Rost v USA – Is It a Trust?
In this Expert Focus article, Suzanne Reisman discusses whether, in light of Rost v USA, certain foreign entities are construed as trusts in the United States, before outlining some of the obligations and penalties associated with foreign trusts.
The US Fifth Circuit Court of Appeals’ recent decision in Rost v USA confirms that a Liechtenstein stiftung is a trust for US income tax purposes. Rost v USA is relevant to entities organised in various jurisdictions utilised by international families.
Rost v USA involved a US citizen who created a Liechtenstein stiftung for the benefit of his family. The US Internal Revenue Service (IRS) imposed penalties in connection with the taxpayer’s failure to file IRS Forms 3520 and 3520A in a timely manner.
The Fifth Circuit affirmed the imposition of penalties, rejecting the notion that because there was no case law, statute or regulation specifically addressing the characterisation of Liechtenstein stiftungs, the penalties violate US law and the taxpayer’s constitutional due process rights.
The determination of whether a trust which has such characteristics is to be treated for tax purposes as a trust or as an association depends on whether there are associates and an objective to carry on business and divide the gains therefrom.
A trust by any other name
Whether an entity is a trust for US tax purposes is a matter of substance over form. The purpose of the entity as determined from a US perspective overrides the characterisation of the entity under the entity’s governing law. The enquiry differs from the relatively permissive nature of the US “check the box” elections that afford practitioners greater latitude in choosing the tax classification of an entity that is not a “per se” corporation.
The US Treasury regulations distinguish “ordinary trusts” from business trusts and investment trusts. Ordinary trusts include lifetime and testamentary entities whereby trustees take legal title to property to protect or conserve the property for the beneficiaries, which may include the settlor.
Business trusts are nominally trusts but are not created to protect or conserve the property for beneficiaries. Instead, they are created by one or more of the beneficiaries as a structure through which to operate a business. They are classified as partnerships or corporations. Whether an investment trust will be classified as a trust depends upon a variety of factors including whether:
- the trust agreement includes the power to vary the investment of the certificate holders; and
- there are multiple classes of ownership.
Regulations in effect prior to the enactment of the entity (or check the box) election regulations in 1997 clarify the application of these concepts. “Since centralization of management, continuity of life, free transferability of interests, and limited liability are generally common to trusts and corporations, the determination of whether a trust which has such characteristics is to be treated for tax purposes as a trust or as an association depends on whether there are associates and an objective to carry on business and divide the gains therefrom”.
Historically, civil non-charitable foundations did not exist in the United States (although, New Hampshire and Wyoming have civil foundation laws now). Nonetheless, the US tax characterisation of civil law foundations remains largely unchanged over the past 70 years. In 1957, a US appeals court in Estate of Swan v Commissioner determined that a stiftung created to provide for the founder’s children was properly characterised as a trust rather than a corporation.
In 2009, the IRS Chief Counsel’s Office issued guidance discussing the classification of Lichtenstein anstalts and stiftungs. The memorandum relied on Estate of Swan, stating that the key attributes of a trust are:
- a settlor;
- designated beneficiaries;
- assets; and
- “a trustee that has legal title and a legal duty to protect and conserve the assets for the designated beneficiaries”.
The memorandum concluded that generally anstalts would not be classified as trusts because they are created primarily for commercial purposes. Stiftungs would generally be classified as trusts unless the facts and circumstances indicate that it is created primarily for commercial purposes.
Rost acknowledges that the characterisation of each foundation must be determined on a case-by-case basis under US Federal law. The Court focused on the fact that the stiftung’s council functioned as independent trustees, it had beneficiaries, it was prohibited from conducting commercial trade and it had a familial rather than a business purpose.
The stakes are high – penalties are significant and liberally imposed
The onus is on taxpayers to comply with their obligations and the reasonable cause exception is narrowly construed.
A US taxpayer’s failure to file a complete, accurate and timely Form 3520/3520A may result in the assessment of significant penalties.
- Form 3520: The IRS may impose penalties equal to the greater of USD10,000 or 35% of the amount directly or indirectly received from, transferred to, or resulting from the creation of a foreign trust by a US taxpayer.
- Form 3520A: A US taxpayer who is taxed as a grantor of a foreign trust may be subject to penalties equal to the greater of USD10,000 or 5% of the value of that portion of the trust the taxpayer is deemed to own as of the close of the taxable year.
The onus is on taxpayers to comply with their obligations and the reasonable cause exception is narrowly construed. Reliance on a professional advisor may constitute reasonable cause, as indicated in Nance v United States, although foreign law prohibitions against disclosure (civil or criminal) do not.
Taxpayers must demonstrate that they were unable to comply despite the exercise of ordinary care and prudence. Generally, if taxpayers manage to work during the relevant period, physical or mental health issues will not excuse non-compliance, as indicated in Watts v Commissioner. Similarly, according to the Fifth Circuit Court of Appeals in U.S. v Bittner, speaking only limited English, being compliant in one’s home jurisdiction and swiftly rectifying a non-willful failure to file an FBAR is insufficient to justify penalty abatement.
In 2015, the United States added another weapon to its arsenal. The government may revoke a US taxpayer’s passport if the taxpayer has “seriously delinquent tax debt” after a notice of federal tax lien and levy have been issued and all administrative remedies have been exhausted. It is not unconstitutional to revoke the passport of a taxpayer in connection with the failure to report income from a foreign trust, as specified in Franklin v United States.
The Inflation Reduction Act (enacted in 2021) provides USD80 billion of funding for the IRS, which will provide additional resources for audits of international taxpayers.