Modification to trust agreements to avoid 35% "built-in gain" excise tax for 1997.

• Author: Zysik, Jeffrey C.

In 1996, for the first time, the Code contains statutory definitions of domestic and foreign trusts. The new definitions, contained in Sec. 7701(a)(30)(E) and (31),were enacted as part of the Small Business Job Protection Act of 1996 (SBJPA), and apply to all trust tax years beginning after 1996, or, by election of the trustee, to trust tax years ending after Aug. 20, 1996. These newly enacted definitions will require all trustees to examine their existing trusts to determine whether any require reclassification. If a domestic trust is reclassified as a foreign trust by reason of the new definitions, Sec. 1491 may impose a 35% excise tax on the "built-in gains" of the trust's assets.

Sec. 7701(a)(31) defines a "foreign trust" as any trust that is not a "U.S. Person." A trust is a U.S. Person under Sec. 7701(a)(30)(E) if "(i) a court within the [U.S.] is able to exercise primary supervision over the administration of t he trust, and (ii) one or more [U.S.] fiduciaries have the authority to control all substantial decisions of the trust." Although the new definitions should simplify the process of classifying trusts as foreign or domestic (prior law applied a facts and circumstances test), a major problem can occur in the year the new definitions first apply to a trust, due to a modification made in the SBJPA to Sec. 1491.

Sec. 1491 imposes a 35% excise tax on an asset's "built-in gain" when the asset is transferred from, among other things, a U.S. trust to a foreign trust. The last sentence of Sec. 1491 states that on the date a trust ceases to be a U.S. trust, it will be deemed to have transferred all of its assets for purposes of Sec. 1491 to a foreign trust. As a result of the new definitions, it is possible for a trust treated as a domestic trust under prior law to become a foreign trust solely by operation of the new definition, and as a result trigger a Sec. 1491 excise tax liability. This result can occur even though the trust may prefer to remain a domestic trust for U.S. tax purposes.

The Sec. 1491 excise tax will not apply if the trust is a grantor trust under Sec. 671, et. seq., both before and after the trust migrates. The tax will apply, however, if the trust ceases to be a grantor trust while defined as a foreign trust; see Rev. Rul. 87-61.

To remedy this potential problem, the Service has provided a safe harbor period in Notice 96-65 for existing trusts to comply with the domestic trust definition. Under the safe harbor, a...