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Taxation of Investment Trusts

This article on investment trusts continues a series of articles on classification of foreign trusts. In earlier essays, I explored the definition of foreign trusts and some of the exceptions to this definition. In the present writing, I would like to discuss the general circumstances when investment trusts would be treated as corporations or partnerships rather than ordinary foreign trusts (this discussion focuses on foreign trusts, but it is also equally applicable to domestic trusts).

Investment Trusts: Definition and Taxation

Where several individuals, in a voluntary association, create a trust as a means of pooling their capital into investments in which interests are sold, such a trust is considered to be an “investment trust”. The principal law concerning investment trusts can be found in IRS Regs. §301.7701-4(c).

The taxation of investment trusts is a complex and mostly depends on two factors: the number of classes of ownership interests in the trust and the power vested in the trustee under the trust agreement to vary the investment (and reinvestment) of the certificate holders. In certain circumstances, investment trusts are taxed as ordinary trusts while, in other circumstances, they can be taxed as business entities.

One-Class Investment Trusts: Definition and Taxation

One-Class Investment trusts are investment trusts “with a single class of ownership interests, representing undivided beneficial interests in the assets of the trust”. IRS Regs. §301.7701-4(c)(1).

Generally, one-class investment trusts are taxed as ordinary trusts as long as “there is no power under the trust agreement to vary the investment of the certificate holders.” Id. The concept of “power to vary the investment” is highly complicated and requires detailed exploration of relevant case law and PLRs. The focus of the IRS examination will be on the Trust Agreement and related documents.

Multiple-Class Investment Trusts: Definition and Taxation

Multiple-class investment trusts are investment trusts with multiple classes of ownership interest. Generally, it is much harder for a multiple-class investment trust to be taxed as a trust, rather than a business entity.

IRS Regs. §301.7701-4(c)(1) sets forth the legal test which states that multiple-class investment trusts will generally be taxed as business entities unless two conditions are satisfied: (1) “there is no power under the trust agreement to vary the investment of the certificate holders”, and (2) “the trust is formed to facilitate direct investment in the assets of the trust and the existence of multiple classes of ownership interests is incidental to that purpose”. Id.

This is a tough, but not an impossible test to meet.  In fact, one can point to multiple PLRs where the IRS agreed with the taxpayers that this test was met. Nevertheless, a high degree of precision, planning and professionalism is needed to assure that the test is met.

Contact Sherayzen Law Office for Professional Help With Foreign Trusts

If you are a beneficiary or grantor of a foreign trust, you need to secure the help of an experienced international tax lawyer as soon as possible. This is why you need to contact Sherayzen Law Office for professional help concerning foreign trusts as soon as possible. Our founder, attorney Eugene Sherayzen, has developed deep expertise in international tax law in order to help hundreds of U.S. taxpayers around the world. He can help You!

Contact Us Today to Schedule Your Confidential Consultation!

Foreign Trust Tax Treatment in the United States: Historical Overview

Over the years, the US tax treatment of foreign trusts has undergone dramatic changes. It is important to study and understand this history in order to properly understand and interpret current US tax laws concerning foreign trust. In this essay, I will provide a broad overview of the history of foreign trust tax treatment in the United States since before 1962 until the present time.

Foreign Trust Tax Treatment Prior to 1962

Before 1962, the US tax laws treated in the same manner all foreign trusts, whether they had a US beneficiary or foreign one. A complex foreign trust established by a US grantor for the benefit of a US beneficiary was taxed similarly to the one established by a foreign granter for a US beneficiary. Moreover, since foreign-source income of a foreign trust was not included in the trust’s gross income for US income tax purposes, this trust would not have any DNI (distributable net income)!

Such treatment of foreign trusts led to a lot of abuse whereby large portions of income were never taxed in the United States. For example, prior to 1962, a foreign trust’s income would not be subject to US taxes in a situation where the trust was located in a country with low or no income taxes and the corpus consisted solely of foreign assets.

While in some situations US beneficiaries might have been taxed when the trust income was actually distributed (under the regular five-year throwback rule), careful tax planning could have prevented even such taxation of the beneficiaries in light of the fact that foreign-source income was excluded from DNI. Moreover, distributions of accumulated foreign trust income contained no undistributed net income (UNI) and were not subject to taxation under even the limited five-year throwback rule.

The Watershed Legislation in Foreign Trust Tax Treatment: the Revenue Act of 1962

The foreign trust tax treatment changed dramatically with the Revenue Act of 1962. The new legislation introduced two major changes to foreign trust tax treatment in the United States. First, it changed the calculation of DNI by requiring foreign trusts to add foreign-source income to it (unless such treatment was exempt by a treaty). Moreover, foreign trusts with US grantors now had to include capital gains in DNI.

Second, the Revenue Act of 1962 created the throwback rule on accumulation distributions from a foreign trust if the trust was created by a US person. Furthermore, important exceptions to throwback rule, such as exclusions for emergency distributions of accumulated income, were made unavailable to foreign trusts by the Act. Finally, the throwback rule became unlimited for foreign trusts while there was a five-year limitation on its application to domestic trusts.

Despite these profound changes in the foreign trust tax treatment, the Revenue Act of 1962 still failed to eliminate some important advantages of using foreign trusts to lower US tax liability. For example, the unlimited throwback rule did not seriously impact the foreign trust advantages in its ability for potentially unlimited tax deferral and tax-free income accumulation. Of course, this meant that the possibility of the rate of earnings of a foreign trust was likely to be much greater than that of US domestic trusts.

Furthermore, nothing was done to limit the ability of the US grantor and beneficiaries (and their families) to access undistributed funds of a foreign trust. For example, they could still receive these funds through loans, private annuities, like-kind exchanges and other similar “indirect” methods.

Finally, with respect to foreign trusts with US grantors, the foreign trusts were required to allocate capital gains to DNI. This meant that every distribution by a foreign trust contained a mixture of ordinary income and capital gains. US domestic trusts could not do that, because capital gains of a domestic trust could not be distributed until current and accumulated ordinary income was distributed.

Thus, perversely, the new foreign trust tax treatment afforded foreign trusts an important advantage in the form of its ability to distribute part of its capital gains to the beneficiaries more quickly than a domestic trust. This advantage became especially evident once the unlimited throwback rule was extended to domestic trusts in 1969.

Tightening of Screws in the Foreign Trust Tax Treatment: the Tax Reform Act of 1976

By 1976, these obvious advantages in the foreign trust tax treatment became unacceptable for the US Congress. Therefore, it acted in a major piece of US tax legislation known as the Tax Reform Act of 1976. While the Act was very broad, there were five key changes to the foreign trust tax treatment in the United States.

First, the new legislation re-classified foreign trusts that were created by US persons and had or could potentially have at least one US beneficiary as a grantor trust under IRC Section 679.

Second, the Act of 1976 required an automatic inclusion of capital gains of a foreign trust in the foreign trust’s DNI.

Third, it eliminated the loophole with respect to foreign trust distributions of income that accumulated prior to a beneficiary’s twenty-first birthday. Now, such distributions were taxed.

Fourth, with the obvious desire to attack the tax advantage in foreign trust tax treatment with respect to accumulated income, the Congress imposed a 6% simple interest charge on the tax imposed on a beneficiary of a foreign trust with respect to accumulations after December 31, 1976.

Finally, the last major change attacked the ability of US grantors to avoid US capital gain taxes by transferring appreciated assets into foreign trusts. The Act of 1976 imposed a 35% excise tax on the transfer of all appreciated assets to a foreign trust by a US grantor, unless the grantor elected to recognize the gain at the time of the transfer.

Changing the Foreign Trust Tax Treatment under IRC Section 672(f)

Another change in the foreign trust tax treatment came under the Revenue Reconciliation Act of 1990 with respect foreign grantor trusts that had a foreign grantor and a US beneficiary who had made gifts to the foreign grantor. This new law was summarized in IRC Section 672(f). Section 672(f) states that, in a situation where a foreign trust has a US beneficiary and should have been a grantor trust under the ordinary grantor trust rules found in IRC Sections 671 through 678 but for the fact that the grantor was a foreign person, this trust should be treated as owned by the trust’s US beneficiary to the extent that this beneficiary has made prior gifts to the foreign grantor.

There is still a small exception that a “gift shall not be taken into account to the extent such gift would be excluded from taxable gifts under section 2503(b).” 26 U.S.C. Section 672(f)(5)

1996 and 1997 Changes in the Foreign Trust Tax Treatment

The last major change in foreign trust tax treatment that I wish to mention here was introduced in the Small Business Job Protection Act of 1996 (as slightly modified by the Taxpayer Relief Act of 1997). The Act of 1996 introduced major revisions in the rules of foreign trust tax treatment, arguably on the scale of the Tax Reform Act of 1976.

Five major areas of foreign trust tax treatment were in focus. First, the definition of a foreign trust was clarified with a strong bias toward treating a trust as a foreign trust. Two new tests, the court test and the control test, were introduced (and clarified further in the Treasury regulations). These changes were codified in IRC Section 7701.

Second, the reporting requirements for foreign trusts (Forms 3520 and 3520-A) were introduced. This was a major change in the reporting burden for US taxpayers and foreign trusts with US beneficiaries.

Third, the penalties for failure to report transfers to a foreign trust were introduced.

Fourth, new rules were put in place to reduce the utility of foreign trusts by individuals who were planning to become US residents.

Finally, new restrictions were placed to reduce the utility of using foreign trusts by individuals who were planning to surrender their US residency or citizenship.

Contact Sherayzen Law Office for Tax Help With Foreign Trusts

Over the years, one can see profound changes in the foreign trust tax treatment; in this brief article, I only focused on some of the major changes in the foreign trust tax treatment, but there were other developments that took place (for example, FATCA compliance for foreign trusts).

These changes in foreign trust tax treatment generally indicate the trend toward stricter regulation of foreign trusts, increasing reporting burden on US taxpayers and foreign trusts, and the reduction in any type of an income tax advantage of foreign trusts. In fact, the foreign trust law has become so complex that one should not try to resolve these matters without the help of an experienced tax professional.

Despite these burdens, there is still a large number of foreign trusts with US grantors and US beneficiaries. The latter situation (i.e. US beneficiaries) often occurs when a foreign beneficiary becomes a US beneficiary through immigration. Oftentimes, these new US beneficiaries are not even aware of the existence of foreign trusts until significant US tax non-compliance occurs.

This is why it is so important to contact Sherayzen Law Office for professional help with respect to your foreign trusts as soon as possible. We have helped US beneficiaries, US grantors and foreign trusts around the world to do proper tax planning and comply with US reporting requirements (including Forms 3520, 3520-A and the voluntary disclosures associated with these forms). We can help You!

Contact Us Today to Schedule Your Confidential Consultation!