November 16, 2017 - Haoshen Zhong

Pre-1997 Unit Trust Funds

Pre-1997 unit trusts

This scenario is loosely based on some analysis we did for a client:

I bought 10% of units in a private unit trust in a foreign country back in 1990. All other unit holders are nonresident aliens. We could transfer the units by giving notice to the trust without seeking permission. All unit holders are personally liable for the debts of the trust in proportion to their unit holding. It invested in stocks and bonds. It and its nonresident alien shareholders never filed anything in the US tax system.

In this post, I will discuss why this unit trust was a PFIC when it was bought and why it underwent a deemed liquidation in 1997.

What are PFICs?

Passive foreign investment company (PFIC) is a classification under US tax law. When a US person receives a distribution from a PFIC or sells shares in a PFIC for a gain, special rules apply. The rules are less than desirable for the taxpayer, so it is desirable to avoid PFIC classification.

A PFIC is a foreign corporation that meets at least 1 of 2 tests:

  • Income test: At least 75% of the corporation’s income is passive income.
  • Asset test: At least 50% of the corporation’s assets produce passive income or are held for the production of passive income. IRC §1297(a).

Passive income includes items such as dividends, interest, and gains from selling assets that produce dividends and interest. IRC §§1297(b), 954(c)(1). Because this unit trust invests in stocks and bonds only, all its income is from dividends, interest, or gains from selling property that produce dividends and interest.

The unit trust meets both the income test and the asset test. The only way to avoid classifying the unit trust as a PFIC is for it to be not a foreign corporation.

The unit trust is a business entity

A corporation is a type of business entity. Reg. §301.7701-2(b).

The unit trust is organized as a trust, but tax law recognizes a special category of trusts called investment trusts. See Reg. §301.7701-4(c). When the trustee of an investment trust may vary the investments of the trust, then the investment trust is a business entity. Reg. §301.7701-4(c).

The point of the unit trust is that the trustee should use its expertise (or its agents’ expertise) to determine which investments produce the best return on income, and adjust its investments accordingly. It is a trust organized for investment, and it permits the trustee to vary the investments. It is a business entity under US trust law.

The unit trust is a foreign business entity

A domestic business entity is organized under US law. Reg. §301.7701-5(a). A foreign business entity is any business entity that is not domestic. Reg. §301.7701-5(a). This unit trust is organized in a foreign country under foreign law, not under US law. It is a foreign business entity.

The unit trust was a corporation in 1990

If you read regulation sections 301.7701-2 and -3, you will find that this type of unit trust is not a per se corporation. Reg. §301.7701-2(b)(8). Because all unit holders are personally liable for the trust’s debts, it is a partnership by default. Reg. §301.7701-3(b)(2)(i)(A).

This is true under the current rules, but this shareholder had the unit trust in 1990.

In 1997, the IRS adopted the current rules for classifying entities. TD 8697, 61 FR 66589. Under the former regulations, a business entity is a corporation if it possessed more than half the following characteristics; otherwise it is a partnership (Notice 95-14; 1995-1 CB 297, citing former Reg. §301.7701-2):

  • It had continuity of life
  • It had centralization of management
  • The members’ liability for the organization’s debts is limited to the organization’s assets; and
  • There is free transfer of interests

Continuity of life means that the entity continues to exist independently of its members. A unit trust can continue to exist if any or all unit holders change. It has continuity of life.

One or more trustees manage the trust on behalf of the unit holders. It has centralization of management.

Each unit holder is personally liable for the unit trust’s debts in proportion to his unit holding. This means the members’ liabilities are not limited to the unit trust’s assets.

This particular unit trust permits its unit holders to transfer interests freely, i.e. without seeking any other members’ permission or the permission of the unit trust. The person making the transfer merely needs to provide notice.

This unit trust meets 3 out of 4 criteria. It was a corporation under the pre-1997 regulations. Notice, though, that the unit trust could have toggled its classification to partnership by restricting the transfer of units.

The unit trust underwent a deemed liquidation in 1997

In 1997, the current classification rules came into effect, and the current rules reclassify the unit trust as a partnership. Reg. §301.7701-3(h)(1). There is a transition rule: “The entity’s claimed classification(s) will be respected for all periods prior to January 1, 1997, if [3 criteria are met].” Reg. §301.7701-3(h)(2).

That this transition rule talks about periods before 1997 only suggests that the entity does not keep its classification from before 1997 under the new rules. This is not surprising: The new rules permit the entity to choose its classification, and the IRS expected the entity to choose.

Here, the unit trust did not make a choice, so it changed from a corporation to a partnership in 1997. There was a deemed liquidation in 1997.

The unit trust would not have been reclassified as a partnership if it were publicly traded

Under the current regulations, the regulations classify the unit trust as a partnership. Suppose the unit trust is publicly traded rather than private.

The Code says that a publicly traded partnership is a corporation. IRC §7704(a). If more than 90% of its income is interest, dividends, real property rents, gain from the sale of real property, certain mineral income, or capital gain from the sale of assets that produce the previous types of income, the partnership might be exempt from this rule. IRC §7701(c), (d). But this exception does not apply if the partnership would be a regulated investment company had it been organized in the US. IRC §7704(c)(3).

This particular unit trust, which holds itself to be an investor in the securities market, likely would be a regulated investment company in the US. IRC §851(a); 15 USC 80a-3(a), -4(2), (3). Thus, a publicly traded unit trust of this type would be a corporation even under the current rules.