|
|
| A
complete listing of the proceedings and speakers is
available on the
Institute's Web site |
Each
report can also be accessed at any time from the ABA-PTL
Discussion List's Web-based
Archive |
| The
ABA-PTL List is an outstanding resource for Probate
and Trust Lawyers. Join
Today |
2004
Index (back)
Report 12
Thursday, January 8, 2004 (Continued)
Reporter: John Warnick Esq.
10:45 - 11:30 a.m.
Trust Classification Times Four
Robert C. Lawrence, III
Mr. Lawrence started out explaining that his talk will really
be an overview, because of the time limitations, and that
the real substance will be discussed during the workshop.
Reporter's Notes: The afternoon workshop really applied,
in much greater detail, the rules which Mr. Lawrence touched
on duriing his general session. Therefore, we are posting
the afternoon session as part of these general session remarks.
Mr. Lawrence then asked why the foreign trust rules should
be important to you if your practice is primarily a domestic
practice. You may think it has no relevance to your practice.
That is a mistake. The globalization trends are so strong
that Mr. Lawrence believes in the coming years you will be
faced with clients that have multinational holdings or multinational
families.
Mr. Lawrence went back to the Roman empire to trace the development
of "trusts" or entities similar to trusts. . He
noted that these concepts have developed independently in
Teutonic culture, Gallic culture and Anglo-Saxon culture.
At the time of the French revolution they abolished their
trust equivalent and when the Napoleonic code spread throughout
Europe it contained no statutory form of trust. Instead the
"usufruct" developed under French law. But starting
in Liechtenstein after the First World War the trust concept
has been recognized as the "treuhand".
So it is likely that when you first deal with the client
that has an interest in one of these foreign trusts you will
be dealing with a treuhand or some other hybrid arrangement.
You will then have to put that foreign entity under the microscope
of U.S. law and determine how it will be classified for U.S.
tax law and apply our principles of law to tax them.
What is the U.S. tax definition of what is a "trust"?
Under the Regulations the term "trust" refers to
"an arrangement created under will or 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."
The emphasis here is on the function of the trustee in protecting
or conserving the property for the benefit of the beneficiaries.
What happens if your foreign entity doesn't meet the definition
of a trust. You need to go back to the check the box regulations.
If
you don't check the box, when that entity is analyzed 10 or
15 years later and the foreign entity is not regarded as a
trust, then the default provisions for entity classification
become applicable and it would be treated as a partnership
if it had more than one member and at least one member does
not have limited liability, or as an association taxable as
a corporation if all members have limited liability, or disregarded
as an entity separate from its owner, if it has a single owner
that does not have limited liability.
The existence of associates and the objective to carry on
a business are the two attributes which case law has identified
as being present in associations and partnerships. The absence
of either attribute will cause an entity to be classified
as a trust for U.S. tax purposes.
Mr. Lawrence noted that it is unusual to see a trust drafted
in the U.K. that won't have powers clauses that permit the
carrying on of business and that it is there mere existence
of the power rather than whether it is actually being used
to conduct a business that matters.
Once we determine that we are dealing with a trust we have
to move to the second classification: whether the trust is
a foreign trust or a U.S. trust. That classification will
depend on whether we are dealing with pre-1996 or post-1996
law. The pre-1996 law had a totally useless definition and
the courts ended up using a facts and circumstances test.
The post-1996 law requires that a trust meet two requirements
to qualify as a U.S. trust: (1) a court within the U.S. must
be able to exercise primary supervision over the trust's administration
(the "Court Test"); and (2) one or more U.S. persons
must have the authority to control all substantial decisions
of the trust (the "Control Test"). If a trust fails
to meet either of these requirements, it is a foreign trust
for U.S. tax purposes.
Mr. Lawrence pointed out that having an arbitration clause
in your trust will result in the trust being classified as
a foreign trust because the Court Test would not be satisfied
if a U.S. court wouldn't be able to exercise primary jurisdiction.
The regulations provide a safe harbor for satisfying the
Court Test. A trust will satisfy the Court Test if (i) the
trust instrument does not direct the trust be administered
outside the U.S.; (ii) the trust is in fact administered exclusively
in the U.S. and (iii) the trust is not subject to a flee provision.
Bob Lawrence also pointed out that the flee cause doesn't
flunk the Court test if it is limited to a foreign invasion
of the U.S. or widespread confiscation or nationalization
of property in the U.S.
Mr. Lawrence pointed out that the regulations provide a list
of substantial decisions for purposes of the Control Test.
But that list doesn't include approvals of accountings, decisions
to migrate, to borrow or lend, or to guarantee a loan to a
beneficiary. And you have to be very careful that you don't
lodge any substantial decision in anyone that isn't a U.S.
person.
Mr. Lawrence feels this Control Test is a great thing from
the U.S. point of view. The only problem is that the U.S.
wanted an objective test and the Control Test can be very
subjective. From a U.S. Trust company perspective this is
a great marketing opportunity to foreign individuals because
they can offer the stability and advantages of administration
in the U.S. and so long as there is just one substantial decision
lodged in a non U.S. person, the trust will be treated as
a foreign trust for U.S. tax purposes.
Once the grantor dies, you may not want the trust to continue
as a foreign trust. So if you have a U.S. trustee, you can
easily migrate that trust into the U.S. upon the grantor's
death if that is desirable. Bob Lawrence pointed out that
there is a distinct advantage to having a U.S. trustee in
these circumstances in terms of being able to migrate the
trust into the U.S. His experience in transitioning a trust
from a foreign trustee to a U.S. trustee indicates you need
plenty of lead time to get this accomplished. He has seen
it take up to two year time to migrate that trust into the
U.S. upon the grantor's death. Since there are many potential
tax consequences during this period, it may prove very advantageous
to already have a U.S. trustee in place.
But Mr. Lawrence pointed out that out that what you need
to take away from this is to be very careful of what powers
you have in your trust instruments and to whom you give those
powers, whether in a fiduciary capacity or in a non-fiduciary
capacity. You have got to be very careful in drafting your
domestic trusts and monitor the status of powerholders because
they may leave the U.S. and it may change. You have a 12 month
change in which you can cure an inadvertent change but if
you don't cure that change then there may well be a change
in the trust classification and the trust may become subject
to the § 684 tax on transfers or there may be a different
tax result.
The third area of classification is whether the trust is
grantor or nongrantor. The grantor powers are found at §
673 to § 677. Prior to 1996, Rev. Rul. 69-70 provided
that if you had a foreign grantor trust and there was no U.S.
income in the trust, then the income of the trust would be
taxable to the foreign grantor and there would be no tax on
distributions to U.S. beneficiaries. The IRS didn't like this.
The 1996 legislation changed all of this. We were successful
in carving out a few exceptions. One of these is for a foreign
trust that is revocable. The revocation has to be in the control
of the foreign grantor and not in the control of the beneficiaries.
The second exception is for a trust where the only distributions
during the grantor's lifetime are to the grantor or the grantor's
spouse. This exception permits an irrevocable trust and can
provide assurances to the ultimate beneficiaries that the
trust won't be subject to further change.
There is an important grandfather exception for trusts which
were in existence in September 1995 but the trusts had to
be classified as a grantor trust under § 676 and §
677(a)(1) and (2). There isn't symmetry between the grandfather
provisions and what the current law is. To preserve grandfather
status you have to be very careful about future contributions
that are made to a grandfathered foreign grantor trust and
make sure that is accounted for separately and in Mr. Lawrence's
opinion segregated from the balance of the trust assets.
You also need to be aware of § 679 and 684. These will
be covered in greater detail in the workshop.
Next he discussed the taxation of U.S. Beneficiaries of foreign
non-grantor trusts. The beneficiary will be taxed on these
distributions and there will need to be a return filed on
Form 3520. One difference between the foreign non-grantor
trust and domestic trust is that there is the possibility
that the U.S. beneficiary will be taxed on realized capital
gain in the foreign trust. DNI for the foreign grantor trust
is enhanced by realized capital gains. If not all the income
is distributed out in the year it is earned then we have UNI
(undistributed net income). But it is important to note that
the capital gain if it doesn't get completely distributed
in the year of realization will be treated as UNI and there
is a conversion of its character from capital gain to ordinary
income so that in the year when it is distributed eventually
to the U.S. beneficiary it will no longer be treated as capital
gain but will be taxed as ordinary income to the U.S. beneficiary.
Mr. Lawrence also noted that in addition to the income tax
imposed on UNI distributions made to a U.S. beneficiary, there
is also a nondeductible interest charge imposed. A weighted
average method is used to determine the period for which interest
is charged with a different rate charged for accumulations
through 1995 and a floating rate determined under § 6621
applied to accumulations after 1995.
Mr. Lawrence also noted that it is important to plan and
draft for the possibility that the foreign trust could receive
a step-up in basis upon its assets upon the death of its grantor.
This will significantly reduce what the tax might be if that
trust is converted to U.S. trust status after the grantor's
death. Some people think that it is useful to keep the foreign
trust offshore after the grantor's death. But it doesn't provide
much flexibility if you don't have distributions for a long,
long time. You have to be very careful if you have a client
that is a beneficiary of a foreign trust and there are accumulations.
You have to plan for the distribution of those accumulations.
It is a rather complicated exercise because often these accumulations.
Mr. Lawrence mentioned that he wanted to briefly mention
the problems associated with ownership of foreign corporations
held by foreign trust. You have to look to see what your entity
structure is and how you will migrate this trust and/or deal
with the accumulations in the trust or the corporation.
Mr. Lawrence concluded with a summary of the usufruct, the
treuhand, the stiftung and the anstalt. The treuhand is not
a testamentary document. It has to be intervivos but it can
extend beyond the death of the transferor. It is a third party
beneficiary form of ownership. There is no third party beneficiary
form of enforcement. The stiftung is primarily for charitable
purposes. The anstalt is used for commercial purposes. You
still have to go through the same classification routines
with these entities where you will first have to determine
if it is a trust or an association, then presuming you find
it is a trust you will have to determine if it is foreign
trust or a U.S. trust, then you will have to consider whether
it is a grantor trust or a non-grantor trust. Finally, once
you have identified what you are dealing with then you will
have to analyze the income and transfer tax consequences of
the arrangements and what reporting requirements it is subject
to.
******************
Special Sessions IV Workshop - Thursday afternoon.
Session IV-D - Foreign Trusts
Robert C. Lawrence, III
Jane Tse
Dina Kapur Sanns
Cadwalader, Wickersham & Taft
Note: The examples are shown in italics.
Ellen, a U.S. citizen, lives in London with her husband,
Jean-Marc. Ellen and Jean-Marc have three adult children who
are U.S. citizens. Ellen is the sole shareholder of a U.K.
corporation which is in the business of exporting textiles,
El- Jean Holdings. On August 10, 1999, sells her El-Jean Holdings
shares to Jean-Marc for cash. At the time of the sale the
shares are valued by an independent appraiser at $100,000.
On Sept. 19, 1999, Jean-Marc creates and funds a trust with
the El-Jean Holdings shares known as the El-Jean Holdings
Trust. On February 5, 2000, the El Jean Holdings Trust sells
the shares to an unrelated corporation for $200,000. At the
same time that Jean-Marc created the El Jean Holdings Trust
he creates a second foreign trust, called the Last Resort
Trust, with a nominal amount of cash from his personal bank
account. The Last Resort Trust is an irrevocable, discretionary,
sprinkle trust for the adult children. The El-Jean Holdings
Trust is an irrevocable discretionary trust for the benefit
of Ellen and Jean-Marc but it provides that upon the first
to occur of the death of Jean-Marc or the divorce of Jean-Marc
and Ellen, the trust will terminate and be distributed to
the Last Resort Trust. Until such triggering events, however,
the trustee may, in its sole and absolute discretion, pay
or apply the income or principal of the El-Jean Holdings Trust
to or for the benefit of Jean-Marc and/or Ellen, to the exclusion
of either one of them. The trustee of both trusts is a foreign
trust company but Jean-Marc may replace the trustee with any
other trustee.
1 (A) What is the classification of the El-Jean Holdings
Trust and the Last Resort Trust for U.S. income tax purposes?
Are they a grantor or non-grantor trust as to Jean-Marc or
Ellen?
Jane responded to this question by analyzing whether Jean-Marc
would be treated as a grantor of the trust. Let's assume the
August 10, 1999 sale was made for adequate and full consideration
and that Jean-Marc is really the sole contributor of assets
to the El-Jean Holdings Trust. Will Jean-Marc be treated as
the owner of the El-Jean Holdings Trust for Subpart E of Subchapter
J of the Internal Revenue Code. Jean-Marc won't be treated
as a grantor/owner of the El-Jean Holdings Trust under §
672(f)(2) of the IRC because it doesn't fit within any of
the three exceptions. Jean-Marc can't revoke and revest the
assets of the trust in himself, either by himself or with
anyone else's consent. It is also possible that income or
principal could be distributed during Jean-Marc's lifetime
to his children if he and Ellen divorced. Distributions from
the trust won't be taxable as compensation to Jean-Marc. So
none of the three exceptions apply and the trust isn't subject
to the grandfathering rule either since it was executed after
September 19, 1995.
Dina responded to this question by analyzing whether Ellen
would be treated as a grantor of the trust. Ellen could be
viewed as the grantor under IRC § 679 of the El-Jean
Holdings Trust if she were viewed as having made an "indirect"
contribution to the trust through Jean-Marc if the fair market
value exception were not made. So if the shares were really
worth $200,000 at the time Ellen sold her shares to Jean-Marc,
then she would be treated as the owner of 50% of the El-Jean
Holdings Trust because she will be viewed as having made an
indirect contribution through Jean-Marc for the portion of
the value for which she didn't receive adequate consideration.
It should be pointed out that these transfers took place prior
to August 8, 2000, the effective date of the regulations that
introduced the intermediary rule under § 679. Those intermediary
rules have a very broad application. They basically provide
that if a U.S. person transfers property to a foreign trust
through an intermediary with a tax avoidance purpose then
§ 679 applies. But because these transfers took place
prior to August 8, 2000 the only way that Ellen can be deemed
to be the grantor in our example would be if in fact the shares
were worth more than the consideration she received from Jean-Marc.
Mr. Lawrence pointed out, however, that there was an independent
appraisal. It would appear that this appraisal should hold
up. But there could have been some intervening event between
the initial sale and the second sale that is responsible for
the appreciation. If that were the case, then Ellen would
not be the grantor.
Mr. Lawrence pointed out that transfers between family members
frequently take place informally and without the benefit of
an independent appraisal which makes it troublesome to be
able to rely on the adequate consideration exception.
1 (B) Assume the same facts but with the modification
that the transactions all take place a year later.
Dina explained that in this variation of the facts the transfers
have fallen on the other side of the effective date of the
§ 679 regulations which will bring the intermediary rules
into play.
Mr. Lawrence asked Jane to explain why the $100,000 gift
tax exclusion under 2503(b) as some bearing on the first example.
Jane noted that there is an exception to § 672(f)(5)
for gifts which are covered by the annual exclusion under
2503(b). Thus, if there was a gift transfer to Jean-Marc and
the fair market value exception did not apply, this transaction
still wouldn't be covered by § 672. Jane also pointed
out that the annual exclusion is increased to $100,000 (adjusted
for inflation now to $114,000 if I understood her correctly)
if the donee spouse is not a U.S. citizen.
Dina, however, noted that the annual exclusion exception
does not apply to § 679. So in the second variation where
the transfer by
Jean-Marc took place after August 7,2000, the annual gift
tax exclusion would not keep the transaction from being covered
by the intermediary rules.
Mr. Lawrence: What are the U.S. income tax reporting requirements
applicable to Jean Marc or Ellen upon the creation of the
trust, if any?
Dina: Ellen would be the grantor/owner of 50% El-Jean Holding
Trust. She would have to report the transfer to the trust
on Form 3520. If the intermediary rule applied then she would
be deemed to have made the transfer to the trust when Jean-Marc
made the transfer. The Trust would also have to annually file
a form 3520A and provide Ellen with a Foreign Grantor Trust
statement so she could properly report 50% of the income from
the trust on her income tax return. If she failed to do so,
the penalty would be 5% of the assets deemed to be owned by
her. She would also have to make sure that the trust provided
each U.S. beneficiary with a Foreign Grantor Trust beneficiary
statement so they could properly report as well.
Jane: On the other hand, if under the first set of facts
Jean-Marc were treated as the sole contributor to the Foreign
Trust there is no reporting requirement for Jean-Marc upon
the formation and funding of this trust. However, if the trust
subsequently makes distributions to Ellen the trust will have
to furnish her with a Foreign Trust beneficiary statement
and Ellen would have to report the income which she received
as a result of the distributions to her. If she fails to report,
there would be a penalty as to 35% of the gross distribution.
Mr. Lawrence: If the sale of the El-Jean Holding Company
shares to Jean-Marc were for fair market value, there would
have been no reporting requirement for Ellen in our first
variation. Likewise, if But if Ellen were required to report
the transfer to the trust on a Form 3520 and she failed to
report, there is a penalty of 35% of the initial value of
the assets transferred.
Mr. Lawrence: What the analysis change if Ellen sold the
shares to Jean-Marc for a note payable in three years. This
gets into the qualified obligation issues.
Jane: § 679(a)(3) But the regulations say that you take
any obligation from a grantor/owner or beneficiary of the
trust shall not be taken into consideration unless it is writing
and the term is for less than five years and it is denominated
in U.S. Dollars and the yield is not more than 130% of the
AFR. If it meets the "qualified obligation" then
it will be taken into consideration. Jane pointed out that
if there is a valuation problem, the qualified obligation
would only work as to 50% of the transaction and would still
leave Jane being treated as the owner of 50% of the trust.
Question: In the example it states that Jean-Marc can remove
and replace the trust. Isn't it conceivable that he could
thereby appoint himself as trustee and make a distribution
to himself or Ellen of all the assets of the trust. Wouldn't
this cause a problem.
Jane: This is a very good question and you have picked up
on one of the important points in our example. However, as
to a foreign person the revocation power has to be held by
Jean-Marc. It isn't sufficient that he can remove and replace
the trustee. Even if he holds the power and it is subject
to the consent of an independent trustee, who he can remove
and replace, that will not be enough. He must hold the power
to revoke or hold it subject only to the consent of a related
or subordinate party.
Mr. Lawrence: And who is in fact subservient to him.
Dina: The point here is that what is sufficient under 676
for domestic trusts doesn't work under 672(f) for foreign
trusts.
Question: If under governing law Jean-Marc's creditors could
reach the trust, even that wouldn't be tantamount to a general
power of appointment.
Panel: True.
Question: These penalties are quite severe and up until a
year ago we had been successful in getting the IRS to abate
these penalties where CPAs are overlooked the reporting requirements.
Mr. Lawrence: I haven't seen any change particularly. The
IRS seems to be relatively understanding especially when there
is an intent to comply and the taxpayer is coming forward
voluntarily and saying Mea Culpa.
Question: What happens if the foreign spouse, because of
laws in their own jurisdiction, gives property to the U.S.
citizen who then contributes it to a foreign trust that was
grandfathered.
Mr. Lawrence: First, the U.S. spouse will have certain reporting
requirements once they receive a gift from their foreign spouse.
Second, the U.S. spouse would be a grantor as to that portion
of the foreign trust which is attributable to the contribution
by the U.S. spouse. If that property were commingled and there
isn't separate accounting, that would taint the trust and
destroy the grandfather status of the foreign trust.
Question: If it was separately accounted for, could you preserve
the grandfather status?
Mr. Lawrence: I would actually keep it separate. But you
must account for it separately. But I would advise the trustee
to keep it entirely separate.
Question: Would this be a U.S. trust or a foreign trust.
Dina: You are going to have to go back to the Court Test
and the Control Test to make that determination.
Question: If the trust is amendable by the trustee during
the lifetime of the U.S. citizen and the foreign spouse but
by its express terms its income can only be paid to the U.S.
citizen and the foreign spouse, is there a problem?
Mr. Lawrence: Yes, there is a problem. The second exception
is a mandatory requirement. It doesn't permit any possibility
of alternation.
Dina: The way to get around this problem is to limit the
power to amend in the trustee's hands to provide that it can
only be amended to benefit the U.S. citizen and the foreign
spouse.
Jane: U.K. Trusts almost always have that power in the trustee.
Question: In Canada it is fairly typical to have the trust
established not by the family itself but by a family friend
who puts in $100. I feel that the family friend is merely
a nominee.
Mr. Lawrence: The initial seed funding would leave that person
as a grantor and owner as to their contribution but if the
family then contributes $1,000, that person would not be grantor
as to that additional contribution. This desire for confidentiality
drives this. Sometimes the institution can be the grantor.
1 (C) Assume the facts as above except that Ellen sells
the shares to Jean Marc on August 10, 2000 and then Jean-Marc,
rather than the trust, sells them on February 5, 2001 to a
third party for $200,000. Jean-Marc then purchases marketable
securities which he contributes to the El-Jean Holdings Trust
two years later. Would there be any change in the outcome
or analysis.
Jane: It doesn't matter that Jean-Marc is contributing other
assets to the trust other than the assets which were originally
transferred to him by Ellen. The analysis under 679 doesn't
change.
Mr. Lawrence: Another problem we might focus on is what happens
if Jean-Marc purchases U.S. stocks with the proceeds of the
sale of the El-Jean Holdings stock. That raises a very serious
problem. Under § 2104 if the asset is situated in the
U.S. at the time of transfer or time of death, then §
2036 or § 2038 applies and those assets will be taxable
in the estate of Jean-Marc. If Jean-Marc contributes assets
to the trust which are subject to § 2036 or § 2038,
then that puts a taint on that trust as to those assets and
if they grow to be worth $20,000,000 15 years later that $20,000,000
would be included in Jean-Marc's estate and § 2104(b)
would apply. The only way around it is to terminate the trust
and start over. I'm not aware of any other way to solve that
problem.
1 (D) Assume the same facts except that Ellen sells the
shares to Jean-Marc on August 10, 2000 and he contributes
them to the trust on September 19, 2000 and the trust sells
them on February 5, 2001 for $100,000 rather than $200,000.
Also, assume that Jean-Marc can revoke the trust but only
with the consent of the trustee and the trustee would consent
to the revocation because otherwise Jean-Marc would remove
the trustee. Does the analysis change?
Dina: Even though the transfer takes place after the effective
date of the § 679 intermediary rules, we are assuming
that the fair market value exception is met. So here it is
clear that Ellen is not the grantor but that Jean-Marc is
the grantor of the trust. The issue is whether the trust is
a grantor trust as to Jean-Marc. As Jane explained earlier,
there is a chance that the trust could terminate during Jean-Marc's
lifetime and be distributed to the Last Resort Trust. So the
question here is whether the revocable trust exception is
met. Even though Jean-Marc can revoke the trust it is subject
to the consent of the trustee and the trustee's powers are
not attributed to Jean-Marc. Therefore, the revocable trust
exception is not met.
The next example asks if the analysis would change if Jean-Marc
removed the trustee and appointed a trustee who is related
and subordinate to Jean-Marc. The answer is no because there
is a special rule under the revocable trust exception regulations
which says that once a trust is tainted for purposes of the
revocable trust exception it is tainted for all other years.
So even though now the trustee is related and subordinate
it is still tainted and will continue to be tainted.
Mr. Lawrence The next example asks if the analysis would
change if Jean-Marc names a related or subordinate trustee
at the outset. And here the answer is yes, the analysis does
change. Because in this example from the outset the trustee
is a related or subordinate trustee so it would constitute
a grantor trust as to Jean-Marc trust.
1 (E) Assume the same facts as above except that Ellen
sells the El Jean Holdings shares to Jean-Marc on August 10,
2000; he contributes them to the trust on September 19, 2000;
and the trust sells them on February 5, 2001 for $100,000
(not $200,000). Assume further that the trustee of the El
Jean Holdings Trust may exclude and add beneficiaries in its
complete and absolute discretion. In 2004, Ellen and Jean-Marc
move to New York City but leave their children behind. Prior
to such move the trustee executes a deed excluding Jean-Marc
and Ellen as beneficiaries of the El Jean Holdings Trust and
adding their adult children as beneficiaries. October 30,
2004, Ellen and Jean-Marc move to New York City and in the
process Jean-Marc obtains a green card.
Jane: Here we are trying to illustrate the preimmigration
rules of § 679(a)(4). Because Jean-Marc's immigration
starting date is within five (5) years of the transfer to
the El Jean Holdings Trust, he would be treated as the owner
of the trust under § 679.
Mr. Lawrence. If there is accumulation income inside of this
trust on the starting date of his immigration status, that
income will be attributable to him and treated as being a
portion of the trust owned by Jean-Marc but it would not be
immediately taxable to him in that year.
Would the analysis change if the adult children were
nonresident aliens?
Jane: It wouldn't change the analysis under these facts because
the trustee still has the power to add beneficiaries and could
add U.S. beneficiaries at any time.
Mr. Lawrence: There were a lot of abuses in this area. There
would be an arrangement there would be no U.S. beneficiary
during the lifetime of the grantor. Then miraculously after
a year the trustee would add the grantor's children as beneficiaries.
Mr. Lawrence was never comfortable with this but now it is
absolutely clear this won't work.
Would the analysis change if the adult children were
nonresident aliens and at the same time the trustee excluded
Jean-Marc and Ellen as beneficiaries, it irrevocably released
its powers to add future beneficiaries?
Would the analysis change if Ellen and Jean-Marc move to New
York City on October 30, 2005?
Jane: Yes, the analysis would change because now the residency
starting date would be more than five years after the transfer
by Jean-Marc to the El Jean Holdings Trust.
1 (F) Assume the same facts as in E except that after
moving to New York City, Ellen and Jean-Marc stay for a period
of time and then return to London on November 1, 2007.
Would the analysis change if the trustee exercises its
power to add Ellen and Jean-Marc as beneficiaries and exclude
their adult children as beneficiaries and at the same time
irrevocably releases it powers to add or exclude beneficiaries
prior to Nov. 1, 2007?
Dina: This is illustrating the application of § 684.
The only reason Jean-Marc was treated as the owner of this
trust while he was in the U.S. was because § 679 applied.
But when he moves out of the U.S. and becomes a foreign person
again, § 679 will no longer apply. This would create
a § 684 event and he would be treated as transferring
all of the assets to the trust in a taxable sale immediately
prior to becoming a foreign person.
Would the analysis change if the trustee distributes
the trust fund to another trust which is created by Jean-Marc
for the same beneficiaries but over which Jean-Marc retains
the power to revoke prior to Nov. 1, 2007?
Dina: Yes, this would change the analysis because the second
trust would meet the revocable trust exception and would be
treated at all times as a grantor trust. Thus, when the transfer
takes place prior to Jean-Marc leaving the U.S. we have a
grantor trust to grantor trust transfer and this will avoid
the § 684 problem. But note that this technique is only
available before 2011. § 684 has now been amended for
years starting after 2010 to only apply if the grantor/owner
is a U.S. person.
Question: We have had a couple of sessions dealing with the
five U.S. jurisdictions which offer asset protection. Do you
feel there is a continuing advantage to going offshore strictly
from an asset protection trust.
Mr. Lawrence: I think you are really talking about creditor
protection trusts. I consider true asset protection trusts
the types of trusts which were created to protect assets in
the event of invasion such as those we created for Kuwaiti
citizens before the Iraqis invaded Kuwait in the early 1990s.
I find the idea of trying to avoid your creditors morally
repugnant. But in terms of analysis, you have to look first
at your local law. I don't think that there is any reason
to take a domestic trust and tainting it "foreign".
When you are dealing with a foreign jurisdiction there are
more hurdles to overcome than when you are dealing with a
domestic jurisdiction. You have the full faith and credit
clause. You don't have those issues with a foreign jurisdiction.
The questioner responded to the moral issue by discussing
what he perceived to be a "tort crisis" in the U.S.
and pointed out the example of the Rhode Island nightclub
fire where any deep pocket is being pulled into the litigation
on a joint and several liability basis even though many of
them have no moral culpability for the tragedy.
Mr. Lawrence agreed that the proliferation of contingent
fee litigation has gotten out of hand.
Question: If you have a problem getting the form 3520A out
of the foreign trustee, does the U.S. beneficiary have any
standing to file a 3520A on their initiative to avoid the
penalties. Bob Lawrence responded that you have a major problem
on your hands and the IRS can determine that any distribution
is all ordinary income. Jane pointed out that the penalty
is actually imposed on the U.S. owner so ultimately the U.S.
owner has significant incentives to cause the foreign trustee
to act.
Dina: The 3520A is only relevant if you have a U.S. owned
foreign grantor trust. If it is a true foreign grantor trust
or foreign non-grantor trust then it doesn't have to file
the 3520A but it does have to provide the U.S. beneficiary
with a beneficiary statement.
II. After moving to the U.S. and obtaining a green card,
Jean-Marc learns of the death of his aunt. At the same time
Jean-Marc and his siblings learn of a Cook Islands trust established
for their benefit by their deceased aunt during her lifetime.
Assume that the trust is, and has always been, a foreign non-grantor
trust which provides for the division of the trust funds into
equal shares on a per stirpital basis for the grantor's nieces
and nephews. Each share is held in a separate sub-trust for
the individual for whom it was set apart and such individual's
lineal descendants. The separate sub-trusts are discretionary,
sprinkle trusts and the trustee may, in its sole and absolute
discretion, pay or apply the income and/or principal of the
sub-trust to or for the benefit of any of all of the beneficiaries
thereof to the exclusion of any one of them. Jean-Marc has
a sister and a brother. The brother has been physically present
in the U.S. for several years and is treated as a U.S. resident
for U.S. federal income tax purposes. The sister is a French
resident living in London. The brother has three children,
who were born in the U.S. and are U.S. citizens. None of Jean-Marc
nor any of his siblings were aware of the existence of the
trust prior to their aunt's death. none of them of any of
their issue have ever received distributions from this trust.
The trust's sole asset is shares of a New Zealand holding
company valued at $38 million and the trust has a $0 basis
in those shares. The New Zealand holding company has accumulated
earnings and profits of $12 million and has never declared
a dividend. The New Zealand holding company declares a dividend
of its accumulated earnings and profits.
(A). Analyze the U.S. federal income tax consequences
and reporting requirements, if any, applicable to the U.S.
beneficiaries of the trust as a result of the receipt by the
trust of such dividend.
Jane: There is a two level analysis here. First we to determine
if the New Zealand holding company is a CFC, a FPHC or a PFIC.
Here there are three separate trusts. Two of these trusts
are for the benefit of U.S. persons: Jean-Marc and his brother.
We reach that conclusion through attribution. But since 50%
of either the vote or value of the New Zealand holding company
is owned (through attribution) by U.S. shareholders, this
company meets the definition of a CFC. The New Zealand holding
company would also be a FPHC because more than 50%, by vote
or value, of the outstanding stock is owned by or for not
more than five individuals who are U.S. citizens or residents.
Again by attribution we would have Jean-Marc and his brother
both treated by attribution as owning more than 50% of the
stock. The test for the PFIC doesn't look to ownership but
rather to the source of the company's income. In our example
we are assuming that all of the sources of income of this
holding company are passive. Therefore, we meet all three
of the definitions.
Mr. Lawrence: That is not a good result. Is there some sort
of prioritizing.
Jane: In this case Jean-Marc and his brother don't own this
stock directly but rather through discretionary trusts. The
rules are not very clear on whether the beneficiaries are
actually taxed on the income of the companies where there
is a discretionary trust.
Dina: I think the CFC rules take precedence over the rules.
Under the CFC rules you look not only to direct and indirect
ownership but also to constructive ownership. But for CFC
income purposes, the constructive ownership rules are ignore.
For purposes of CFC income you look only at direct and indirect
ownership. If we look at indirect ownership we have two trusts,
each of which owns 33.3% of the New Zealand holding company.
There are four beneficiaries of each trust. Each beneficiary
would be deemed to own approximately 8.2% of the company through
indirect ownership. However, that assumes that each of these
beneficiaries have fixed entitlements under the trust. And
as Jane pointed out these are fully discretionary trusts and
there have been no distributions made to date. So it would
be very hard to determine which of the beneficiaries is stuck
with CFC income so we would argue that for income inclusion
purposes it would be inequitable to tax any beneficiary until
there has been a pattern of distributions established. But
it isn't clear-cut how you allocate income when you are dealing
with a discretionary trust.
Mr. Lawrence: If there is a fixed interest trust, on the
other hand, I think there is a much more difficult argument
to be made. Think about this. This is really unfair. The income
that is being earned at the lower corporate level is being
imputed up to the beneficiaries and taxed to them even they
don't get the income nor have any right to the income. The
position that our government is taking under the regulations
is really unfair. I wonder if a court could be persuaded that
the equities here are being overlooked and that the regulations
should be upheld.
Question: This is more of a clarification but in the example
it doesn't indicate that the New Zealand holding company has
any related party "trading" or "service"
income nor does indicate that it has personal holding company
passive income, so we don't know whether the company has any
so-called "bad" Subpart F income. The questioner
pointed out that it is clear that it is a CFC. But if it doesn't
have Subpart F income then you still have to deal with the
PFIC rules. You do have the QEF election but my question is
if this is a foreign nongrantor trust and there are no distributions,
then how does the QEF election interface with the throwback
rules when the trust finally makes a distribution?
Dina and Jane: The U.S. beneficiary, rather than the trust,
makes the QEF election. Once the QEF election is made the
company doesn't have to make a distribution the income is
deemed to be distributed.
Jane: In our example it is to late to make a QEF election
because that QEF election has to be made in the first year
of the U.S. shareholder's holding period.
(1) Assume the same facts as above except that the trust
is a discretionary sprinkle trust for the grantor's nieces
and nephews and their lineal descendants instead of three
separate sub-trusts.
Bob Lawrence: If you move from separate trusts to a pot
trust, if you do have UNI up at the trust level you can make
a stripping distribution to foreign beneficiaries of the UNI
and then in later years make distributions in later years
to the U.S. Beneficiaries. I see nothing in the regulations
which would prohibit that.
Jane: In this variation we were trying to illustrate if the
trust is a discretionary trust it is even more difficult to
determine if the New Zealand holding company are a CFC, PFIC
or FPHC. There would be better arguments that the New Zealand
holding company is not a CFC or FPHC and there is no income
inclusion.
(B) Assume the same facts as above except that the New
Zealand holding company does not declare a dividend and instead
the trustee sells its shares to a third party.
Dina: If we take the position that we have a 10% shareholder
of a CFC, the sale to the third party would be an indirect
disposition under the PFIC rules. But in our example the 10%
ownership only through constructive ownership, so while the
statute seems to capture this it isn't clear and even if PFIC
did apply the similar facts and circumstances test is used
to ascertain the ownership and we would argue it is not ascertainable.
1. Would the analysis change if local law requires capital
gains of the trust to be allocated to principal and the trust
only provides for discretionary income distributions for the
next one hundred years?
Dina: The argument would be even more compelling if the capital
gain were allocated to principal and the trust only provided
for income distributions for the next 100 years because the
beneficiaries would have no prospect for ever receiving any
of the capital gains from that sale.
(C) Assume the same facts as in (B) above except that
after such sale, the trustee reinvests the sales proceeds
of the trust through an underlying holding company.
1. Analyze the U.S. federal income tax consequences and
reporting requirements, if any, applicable to the U.S. beneficiaries
as a result of the trustee reinvesting the sales proceeds
through another holding company wholly-owned by the trust.
Jane: In (C) we are assuming that the CFC, PFHC and PFIC
rules do not apply and that the beneficiaries are not subject
to tax under those regimes. In this case the trust would realize
the gain at the trust level and it would be DNI that year
and in subsequent years if not distributed it will be UNI.
If the trustee continues to reinvest the sales proceeds through
an underlying holding company they will continue to be problems
with CFC, PFHC and PFIC. So we don't recommend that. Instead,
we would suggest the new holding company make an election
to be a disregarded entity for U.S. tax purposes. In that
case we would eliminate the problems with PFHC, PFIC and CFC.
Nevertheless if not distributed there will still be a problem
for the beneficiaries down the line. So we prepared these
charts in the supplement to illustrate the difference between
distributing 50% of the income annual with catch up distributions
in year 10 and 20 versus making distributions of 100% of the
income annually
Would the analysis change if the new holding company
had an election in effect to be treated as a disregarded entity
for U.S. tax purposes?
Would the analysis change if the holding company distributes
50% of its current earnings to the trust each year, and the
trust in turn distributes the same to its beneficiaries an
din years 10 and 20, the holding company distributes all of
its current and accumulated earnings to the trust and the
trust in turn distributes the same to the beneficiaries.
Jane: There is a rule under 665 that there can never be an
accumulation distribution in a year where the distribution
does not exceed fiduciary accounting income. If the company
makes a distribution of $26.8 million to the trust in the
tenth year, even though that amount exceeds the DNI for that
year the beneficiary will not be treated as receiving an accumulation
distribution but rather will only be taxable on the DNI distribution
in that tenth year which is $5.8 million.
Dina: So this rule lets you transfer more than $26 million
of value to the beneficiary with the beneficiary only being
subject to tax on the $5.8 million of DNI.
Jane: What we are basically doing in this example is allowing
the trust to accumulate income and then permitting the trustee
to distribute that accumulated income to the beneficiaries
without any tax consequences.
Mr. Lawrence: It is much more favorable then if there would
general distributions of all DNI ever year. Obviously this
foreign stuff is very complicated. It is like multi-dimensional
chess.
Would the analysis change if the holding company distributes
100% of its current earnings to the trust each year, and the
trust, in turn, distributes the same to the beneficiaries?
The chart illustrates the superiority of the 50% distribution.
Analyze the U.S. Federal income tax and reporting requirements,
if any, applicable to U.S. beneficiaries who receive distributions
of the earnings (current and accumulated) of the holding company
which are distributed to the trust. The panel ran out of time
and didn't cover this.
__________________________________________
GENERAL INFORMATION ABOUT INSTITUTE:
Inquiries/Registration:
University of Miami School of Law
P.O. Box 248087
Coral Gables, FL 33124-8087
Telephone: 305-284-4762 / FAX: 305-284-6752
Web site: www.law.miami.edu/heckerling
E-mail: heckerling@law.miami.edu
===========================================
Headquarters Hotel - Fontainebleau Hilton
4441 Collins Avenue
Miami Beach, FL 33140
Telephone (305) 538-2000, FAX (305) 674-4607
==================================================
NOTICE: Although audio tapes of all of the substantive session
at the Miami Institute currently are only made available to
Institute
registrants for purchase, the entire proceeding of the Institute
are published annually by Lexis/Nexis. For further information,
go to
their Web site at http://www.lexisnexis.com/productsandservices.
The text of these proceedings is also available on CD ROM
from
Authority On-Demand by LexisNexis Matthew Bender. For further
information, contact your sales representative, or call (800)
833-
9844, or fax (518) 487-3584, or go to http://www.bender.com,
or write to Matthew Bender & Co., Inc., Attn: Order Fulfillment
Dept.,
1275 Broadway, Albany, NY 12204.
______________________________________________________
Brought to you by the ABA-PTL Discussion List Moderators
URL for ABA-PTL searchable Web-based Archives:
http://mail.abanet.org/archives/aba-ptl.html
|
