§318 Employee Trust Attribution | Foreign Trust US Tax Law Firm

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In a previous article, I explained special §318 rules concerning grantor trusts as an exception to the general §318 trust attribution rules. Today, I will discuss the special §318 employee trust attribution rules as another exception to the general §318 trust attribution rules.

§318 Employee Trust Attribution: Focus on Tax-Exempt Employee Trusts

First of all, it is important to define the type of employee trust which is the subject of today’s article. The focus is on employee trusts described in §401(a) and which are tax-exempt under §501(a), collectively “tax-exempt employee trusts”. In other words, we are discussing mostly trusts which were created under qualified pension, profit-sharing and stock bonus plans.

§318 Employee Trust Attribution: Main Rule – No Attribution to Tax-Exempt Employee Trusts

Under §§318(a)(2)(B)(i) and 318(a)(3)(B)(i), there is no downstream and upstream (respectively) attribution of stock between a tax-exempt employee trust and its beneficiaries. In other words, there is no §318 attribution of corporate stocks from a tax-exempt employee trust to its beneficiaries and there is no §318 attribution of corporate stocks from the beneficiaries to the trust.

Under §501(b), the non-attribution rule applies even in situations where a tax-exempt employee trust is subject to tax on its unrelated business income.

§318 Employee Trust Attribution: Certain Exceptions to Non-Attribution

The non-attribution rule with respect to tax-exempt employee trusts is reasonable and just. There are, however, certain exceptions to this rule.

A major exception concerns ESOP trusts. Under Petersen v. Commissioner, 924 F.3d 1111 (10th Cir. 2019), the non-attribution of stock ownership from tax-exempt trust to employee beneficiaries does not apply to certain ESOP trusts.

Moreover, certain tax-avoidance transactions will render the non-attribution rule inapplicable. For example, under §409(p)(3)(B), an individual is deemed to own stocks held by an ESOP trust for the purposes of determining whether there has been a prohibited allocation of S-corporation stock to a disqualified person.

§318 Employee Trust Attribution: Special Case of “Loss Corporations”

A “loss corporation” presents an interesting set of issues with respect to §318 employee trust attribution rules.

Let’s first define the loss corporation. The IRC §382(k)(1) provides the following definition of a loss corporation: “a corporation that is entitled to use a net operating loss carryover or having a net operating loss for the taxable year in which the ownership change occurs. Such term shall include any corporation entitled to use a carryforward of disallowed interest described in section 381(c)(20). Except to the extent provided in regulations, such term includes any corporation with a net unrealized built-in loss.”

The IRC §382(g) defines “ownership change” as a two-step process. First, there must be an “owner shift”, which means with respect to a 5% shareholder, that there is a change in the respective ownership of stock of a corporation, and such change “affects the percentage of stock of such corporation owned by any person who is a 5-percent shareholder before or after such change.” Second, the ownership change occurs if, immediately after any owner shift, “the percentage of the stock of the loss corporation owned by 1 or more 5-percent shareholders has increased by more than 50 percentage points” over “the lowest percentage of stock of the loss corporation (or any predecessor corporation) owned by such shareholders at any time during the testing period.” Id. The testing period is three years. §382(i).

Now that we know what a loss corporation is, we can analyze its interaction with the §318 employee trust attribution rules. Generally, under §318(a)(2)(B)(i), the participants in a qualified plan under which a tax-exempt employee trust is established are not treated as owners of any shares of a “loss corporation” owned by the trust.

This general rule, however, contains an important exception where the IRS will treat beneficiaries of the tax-exempt employee trust as owners of the loss corporation for certain §382 purposes. See 114 Reg. §1.382-10, T.D. 9269, 71 Fed. Reg. 36,676 (June 28, 2006), applicable to all distributions after June 23, 2006 (for distributions on or before June 23, 2006, see former Reg. §1.382-10T).

Why do we have this exception? The problem is that, by blocking the operation of general §318 trust attribution rules, a distribution of stocks in a loss corporation by the tax-exempt employee trust to the plan beneficiaries may cause an “ownership change” since the beneficiaries are not treated as owners of any interest in a loss corporation. Once the ownership change occurs, §382 may limit the amount of taxable income that can be offset by certain loss carryovers and recognized built-in losses of the loss corporation. Hence, the IRS enacted this exception to §318(a)(2)(B)(i) for certain §382 purposes. This is one of many examples of “an exception to an exception” that saturate the Internal Revenue Code.

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US tax law is incredibly complex (as the discussion of the loss corporation and its interaction with §318 employee trust attribution rules demonstrates); the complexity increases even more at the international level. US taxpayers who deal with US international tax law without the assistance of an experienced international tax lawyer run an enormous risk of violating US tax laws and incurring high IRS penalties.

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

Sherayzen Law Office is a highly experienced international tax law firm which specializes in US international tax compliance and offshore voluntary disclosures. We have helped hundreds of US taxpayers to successfully resolve their US international tax compliance issues, and We Can Help You!

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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.

Contact Sherayzen Law Office for Professional Help With US International Tax Law

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.

Sherayzen Law Office is a highly experienced international tax law firm which specializes in US international tax compliance and offshore voluntary disclosures. We have helped hundreds of US taxpayers to successfully resolve their US international tax compliance issues, and We Can Help You!

Contact Us Today to Schedule Your Confidential Consultation!

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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If you are an executor or a personal representative of an estate and there is a reason to believe that the decedent failed to file FBARs in the past, then contact Sherayzen Law Office for professional help as soon as possible.

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