The IRS & Offshore Trusts: FATCA

On March 18, 2010, President Obama signed the Hiring Incentives to Restore Employment Act (“HIRE”) Act (P.L. 111-147, the “Act”) which included the Foreign Account Tax Compliance Act (“FATCA”) which contained new foreign account tax compliance rules. Under the Act, new reporting and disclosure requirements for foreign assets were phased in between 2010-2014.

Under FATCA:

1) If a foreign trust is treated as having a US beneficiary, an amount accumulated is treated as accumulated for the US Person’s benefit even if that Person’s interest is contingent. The Act clarifies that the discretion to identify beneficiaries may cause the trust to be treated as having a US beneficiary. This provision is effective after March 18, 2010.

2) The Act creates a rebuttable presumption that a foreign trust has a US beneficiary if a US person directly or indirectly transfers property to a foreign trust, effective date after March 18, 2010.

3) The Act provides that the uncompensated use of the foreign trust property by a US grantor, a US beneficiary (or a US person related to either of them) is treated as a distribution by the trust. The use of the trust property is treated as a distribution to the extent of the fair market value of the property’s use to the US Grantor/Beneficiary, unless the fair market value of that use is paid to the trust;

4) A loan of cash, or marketable securities by a foreign trust, or the use of any other property of the trust, to or by any US person is also treated as paid or accumulated for the benefit of the US person. This provision applies to loans made and uses of property after March 18, 2010.

5) Under the Act, any US Person treated as the owner of any portion of a foreign trust must submit IRS-required information and insure that the trust files a return on its activities and provides such information to its owners and distributees. This new requirement is in addition to the requirement that US persons are responsible for insuring that the foreign trust complies with its own reporting requirements. This provision is effective for tax years beginning after
March 18, 2010.

6) Under the Act, the minimum penalty for failure to provide timely and complete disclosure on foreign trusts was increased to the greater of: $10,000 or 35% of the amount that should have been reported.

7) Prior to the Act, in the case of the failure to properly disclose by the US owner of a foreign trust the year-end value, the minimum penalty would have been the greater of $10,000 or 5% of the amount that should have been reported. This increased penalty is effective for tax returns required to be filed after December 31, 2009.

IRC Sec. 671-679 determines whether a trust is a grantor trust (for US income tax purposes), if so all items of income, deduction and credit are reported on the grantor’s US federal income tax return and the grantor is responsible for payment of any income tax due (see Treas. Reg. 1.671-3(a)(1).

A grantor is the person who creates a trust directly, or indirectly makes a gratuitous transfer of property to a trust (a Settlor is the person who intentionally causes the trust to come into existence).

An “Inbound Trust” has a grantor who is a foreign person. If the trust has a US beneficiary who has made one or more gifts to that foreign person, the US person (not the foreign grantor/donee) is the trust owner to the extent of the gifts (IRC Sec. 672 (f)(5). This key IRC provision precludes foreigners; immigrating to the US, from giving property to another foreigner who agrees to fund a US trust for the benefit of the immigrating foreigner, who then denies he was the grantor of the trust (i.e. the “straw transferor”). Under IRC Sec. 672(f)(5) the immigrating foreigner receives the same treatment he would have received had he created the trust directly (Treas. Reg. Sec. 1-672(f)-5(a)(1).

An “Outbound Trust” has a grantor who is a US person, who creates a foreign trust, that has one or more US beneficiaries (IRC Sec. 679) (i.e. an Offshore Trust). The US person, who transferred the assets, is treated as the owner of the portion of the trust attributable to the property transferred (IRC Sec. 679(a)(1). If a foreign trust accumulates income during a year in which it has no US beneficiary, a US transferor (who would have been treated as owner of a portion of the trust during the prior year, but for the fact that it had no US beneficiary) is taxable on undistributed net income for all prior tax years(to the extent the undistributed net income remains in the trust at the end of the taxable year).

IRC Sec. 679 only applies to a transfer to a “foreign trust” (i.e. not a domestic trust) only if a trust has a US beneficiary (IRC Sec. 7701 (a)(31)(B). A foreign trust is defined as any trust that does not qualify as a US person (IRC Sec. 7701(a)(31)(B). A US person is defined under IRC Sec. 7701(a)(30) as citizen or resident of the US (including a resident alien), and includes: a US partnership, corporation or any estate, other than a foreign estate (defined in IRC Sec. 7701(a)(31)(A).

A US person includes a US trust (a domestic trust) which is a trust if “a court within the US is able to exercise primary supervision over the administration of the trust,” and “one or more US persons have the authority to control all substantial decisions of the trust” (Treas. Reg. Sec. 301.7701-7(a)(1).

Under IRC Sec. 679(c), a foreign trust always has a US beneficiary unless “under the terms of the trust, no part of the income or corpus of the trust may be paid or accumulated during the taxable year to or for the benefit of a US person (IRS Sec 679(c)(1)(A). Under Treas. Reg Sec. 1.679-2(a)(2)(i), this determination is independent of whether there is an actual distribution of income or corpus to a US person during the year. If the trust authorizes accumulations for possible distributions to any US person in the future, the trust has a US beneficiary throughout the intervening period. Treas. Reg. Sec. 1-679-2(a)(2)(iii),(Ex 2). Even if the only interest a US person has is a right to receive corpus upon termination, the trust has a US beneficiary (Treas. Reg. 1.679-2(a)(2)(iii)(Ex 3).

If a US trust becomes a foreign trust, under IRC Sec. 679 the trust becomes a foreign grantor trust (Treas. Reg. 1.679-6) and IRC Sec. 679 applies as though the grantor had on that date transferred “an amount equal to the portion of such trust attributable to the property previously transferred (IRC Sec. 679(a)(5), including undistributed net income of the trust for periods, before the trust became a foreign trust (IRC Sec. 679(a)(5).

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    […] Under FATCA, new reporting and disclosure requirements for foreign assets were phased in between 2010-2014.  […]