Is a Stiftung a Foreign Trust? Form 3520 Penalties?
In the recent case of Rost v. United States, the Fifth Circuit analyzed whether a foreign entity should be classified as a foreign trust subject to IRS Form 3520 penalties. The case arose in the context of a Liechtenstein Stiftung and illustrates the facts-and-circumstances test prescribed by Treasury regulations to determine whether a foreign trust exists.
Here’s the background: The IRS assessed almost $1.4 million in penalties against the founder of a Liechtenstein Stiftung for failing to timely file Forms 3520 and to ensure that the Stiftung timely filed Forms 3520-A. After the IRS notified the founder of its intent to levy the penalties, he contested his liability and requested a collection due process hearing. The IRS Appeals Office sustained the levy notices but granted a partial penalty reduction. After paying the penalties, as adjusted, the founder filed administrative refund claims with the IRS and ultimately brought suit, arguing that because no statute, regulation, or judicial decision provides that a Liechtensteinian Stiftung is a foreign trust for federal tax purposes, the penalties violated the government’s “duty of clarity when imposing sanctions,” the Administrative Procedure Act (APA), and the Due Process Cause.
Applying a facts-and-circumstances test, the court held that the Stiftung qualified as a foreign trust based on its purpose and form, as stated in its organizing documents, and because it failed the tests for domestic trusts set forth in Treasury regulations.
The Formation of the Stiftung and the Assessment of Form 3520 Penalties
Rebold was a U.S. citizen. In 2005, he created the Enelre Foundation as a Stiftung under the laws of Liechtenstein. At the time of Enelre’s founding, Rebold was the settlor and primary beneficiary, and his children were secondary beneficiaries. Rebold opened bank accounts for Enelre at Credit Suisse, UBS, and Bank Wegelin. He transferred $2 million to Enelre in 2005 and another $1 million in 2007. Neither Rebold nor Enelre filed Form 3520 or 3520-A disclosing to the IRS the creation of Enelre or these transfers.
What are the potential penalties for Form 3520 and Form 3520-A reporting failures? The penalty for a failure to timely file Form 3520 is 35% of the gross value of the property or distribution exchanged, 5% of the gross value of the foreign trust’s assets, or $10,000—whichever is greatest. The penalty for a failure to timely file Form 3520-A with correct and complete information is the greater of $10,000 or 5% of the gross value of the portion of the trust’s assets treated as owned by the U.S. person at the close of that tax year.
What is a Lichtenstein Stiftung?
Stiftung is translated from German to English as “foundation,” “establishment,” “donation,” or “endowment.” A stiftung is created under the laws of Liechtenstein that resembles a trust, but not limited to specific lives in being. A stiftung can own property and is controlled by an administrator (known as a stiftungerat) whose powers and duties are comparable to a trustee. A Stiftung does not have members or a board of directors.
In forming a Stiftung, the founder transfers specific assets to the Stiftung that are then endowed for specific purposes, states the objectives of the Stiftung, and appoints its stiftungerat. A stiftung can be created for charitable or personal purposes but cannot be created to undertake commercial activities. Liechtenstein law provides that in certain cases commercial activities may be undertaken by a stiftung if such activities serve its noncommercial purposes. Once formed, the stiftung is entered onto the Register in Liechtenstein and must have a minimum amount of initial capital. The stiftung exists for the benefit of those named in its formation documents as being appointed as beneficiaries.
What is a Lichtenstein Stiftung for Federal Tax Purposes?
Neither the IRC nor its regulations specifically classify or provide for special treatment of stiftungen, although § 301.7701-2(b)(8) classifies a Liechtenstein Aktiengesellschaften as a corporation. Rather, the IRS provides that each stiftung must be analyzed on its own facts and circumstances.
Reporting Foreign Trusts
The Internal Revenue Code requires disclosures regarding foreign trusts. It requires that a “United States person” report the creation of any foreign trust and the transfer of any money or property (directly or indirectly) to a foreign trust.
A “United States person” includes U.S. citizens and residents. These reportable events are disclosed to the IRS on Form 3520, and a failure to timely file the form or to fully disclose all required information gives rise to a “penalty equal to the greater of $10,000 or 35 percent of the gross reportable amount. The “gross reportable amount” is the gross value of the property involved in the event (determined as of the date of the event).
The code provides that anyone treated as the owner of a foreign trust under the IRC’s grantor trust rules must “ensure” that the trust annually makes a return that sets forth a full and complete accounting of all trust activities and operations for the year, the name of the United States agent for such trust, and such other information as the Secretary may prescribe. The return is made on Form 3520-A. Failure to timely file the form or to fully disclose all required information results in a penalty equal to the greater of $10,000 or 5 percent of the gross reportable amount. The “gross reportable amount” is the gross value of the portion of the trust’s assets at the close of the year treated as owned by the United States person.
When is a Trust a “Foreign” Trust?
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. 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.
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.
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. 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.
An arrangement’s purpose thus distinguishes a trust from other entities. Any entity recognized for federal tax purposes that is not properly classified as a trust under § 301.7701–4 is a business entity. 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. “Business trusts,” for example, generally are created by the beneficiaries simply as a device to carry on a profit-making business that normally would have been carried on through business organizations that are classified as corporations or partnerships under the IRC.
In classifying an arrangement as a trust or other business entity for tax purposes, there is no one rule or set formula, and each case must be decided upon its own particular facts. 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.”
An arrangement’s most relevant features for tax-classification purposes are its “nature,” “purpose,” and “operations.” The form of organization under which the arrangement operates may furnish persuasive evidence of a classification but cannot be regarded as decisive. 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.
In assessing these features, the arrangement’s organizing documents are determinative. 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.”
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). 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”).
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 U.S. if a U.S. court were to attempt to assert jurisdiction over it. 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. This includes anyone with authority over substantial decisions, not only trust fiduciaries. Substantial decisions are those authorized or required under the trust instrument and applicable law that are not ministerial.
Foreign trust issues can give rise to many challenges and potential pitfalls, including penalties under Forms 3520 and 3520-A. Freeman offers counsel with respect to foreign trusts, such as compliance and Form 3520 penalty defense.