This article begins to explore one of the most obscure, yet highly important questions in U.S. international tax law – foreign trust classification and what law is relevant in the determination of such a classification. This area of law is very complex and I cannot hope for more than providing just some general contours of it in this essay.
Foreign Trust Classification: Relevant Law
In order for an entity to be classified as a foreign trust, one must establish that the entity is a “trust” and the entity is “foreign”. In this article, I will only discuss the definition of a trust and leave the subject of determining whether a trust is foreign for future discussion.
Both parts of this definition are determined by federal income tax law. The substantive trust law under which the trust was created, while often determinative of rights and duties of relevant parties (i.e. grantor, trustee and the trust’s beneficiaries), does not establish whether an entity should be treated as a trust. Nevertheless, the substantive trust law is still very important in order to establish the facts and context for federal income tax analysis.
The most important federal income tax law concerning foreign trusts can be found in Section 7701 of the Internal Revenue Code (IRC) and relevant regulations. The IRS decisions and rulings (such as Private Letter Rulings) are also highly important in entity classification.
Foreign Trust Classification: General Definition of a Trust under Federal Law
Generally, at the simplest level, a trust is an arrangement where the title to property is held by a fiduciary – a person with the responsibility to conserve the property for a benefit of another person or person (called beneficiaries). As beneficiaries, these persons should not participate in any fiduciary responsibilities.
IRS Regulations in §301.7701-4(a) provide more details about what entity would be considered as a trust:
In general, the term “trust” as used in the Internal Revenue Code refers to an arrangement created either by a will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts. Usually the beneficiaries of such a trust do no more than accept the benefits thereof and are not the voluntary planners or creators of the trust arrangement. However, the beneficiaries of such a trust may be the persons who create it and it will be recognized as a trust under the Internal Revenue Code if it was created for the purpose of protecting or conserving the trust property for beneficiaries who stand in the same relation to the trust as they would if the trust had been created by others for them. Generally speaking, an arrangement will be treated as a trust under the Internal Revenue Code if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.
Foreign Trust Classification: Most Important Aspects of this Definition of a Trust
Two aspects of this long definition of a trust are especially relevant for foreign trust classification. First, the title to property has to be held by a fiduciary, not the beneficiary. This means that all arrangements outside of the United States will not fall under the foreign trust classification if the title is preserved by the beneficiary.
Second, for the purposes of foreign trust classification, the most important practical focus of the IRS has been on the separation of management of a foreign trust from the enjoyment of the benefits that the trust provides. Undoubtedly, such inquiry heavily depends on the particular facts of the case and would require a separate exploration beyond the scope of this article. It is worth mentioning, however, that, in situations where the beneficiary preserves the right to dispose of an asset supposedly held by a foreign trust, the IRS may rule that the arrangement does not fall within the boundaries of the foreign trust classification.
Foreign Trust Classification: Exceptions
In another article, I will explore certain exceptions to foreign trust classification. Here, I will simply state that not all trusts are treated as trusts even if the title belongs to the fiduciary. On the other hand, some arrangements will be treated as foreign trusts even in situations where one would not expect such classification (certain foreign pension arrangements, for example).
Contact Sherayzen Law Office for Help With Foreign Trusts
U.S. tax laws concerning foreign trust are highly complex and require substantial tax compliance. If you own a foreign trust or you are a beneficiary of a foreign trust, you need to contact Sherayzen Law Office as soon as possible for professional legal help. We have helped U.S. taxpayers around the world and we can help you!