Regulations clarify rules regarding residency classification of trusts.

• Author: McCarthy, Nancy Ellen

The Small Business Job Protection Act of 1996[1] substantially modified the rules applicable to foreign trusts, added reporting requirements relating to foreign trusts, and introduced severe penalties for compliance failure. The Act also changed the rules for determining a trust's nationality for federal income tax purposes.

Inadvertent conversion of a trust to foreign trust status or unintended classification of a new trust as foreign rather than domestic may result in burdensome filing and withholding requirements, as well as increased interest charges on deferred tax relating to accumulation distributions and harsh penalties for noncompliance. For example, any United States person who transfers property to a foreign trust, other than by death, must notify the Internal Revenue Service within 90 days of such transfer.[2] A transferor will be subject to a penalty equal to 35 percent of the gross value of property transferred to the trust for failure to file the notice of transfer and will be subject to additional fines of $10,000 per month for failure to comply within 90 days after the mailing of an IRS notice relating to such failure.[3] Also, each United States beneficiary who receives a distribution from a foreign trust must make an annual return identifying the trust and distributions received from the trust.[4] A beneficiary will be subject to a penalty equal to 35 percent of the trust distributions received for failure to file such return and will be subject to an additional $10,000 penalty per month for failure to comply within 90 days after the mailing of an IRS notice relating to such failure.[5] In no event, however, may the above penalties, exceed the gross reportable amount.[6] Other substantial penalties may result under Code [sections] 6048(a) from inadvertent foreign status, including failure to notify the IRS of other reportable events or to file required annual returns concerning the trust.

Additionally, if a domestic trust is expatriated, it may be subject to the excise tax imposed by Code [sections] 1491 on transfers of property by United States persons to foreign trusts, equal to 35 percent of the unrealized appreciation in the transferred property.[7] Furthermore, new Code [sections] 1494(c) imposes a penalty (per Code [sections] 6677(a)) for failure to file a return with respect to any transfer described in Code [sections] 1491, equal to 35 percent of the gross value of the property transferred, even if it exceeds the tax due under Code [sections] 1491. I.R.S. Notice 97-18, 1997-10 I.R.B. 35, provides that a United States transferor is not required to report a Code [sections] 1491 transfer if such transfer is subject to the reporting requirements of certain other Code sections, including Code [sections] 6048(a). However, if the United States transferor has not complied with the reporting requirements of that other section, the United States transferor will not be treated as having satisfied its reporting obligation under Code Section 1494 and will be subject to penalties under Code [sections] 1494(c), but the amount of the penalty imposed under Code [sections] 1494(c) will be reduced by the amount of the penalty imposed for failing to comply with the reporting requirements of that other Code section.

In addition to the reporting requirements and penalties, the Act increased the interest charge imposed on taxes due on distributions of accumulated income from foreign nongrantor trusts. Previously, the interest rate applicable to deferred tax on accumulation distributions from foreign nongrantor trusts was six percent simple interest. The Act provides that interest is now to be calculated using the floating interest rate applicable under Code [sections] 6621(a)(2) to underpayments of tax, compounded daily.[8] The Act also added Code [sections] 643(i) which treats certain loans of cash or marketable securities by a foreign nongrantor trust to a United States beneficiary or a United States grantor as distributions. Furthermore, United States persons who control the payment to a foreign trust of items of income such as interest, dividends, annuities, or other fixed or determinable annual or periodic gains, profits, and income may be required to withhold tax from the payment of such items.[9] In light of these enhanced reporting requirements, withholding requirements, interest charges, and penalties that hinge on whether the trust is foreign or domestic, the Act established a new test for determining the nationality of a trust.

Nationality of Trusts Under the New Rules

Before the Act, there was little guidance for...