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

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 to file as a domestic trust if the following conditions are satisfied: 1. The trustee must initiate modification of the trust to conform with the domestic trust criteria by the due date (including extensions) for filing the trusts income tax return for its first tax year beginning after 1996. A "modification" includes any action taken (judicial or nonjudicial) to reform, amend, modify or alter the trust that is effective under local law. 2. The trustee must complete the modification within two years of that date. 3. The trustee must attach a statement to the trusts income tax return. (The information required to be included in the statement is provided in Appendix A on page 138.)

A domestic trust that fails to meet these conditions will be treated as a foreign trust for all purposes of the Code for all tax years beginning after 1996. In that event, U.S. persons treated as owning all or a portion of the trust and beneficiaries whose tax liability was affected by the change will be required to file amended returns for any year the trust incorrectly relied on the notice to file as a domestic trust.

The District Director may grant an extension of time for completing the modification beyond two years, on receipt of a written statement from the trustee that reasonable actions have been taken to meet the domestic trust criteria, but, due to circumstances beyond the trustees control, the trust is unable to meet such criteria within the two-year period.

Election to Apply New Trust

Criteria Retroactively 

A trustee may elect to apply the new trust definition to the trusts first tax year ending after Aug. 20, 1996. If this election is made, the new trust criteria must be applied for the entire election year. The election is made by attaching a statement to the trust's income tax return for that year. (The information required to be included in the statement is provided in Appendix B on page 139.)

A trust that changes from domestic to foreign as a result of the election must also attach a statement to its return agreeing to treat the change as a transfer of the trusts assets to a foreign trust for purposes of Sec. 1491, except to the extent the grantor or another person is treated as the owner of the trust under Secs. 673 through 679 when such trust becomes a foreign trust.

However, under a transition rule in the statute, a domestic trust with a foreign grantor treated as its owner under present law that becomes a foreign trust as a result of the new rules will be exempt from the Sec. 1491 excise tax, if the trust becomes a foreign trust before 1997, or if the assets of the trust are transferred to a foreign trust before 1997 (SBJPA Section 1904(e)). Therefore, a domestic grantor trust with a foreign grantor that becomes a foreign non-grantor trust under the new rules should seriously consider making the election.

Application of Secs. 1491

Through 1494

Except to the extent the trust is a grantor trust, if the status of a trust changes from domestic to foreign as a result of the new law, the trust will be treated as having made a transfer of all of its assets to a foreign trust. If the trust fails to meet the conditions above to continue to file as a domestic trust, the transfer will be deemed to occur on the first day of the trusts first tax year beginning after 1996.

The excise tax imposed by Sec. 1491 is due and payable at the time of the transfer. The notice provides that an excise tax arising as a result of a change in status under the new law may be paid by attaching Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation, Foreign Estate or Trust, or Foreign Partnership, and including the tax with the trust's income tax return for the year that includes the transfer. Interest may accrue on the tax from the date the transfer is deemed to occur until the tax is paid with the trust's return. Failure to report a transfer of property described in Sec. 1491 may result in penalties; see Notice 96-60.

If a trust acts in good faith to modify the trust so as to continue to file as a domestic trust, but fails to meet the domestic trust criteria by the end of the two-year period, penalties will not be imposed if the trustee makes a return on Form 926 within 30 days after the end of the two-year period to report the Sec. 1491 transfer and to pay any excise tax and interest due.

Until further guidance is provided, the trust cannot elect to apply the principles of Sec. 367 to reduce or eliminate the excise tax, unless the trust obtains a letter ruling on the application of the principles of Sec. 367. However, the other exceptions in Sec. 1492 continue to apply.

Recommended Action

All trusts classified as domestic trusts that were created outside the U.S. or that have foreign fiduciaries that control the major trust decisions should be examined to determine the effect of these rules.

Appendix A: Election to Rely on Notice 96-65 to File

as a Domestic Trust

The statement must be entitled "Election to Rely on Notice 96-65 to File as a Domestic Trust" and must be attached to the trust's income tax return for each tax year that this notice is relied on to file as a domestic trust. The statement must be signed under penalties of perjury by the trustee and contain the following information: 1. A statement that the trust is relying on this notice to file as a domestic trust for the tax year. 2. A statement that the trustee filed original income tax returns treating the trust as a domestic trust for each tax year of the trust beginning after 1994 and will continue to file as a domestic trust while actions are being taken to meet the domestic trust criteria. 3. The date on which actions to modify the trust to meet the domestic trust criteria were initiated and a brief description of both completed and forthcoming actions necessary to meet the domestic trust criteria. 4. The name, taxpayer identification number and address of any U.S. person who, but for the relief provided in this notice, would be treated as the owner of all or a portion of the trust under Sec. 679 for any tax year of the trust beginning after Dec. 31, 1996. 5. A statement that, if the trust does not meet the domestic trust criteria in Sec. 7701(a)(30) by the end of the two-year period, the trustee will file all of the trust's applicable returns (whether original or amended) for tax years of the trust beginning after 1996, treating the trust as a foreign trust.

Appendix B: Election Under SBJPA Section 1907(a)(3)(B) to Apply

New Trust Criteria Retroactively

To make the election, the trustee must attach a statement entitled "Election Under Section 1907(a)(3)(B) of the Small Business Job Protection Act of 1996 to Apply New Trust Criteria Retroactively: to the trust's income tax return for its first tax year ending after Aug. 20, 1996. The statement must be signed under penalties of perjury by the trustee and contain the following information: 1. A statement that the trust is relying on this notice to apply the new trust criteria for its first tax year ending after Aug. 20, 1996. 2. A declaration stating whether the trustee has filed an original U.S. income tax return treating the trust as a domestic trust for any of the three immediately preceding tax years. 3. A declaration stating whether, during the election year, there has been a change in trust status.