What Counts as a Foreign Trust for IRS Trust Reporting Requirements?
Accounts and organizations created under foreign laws do not always fit easily into the Internal Revenue Code’s models, but that does not excuse the founders from following IRS trust reporting requirements. Understanding what counts as a foreign trust isn’t always easy. If you err on the side of not-reporting when you should, the mistake could cost you substantially in trust reporting penalties.
Patriarch Dies While Contesting IRS Trust Reporting Penalties
John Rebold was a U.S. citizen working overseas as an oil and gas engineer. In 2005, he formed the Enelre Foundation (named after his wife’s name in reverse) to provide education and general support for himself and his children. The organization was a Stifung under the laws of Liechtenstein, and formed in Switzerland. Rebold was the founder, primary beneficiary, and settlor of the account. His children were secondary beneficiaries. In funding the foundation, Rebold transferred $3 million into Swiss bank accounts at Credit Suisse, UBS, and Bank Wegelin between 2005 and 2007.
In 2010, when UBS entered into a global settlement with the IRS, it informed Rebold that his accounts would be turned over to the IRS. Rebold spoke with a tax attorney who advised him he was “an American who set up a foreign trust, so [h]e will need to [complete foreign trust reporting documents] as well as amended US returns.” He advised Rebold to enroll for the now-closed voluntary disclosure program because he “will owe some serious tax! Nothing to be taken lightly.” Rebold’s attorney then tried to find a way to treat Enelre Foundation as something other than a foreign trust for IRS trust reporting purposes, acknowledging that was not easy.
Three years later, Rebold’s daughter, Daphne Rost, took over administration of the Enelre Foundation as power of attorney for her father. She filed a 2005 trust reporting document on her father’s behalf reporting for the first time that he owned a portion of Enelre and had transferred money to it. She filed annual trust reporting showing year-end balances of:
- $1,680,272 in 2005
- $1,807,873 in 2006
- $3,116,898 in 2007
Based on those reports, the IRS assessed $1,380,252.35 in penalties against Rebold for failure to file his foreign trust reports. He contested the penalties. They were upheld at a due process hearing, but the IRS Appeals Office cut the amount in half. He paid the penalties and then sought a refund, first from the IRS, and then in court. Unfortunately, Rebold died before the court case came to its conclusion. His daughter continued the case as executor on behalf of his estate.
Grantors Must Report Foreign Trusts
When a “United States person” creates or transfers money or property into a foreign trust” it must report that to the IRS using Form 3520, “Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts.” If they fail to timely file the form or fully disclose the information required, they could face a “penalty equal to the greater of $10,000 or 35 percent of the gross reportable amount” that being the property involved in the creation or transfer.
In addition, the owner of a foreign trust must make certain the trust files an annual tax return disclosing all trust activities and the United States agent for the trust. Failure to file that tax return is $10,000 or five percent of the portion of the trust’s assets owned by a U.S. person at the close of the year. Sole owner / beneficiaries can face the higher of the two penalties.
What Counts as a Foreign Trust for IRS Trust Reporting?
When the court determines whether an entity counts as a foreign trust, it must answer two questions:
- Was the organization organized as a trust or a business entity?
- Is the trust domestic or foreign
Trust vs Business Entity
The Internal Revenue Code (IRC) defines a trust as an arrangement where “trustees take title to property for the purpose of protecting or conserving it for the beneficiaries.” Those beneficiaries “cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.” In other words, the difference between a trust and a business entity is whether those who receive the benefit of the organization’s success are involved in the business of making it profitable. If they are, it is likely a business entity. If not, it is a trust. This is a fact-specific question that depend on the arrangement’s:
- Nature
- Purpose
- Operations
The entity’s formal organizing documents often set these factors. Taxpayers cannot say that an organization’s “purpose was other or narrower than that which they formally set forth in the instrument under which their activities were conducted.” The court will examine the articles of incorporation, foundational documents, partnership agreement, or any other formative documents to determine whether it is a business entity or trust for IRS trust reporting purposes.
Domestic vs Foreign Trust
After the court decides that an organization is a trust, it must be classified as either “foreign” or “domestic.” A domestic trust:
- Falls under the primary jurisdiction of a United States court, and
- Has one or more United States persons with authority and control over trust decisions
If a trust is administered exclusively within the United States, it is a domestic trust. However, if a trust has an “automatic migration provision” that moves it outside the U.S. if a court were to “attempt to assert jurisdiction over it” then the entity is a foreign trust. The second requirement covers anyone with authority over substantial, non-ministerial decisions, not just trustees or other fiduciaries.
Is a Lichtensteinian Stifungen a Foreign Trust?
When it comes to the U.S. tax code, the IRS’s classification of an organization is what matters, not the local law under which the organization was created. The IRC does not include a specific regulation for Lichtensteinian Stifungen. The word Stifung is German for “foundation” or “endowment”. Its founding documents prohibit “commercial trade” and do not provide for the allocation of profits. It also refers to the entity as a “trust” with “trustees”. The Court said the limitations on the Stifung’s purpose – for educational and support of the beneficiaries – were “familial” in nature and “characteristic of an ordinary trust”. It found that the Stifung’s board members served the same function as independent trustees, and that Enelre’s attorney considered them as such. The foundation also had beneficiaries like an ordinary trust, and Rebold acted as a trust grantor would. Thus, Enelre was considered a trust.
Enelre Foundation was not domestic because the Stifung’s organizational documents included an arbitration clause referring disputes to arbitration under Liechtenstein law, giving that country, rather than the U.S., primary jurisdiction over the organization. In addition, Enelre’s board included non-U.S. taxpayers, causing it to fail the control test as well.
The Court emphasized that there is no universal treatment for all Stifung. Instead each organization must be considered based on the facts and circumstances of that entity. Owners of such entities should work closely with a tax attorney experienced in handling foreign trust reporting to see if their entity qualifies as a foreign trust for IRS tax reporting purposes.
Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 30 years experience. If you have questions regarding foreign trust account reporting requirements, contact Joe Viola to schedule a consultation.
