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

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 trust that may be a foreign trust by reason of the new definition is given a two-year period to meet the new definition. The safe harbor is available to trusts that were domestic trusts prior to application of the new definitions and in existence on Aug. 20, 1996 (an "existing trust"), provided the trust does not elect to apply the new definitions to the first trust tax year ending after Aug. 20,1996. Existing trusts may continue to file as domestic trusts (even though they may be foreign trusts under the new definition) without imposition of the Sec. 1491 excise tax for tax years beginning after 1996, provided the trustee:

1. Initiates modification of the trust to conform with the domestic trust criteria by the due date (including extensions) for filing the trust's income tax return for its first tax year beginning after 1996;

2. Completes the modification within two years of the above-referenced due date; and

3. Attaches a statement to the trust's income tax return, entitled "Election to Rely on Notice 96-65 to File as a Domestic Trust."

If, prior to the end of the two-year period, the trust meets the Code's definition of a domestic trust, the trust will be deemed a domestic trust during the two-year period for all Code purposes If the trust fails to become a domestic trust within the two-year period, the safe harbor period may be extended at the District Director's discretion, if a trustee has taken reasonable actions to comply with the requirements of Notice 96-65 during the two-year period, but (due to circumstances beyond the trustee's control) the trust fails to qualify as a domestic trust within that period.

If, at the end of the safe harbor period, the trust does not meet the definition of a domestic trust, the trust will be deemed a foreign trust for all tax years beginning after 1996 for all Code purposes. The trust will be required to file amended income tax returns for the affected tax years and the Sec. 1491 excise tax will be applied as of Jan. 1, 1997. In addition, amended returns may be required for (1) any U.S. person treated as the trust grantor by reason of the grantor trust rules and (2) any beneficiary whose tax liability is affected by the change of trust situs.

To take advantage of the safe harbor, a statement entitled "Election to Rely on Notice 96-65 to File as Domestic Trust" must be attached to the trust's income tax return for each tax year the notice is relied on by the trust in filing as a domestic trust. The election statement must contain the following information:

1. A statement that the trust is relying on Notice 96-65 to file as a domestic trust;

2. A statement that, for each of the trust's tax years beginning after 1994, the trustee filed original income tax returns treating the trust as domestic, and will continue to file as a domestic trust while actions are undertaken to meet the new law's domestic trust criteria;

3. The date on which the actions to modify the trust were initiated, including a brief description of those modifications previously completed and of the expected additional actions necessary to meet the new definition;

4. The name, taxpayer identification number and address of any U.S. person who, but for the relief provided by Notice 96-65, would be the trust's grantor by reason of Sec. 679 during any tax year of the trust beginning after 1996; and

5. A statement that should the trust fail to meet the new definition of a domestic trust 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 beginning after 1996 to treat the trust as a foreign trust.

The election statement must be signed by the trustee under penalties of perjury.

If a trustee chooses to take advantage of the Notice 96-65 safe harbor, the trust need only file a Form 1041, and attach the required statement. I f the trustee determines a trust is a foreign trust by reason of the new definitions and does not take advantage of the safe harbor, or fails to take advantage of the safe harbor from failure to recognize that the new definition applies, the 35% excise tax of Sec. 1491 may be imposed. In addition, trusts that are not currently grantor trusts may become grantor trusts under Sec. 679 by reason of the change in the trust's status. If so, numerous filing requirements may be imposed by Sec. 6048, with severe penalties possible for failure to comply with these filing requirements.

From Jeffrey C. Zysik, J.D., Washington, D.C.