IRS issues guidance on the treatment of a trust as foreign or domestic.

• Author: Dichter, Arthur J.

The Small Business Job Protection Act of 1996 (SBJPA) changed the definition of foreign and domestic trusts for Federal income tax purposes. As a result of these changes, trusts previously classified as domestic may be reclassified as foreign for years beginning after 1996, and may be subject to a 35% excise tax on the gain inherent in the trust property. On Dec. 6, 1996, the IRS issued Notice 96-65 to provide guidance on these new rules. Action may be required by a domestic trust in existence on Aug. 20, 1996 (the SBJPA's enactment date) in order to retain its status as a domestic trust and avoid the excise tax.

Background

Prior to the SBJPA, trusts were classified as domestic or foreign based on facts and circumstances with no clear guidelines. Under the SBJPA, a trust win be classified as a domestic trust if a U.S. court has primary jurisdiction over the trust and at least one U.S. fiduciary has the authority to control all of its substantial decisions (Sec. 7701(a)(30)). A foreign trust is any trust that is not a domestic trust (Sec. 7701(a)(31)).

Sec. 1491 imposes a 35% excise tax on the appreciation of property transferred by a U.S. person to a foreign entity, including a foreign trust (less any gain recognized on the transfer by the U.S. person). For purposes of Sec. 1491, a domestic trust that becomes a foreign trust will be treated as having transferred all of its assets to a foreign trust. Therefore, there may be a 35% excise tax on any appreciated property. This rule will not apply to the extent a grantor or other person is treated as the owner of all or a portion of the trust under the grantor trust rules when such trust becomes a foreign trust.

The new definition applies in determining the status of a trust for tax years beginning after 1996.

Pursuant to Notice 96-65, certain trusts will be allowed additional time to comply with the new definition of a domestic trust, and will be allowed to continue to file as domestic trusts during that period. The notice also allows the trustee to make an election to have the new definitions apply to the first tax year ending after Aug. 20, 1996. Finally, guidance is provided on the application of Secs. 1491 through 1494 when a trust changes from domestic to foreign because of the new definitions.

Additional Time to Comply With

New Domestic Trust Criteria

A domestic trust in existence on Aug. 20, 1996 that would otherwise be treated as a foreign trust by operation of the new law may continue...