Today’s topic is based on some war stories we have seen. Here is the general situation we have had to deal with:
I am a US citizen living abroad and married to a foreign national. She and I both owned some PFICs. We transferred them to a family trust whose trustee is a private company we own 50-50. Our children and we are beneficiaries of the family trust. Do I have to report the PFICs held in the family trust as my own?
Today’s post will discuss some of the uncertainties and possible results for PFIC attribution through a trust.
Passive foreign investment company (PFIC) is a special category under US tax law. When a US person has income from a PFIC, the income is taxed and reported under extremely punitive rules. IRC §1291. It is generally a good idea for a US person to avoid owning PFICs.
PFICs can include shares in pooled investment vehicles such as mutual funds, money market funds, exchange traded funds, and the like. It can happen even if the investment vehicle is not organized as a company under foreign law. For this post, we will not get into details about what a PFIC is. We assume the couple owned PFIC shares and transferred them into the family trust.
Let us divide the PFIC shares into 2 sets: shares that the US spouse transferred into the trust and shares that the foreign spouse transferred into the trust.
For the shares the US spouse transferred into trust, the result is simple: Report the PFIC shares as if the US spouse still owns them. This is the result of how trusts are taxed in general rather than any specific rules about PFICs, so let us go through a quick primer on trusts.
To discourage the use of trusts to defer tax, the Internal Revenue Code has rules to tax individuals as owners of a trust (or a portion of the trust), as if the individuals owned the assets directly. IRC §§671-679. Usually, the individual is a grantor of the trust (a person who transferred assets into the trust), though it is possible for a beneficiary to be taxed as the owner.
If a US person transfers assets into a foreign trust, and the trust has a US beneficiary, then the US person continues to be taxed on the portion of the trust attributed to the transfer. IRC 679(a).
Here, the family trust is foreign, because its trustee is a foreign private company. Reg. §301.7701-7(a). The US spouse transferred PFICs into the family trust. He is a beneficiary of the family trust. Therefore, he continues to be taxed on the PFICs he transferred into the family trust as if he still owned them. He reports the PFICs as if he owned them directly.
There are also trust reporting requirements (such as Form 3520 and Form 3520-A), but those are beyond the scope of this post.
Now for the PFICs that the foreign spouse transferred into the family trust. The rules are more complicated here.
When a foreign person transfers assets into a trust, the conditions that permit the foreign person to be taxed as the owner of the trust are much more limited than when a US person makes the transfer. IRC §672(f)(1). For a family trust, the foreign spouse can be taxed as an owner only if
For a family trust, the children are usually beneficiaries. Therefore, the grantor and her spouse are not the only possible recipients of trust distributions during the grantor’s lifetime. Family trusts almost never satisfy the second rule.
From what I have seen, often neither spouse has any direct powers over the trust–they exercise power indirectly through the trustee company. In these situations, neither spouse has sole power to take out trust assets. Therefore, these trusts do not satisfy the first rule.
Every trust is set up differently, so it would be necessary to examine the trust documents to see who has power over the trust and what powers they have. It is not always clear that the foreign spouse can be taxed as the owner of any portion of the trust.
Keep in mind that a trust can be split into more than 1 portion. It is possible for a portion of the trust to be taxed to someone as the owner, and for another portion of the trust to be taxed to the trust itself.
Let us assume that, under the trust rules, no one is taxed as the owner of the PFIC shares the foreign spouse transferred into the family trust. What do the PFICs rules say?
The Code simply says that when a trust owns PFICs, the PFICs are attributed to the beneficiaries proportionately. IRC §1298(a)(3).
The regulations simply add that all the facts and circumstances should be taken into account, and you should use substance over form. Reg. §1.1291-1(b)(8)(i). For now, the IRS permits any reasonable method. 78 Fed. Reg. 79604 (2013).
Some examples of methods we would consider reasonable:
If the trust specifies how the income must be distributed, and the trustee follows the trust instructions, then the trust instructions tell us how to attribute the shares. Unfortunately, most family trusts are discretionary, meaning that the trust instrument does not specify how income must be distributed.
If there was a pattern of distributions between the beneficiaries before the PFICs were transferred into trust, then generally that pattern of distributions controls how income of the trust is taxed. For example, if the trust distributes 100% of its income to the foreign spouse each year, then it would be prudent to attribute all PFICs to the foreign spouse.
If there is no clear pattern of distribution, then we take a reasonable shortcut: Attribute the PFICs to the grantor who transferred them into trust. After all, the family trust is effectively revocable: The spouses control the trustee company, and through the company’s powers as trustee, the spouses can return the trust assets to themselves.
The substance of the arrangement is that the spouses can dissolve the trust at any time, at which time the trust assets presumably return to their original owners. Thus, the substance of the trust arrangement suggests that, for the PFIC shares the foreign spouse transferred to the trust, we should attribute the shares to the foreign spouse.