How Courts Determine if a Foreign Entity is a Trust in the U.S.

How do I Know if a Foreign Legal Structure is a Trust?

Is my Foreign Legal Structure a Trust?

There are many different types of foreign entities across the globe. A foreign entity may be a foreign corporation, trust, partnership — or other venture. For example, a Sociedad Anonima (S.A.) is considered a per se corporation under US Tax law – which means that the S.A cannot be disregarded for US tax purposes and oftentimes leads to the filing of Form 5471 (Foreign Corporations) — although some exceptions, exclusions, and limitations may apply. Some foreign entities may have dual purposes under foreign tax law which may lead to conflicting US tax classification issues – depending on the facts surrounding the entity. For example, is the entity being used as a trust or as a corporation? This type of issue is common with foreign foundations especially — as was the case of a Panamanian Foundation, as well as the Stiftung (a common entity formation in Liechtenstein). In the 2022 case of Rost/Rebold we summarized below, the Court found the Stiftung to be a Trust – and the late-filed Form 3520 resulted in significant penalties. And more recently in the case of Fairbank the court determined a foreign entity was a trust (even though the parties reported it as a corporation). Since the Fairbank ruling was more detailed in explaining the process the Tax Court took to reach the determination that a foreign entity was a trust, we wanted to update our prior post with references to the Fairbank ruling.

Entity Classification – Fairbank (2023)

• • • “The Code prescribes the classification of various organizations for federal tax purposes. Treas. Reg. § 301.7701-1(a)(1).

    • “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.” Id.

    • In general, an arrangement will be treated as a 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 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. See Elm St. Realty Tr. v. Commissioner, 76 T.C. 803, 814–15 (1981); Treas. Reg. § 301.7701-4(a).”

What does this mean?

It means that for federal tax purposes, the US government will apply US tax law to determine how the organization will be recognized in the United States. Even if the organization/entity would be recognized differently under foreign tax laws — that does mean it is how it will be categorized under United States tax law.

Elements of a Foreign Trust

• • • “The four elements of a trust for federal tax purposes are

      • (1) a grantor,

      • (2) a trustee that takes title to property for the purpose of protecting or conserving it,

      • (3) property, and

      • (4) designated beneficiaries.

    • See Treas. Reg. § 301.7701-4(a).22 This Court applies a facts and circumstances analysis when determining whether an arrangement should be treated as a trust or a business entity by determining whether the arrangement includes (1) associates and (2) an objective to carry on a business and divide the gains therefrom. See Elm St. Realty Tr., 76 T.C. at 809–18; see also Morrissey v. Commissioner, 296 U.S. 344, 356–58 (1935). The absence of either of these essential characteristics will cause an entity to be classified as a trust. See Estate of Bedell v. Commissioner, 86 T.C. 1207, 1218 (1986); Elm St. Realty Tr., 76 T.C. at 818.”

What does this mean?

The above-referenced paragraph refers to the basics of what is required in order to establish a trust under US tax law.

Is it Really a Foreign Trust?

• • • “When distinguishing between an association and a trust for tax classification purposes, relevant features of the arrangement are its “nature,” “purpose,” and “operations.” See Swanson v. Commissioner, 296 U.S. 362, 365 (1935); Morrissey v. Commissioner, 296 U.S. at 357. In assessing these features, weight should be given to the arrangement’s organizing documents. See Swanson v. Commissioner, 296 U.S. at 363–65; Morrissey v. Commissioner, 296 U.S. at 360–61.

    • The Supreme Court noted that the “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.” Helvering v. Coleman-Gilbert Assocs., 296 U.S. 369, 374 (1935).

    • Respondent argues that under the facts and circumstances analysis, Xavana Establishment qualifies as a trust.

      • Xavana Establishment’s organizing documents state that it is to operate “on a trust basis,” its purpose is the “investment and management of assets,” and its “capital and its results as well as any clear profits of [Xavana] Establishment shall be due to the beneficiaries.”

      • It is irrefutable that Mrs. Fairbank is reflected as the beneficial owner of Xavana Establishment; and the record does not indicate that Xavana Establishment involved any business associates or operated as a joint enterprise that conducted business.

      • In fact, Xavana Establishment is explicitly noted as neither owning any business premises nor employing any staff working exclusively for it. Furthermore, Xavana Establishment did not operate any trade, manufacturing, or any other business of a commercial type.

      • Accordingly, we conclude that Xavana Establishment is properly classified as a trust for federal tax purposes under Treasury Regulation § 301.7701-4(a).23 The arrangement here closely resembles a typical trust whereby a settlor (here, Mr. Hagaman)24 establishes a trust for the benefit of specified beneficiaries …Consequently, we agree with respondent and find that the governing documents concerning Xavana Establishment, along with other documents in the record, show that Xavana Establishment was a trust for federal tax purposes.”

What does this mean?

In reviewing the underlined documents and the purpose of the arrangement of the establishment at issue in this case, the court determined that it was, in fact, a trust.

US vs Foreign Trust

• • • “Now that we have determined that Xavana Establishment is properly classified as a trust for federal tax purposes, our analysis turns to the issue of whether Xavana Establishment is a domestic trust or a foreign trust. 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). Treasury Regulation § 301.7701- 7(a) provides a two-factor test to determine whether a trust is domestic.

      • A trust is domestic if

        • (1) “[a] court within the United States is able exercise primary supervision over the administration of the trust” (court test) and

        • (2) “[o]ne or more United States persons have the authority to control all substantial decisions of the trust” (control test). Id. subpara.

          • (1). Failure to satisfy either the court test or the control test will result in the trust’s being deemed a foreign trust for federal tax purposes. Id. subpara. (2).

    • A trust satisfies the court test if the governing document does not direct that the trust be administered outside of the United States, the trust, in fact, is administered exclusively in the United States, and the trust is not subject to an automatic migration provision that would move it outside the United States if a U.S. court were to attempt to assert 19 [*19] jurisdiction. Treas. Reg. § 301.7701-7(c)(1), (4)(ii). With respect 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 any of the substantial decisions. Id. para. (d)(1)(iii).

    • Substantial decisions are those decisions that are “authorized or required” under the trust instrument and applicable law, which include, but are not limited to, decisions concerning whether and when to distribute income or corpus, the amount of any distribution, whether to terminate the trust, etc. Id. subdiv. (ii).

    • In this case Xavana Establishment fails to satisfy the court test as defined by section 7701(a)(30)(E)(i). There is nothing in the record to suggest that a court within the United States was able to exercise primary supervision over the administration of Xavana Establishment. In fact, the Contract of Mandate, which is part of the organizing documents concerning Xavana Establishment, states that the parties agree that “disputes relating to this [c]ontract . . . shall be subject to the law of the Principality of Liechtenstein” and that the “place of jurisdiction is agreed as Vaduz, [Liechtenstein].” Accordingly, we find that Xavana Establishment fails the court test. I.R.C. § 7701(a)(30)(E)(i); Treas. Reg. § 301.7701-7(a)(1)(i), (c)(1). Consequently, Mrs. Fairbank’s ownership interest in Xavana Establishment, a foreign trust, gives rise to reporting obligations under section 6048.25.”

What does this mean?

It means that in applying the court and control test to the facts of the case, the tax court determined that this is a foreign trust. Unfortunately, this was bad news for Petitioners, because since it is a foreign trust, it turns out that the taxpayer did not properly file Form 3520. And, since the forms are not filed, the statute remains open and the appellant’s argument that the taxes, interest, and penalties should not apply because the statute of limitations expired was rejected by the court.

Toth Case (2022)

Let’s take a look at how the court came to its conclusion by looking at key portions of the ruling, specifically for a Stiftung.

Federal Tax Law Controls  

The first key issue is that federal tax law controls the classification — meaning that just because an entity is considered a corporation under foreign tax law does not necessitate that it will be considered a corporation under US Tax Law.

• • • 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).

Classification Under US Tax Law

There is no special classification for a Stiftung under US tax law that requires it to be de facto treated as either a foreign Trust or Corporation.

• • • 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).

Not Always A Trust

Just because other courts have found a Stiftung to be a corporation does not mean it will always be treated as a corporation.

• • • 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 argues that because the IRC and its regulations do not specifically classify Liechtensteinian Stiftungen as trusts, they could be corporations, partnerships, or other entities. They very well could, under certain facts and circumstances. But Rost presents no evidence that Enelre should be classified as anything other than a trust. See, e.g., Jones v. United States, 936 F.3d 318, 321 (5th Cir. 2019) (“A non-movant will not avoid summary judgment by presenting ‘speculation, improbable inferences, or unsubstantiated assertions.’” (citation omitted)).

A Stiftung May Also be a Business (Rost)

But, in some circumstances, a Stiftung may be considered a business and not a trust for US Tax law.

• • • Rost also claims that courts have treated a Stiftung as a corporation under the IRC, citing Oak Commercial Corp. v. Commissioner, 9 T.C. 947 (1947), aff’d sub nom. Aramo-Stiftung v. Commissioner, 172 F.2d 896 (2d Cir. 1949). But there, neither the Tax Court nor the Second Circuit evaluated whether the Stiftungen were properly characterized as foreign corporations.

    • The Tax Court merely accepted the IRS’s position that the Stiftungen were corporations because the taxpayer failed to challenge the classification. See Oak Commercial, 9 T.C. at 954-55. Accordingly, the treatment of the Stiftungen there is unhelpful. See Estate of Swan v. Comm’r, 247 F.2d 144, 147 n.3 (2d Cir. 1957); Estate of Swan v. Comm’r, 24 T.C. 829, 860 (1955).

Here, There was No Business Objective

The key distinction in this case vs other cases is that the Stiftung had no business purpose.

• • • 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 (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. 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 (1935); Helvering v. Coleman-Gilbert Assocs., 296 U.S. 369 (1935); Helvering v. Combs, 296 U.S. 365 (1935).

What does this mean?

It means that for federal tax purposes, the US government will apply US tax law to determine how the organization will be recognized in the United States. Even if the organization/entity would be recognized differently under foreign tax laws — that does mean it is how it will be categorized under United States tax law.

Current Year vs Prior Year Non-Compliance

Once a taxpayer has missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist that specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties. 

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