Foreign Foundations — What are they for US Tax Purposes?  Should I Care? Recent Court Case Lays it Out

Today’s post looks at the case of Rost v United States, No 119-CV-0607-RP 2021 BL 435976 (WD Tex., Austin Div., September 22, 2021).  In the Rost case, the Internal Revenue Service (“IRS”) assessed close to USD597,000 in civil penalties for a US taxpayer’s failure to file IRS Forms 3520 and 3520-A, information reporting with regard to foreign trusts.  For the years 2005-2011, the taxpayer did not report transfers of money to and ownership of a certain “foundation” (“the Foundation”) he had created in 2005 under the laws of Liechtenstein as a Stiftung.  The IRS deemed the foundation/Stiftung to be a “foreign trust”, and accordingly assessed the penalties.

The taxpayer’s representative argued that none of the relevant statutes, regulations, or cases specifically state that a Stiftung is a “foreign trust” for purposes of penalties under the Internal Revenue Code (IRC). The representative also argued, among other things, that the penalty assessments violated Due Process, the constitutional prohibition against Excessive Fines, all of which were rejected by the court.  The court stated that it must apply a “facts and circumstances” test to determine if the Foundation is indeed to be characterized as a foreign trust for US tax purposes. The focus of today’s blog post involves the characterization analysis.

Entity Classification

Unfortunately, classification determinations for foreign entities are not an exact science. There are very few cases or rulings providing guidance. The concept of a “foundation” did not derive from the common law, but is rather a civil law concept.  A foundation is a creature of a country’s statutory law (in the Rost case, the laws of Lichtenstein), but foundations are not well understood in common law jurisdictions, such as the United States. Since the US legal system is based on common law, the classification exercise is rendered even more difficult.

A foundation typically shares many characteristics that are common to both a “trust” and a “corporation” and is a bit of a “hybrid” between the two.  For US tax purposes, trusts and corporations are taxed very differently, with a corporation and its owners being subject to what is commonly called a system of “double taxation”, which does not apply to a trust and its beneficiaries.

In general terms, an arrangement will be treated as a “trust” if its purpose is to vest in a trustee responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and who, as such, are not active participants indistinguishable from “associates” in a joint enterprise for the conduct of a business for profit.   An “association” (taxable as a corporation for US tax purposes) implies associates entering into a joint enterprise for the transaction of business. A trust merely “protects and conserves” the property rather than operates as a profit-making business.

Classification of an entity depends not only on the implementing statute (for example, in Rost, the laws of Lichtenstein regarding the creation of a Stiftung), but the intent of the founder, the provisions put into the organizing documents (for example, the foundation charter and by-laws) as well as the actual activities carried out by the foundation.

Let us look at how these factors measured up in Rost.

Rost Court Analysis

The Rost court examined the Foundation’s purpose as stated in its formation documents to defray the costs of education, support, training, and general maintenance of its beneficiaries. The beneficiaries were the deceased taxpayer who created the Foundation, and his family.

The court then examined the Foundation’s actual activities. It found that the Foundation did not involve business associates and was not a joint enterprise conducting a business. The Foundation did not provide for the allocation of profits of a business to its beneficiaries. Most importantly, the Foundation’s formation documents provided that it shall not engage in or conduct business in any commercial manner.

In addition, the Foundation’s assets were settled by the decedent as a grantor and the Foundation paid Trustee fees.

Foreign Trust Reporting on Forms 3520 and 3520-A

In summary, the Rost court found that applying the facts and circumstances test, the Foundation qualified as a “trust”. It was also determined that the trust was a “foreign trust” for US tax purposes.  Whether a trust is “foreign” is not a simple analysis, but is detailed in my blog post here.  Given the court’s determinations, this meant responsibility for filing of IRS Forms 3520 and 3520-A.

In a nutshell, a US person (such as the decedent) must report: (1) creation of a foreign trust; (2) transfers of money or property to a foreign trust; or (3) distributions received, directly or indirectly, from a foreign trust.  Information about these events is generally filed on IRS Form 3520. Failure to report these types of events on a Form 3520 can result in penalties of $10,000 or 35% of the value of the property involved in the unreported transfer or distribution, whichever is greater.

A US person (such as the decedent) who is treated as the “owner” of a foreign trust under certain so-called “grantor trust rules” (found in IRC §§ 671-679) must also annually submit certain information with respect to the trust. Grantors of grantor trusts usually provide the information required on IRS Form 3520-A. Failure to file the Form 3520-A can result in penalties of $10,000 or 5% of the gross value of the relevant trust’s assets, whichever is greater.

To make matters worse, a recent court case makes clear that double penalties can apply for delinquent filings when the US individual is both the grantor of the trust as well as a trust beneficiary.

I have several blog posts explaining in greater detail when these Forms are implicated with foreign trusts, here and here.

Delinquent Forms?

Various options are available to correct the problem of missing information returns for US taxpayers having an interest in any offshore/foreign assets, including foreign foundations and trusts.  Contact me if you need help in sorting out what may otherwise turn into a big tax mess.  I have years of experience and am happy to assist.

Want to Learn More About Foundations? Use them in Tax and Estate Planning?

You can learn a lot more about foreign foundations in my article Handle With Care: How Sharia Law and U.S. Tax Law Affect the Foundations Regime in the United Arab Emirates published in Tax Notes International (TNI) Vol. 98 No. 5 May 4, 2020. Available at no cost on SSRN.

The article discusses the US tax treatment of the newest “foundations” regime in the United Arab Emirates (UAE). The UAE foundations regimes model and follow the laws of modern civil jurisdictions, such as those enacted in many European countries. My piece explains the details, examines the US tax analysis and looks at how foundations can be useful in tax and estate planning structures. In addition, it also discusses the impact of Sharia law with the use of foundations.  The interplay of US tax and Sharia often arises in the Middle East region, where I have been based for many years.  Very few tax professionals have any understanding or appreciation of this interplay.

Contact me if you wish to learn more.

Posted December 2, 2021

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