an accurate information return; in fact, many information return penalties are imposed in a situation where there is no income tax noncompliance at all. This is logical, because pure information returns would never have any income tax noncompliance directly related to them.

Hence, in order to enforce compliance with information returns, the IRS imposes objective noncompliance penalties per each unfiled or incorrect information return. This divorce between income tax noncompliance and information return penalties, however, may produce extremely unjust results. For example, failure to file a Form 5471 for a foreign corporation which never produced any revenue may result in the imposition of a $10,000 penalty.

It should be emphasized that the domestic information return penalties are much smaller in size than those imposed for noncompliance with international information returns. Again the logic is clear: since the temptation to avoid compliance with US international tax laws is much greater overseas, Congress wanted to raise the stakes for such noncompliant taxpayers in order to make the risk of noncompliance intolerable for most taxpayers.

US Information Returns: Special Case of FBAR

The IRS may impose the most severe penalties out of all information returns for a failure to file a correct FinCEN Form 114, commonly known as “FBAR”. The paradox of these penalties is that FBAR is not a tax form, but a Bank Secrecy Act information return. FBAR was created to fight financial crimes, not for tax enforcement. Its penalties were originally meant to deter and punish criminals, not induce self-compliance with US tax laws – this is precisely why FBAR penalties may easily exceed the penalties imposed with respect to any other US international information return.

So, why is the IRS able to use FBAR as a tax information return and impose FBAR penalties? The reason is that the US Congress turned over FBAR enforcement to the IRS after September 11, 2001. Since then, even though FBAR is not part of the Internal Revenue Code, the IRS has used this form as an information return for tax purposes.

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FinCEN Form 114 Estate Filers | FBAR Tax Lawyer & Attorney

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Many taxpayers and even tax professionals are completely unaware of the fact that FBAR needs to be filed not just by individuals, businesses and trusts, but also by estates. In this article, I will discuss FinCEN Form 114 Estate filers (i.e. estates that need to file FinCEN Form 114).

FinCEN Form 114 Estate filers: FBAR Background Information

FinCEN Form 114, commonly known as FBAR, was created in the 1970s as a result of the Bank Secrecy Act of 1970. The original purpose of the form was to fight financial crimes and terrorism; FinCEN was in charge of FBAR rulemaking and FBAR enforcement. After September 11, 2001, the US Congress turned over the function of FBAR enforcement to the IRS.

While the initial justification for the IRS involvement was fighting terrorism, it soon became clear that the IRS would use its new FBAR powers for international tax enforcement. This is exactly what happened; FinCEN Form 114 turned into the most formidable and scary weapon of the IRS to force US taxpayers to turn over their foreign bank account information.

FinCEN Form 114 Estate filers: FBAR Filing Requirements

If a US person has a financial interest in or signatory authority over foreign financial accounts and the aggregate value of these foreign financial accounts exceeds $10,000 at any time during the calendar year, then he has to file FBAR for that year. FBAR requires its filers determine the highest value of each of his accounts in “native” currency (i.e. the currency in which the account is denominated) first and then report this highest balance in US dollars. The Department of the Treasury publishes every year special FBAR currency conversion rates.

Prior to 2016 FBAR, the FBAR deadline was June 30 of each year. Starting 2016 FBAR, the FBAR deadline is aligned with the tax return deadline; as of the tax year 2019, the FBAR deadline is automatically extended to October 15. This may change in the future years.

FinCEN Form 114 Estate filers: Estates Must File FBARs

It is not just individuals, businesses and trusts who are required to file FinCEN Form 114. Estates must also file FBARs for any foreign accounts in the estate. It should be remembered that indirect ownership of foreign accounts (for example, through corporate shares in the estate) may also result in the requirement to file FBARs. Failure to file FinCEN Form 114 timely may result in the imposition of FBAR penalties on the estate.

FinCEN Form 114 Estate filers: Executor Liability for Decedent’s FBAR Noncompliance

If you are an executor of an estate and you discovered that the decedent should have filed FinCEN Forms 114 for prior years but never did so, then you need to explore your offshore voluntary disclosure options as soon as possible. There is a powerful incentive for the executors to resolve the decedent’s FBAR noncompliance – failure do so may result in the imposition of FBAR penalties on the executor of the estate.

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§318 Downstream Trust Attribution | Foreign Trust Tax Lawyer & Attorney

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The attribution of stock ownership to constructive owners is a highly important feature of US domestic and international tax law. The Internal Revenue Code (“IRC”) §318 contains complex constructive ownership rules concerning corporate stock; these rules vary depending on a specific §318 relationship. This article focuses on an important category of §318 relationships – trusts. Since these rules are very broad, I will discuss today only the §318 downstream trust attribution rules; the upstream rules and important exceptions to both sets of rules will be covered in later articles.

§318 Trust Attribution: Downstream vs. Upstream Attribution

Similarly to other §318 attribution rules, there are two types of §318 trust attribution: downstream and upstream. The downstream attribution rules attribute the ownership of corporate stocks owned by a trust to its beneficiaries. The upstream attribution rules are exactly the opposite: they attribute the ownership of corporate stocks owned by beneficiaries to the trust. As I stated above, this article focuses on the downstream attribution.

§318 Downstream Trust Attribution: Attribution from Trust to Beneficiary

Under §318(a)(2)(B)(i), corporate stocks owned, directly or indirectly, by or for a trust are considered owned by the trust’s beneficiaries in proportion to their actuarial interests in the trust.

Notice that the size of the actuarial interest does not matter. Moreover, §318(a)(2)(B) will apply even if the beneficiary does not have any present interest in a trust, but only a remainder interest (also calculated on an actuarial basis). This rule is the exact opposite of the §318 estate attribution rules.

Furthermore, the decision to attribute shares based on the actuarial interest, rather than actual one, may result in a paradoxical result where stocks are attributed to a person who will never become the actual owner of the shares.

§318 Downstream Trust Attribution: Determination of Actuarial Interest

Treas. Reg. §1.318-3 stated that, in determining a beneficiary’s actuarial interest in a trust, the IRS will use the factors and methods prescribed (for estate tax purposes) in 26 CFR § 20.2031-7.

The attribution of shares from the trust to its beneficiary should be made on the basis of the beneficiary’s actuarial interest at the time of the transaction affected by the stock ownership.

§318 Downstream Trust Attribution: Unstable Proportionality

The adoption of the attribution of stock based on the actuarial interest in a trust creates a constant calculation problem for beneficiaries, because the actuarial interest of the beneficiary in a trust varies from year to year. The variation of actuarial interest means that the number of shares attributed from a trust to its beneficiary will change every year.

For example, the actuarial interest of a beneficiary with a life estate in a trust will decrease every year as he ages. On the other hand, the actuarial interest of the owner of the remainder interest in the trust will increase with each year. Hence, the number of stocks attributed to the life tenant will decrease each year, while the attribution of stocks to the holder of the remainder interest will increase each year.

§318 Downstream Trust Attribution: Special Presumption Concerning Power of Appointment

Based on 95 Rev. Proc. 77-37, §3.05 (operating rules for private letter rulings), the IRS has adopted a special presumption with respect to when children will be considered beneficiaries for the purpose of §318 trust attribution rules. In order to understand this rule, we need to describe the setting in which it will most likely apply.

Oftentimes, estate plans are set up where the surviving spouse will have a life interest in a trust’s income and a power of appointment over the trust corpus. In such situation, estate planners often insert a clause that, if a spouse fails to exercise the power of appointment, the trust corpus will automatically go to the children.

In this situation, the IRS stated that, absent evidence that the power of appointment was exercised differently, it is presumed that it was exercised in favor of the children. By adopting this presumption, the children are immediately considered beneficiaries for the purpose of the stock attribution rules under §318.

§318 Downstream Trust Attribution: Planning to Avoid Attribution

In order to prevent the application of the trust attribution rules under §318, a beneficiary must renounce his entire interest in the trust. See Rev. Rul. 71-211. Such renunciation is valid only if it is irrevocable and binding under local law.

§318 Downstream Trust Attribution: Special Case of Voting Trusts

Under Rev. Rul. 71-262 and CCA 200409001, §318(a)(2)(B) does not apply in the context of a voting trust (i.e. where trustee has the right to vote the stock held in trust, but the dividends are paid to the certificate holder). This is because the certificate holder is deemed to be the owner of the shares and there is no attribution of ownership from the trust.

§318 Downstream Trust Attribution: Grantor Trusts and Employee Trusts

While it is beyond the scope of this article to describe them in detail, there are special rules that apply to the attribution of stock from grantor trusts and employee trusts. I will discuss these rules in more detail in the future.

Contact Sherayzen Law Office for Professional Help With US Tax Issues Concerning Foreign Trusts

If you are considered an owner or a beneficiary of a foreign trust, contact Sherayzen Law Office for professional help with your US tax compliance issues. Our firm is highly experienced in US international tax law, including foreign trust compliance. We have also helped taxpayers around the world with their offshore voluntary disclosures involving foreign trusts.

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