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International Inheritance Estate Tax. Civil Law Trusts Are Not Trusts for U.S. Tax Law

I originally wrote this post in 2013. When folks read International Inheritance Estate Tax. Civil Law Trusts Are Not Trusts for U.S. Tax Law, they are concerned.

This last year, I have received many calls from Americans whose deceased parents formed a foundation or a trust in a non-common law country (such as Panama).  If an entity is not a trust, then it is either a foreign corporation or if you are lucky, an alter ego

The inheritance of a foreign corporation causes unexpected and undesired income taxes.  Yes, the problem is income tax.    Extremely different income tax laws apply to a distribution from a corporation versus a trust.  You can learn about saving taxes with a trust on this link.

When I first wrote this post, CPAs were freaking out over the foreign trust reporting of a Mexican land trust.  They could not believe that Under international inheritance estate tax civil law trusts are not trusts for U.S. tax law.

Their clients owned property along the beautiful Baja California, Mexico, Pacific Coast.   Mexico has an anti-immigrant law that prohibits foreigners from owning property.  Instead, a trust with a fixed period of 30 years owns the property.   

If the Mexican land trusts is a trust, then Form 3520-A and  Form 3520 must be filed.  The penalty for late filing is five percent per year of the gross value of the trust’s assets. 

The IRS does great work.  It knows that just because an entity is called a “trust”, the name means nothing.   This 2013-14 revenue ruling is a great educational tool. Knowing the definitions is necessary for tax planning. The tax laws for trusts are unique.  

The IRS ruling is below in blue. The concept applies to all civil law trusts.  The U.S. has common law trusts (as well as the UK and its territories, Canada, Australia and  New Zealand).   You can learn about trust estate tax planning for common law countries on this link.

If you would like help with your tax planning, then please contact me,  Brian Dooley CPA,MBT,  at [email protected]  

At the end of this blog is the IRS warning that International Inheritance Estate Tax. Civil Law Trusts Are Not Trusts for U.S. Tax Law.

Part I    Section 7701 — Definitions  26 CFR 301.7701-4: Trusts

ISSUE

Is the fideicomiso or Mexican Land Trust arrangement (“MLT”), described below, a trust under Treasury Regulation § 301.7701-4(a)?

FACTS

The Mexican Federal Constitution prohibits non-Mexican persons from directly holding title to residential real property in certain areas of Mexico (“restricted zones”). Non-Mexican persons, however, may hold residential real property located in the restricted zones through an MLT with a Mexican bank after obtaining a permit from the Mexican Ministry of Foreign Affairs.

Situation 1

A, a U.S. citizen, is the sole owner of X, a limited liability company organized under the laws of state Z in the United States. X is disregarded as an entity separate from its owner under § 301.7701-2(a) (a disregarded entity). A, through X, wanted to purchase Greenacre. Greenacre is Mexican residential real property located in a restricted zone. Neither A nor X may hold title directly to Greenacre under Mexican law.

X obtained a permit from the Mexican Ministry of Foreign Affairs and signed an MLT agreement with B, a Mexican bank. X negotiated the purchase of Greenacre directly with the seller of the property and paid the seller directly.

The seller had no interactions with B with respect to the sale. At settlement, legal title to Greenacre was transferred from the seller to B, subject to the MLT agreement, as of the date of sale. No property other than Greenacre is subject to the MLT agreement.

Under the terms of the MLT agreement, X has the right to sell Greenacre without permission from B. Further, B must grant a security interest in Greenacre to a third party, such as a mortgage lender, if X so requests. X is directly responsible for the payment of all liabilities relating to Greenacre. X must pay any taxes due in Mexico with respect to Greenacre directly to the Mexican taxing authority.

X has the exclusive right to possess Greenacre and to make any desired modifications, limited only by the need to obtain the proper licenses and permits in Mexico.

If Greenacre is occasionally leased, X directly receives the rental income and A, as the owner of X, reports the income on A’s U.S. federal income tax return.

Although B is identified as a fiduciary in the MLT agreement, it disclaims all responsibility for Greenacre, including obtaining clear title. B has no duty to defend or maintain Greenacre. B collects a nominal annual fee from X.

There is no other agreement or arrangement between or among A, X, B, or a third party that would cause the overall relationship to be classified as a partnership (or any other type of entity) for U.S. federal income tax purposes.

Situation 2

The facts are the same as in Situation 1 except that X is a corporation organized under the laws of State Z in the United States. X is treated as a corporation under § 301.7701-2(a). If Greenacre is occasionally leased, X directly receives the rental income and reports the income on its U.S. federal income tax return.

Situation 3

The facts are the same as in Situation 1 except that A deals directly with B without interposing X or any other entity. A obtained the permit from the Mexican Ministry of Foreign Affairs, signed the MLT agreement with B, and negotiated the purchase of Greenacre. Additionally, the provisions of the MLT agreement that apply to X in Situation 1 instead apply to A.

If Greenacre is occasionally leased, A directly receives the rental income and reports the income on A’s U.S. federal income tax return. B collects a nominal annual fee from A.

There is no other agreement or arrangement between or among A, B, or a third party that would cause the overall relationship to be classified as a partnership (or any other type of entity) for U.S. federal income tax purposes.

LAW AND ANALYSIS

Section 301.7701-1(a)(1) provides that 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.

Section 301.7701-2(a) defines a “business entity” as any entity recognized for federal tax purposes (including an entity with a single owner that may be disregarded as an entity separate from its owner under § 301.7701-3) that is not properly classified as a trust under § 301.7701-4 or otherwise subject to special treatment under the Code.

If a business entity with only one owner is disregarded as separate from its owner, its activities generally are treated in the same manner as a sole proprietorship, branch, or division of the owner.

Section 301.7701-4(a) provides that the term “trust” refers to an arrangement created by a will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries.

Usually, the beneficiaries of such a trust do no more than accept the benefits thereof and are not the voluntary planners or creators of the trust arrangement.

However, the beneficiaries of a trust may be the persons who create it, and it will be recognized as a trust if it was created for the purpose of protecting and conserving the trust property for beneficiaries who stand in the same relation to the trust as they would if the trust had been created by others for them.

Generally, an arrangement is treated as a trust if it can be shown that the purpose of the arrangement is to vest in trustees the responsibility for the protection and conservation of the property for beneficiaries who cannot share in the discharge of this responsibility.

Rev. Rul. 92-105, 1992-2 C.B. 204, addresses the transfer of a taxpayer’s interest in an Illinois land trust under § 1031.

Under the facts of the ruling, an individual taxpayer created an Illinois land trust and named a domestic corporation as trustee. Under the deed of trust, the taxpayer transferred legal and equitable title to the real property to the trust, subject to the provisions of an accompanying land trust agreement.

The land trust agreement provided that the taxpayer retained exclusive control of the management, operation, renting and selling of the real property, together with an exclusive right to the earnings and proceeds from the real property. Under the agreement, the taxpayer was required to file all tax returns, pay all taxes, and satisfy any other liabilities on the real property.

Rev. Rul. 92-105 concludes that, because the trustee’s only responsibility was to hold and transfer title at the direction of the taxpayer, a trust, as defined in § 301.7701-4(a), was not established. The ruling holds that, on the facts described in the ruling, the trustee was a mere agent for the holding and transfer of title to the real property, and the taxpayer retained direct ownership of the real property for federal income tax purposes.

Situation 1

Because B’s only duties under the MLT agreement are to hold the legal title to Greenacre and transfer title at the direction of X, the MLT is not a trust. X retains the right to manage and control Greenacre. X has the right to collect any rent on Greenacre.

 Also, X has the obligation to pay directly any taxes and other liabilities due on Greenacre. Accordingly, because X is treated as a disregarded entity under § 301.7701-2, A is treated as the owner of Greenacre.

Situation 2

The MLT is not a trust, and the analysis is the same as in Situation 1 except that because X is treated as a corporation under § 301.7701-2(a), X is treated as the owner of Greenacre.

Situation 3

Because B’s only duties under the MLT agreement are to hold the legal title to Greenacre and transfer title at the direction of A, the MLT is not a trust. A retains the right to manage and control Greenacre. A has the right to collect any rent on Greenacre. In addition, A has an obligation to pay directly any taxes and other liabilities due with respect to Greenacre. Accordingly, A is treated as the owner of Greenacre.

HOLDING(S)

In all three situations described above, the MLT is not a trust within the meaning of § 301.7701-4(a).

If, under the MLT agreement, B holds legal title to any assets other than Greenacre or is permitted or required to engage in any activity beyond holding legal title to Greenacre, the holding of this revenue ruling does not apply and the rules of §§ 301.7701-1 through 301.7701-4 will determine the federal tax classification of the MLT.

The IRS’ Warning: International Inheritance Estate Tax. Civil Law Trusts Are Not Trusts for U.S. Tax Law

Note that a fideicomiso (Mexican Land Trust) that is described in Rev. Rul. 2013-14, 2013-26 I.R.B. 1267, is not a trust for U.S. tax purposes, Thus, the U.S. owner of the fideicomiso is not required to file a Form 3520 or a Form 3520A.   In this case, it helped the taxpayer because  it was an alter ego. 

The IRS warning that International Inheritance Estate Tax. Civil Law Trusts Are Not Trusts for U.S. Tax Law has a more deadly result if the entity is a corporation.   Distributions from corporations are usually taxed as a “non-qualified dividend”.    These dividends are taxable at the highest rate.  

Foreign Inheritance and Gift Tax Planning and Strategies

The IRS headline Aliens with any U.S. Assets Must File Estate Tax Returnsis shocking to their adult children in America.   So, I wrote this blog on Foreign Inheritance and Gift Tax Planning and Strategies  to help you save taxes.

Also, it gets worse for those decedents owning foundations, foreign trusts, foreign companies, Stiftung, and Anstalts.   The heirs could owe the IRS both estate taxes and income taxes on their inheritance.

The label of the entity (such as trust) does not decide the entities IRS tax classification.     An entity labeled a “trust” can be classified for tax law a corporation.  Similarly, a foreign corporation can be categorized by the IRS as a trust.

Suzan’s father is a French citizen.  When he passed away, he was residing in Spain.  To avoid French and Spain taxes, he formed a Panama foundation.  In our telephone calls, Suzan labeled the foundation as a Panama trust.

As you expect, U.S. taxation of a foreign trust is very different from a foreign corporation.  Two factors differentiate corporations from trusts.  They are:
(1) the presence of associates; and
(2) the objective to carry on business and divide the gains.

One court case held that term “associates” does not mean plural.  The court held that a trust with a single beneficiary has associates.   Because of this case, the IRS seems to be focusing on the objective to carry on business.   An IRS legal opinion, on this link, highlights this.

For our French readers, this link has a comprehensive explanation of the American inheritance and estate  tax law..

Continue reading

“Check the Box” Risks for Liechtenstein Anstalts, Liechtenstein Stiftungs, and Panama Foundations

Do it yourself tax planners have been easy prey for the IRS International Tax Auditors.  The internet is full of the article on the “check the box” election.  It seems simple.  Even the IRS makes it seems simple when you read page 4 of the instructions (to Form 8832), but only if you read the instructions as a layman.

When you read the instruction, the IRS uses the term “foreign eligible entity.”  Our brains automatically give the words a meaning.  However, a tax expert looks up each word independently.  Yep, we look up “foreign,” “eligible” and “entity.”

When you dive deep into the regulations, you learn that an “eligible entity” (domestic and foreign) must be a “business entity” (another tax define the term).  Anstalts, Stiftungs, and foundations may not be a business entity and thus the check the box election does not apply to them.

Regulation 301. 7701-2 defines Business entities as follows:
“a business entity is any entity recognized for federal tax purposes (including an entity with a single owner that may be disregarded as an entity separate from its owner under § 301. 7701-3) that is not properly classified as a trust under § 301.7701-4.”

“Not properly classified as a trust” is what destroys Liechtenstein Anstalts Liechtenstein Stiftungs, and Foundations tax classification and tax planning.   The IRS ruling at the end of this blog, (in blue ink) highlights the thin edge between a foreign corporation and a foreign trust.

This blog will tell you and your international tax accountant or international tax attorney all that they need to know.  The story started almost one hundred years ago with the birth (in 1913) of the income tax law.

The tax law defines a corporation as an entity that a state (or a country) classifies as a corporation and associations that have corporate characteristics.  The decision that a character is “corporate” is subjective (an exception applies to per se corporations, more on this link).

It starts in the roaring 20s.  During that period, the Treasury Department issued regulations that defined the term “association” broadly enough to include unincorporated entities, such as business trusts.[1]

In Supreme Court case, Morrissey v. Commissioner [2] decided in 1935,  the Supreme Court held that a trust formed to develop and operate golf courses was taxable as an association classified as a corporation (for tax purposes).  The Morrissey case is significant because it developed an approach to entity classification that is known as the “resemblance test.”

The Supreme Court considered those features of a trust created to carry on a business enterprise that would make the trust the same as a corporation.

For example, the ability to hold title to the property; centralized management; continuity of life upon the death of an owner; a structure that facilitates the transferability of beneficial interest; and limited liability.[3]  The Court determined that the business trust at issue was an association taxable as a corporation because it had the preceding corporate powers.[4]

Of course, the IRS victory was a two-edged sword, and it became a new tax loophole.  Tax planners discovered the tax advantages in being taxed as corporations.

Corporations could set up tax-deferred pension plans, which were particularly advantageous at a time when individual tax rates were significantly higher than corporate rates.[5]  Professionals that were unable to incorporate under local law formed unincorporated associations that were structured to be taxed as associations under the Morrissey resemblance test.

Beaten up, the IRS found themselves in court trying to undo their Supreme Court victory.  in the Ninth Circuit in the 1954 case of United States v. Kintner[6].  In 1954, doctors could not incorporate their business.  So a group of California doctors formed a trust to own their medical practice.  This allowed them to avoid taxes with the use of “corporate” pension plan.

The Court case determined that an unincorporated professional association formed for the practice of medicine and surgery could be taxed as an association and its pension plan would qualify for tax-deferred benefits under the Code.

The IRS argued against corporate status (taking the opposite position from its Supreme Court case victory).  The Kintner court rejected the government’s argument.  The court held that the association should be taxed as a corporation.

Because of this defeat, six years later, the IRS issued new regulations.  It is these regulations that apply today in defining a business entity versus a trust.

These regulations, which came to be known as the Kintner regulations, adopted an approach to entity classification similar to the resemblance test outlined in Morrissey.  The Kintner regulations identified six corporate characteristics.

If an unincorporated organization possessed more corporate than non-corporate characteristics, it was taxable as an association.  In distinguishing between a trust and a corporation, characteristics common to both trusts and companies were ignored.  Accordingly, just two of the six factors were used to differentiate companies from trusts: (1) the presence of associates; and (2) the objective to carry on business and divide the gains.  As you will read below, the courts have consistently ruled that one trust beneficiary can be the “presence of associates.”

The remainder of the blog summarizes the leading court cases and IRS ruling.  The point, for you the reader, is to learn you must analyze the laws of the foreign country to decide if the entity and its formation documents create a business entity.  The last IRS ruling, at the beginning of this blog, drives home the tax risk.  If your tax planning is for a foreign corporation but your entity is a foreign trust or disregarded (because of the foreign laws), you are screwed.

From July through October of 1977, the IRS issued several private letter rulings (PLR) classifying certain foreign organizations with single owners.[7]  In these PLRs, the IRS held that the foreign organizations lacked “associates with an objective to conduct business and divide the gain therefrom” and therefore were not a “business entity”.

Even more startling, in some of the PLRs concluded that the organizations could not be classified as trusts.[8]   The taxpayer got the worst of all tax results. The foreign organizations were “an integral part” of the sole owner for tax purposes.[9]

Instead, the Tax Court determined that “where there is a single owner, the regulations are not intended to require multiple associates or a sharing of profits among them.”[10]  Thus, under Hynes, a trust carrying on business for profit could never be taxable as a trust because it would always possess the two characteristics that distinguish an association from a trust.  This of course, would cause chaos in the world of taxation.

In 1992 in the case of Barnette versus IRS Commissioner,[11] the Tax Court considered whether German an entity (organized as a GmbH) should be classified as a separate corporation or disregarded and classified as a branch.

The absence of “associates” and an objective to carry on a business for “joint” profit are common to both one-man corporations and sole proprietorships, so the Tax Court ignored this.  In looking at the Kintner regulation, the court held that the GmbH possessed more corporate than non-corporate characteristics and therefore was an association taxable as a corporation (a “business entity”).[12]

In 1973, IRS revenue ruling 73-254 provided that, for purposes of applying the Kintner regulations, the local law of the foreign country would be applied to determine the legal relationships of the members and their interests in the assets.

In 1977, IRS revenue ruling 77-214 applied the four-factor test in the Kintner regulations to determine that a German GmbH was taxable as an association.  The decision specifically noted that the GmbH at issue was a juridical person but that, under German law, a GmbH could assume the characteristics of an association or a partnership depending on its memorandum of association.  Thus, it could not be automatically treated as a partnership or corporation for federal tax purposes.

In 1988, IRS revenue ruling 88-8 [13] held that all foreign entities are considered unincorporated organizations and therefore must always be classified by application of the four-factor test of the Kintner regulations.  This means you must look at the laws for the foreign country and make a determination.

IRS revenue ruling 88-8 involved the classification a U.K. unlimited company.  The entity was formed under Great Britain’s “corporation” statute.  Nevertheless, the ruling held that the entity was not a corporation for U.S. tax law.  It lacked the corporate characteristics of limited liability and free transferability of interests.

In 2009, the IRS issued a legal opinion  (IRS Generic Legal Advice AM 2009-012) of this issue (see the full opinion on this blog).

Here is what the IRS stated about Liechtenstein Anstalts

Based upon the information submitted, we believe that, subject to the facts and circumstances of each situation, Liechtenstein Anstalts are not properly treated as trusts under § 301.7701-4(a) of the regulations because, in most cases, their primary purpose is to actively carry on business activities. Further, Liechtenstein Anstalts are not subject to special treatment under the Code.

Therefore, Liechtenstein Anstalts are classified as “business entities” under § 301.7701-2(a).  IRS’s Opinion with the reminder that their opinion would vary case by case(Author note:  Please note that the IRS is telling to look at the foreign law).

Here is what the IRS stated in Liechtenstein Stiftungs

Based on the information submitted, we believe that, subject to the facts and circumstances of each situation, Liechtenstein Stiftungs are properly treated as trusts under § 301.7701-4(a) of the regulations.  (Author note: Here the IRS has the opposite conclusion but in the same legal opinion)  In most cases, the Stiftung’s primary purpose is to protect or conserve the property transferred to the Stiftung for the Stiftung’s beneficiaries and is usually not established primarily for actively carrying on business activities.

However, it is important to note that if the facts and circumstances indicate in a particular case that a Stiftung was established primarily for commercial purposes as opposed to the purpose of protecting or conserving property on behalf of the beneficiaries, the Stiftung in such case may be properly classified as a business entity under § 301.7701-2(a).

Accordingly, it is important to analyze the facts and circumstances of each case to determine whether a particular Stiftung was established to protect and conserve property of the Stiftung or, was created as a device to carry on a trade or business.

FOOTNOTES

[1] See Art.  1502, Regulation No. 45, T.D. 3146 (1920) (associations and joint stock companies include certain common law trusts and other organizations that do business in an organized capacity); Art.  1504, Regulation No. 65, T.D. 3640 (1924) (reflecting decision of Hecht v. Malley, 265 U.S. 144 (1924), by treating operating trusts as associations, regardless of degree of beneficiaries’ control, where beneficiaries’ activities included more than collecting funds and making payments to beneficiaries); Art.  21-23, Regulation 64, T.D. 4575 (1935) (trust treated as an association if it is an arrangement conducted for profit where capital is supplied by beneficiaries and the trustees are in effect the managers of the arrangement, whether or not beneficiaries appoint or control trustees).

[2] 296 U.S. 344 (1935).

[3] Id. at 359.

[4] Id. at 360.

[5] See Kurzner v. United States, 413 F.2d 97, 101 (5th Cir. 1969).  See also Hobbs; supra note 334, at 481-83.

[6] 216 F.2d 418 (9th Cir. 1954).

[7] See PLR 77-43-060 (July 28, 1977) (classifying a German GmbH); PLR 77-43-077 (July 29, 1977) (classifying a French societe a responsabilite limitee); PLR 7747-083 (Aug. 26, 1977) (classifying a German GmbH); PLR 77-48-038 (Aug. 31, 1977) (classifying a German limited liability company); PLR 78-02-012 (Oct. 11, 1977) (classifying a Brazilian limited liability company).

 

[8]  See PLR 77-43-060; PLR 77-48-038.

[9]  Id. at 1280.

[10] Id.  The Tax Court determined that because the trust clearly had five of the six corporate characteristics, it would be taxable as an association.  Id. at 1286.  See General Counsel Memorandum 38,707 (May 1, 1981) (IRS will follow Hynes).

[11] T.C. Memo.  1992-371, 63 TCM (CCH) 3201 (1992).

[12] 63 TCM at 3201-12.

[13] 1988-1 C.B. 403.