We discussed in our previous blog what constitutes a “business trust” for Federal Tax Purposes.
In this week’s blog we will look a bit more in depth at what constitutes an “ordinary trust” for US Federal Tax Purposes and if your entity is one.
Trusts are used all over the world and are generally regarded as extremely beneficial vehicles to hold assets and investments.
However, make sure that you understand how the IRS will classify your trust and what the implications of that will be for the trust and its beneficiaries.
This article will broadly examine the issues local and global tax advisors must address when a client uses a trust structure for US expansion and how it will be classified for federal tax purposes.
While many believe that classifying a “trust” is a matter of local law, the determination of trust status for U.S. tax purposes must be made in accordance with the U.S. tax rules. Such determination is not always a simple matter.
A trust is a separate legal entity or arrangement typically used for family and estate planning purposes. Trusts allow assets to be held by an entity, other than a natural person. Accordingly, trusts are often used to hold property and facilitate a transfer of such property to beneficiaries without the need for probate proceedings.
Classifying a trust for US Federal Tax purposes is of critical importance. This is applicable to domestic and foreign trusts and would politely ask the reader to leave any ignorance regarding the classification of their trust right about here before continuing with this blog. The reason for such a request is codified below –
Reg. 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.
DEFINING A “TRUST” FOR US FEDERAL TAX PURPOSES
The entity classification rules use the term “ordinary” trust to distinguish such an entity from a “business” trust.
For an arrangement to be considered a trust for US Federal Tax Purposes, the entity needs to be an “entity separate from its owner” that is treated as an “ordinary trust” (in contrast to a “business trust” as discussed in our previous blog).
In terms of the Internal Revenue Code, an arrangement will be treated as an “ordinary trust” if it can be shown that the purpose of the arrangement is to vest in trustees, responsibility for the protection and conservation of property for the beneficiaries who cannot share in the discharge of this responsibility and therefore are not associates in a joint enterprise for the conduct of business for a profit. The beneficiaries of such a trust usually do no more than accept the benefits thereof and are not voluntary planners or creators of the trust arrangement.
However, when it comes to the protection of a family’s wealth more so than not, the beneficiaries and the people who created the trust are one in the same. Such an arrangement will still be recognized as a trust for US Federal Tax Purposes if it were created for the purposes of protecting or conserving the trust property for the beneficiaries who stand in the same relation to the trust as they would have been if the trust had been created by someone other than them.
Once it has been established that the entity will be classified as a trust for US Federal Tax Purposes it should be determined whether the trust is a domestic or foreign trust.
DOMESTIC OR FOREIGN TRUST
This classification is extremely important as it impacts how the trust activities should be reported and taxed in the US.
A trust will be considered to be a foreign trust unless it meets the following two tests: –
The Court Test −
A trust will meet the court test if a court within the United States is able to exercise primary supervision over the administration of the trust.
The Control Test –
A trust will meet the control test if one or more United States persons have the authority to control all substantial decisions of the trust with no other person having the power to veto any of the substantial decisions.
If the trust meets both the Control test and the Court test, the trust is treated as a domestic trust and if the trust fails either the Control Test or the Court Test, the trust is treated as a foreign trust.
So, you would think that classifying the entity as a trust and determining if its domestic or foreign is sufficient to understand the tax implications in the US right?
Try and recall the previous blog when it was recommended to utilize metacognition when classifying entities for US tax purposes. Well the same applies here.
Once it has been established if the trust is a domestic or foreign trust, the next step is to determine if the trust will be regarded as a grantor or non grantor trust.
IS YOUR TRUST A GRANTOR OR NON GRANTOR TRUST?
Determining whether a trust is a grantor or non grantor trust is of upmost importance as it affects who is taxed on the trust income and when they are taxed. If a foreign trust is characterized as a grantor trust under IRC §§ 671–679, the grantor or another person is treated as the owner of the trust. If a U.S. person is treated as the owner of a trust for U.S. Federal Tax Purposes under the grantor trust rules, then the U.S. person must report its share of trust income, deductions and credits on its income tax return as if those items were directly received by or paid to that U.S. person.
Right about now, you might be asking yourself what exactly is a grantor? Now to explain this in one blog is impossible, so I have tried and given a simplified summary of it below.
Although the term “grantor” is generally used to refer to anyone who places property in trust, the term “grantor trust” has a specific technical meaning.
Internal Revenue Code (IRC) §§ 671-679 are commonly referred to as the “Grantor Trust Rules.” IRC §§ 671-678 apply to both domestic and foreign trusts. IRC § 679 applies only to foreign trusts and takes precedence over the rules found in IRC §§ 673-678 with respect to a foreign trust.
Please view our Grantor Trust video series for more information.
For purposes of the grantor trust rules, the grantor is generally identified as the individual or corporations who both creates and funds the trust. Situations occur in which the grantor is an entity other than the trust’s creator, however, and it may be necessary to “peel off a façade to get at the truth.
Reg. §1.671-2(e) defines who is the grantor of a trust for purposes of the grantor trust rules. The regulations state that, for purposes of the grantor trust rules, the “grantor” of a trust includes:
any person to the extent such person either creates a trust, or directly or indirectly makes a gratuitous transfer of property to a trust.
Any foreign trust not determined to be a grantor trust will be treated as a foreign non-grantor trust for U.S. tax purposes.
THE SEMMELWIES REFLEX – MENTAL MYOPIA
The Semmelweis Reflex is a metaphor for the rejection of new knowledge because it contradicts existing norms, beliefs, or paradigms. It is a form of mental myopia that can spell doom, even for the most successful organization or person.
If the content of this blog is regarded as new knowledge for the reader, please be cognizant of mental myopia and its potential impact on your Trust.
To summarize the above, ask yourself the following questions –
- Is the entity classified as a Trust for Federal Tax Purposes?
- Is the Trust classified as a Domestic or Foreign Trust for Federal Tax Purposes?
- Is the Trust classified as a Grantor or Non Grantor Trust for Federal Tax purposes?
The classification of your trust as domestic, foreign, grantor or non grantor for US Federal Tax Purposes has a direct impact on the tax treatment and disclosure obligations in the US. Make sure you consult tax experts who can assist you with this. At Asena we can assist with mitigating risk on your existing trust or advise on how to utilize a trust for future structuring in the US.