Prologue – The “Take Away” And Summary For Americans Abroad
A Mexico Land TRUST, is not a FOREIGN TRUST for IRS purposes – ("cannot be what it isn't"). But, a Liechtenstein “Stiftung” – private FOUNDATION with no reference to the word TRUST is a FOREIGN TRUST for IRS penalty purposes – ("would be what it isn't"). https://t.co/3qaB8NWrnF pic.twitter.com/iHkZMP8iAS
— John Richardson – lawyer for "U.S. persons" abroad (@ExpatriationLaw) November 16, 2022
The general message is contained in the above twitter thread. Americans abroad are likely to have financial involvements with a number of different kinds of “entities” that are “local” to them and “foreign to the United States. Examples may include: pension plans, tax advantaged savings plans, small business corporations and more. The descriptive title of these “entities” is irrelevant to their classification under US tax rules.
What an individual understands to be a foundation, trust, corporation, pension or anything else could be classified under US tax rules in in a number of different (and unexpected) ways. The US classification for tax purposes will be determined by the “facts and circumstances” and characteristics of the entity. Furthermore, the classification will determine BOTH (1) how the entity is subject to US taxation and (2) the specific reporting requirements (and potential penalties) that apply to that entity.
(It is important for Americans abroad to understand the risk that income earned by the “foreign to the US” corporation or trust (but local to them) may be deemed to have been earned by the individual. This may be true even when that income has not been received by the individual. This is the consequence of Subpart F, GILTI and the Grantor trust rules. These specific topics will be left for separate posts.)
Part A – Treasury Regulations And Americans Abroad
The rules for the classification of entities
Section 7701 of the Internal Revenue Code is where definitions are found. Interestingly, “corporations” and “trusts” are NOT defined in 7701 (the legislative provisions). They are defined in Treasury Regulations.
The US classification of entities will be made by applying US Treasury regulations which begin here:
How the Treasury Regulations apply to the lives of Americans abroad is not always clear. Nevertheless, as the recent 3520A Penalty Fundraiser indicates:
Individuals who engage with “foreign” entities have dramatically increased their chances of being subject to various penalties!
But, it’s important to note that:
The regulations do NOT generally distinguish between resident Americans and Americans abroad (where the “foreign” entity is local to the individual).
It is clear that individuals (particularly Americans abroad) are at risk of:
1. Engaging with non-US entities that qualify as “foreign trusts” or “foreign corporations” under the Treasury Regulations; and
2. Are subject to draconian penalties for the failure to report those foreign trusts or corporations to the IRS!
Individuals are subject to penalties for not properly characterizing foreign “entities” according to the relevant Treasury Regulations! Penalty abatement for “reasonable cause” is often difficult.
A general hostility to “All Things Foreign”
The Internal Revenue Code and associated regulations are extremely hostile to income streams and assets that are “foreign” to the United States. They are (likely) drafted with the intention of applying to US residents who use “foreign” assets to avoid or defer US taxation. The problem is that with respect to Americans abroad:
The assets that are foreign to the United States are LOCAL to Americans abroad. Hence, the United States in effect imposes a separate and more punitive tax system on Americans abroad than on resident Americans.
The 2019 3520A “Foreign Trust” penalties
The 2019 3520A penalties received by thousands of Americans abroad are a perfect example of:
1. The problem of what happens when non-US entities are treated as “foreign trusts”; and
2. How quick the IRS is to assess penalties.
(In fairness, Treasury has tried to improve the situation with Rev. Proc. 20-17 which removed certain categories of foreign financial assets from the 3520 and 3520A reporting regime.)
Bottom Line: The Internal Revenue Code impacts Americans abroad in ways that they neither anticipate nor understand. The vast majority of Americans abroad would never imagine that opportunities that are used for legitimate tax planning purposes in their country of residence – for example a Kiwisaver – could be subject to punitive taxation and reporting by the United States.
The Problem Of Treasury Regulations – The Power To Regulate Is The Power To Destroy
As one commenter on twitter suggests … pic.twitter.com/YwwRBxFeTO
— John Richardson – lawyer for "U.S. persons" abroad (@ExpatriationLaw) November 17, 2022
It is clear that in making regulations, Treasury does NOT as a general rule consider the circumstances of Americans abroad. This leads to results that are of significant negative consequence to middle class Americans attempting to live outside the United States.
It may take years before the damage becomes apparent. For, example in 1996 the Treasury regulations were amended to define almost all Canadian Controlled Private Corporations as “per se” corporations. The effect of this was experienced most profoundly in the 2017 TCJA which effectively confiscated a large portion of the retained earnings (via the “965 Transition Tax)” of those corporations. In addition the TCJA created the GILTI rules which significantly burdened the ability of Americans abroad to utilize small business corporations in their country of residence. The power to regulate is indeed the power to destroy!
US Citizenship Taxation Results In Life Destroying Regulation Of The Lives Of Americans Abroad
The Rost case (discussed in Part B of this post) is analyzed in the context of a US resident with a foreign legal entity. It could easily been discussed in the context of a US citizen living outside the United States. What might seem reasonable (although harsh) in the life of a US resident, becomes extremely unreasonable when applied to US citizens living outside the United States. This is why the United States MUST sever US citizenship from the definition of US tax residency. The US needs to adopt the world standard of residence-based taxation.
Part B – Rost v. United States – An Example Of How To Analyze: When Do The “Foreign” Investment “Entities” Owned By Americans Abroad Qualify As “Foreign Trusts”?
Excellent summary of the Rost. v. U.S. case and it's implications … "U.S. Court Deems A Foundation A Foreign Trust – Greenlighting Penalties" https://t.co/ObedQrBHGk
— John Richardson – lawyer for "U.S. persons" abroad (@ExpatriationLaw) November 18, 2022
Introducing John Rebold and his Liechtenstein foundation
There was no evidence that Mr. Rebold was a US citizen living outside the United States when he created his Liechtenstein foundation. Yet, one could imagine that this is exactly what a long term US citizen residing abroad might do. The basic issue was:
A. Mr. Rebold created the Liechtenstein foundation (which was not called a trust) and didn’t know that it would be a foreign trust under US tax laws. He did not report income from the foundation (presumably on the basis that it was a foreign entity).
B. Upon learning that the foundation was considered to be a trust under US tax law, his executor attempted to properly report the foundation on a Form 3520. The estate was assessed significant penalties.
The estate’s lawyer argued that it was unreasonable to assess penalties when it wasn’t immediately apparent that the Liechtenstein foundation was actually (from a US perspective) a foreign trust that had not been reported.
What follows are some excerpts from the decision of the Fifth Circuit (which is the same court that ruled Bittner was subject to per account FBAR penalties).
The facts were described by the court as follows:
In 2005, John Rebold formed the Enelre Foundation as a Stiftung under the laws of Liechtenstein. Stiftung is a German word meaning, roughly, “foundation” or “endowment.” Enelre’s purpose is to provide education and general support for Rebold and his children. Rebold transferred $3 million to Enelre’s bank accounts. He later learned the IRS would consider Enelre a “foreign trust,” triggering certain reporting requirements. Rebold belatedly filed the reports, and the IRS assessed penalties. Rebold paid the penalties and then filed this refund action. The district court granted summary judgment for the government. We affirm.
The court then analyzed whether the Liechtenstein foundation was a “foreign trust” – note the “facts and circumstances” analysis.
The classification of an organization “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.” Treas. Reg. § 301.7701-1(a). Sections 301.7701–2, 301.7701–3, and 301.7701–4 determine the classification of organizations recognized as separate entities, unless the IRC “provides for special treatment of that organization.” Id. § 301.7701-1(b). Neither the IRC nor its regulations specifically classify or provide for special treatment of Stiftungen . Cf. id. § 301.7701-2(b)(8) (classifying Liechtenstein Aktiengesellschaften as corporations).
Determining whether an arrangement is a foreign trust requires a two-step inquiry: (1) whether it is a trust under section 301.7701-4 or a business entity under sections 301.7701-2 or 301.7701-3, and (2) if it is a trust, whether it is a United States person (i.e. , a domestic trust) or a foreign trust. See I.R.C. § 7701(a)(30)(E), (31)(B) ; Treas. Reg. §§ 301.7701-1(a) – (b), (d), 301.7701-2(a), 301.7701-4(a), 301.7701-5(a), 301.7701-7.
A “trust” in the IRC is an arrangement where “trustees take title to property for the purpose of protecting or conserving it for the beneficiaries.” Treas. Reg. § 301.7701-4(a). An arrangement generally qualifies as a trust if “the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for 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 profit.” Ibid. ; see also Frank Aragona Tr. v. Comm’r , 142 T.C. 165, 175 (2014).
An arrangement’s purpose thus distinguishes a trust from other entities. “[A]ny entity recognized for federal tax purposes … that is not properly classified as a trust under § 301.7701–4” is a “business entity.” Treas. Reg. § 301.7701-2(a). Arrangements “known as trusts because the legal title to property is conveyed to trustees for the benefit of beneficiaries” may nevertheless not qualify as trusts under the IRC “because they are not simply arrangements to protect or conserve the property for the beneficiaries.” Id. § 301.7701-4(b). “Business trusts,” for example, “generally are created by the beneficiaries simply as a device to carry on a profit-making business which normally would have been carried on through business organizations that are classified as corporations or partnerships under the [IRC].” Ibid. ; see Petersen v. Comm’r , 148 T.C. 463, 475 n.8 (2017).
In classifying an arrangement as a trust or other business entity for tax purposes, “there is no one rule or set formula,” and “[e]ach case must be decided upon its own particular facts.” Keating-Snyder Tr. v. Comm’r , 126 F.2d 860, 862 (5th Cir. 1942) ; see also Comm’r v. Horseshoe Lease Syndicate , 110 F.2d 748, 749 (5th Cir. 1940) (“the facts of each case[ ] must control”). The seminal case is Morrissey v. Commissioner , 296 U.S. 344, 56 S.Ct. 289, 80 L.Ed. 263 (1935). There, the Supreme Court held that a trust created for developing tracts of land and constructing and operating a golf course was properly classified and taxed as “an association” (i.e. , a business trust), rather than an ordinary trust, based on its “character” and “salient features,” including the trustees’ “use and adaptation of the trust mechanism.” Id. at 359–61, 56 S.Ct. 289. The Court applied Morrissey ‘s fact-specific approach in three companion cases decided that same day. See Swanson v. Comm’r , 296 U.S. 362, 56 S.Ct. 283, 80 L.Ed. 273 (1935) ; Helvering v. Coleman-Gilbert Assocs. , 296 U.S. 369, 56 S.Ct. 285, 80 L.Ed. 278 (1935) ; Helvering v. Combs , 296 U.S. 365, 56 S.Ct. 287, 80 L.Ed. 275 (1935).
An arrangement’s most relevant features for tax-classification purposes are its “nature,” “purpose,” and “operations.” Morrissey , 296 U.S. at 357, 56 S.Ct. 289 ; Swanson , 296 U.S. at 365, 56 S.Ct. 283. The form of organization under which the arrangement operates “may furnish persuasive evidence” of a classification but “cannot be regarded as decisive.” Morrissey , 296 U.S. at 358, 56 S.Ct. 289. No feature is dispositive; they “all go to the point of whether the trust is being used to achieve the organizational conveniences of the corporate form.” Guar. Emps. Ass’n v. United States , 241 F.2d 565, 571 (5th Cir. 1957).
Morrissey relied on five corporate features to conclude the trust was “analogous to a corporate organization” and thus qualified as an “association,” or “business trust.” 296 U.S. at 359–61, 56 S.Ct. 289. These features are “(1) title to the property held by the entity, (2) centralized management, (3) continuity uninterrupted by deaths among the beneficial owners, (4) transfer of interest without affecting the continuity of the enterprise, and (5) limitation of the personal liability of participants.” Comm’r v. Rector & Davidson , 111 F.2d 332, 333 (5th Cir. 1940) ; see Kurzner v. Comm’r , 413 F.2d 97, 101–04 & n.22 (5th Cir. 1969) (reviewing Morrissey ‘s discussion of “distinguishing attributes of ‘corporateness’ “).
In assessing these features, the arrangement’s organizing documents are determinative. See Swanson , 296 U.S. at 363–65, 56 S.Ct. 283 ; Morrissey , 296 U.S. at 360–61, 56 S.Ct. 289. As the Supreme Court has explained, “parties are not at liberty to say that their purpose was other or narrower than that which they formally set forth in the instrument under which their activities were conducted.” Coleman-Gilbert , 296 U.S. at 374, 56 S.Ct. 285.
See also Abraham v. United States , 406 F.2d 1259, 1262–63, 1263 n.4 (6th Cir. 1969) (finding “broad powers … for conducting a business for profit … carefully spelled out” in the trust instrument could not “be negated by [a] self-serving limiting declaration contained in the last paragraph” that the trust “shall not be deemed or considered a trust operated for financial profit”); Nee v. Main St. Bank , 174 F.2d 425, 429 (8th Cir. 1949) (“The intention, through the creation of a trust, to conduct a business enterprise may accordingly legally be inferred … from the enumeration in the instrument of powers which, if exercised, would necessarily cause such an enterprise to result.”); Sears v. Hassett , 111 F.2d 961, 962–63 (1st Cir. 1940) (noting the “character of the trust” is determined by “the purposes and potential activities as disclosed on the face of the trust instrument”).
Once an entity is deemed a trust, it must be classified as foreign or domestic. A foreign trust is “any trust other than a trust” that is a “United States person” (i.e. , a domestic trust). I.R.C. § 7701(a)(30)(E), (31)(B) ; Treas. Reg. § 301.7701-7(a)(2). A trust is domestic if (1) “a court within the United States is able to exercise primary supervision over the administration of the trust” (the “court test”) and (2) “one or more United States persons have the authority to control all substantial decisions of the trust” (the “control test”). I.R.C. § 7701(a)(30)(E) ; Treas. Reg. § 301.7701-7(a)(1).
A trust satisfies the court test if the governing document “does not direct that the trust be administered outside of the United States,” “[t]he trust in fact is administered exclusively in the United States,” and “[t]he trust is not subject to an automatic migration provision” that would move it outside the U.S. if a U.S. court were to “attempt to assert jurisdiction” over it. Treas. Reg. § 301.7701-7(c)(1), (4)(ii). As to the control test, “control means having the power, by vote or otherwise, to make all of the substantial decisions of the trust, with no other person having the power to veto [them].” Id. § 301.7701-7(d)(1)(iii). This includes anyone with authority over substantial decisions, not only trust fiduciaries. Ibid. Substantial decisions are those “authorized or required” under the trust instrument and applicable law “that are not ministerial.” Id. § 301.7701-7(d)(1)(ii) (providing examples).
The court then considered the penalty issue
Rost’s notice arguments are without merit. Rost first claims the penalties violate the APA because the government relied on an unwritten “rule” promulgated without notice and comment that Stiftungen are foreign trusts for tax purposes. But the government applied no “rule.” See 5 U.S.C. § 551(4) (defining “rule”). As the district court explained, “Rost’s argument is based on the faulty premise that the IRS established a ‘rule’ that a Stiftung always qualifies as a ‘foreign trust.’ ” Rost , 2021 WL 5190875, at *8. The IRS has consistently recognized that each Stiftung must be analyzed on its own facts and circumstances. See, e.g. , I.R.S. Chief Couns. Att’y Mem. AM2009-012, 2009 WL 3336014 (Oct. 7, 2009). Rost does not challenge the validity of the regulations under which Enelre qualifies as a foreign trust. See Treas. Reg. §§ 301.7701-4, 301.7701-7.
Rost next argues the penalties “violate[ ] the duty of clarity for tax laws,” citing Central Illinois Public Service Co. v. United States , 435 U.S. 21, 98 S.Ct. 917, 55 L.Ed.2d 82 (1978). She claims the penalties cannot be imposed “without a clear description of the prohibited circumstances, facts, or status.” This argument, too, is based on the false “presumption that the IRS automatically considers a Stiftung to be a foreign trust for tax and penalty purposes.” Rost , 2021 WL 5190875, at *8.
Rost claims there is “no indication which foreign entities” the government “might deem to be a foreign trust. ” But the IRS is not obligated to promulgate a regulation listing all foreign entities that are or may be classified as a foreign trust. As Morrissey acknowledged, “it is impossible in the nature of things to translate the statutory concept of ‘association’ into a particularity of detail that would fix the status of every sort of enterprise or organization which ingenuity may create.” 296 U.S. at 356, 56 S.Ct. 289. So too for trusts.
In any event, Central Illinois is inapposite. There, the Court held an employer could not be penalized for failing to withhold income taxes on reimbursements of meal expenses for employees day-traveling on business because it was unclear at the time that the meals constituted wages subject to withholding. 435 U.S. at 29, 33, 98 S.Ct. 917. Rost identifies no decision applying this logic outside third-party withholding contexts. Cf. id. at 31, 98 S.Ct. 917 (“Because the employer is in a secondary position as to liability for any tax of the employee, it is a matter of obvious concern that … the employer’s obligation to withhold be precise and not speculative.”). But even if it applied here, the legal framework set forth above is sufficiently precise.
This defense has been dubbed the ” ‘deputy tax collector’ defense, … protect[ing] an employer from liability for failing to withhold employment taxes from its employees when the employer lacks ‘precise and not speculative’ notice of its duty to withhold.” N.D. State Univ. v. United States , 255 F.3d 599, 608 (8th Cir. 2001) (quoting Cent. Ill. , 435 U.S. at 31, 98 S.Ct. 917 ); see also Univ. of Chi. v. United States , 547 F.3d 773, 784 (7th Cir. 2008) ; Gen. Elevator Corp. v. United States , 20 Cl. Ct. 345, 354 (1990).
Finally, Rost argues that the penalties violate due process because there is no “clear, written rule of law” that Stiftungen qualify as foreign trusts. As shown above, the IRC, regulations, and case law provide ample notice that the classification of an arrangement as a trust, and whether it is foreign or domestic, are case-specific inquiries based on the facts and circumstances.
Part C – Mr. Erwin’s Oral Argument In Rost v. U.S.
When is an entity a "foreign trust" and when are penalties for Form 3520 penalties appropriate? Listen to the July 2022 live arguments (both lawyers) before the court in: 21-51064 Rost v. USA, July 6, 2022 https://t.co/8Vw3crNxvx via @YouTube
— John Richardson – lawyer for "U.S. persons" abroad (@ExpatriationLaw) November 18, 2022
Mr. Erwin’s argument is fascinating.
He does NOT frame the issue in terms of whether the Liechtenstein Stiftung is a foreign trust.
He frames the issue in terms of whether the IRS can impose a penalty for failing to file the 3520 when there is no historical precedent (or experience) that the Liechtenstein Siftung is a foreign trust.
It’s interesting how he separates the issue of WHETHER it is a foreign trust from WHETHER (assuming it is a foreign trust) penalties can be imposed.
Although the Fifth Circuit ruled against him, Mr. Erwin’s argument and approach is interesting.
You can listen to the both sides of the oral argument here:
Part D – Conclusion and Epilogue
The Fifth Circuit ruled for the IRS and against the estate/Ms. Rost. Ms. Rost applied for a rehearing of her appeal before the Fifth Circuit. Mr. Joseph Erwin (Counsel to Ms. Rost) concluded his application with:
It is time for courts to stop allowing the Internal Revenue Service and the Treasury Department to ignore due process when imposing penalties without promulgating regulations or offering some form of minimal guidance. The Decision ignores the legal issues presented by Appellant Rost and applies an after-the-fact logic to find that notice was adequate because the court below performed a facts-and-circumstances test and a 2009 internal IRS memorandum was sufficient notice for filing for 2005, 2006, and 2007 information returns. The Decision supports the IRS’ impunity and its arbitrary actions.
Appellants-Plaintiff Executor Rost is entitled to a panel rehearing.
On October 11, 2022 the Fifth Circuit denied the application for a rehearing in Rost v. U.S.
Have a question? Contact John Richardson, Citizenship Solutions.
Subscribe to TaxConnections Blog
Enter your email address to subscribe to this blog and receive notifications of new posts by email.