If a Foreign Entity is a Foreign Trust

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United States persons who have foreign transactions present a number of compliance problems for the IRS. It is difficult for the IRS to know whether taxpayers are simply not paying U.S. taxes on foreign transactions.

The IRS officially recognized the significance of its international tax limitations in 2010 when it renamed its large business division to include the word “international.” The small business division followed shortly after that. The small business division handles audits and examinations for individuals, including individuals who have ownership interests in flow-through entities, such as trusts and partnerships.

The small business division initially focused on examining offshore credit card transactions. Since then, the small business division has focused its efforts on foreign bank account compliance and various foreign transactions. Our tax laws impose various information reporting requirements for foreign accounts and entities and significant penalties for non-compliance.

It is against this backdrop that we have the recent Fairbank v. Commissioner, T.C. Memo. 2023-19 case. The Fairbank case confirms that a foreign entity that is not a corporation can be classified as a trust and, if the taxpayer is not aware of this and does not comply with the foreign trust reporting requirements, the IRS essentially has no time limit on its ability to adjust income tax liabilities for the taxpayer.

Facts & Procedural History

The taxpayer is a U.S. citizen. She divorced her husband in 1983. Her husband was a resident of New Zealand. The taxpayer was awarded child support of $40,000 per year for 20 years. The agreement was modified for lum-sum payments to be made in 1990, 1993, and 1995, with the payments to be made to the taxpayer’s attorney in Switzerland to an entity that the taxpayer owned in Liechtenstein.

The Liechtenstein entity was formed in 1983 with an attorney in Europe to operate it on a trust basis. The entity was organized as an Anstalt under the laws of Liechtenstein. The documents indicated that the capital and profits were due to the beneficiaries designated by the founder and could be revocable or irrevocable.

In 2001 there was a declaration signed that the taxpayer was the beneficial owner of the entity and that it had a single asset consisting of a UBS account in Switzerland. The documents for the UBS account were signed by a Swiss attorney who was an acquaintance of the taxpayer and had known her since 1983. The swiss attorney and another person in Europe were the only signatories to the bank account.

The IRS issued a John Doe Summons to UBS in 2008 for access to records that would identify U.S. citizens and residents who had Swiss accounts. This John Doe summons was widely publicized as UBS initially refused to comply, but then eventually did comply. The IRS discovered the taxpayer’s accounts through this summons.

The records indicated that the taxpayer was the beneficial owner of the UBS account via the Lichtenstein entity.

The IRS audited the taxpayer’s returns, which resulted in the taxpayer’s tax attorney producing all of the records regarding the entity and bank account. Forms 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, were filed for the Lichtenstein entity in 2015 for the 2009 and 2010 tax years. Foreign Bank Account Reports (“FBARs”) were also filed for the s 2009 through 2011, but not for the UBS account. Forms 3520 or 3520-A were not filed for the Lichtenstein entity or UBS account.

In 2018, the IRS issued a Notice of Deficiency in the audit for the 2003-2008 tax years, which primarily consisted of adjustments for the unreported income in the Lichtenstein entity and UBS account.

The Statute of Limitations

The taxpayer argued that all the adjustments in the notice of deficiency are time-barred under Section 6501(a) since the notice of deficiency was not issued within the applicable period of limitations. They claim that the IRS failed to issue the notice of deficiency before the limitations period ended.

Section 6501(a) sets out the general rule for the time period the IRS has to assess tax. It states that, with some exceptions, the IRS must assess any tax within three years after the taxpayer’s return is filed. It also says that if no tax return is filed, the tax can be assessed at any time.

The IRS counters that the period of limitations remained open under Section 6501(c)(8) since the taxpayer failed to notify the IRS of certain foreign transfers with respect to the Lichtenstein entity and UBS account. They argue that Section 6501(c)(8) is applicable, and the period of limitations remains open for the years at issue since taxpayers never furnished the information required to be reported under Section 6048 for foreign trusts. The IRS claimed that the failure to report foreign transfers made the period of limitations remain open and the notice of deficiency was timely.

Section 6501(c)(8) says that if a taxpayer is required to report certain information under any of the listed sections of the tax code which involve foreign transactions and fails to do so, the time for the IRS to assess any tax related to that information does not expire until three years after the taxpayer furnishes the required information to the IRS.

The taxpayer argued that even if Section 6501(c)(8) were to apply and even if the entity was a foreign trust, she furnished the information required to be reported under Section 6048 for foreign trusts. She claimed that she reported all the information required, and thus the period of limitations should have been closed.

Foreign Corporation or Foreign Trust

Whether the statute expired or not depends on whether the Lichtenstein entity is a foreign corporation or a foreign trust. A foreign corporation has different filing requirements in the U.S. than a foreign trust does. The tax court started with this issue.

Section 7701 and the regulations thereunder define what foreign entities are deemed to be corporations for U.S. tax purposes. Section 301.7701-2 provides a list of such entities. For Liechtenstein, the Aktiengesellschaft is listed as a corporation. The regulations do not identify the Anstalt entity at issue in this case. The Anstalt is a hybrid entity that is similar to a corporation but is not a corporation for some purposes under Lichtenstein law.

The court applied a fact-based analysis to determine whether an Anstalt is a foreign corporation or a foreign trust. The general rule is that absent associates and an objective to conduct business and divide the gains, the entity is generally a trust. The court said that the nature, purpose, and operations of the arrangement are relevant, with weight given to the organizing documents.

The court concluded that the entity was properly classified as a trust since it is neither a joint enterprise that conducts business nor has any business associates. It is established for the benefit of the taxpayer, with the entity’s capital and profits due to the beneficiaries and it operates on a trust basis with a trustee holding property for the beneficiaries.

Foreign Trust Reporting

Having determined that the Anstalt was a foreign trust, the court then considered the reporting requirements for foreign trusts. Section 6048 requires the disclosure of foreign trusts to the IRS. Each U.S. person treated as the owner of a foreign trust is responsible for ensuring the trust files an annual return with the IRS. This information is provided by filing Form 3520-A. United States beneficiaries of foreign trusts who receive distributions must also file an information return including the name of the trust and the amount received, which can be done by filing Form 3520.

The court held that the taxpayer retained certain powers in respect of the trust property which was tantamount to dominion and control over the property. This was based on the taxpayer having directed transfers from the trust, etc. As such, the court treated the taxpayer as the owner of the foreign trust. This lead the court to the conclusion that the taxpayer was required to but did not file Forms 3520-A or 3520 for the trust.

The question for the statute was whether the failure to file these forms kept the statute of limitations open. The taxpayer argued that it did not. She noted that she provided the information required to be furnished under section 6048 pursuant to a request by the IRS in 2014 and, therefore, the period of limitations is closed, and the assessment is time-barred. The taxpayer also argued that had she filed Forms 3520-A and 3520, she would “simply be transposing the information already provided to the IRS onto an IRS form.”

The IRS argued that Section 6501(c)(8) is not satisfied “unless and until a taxpayer has filed the required information returns [Forms 3520-A and 3520].”

The court agreed with the IRS. It noted that Section 6501(c)(8) refers to Section 6048. Because the taxpayer was deemed to be the owner of the foreign entity and failed to provide a complete accounting of its activities, and as a U.S. beneficiary, failed to file a return that includes the name of the entity and the aggregate amount of distributions received during the tax years in question, as required by Section 6048(b)(1) and 6048(c)(1) respectively, those sections were not satisfied.

The Takeaway

Those with foreign entities that are not clearly classified as corporations under Section 7701 should take note of this opinion. A foreign entity that can be classified as a trust can hold open the statute of limitations for the IRS to assess tax if the proper trust reporting is not filed. As a precaution, if there is any doubt, taxpayers should consider filing foreign trust reporting forms just to start the running of the statute of limitations. If this fails, one may also need to consider the IRS’s ability to collect foreign assets.

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