Is it a Trust? Domestic or Foreign? Facts & Circumstances Test

Is it a Trust (Facts and Circumstances Test)

One of the most complicated aspects of international tax law is trying to decipher how a foreign entity should be categorized for US tax purposes. This is a very important exercise because depending on whether for example, a foreign entity is determined to be a corporation versus a trust can impact which international information reporting forms are required to be filed. The failure to timely file the necessary forms is very important as well because oftentimes the statute of limitation does not begin to run until the form has been filed. Thus, the statute of limitations may remain open indefinitely in situations in which a taxpayer did not report a specific form that the IRS determines was required. That was the case of Fairbank vs. Commission of Internal Revenue. One of the most important aspects of the opinion is how the court determines that a foreign entity is considered a trust for example — and not a corporation. Technically, it is referred to as the facts and circumstances test and let’s hone in on this part of the court’s ruling.

Entity Classification

• • • “The Code prescribes the classification of various organizations for federal tax purposes. Treas. Reg. § 301.7701-1(a)(1).

    • “Whether an organization is an entity separate from its owners for federal tax purposes is a matter of federal tax law and does not depend on whether the organization is recognized as an entity under local law.” Id.

    • In general, an arrangement will be treated as a trust 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. See Elm St. Realty Tr. v. Commissioner, 76 T.C. 803, 814–15 (1981); Treas. Reg. § 301.7701-4(a).”

What does this mean?

It means that for federal tax purposes, the US government will apply US tax law to determine how the organization will be recognized in the United States. Even if the organization/entity would be recognized differently under foreign tax laws — that does mean it is how it will be categorized under United States tax law.

Elements of a Foreign Trust

• • • “The four elements of a trust for federal tax purposes are

      • (1) a grantor,

      • (2) a trustee that takes title to property for the purpose of protecting or conserving it,

      • (3) property, and

      • (4) designated beneficiaries.

    • See Treas. Reg. § 301.7701-4(a).22 This Court applies a facts and circumstances analysis when determining whether an arrangement should be treated as a trust or a business entity by determining whether the arrangement includes (1) associates and (2) an objective to carry on a business and divide the gains therefrom. See Elm St. Realty Tr., 76 T.C. at 809–18; see also Morrissey v. Commissioner, 296 U.S. 344, 356–58 (1935). The absence of either of these essential characteristics will cause an entity to be classified as a trust. See Estate of Bedell v. Commissioner, 86 T.C. 1207, 1218 (1986); Elm St. Realty Tr., 76 T.C. at 818.”

What does this mean?

The above-referenced paragraph refers to the basics of what is required in order to establish a trust under US tax law.

Is it Really a Trust?

• • • “When distinguishing between an association and a trust for tax classification purposes, relevant features of the arrangement are its “nature,” “purpose,” and “operations.” See Swanson v. Commissioner, 296 U.S. 362, 365 (1935); Morrissey v. Commissioner, 296 U.S. at 357. In assessing these features, weight should be given to the arrangement’s organizing documents. See Swanson v. Commissioner, 296 U.S. at 363–65; Morrissey v. Commissioner, 296 U.S. at 360–61.

    • The Supreme Court noted that the “parties are not at liberty to say that their purpose was other or narrower than that which they formally set forth in the instrument under which their activities were conducted.” Helvering v. Coleman-Gilbert Assocs., 296 U.S. 369, 374 (1935).

    • Respondent argues that under the facts and circumstances analysis, Xavana Establishment qualifies as a trust.

      • Xavana Establishment’s organizing documents state that it is to operate “on a trust basis,” its purpose is the “investment and management of assets,” and its “capital and its results as well as any clear profits of [Xavana] Establishment shall be due to the beneficiaries.”

      • It is irrefutable that Mrs. Fairbank is reflected as the beneficial owner of Xavana Establishment; and the record does not indicate that Xavana Establishment involved any business associates or operated as a joint enterprise that conducted business.

      • In fact, Xavana Establishment is explicitly noted as neither owning any business premises nor employing any staff working exclusively for it. Furthermore, Xavana Establishment did not operate any trade, manufacturing, or any other business of a commercial type.

      • Accordingly, we conclude that Xavana Establishment is properly classified as a trust for federal tax purposes under Treasury Regulation § 301.7701-4(a).23 The arrangement here closely resembles a typical trust whereby a settlor (here, Mr. Hagaman)24 establishes a trust for the benefit of specified beneficiaries …Consequently, we agree with respondent and find that the governing documents concerning Xavana Establishment, along with other documents in the record, show that Xavana Establishment was a trust for federal tax purposes.”

What does this mean?

In reviewing the underlined documents and the purpose of the arrangement of the establishment at issue in this case, the court determined that it was, in fact, a trust.

US vs Foreign Trust

• • • “Now that we have determined that Xavana Establishment is properly classified as a trust for federal tax purposes, our analysis turns to the issue of whether Xavana Establishment is a domestic trust or a foreign trust. A foreign trust is “any trust other than a trust” that is a “United States person” (i.e., a domestic trust). I.R.C. § 7701(a)(30)(E), (31)(B); Treas. Reg. § 301.7701-7(a)(2). Treasury Regulation § 301.7701- 7(a) provides a two-factor test to determine whether a trust is domestic.

      • A trust is domestic if

        • (1) “[a] court within the United States is able exercise primary supervision over the administration of the trust” (court test) and

        • (2) “[o]ne or more United States persons have the authority to control all substantial decisions of the trust” (control test). Id. subpara.

          • (1). Failure to satisfy either the court test or the control test will result in the trust’s being deemed a foreign trust for federal tax purposes. Id. subpara. (2).

    • A trust satisfies the court test if the governing document does not direct that the trust be administered outside of the United States, the trust, in fact, is administered exclusively in the United States, and the trust is not subject to an automatic migration provision that would move it outside the United States if a U.S. court were to attempt to assert 19 [*19] jurisdiction. Treas. Reg. § 301.7701-7(c)(1), (4)(ii). With respect to the control test, control means having the power, by vote or otherwise, to make all of the substantial decisions of the trust, with no other person having the power to veto any of the substantial decisions. Id. para. (d)(1)(iii).

    • Substantial decisions are those decisions that are “authorized or required” under the trust instrument and applicable law, which include, but are not limited to, decisions concerning whether and when to distribute income or corpus, the amount of any distribution, whether to terminate the trust, etc. Id. subdiv. (ii).

    • In this case Xavana Establishment fails to satisfy the court test as defined by section 7701(a)(30)(E)(i). There is nothing in the record to suggest that a court within the United States was able to exercise primary supervision over the administration of Xavana Establishment. In fact, the Contract of Mandate, which is part of the organizing documents concerning Xavana Establishment, states that the parties agree that “disputes relating to this [c]ontract . . . shall be subject to the law of the Principality of Liechtenstein” and that the “place of jurisdiction is agreed as Vaduz, [Liechtenstein].” Accordingly, we find that Xavana Establishment fails the court test. I.R.C. § 7701(a)(30)(E)(i); Treas. Reg. § 301.7701-7(a)(1)(i), (c)(1). Consequently, Mrs. Fairbank’s ownership interest in Xavana Establishment, a foreign trust, gives rise to reporting obligations under section 6048.25.”

What does this mean?

It means that in applying the court and control test to the facts of the case, the tax court determined that this is a foreign trust. Unfortunately, this was bad news for Petitioners, because since it is a foreign trust, it turns out that the taxpayer did not properly file Form 3520. And, since the forms are not filed, the statute remains open and the appellant’s argument that the taxes, interest, and penalties should not apply because the statute of limitations expired was rejected by the court.

Current Year vs Prior Year Non-Compliance

Once a taxpayer has missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist that specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties. 

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure. 

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