New foreign trust tax rules, Part 2 - using trust property for free

Phil Hodgen

Attorney, Principal

Previously in this extravaganza: Part 1 - overview.I'm doing this stuff cheerfully out of sequence. Congress doesn't write the laws in "first things first" order. But this one I suspect will trip up a lot of people. Memo to trustees: this is going to bite you in the bum if you're not careful.

The New Law

Just so you can see the way Congress changes or creates new tax law, this is what the HIRE Act says:

SEC. 533. UNCOMPENSATED USE OF TRUST PROPERTY.(a) In General - Paragraph (1) of section 643(i) is amended—
(1) by striking ‘directly or indirectly to’ and inserting ‘(or permits the use of any other trust property) directly or indirectly to or by’ , and(2) by inserting ‘(or the fair market value of the use of such property)’ after ‘the amount of such loan’ .
(b) Exception for Compensated Use - Paragraph (2) of section 643(i) is amended by adding at the end the following new subparagraph:
‘(E) EXCEPTION FOR COMPENSATED USE OF PROPERTY- In the case of the use of any trust property other than a loan of cash or marketable securities, paragraph (1) shall not apply to the extent that the trust is paid the fair market value of such use within a reasonable period of time of such use.’ .
(c) Application to Grantor Trusts - Subsection (c) of section 679, as amended by this Act, is amended by adding at the end the following new paragraph:
‘(6) UNCOMPENSATED USE OF TRUST PROPERTY TREATED AS A PAYMENT-For purposes of this subsection, a loan of cash or marketable securities(or the use of any other trust property) directly or indirectly to or by any United States person (whether or not a beneficiary under the terms of the trust) shall be treated as paid or accumulated for the benefit of a United States person. The preceding sentence shall not apply to the extent that the United States person repays the loan at a market rate of interest (or pays the fair market value of the use of such property) within a reasonable period of time.’ .
(d) Conforming Amendments - Paragraph (3) of section 643(i) is amended—
(1) by inserting ‘(or use of property)’ after ‘If any loan’ ,(2) by inserting ‘or the return of such property’ before ‘shall be disregarded’ , and(3) by striking ‘REGARDING LOAN PRINCIPAL’ in the heading thereof.
(e) Effective Date - The amendments made by this section shall apply to loans made, and uses of property, after the date of the enactment of this Act.

This is purely for your amusement. It is a lot easier for you to understand if you see the old tax law as updated by these changes.

Merging Changes into Old Law

New wine, old bottles, etc. Here is Section 643(i) of the Internal Revenue Code with all of the changes merged into it:

643(i) Loans From Foreign Trusts For purposes of subparts B, C, and D—(1) General Rule - Except as provided in regulations, if a foreign trust makes a loan of cash or marketable securities (or permits the use of any other trust property) directly or indirectly to or by—
(A) any grantor or beneficiary of such trust who is a United States person, or(B) any United States person not described in subparagraph (A) who is related to such grantor or beneficiary,
the amount of such loan (or the fair market value of the use of such property) shall be treated as a distribution by such trust to such grantor or beneficiary (as the case may be).(2) Definitions And Special RulesFor purposes of this subsection—
(A) Cash - The term ‘cash’ includes foreign currencies and cash equivalents.(B) Related Person
(i) In General - A person is related to another person if the relationship between such persons would result in a disallowance of losses under section 267 or 707(b). In applying section 267 for purposes of the preceding sentence, section 267(c)(4) shall be applied as if the family of an individual includes the spouses of the members of the family.(ii) Allocation - If any person described in paragraph (1)(B) is related to more than one person, the grantor or beneficiary to whom the treatment under this subsection applies shall be determined under regulations prescribed by the Secretary.
(C) Exclusion Of Tax-Exempts - The term ‘United States person’ does not include any entity exempt from tax under this chapter.(D) Trust Not Treated As Simple Trust - Any trust which is treated under this subsection as making a distribution shall be treated as not described in section 651.(E) Exception For Compensated Use Of Property - In the case of the use of any trust property other than a loan of cash or marketable securities, paragraph (1) shall not apply to the extent that the trust is paid the fair market value of such use within a reasonable period of time of such use.
(3) Subsequent Transactions - If any loan (or use of property) is taken into account under paragraph (1), any subsequent transaction between the trust and the original borrower regarding the principal of the loan (by way of complete or partial repayment, satisfaction, cancellation, discharge, or otherwise) or the return of such property shall be disregarded for purposes of this title.

Effective Date

The most important thing you need to know: the new law applies to anything that happens after March 18, 2010. (That is the enactment date for the new law).

ExampleA foreign trust owns a house in the United States. Someone lives in that house rent-free. If that "someone" is a beneficiary or is related to the grantor or a beneficiary of the trust, then the rent-free use of the house is treated as a trust distribution to the grantor (if it is a grantor trust) or the beneficiary (if it is not a grantor trust).You have a problem.

ExplanationHere is what the new law does.

If...the trust owns something and someone is using it

First, look for a situation where a foreign trust owns property, and someone is using it.I have given an example of a house, but it could be anything. If the trust owns art which is hanging on someone's wall at home, that would be covered. Cars, horses, airplanes, jewelry.If a foreign trust owns something and "someone" is using it you have a problem under Section 643(i).

And...the "someone" is a U.S. person

It's not enough that the person using the house (in my example) is a beneficiary, or related to the grantor or beneficiary. The person using the house (in my example) also has to be a "U.S. person". That means a citizen of the United States, a person who holds a permanent resident visa, or someone who is in the United States a sufficient number of days to be treated as a U.S. taxpayer under the "count the days" test.

ExampleA foreign trust owns a house in the United States. Someone is using the house, rent-free.That person is not a citizen of the United States, does not have a permanent resident visa, and only stays in the United States a couple of months per year.You don't have a problem, even though the use of the house is rent-free, because the IRS only cares about situations where a U.S. taxpayer is getting free use of trust assets. The IRS doesn't care about foreign persons getting free use of assets owned by foreign trusts.Section 643(i)(1) does not create a "pretend" trust distribution. (That "pretend" trust distribution creates a taxable income problem, as will be described below). You can stop reading this blog post and go enjoy an adult beverage.

And...the "someone" is the grantor, a beneficiary, or related to the grantor or a beneficiary

The right person has to be using the trust property without paying for it. The person using the trust property has to be:

The grantor of the foreign trust; or
A beneficiary of the foreign trust; or
Related to the grantor of the foreign trust; or
Related to a beneficiary of the foreign trust.

This is logical. :-) A trustee is not going to let a random stranger live in a trust-owned house, rent-free.What does "related" mean? That is defined in Section 643(i)(2)(B)(i):

A person is related to another person if the relationship between such persons would result in a disallowance of losses under section 267 or 707(b). In applying section 267 for purposes of the preceding sentence, section 267(c)(4) shall be applied as if the family of an individual includes the spouses of the members of the family.

I will spare you the pain of the analysis of the definition of "related" under Section 267 and Section 707(b). If you think you have a problem here, do the hard work and figure it out.And..there is no payment for useIf the person using the trust property is paying fair market value for using it, then you're OK. This is Section 643(i)(2)(E).

ExampleA foreign trust owns a house in the United States. A U.S. citizen who is a beneficiary of the trust is living in the house. The foreign trust charges the beneficiary $3,000 per month of rent, because that is what the house would rent for on the open market.Section 643(i)(1) will not create a situation where there is a "pretend" trust distribution (which is explained below). You can stop reading this blog post, put on your running shoes, and do the Mount Wilson Trail from the trailhead to Orchard Camp and return.

Then...you have a "pretend" trust distribution

Truth or consequences. We have the truth. Following my example, a foreign trust owns a house in the United States. A beneficiary is living in the house, rent-free. The beneficiary is a U.S. citizen.Here's the consequence. Section 643(i) creates a "pretend" trust distribution to the grantor (if it is a grantor trust) or to a beneficiary (if it is not a grantor trust).The amount of the "pretend" trust distribution is the fair market value of the use of the property. If a house is being occupied, what is the fair market rental value of that house? What would a stranger pay for rent?Well, so what? You have a "pretend" trust distribution. What does that mean?Answer: it means that the trust is treated as having distributed a certain amount of cash to the beneficiary. You then have to calculate whether that distribution has come out of current income, accumulated income, or capital of the trust. If the trust distribution is treated as having come out of current income or accumulated income, then the beneficiary has taxable income and has to pay income tax.And that's the real problem. The beneficiary has to pay real money in income tax without having received real money from the trust. When you have an expense with no offsetting cash income, you have a liquidity problem. Also known as "I owe the government a ton in taxes y but I don't have any money to pay it!"

Interesting oddities

You know that "related" stuff that I referred to above, and kind of glossed over (because it would take a LONG time to parse it out to you, and you'd get bored and go to sleep and never read my blog again)?The boring part that puts you to sleep is often where you find the interesting stuff.Here is the really interesting point about Section 643(i). If you have a "related person" using trust property for free, that person is getting an economic benefit. But the person paying the tax on that economic benefit is the grantor or the beneficiary.Where Person A (let's say a beneficiary's grandchild) gets economic benefit for free ("Hey, cool! I can live in this really big house for free and not pay $20,000 per month in mortgage payments!"), and Person B (let's say this is the beneficiary) pays the tax out of his/her own pocket ("Hey cool! I get to pay Federal income tax on $240,000 that I never received!"), what possible wealth transfer possibilities pop up in your head?Discuss.