International Tax and Estate Planning: Use of Check-the-Box Election in the Foreign Corporate-Trust Context
The check-the-box election1 is an integral component of international tax and estate planning. A recurring and fundamental theme is that of a revocable foreign trust with a nonresident, nondomiciliary alien as grantor and with contingent U.S. beneficiaries who become vested on the grantor’s demise.
A key consideration in this context is avoiding imposition of the U.S. estate tax. The typical approach has been the insertion of a foreign corporation as wholly owned by the trust to retain assets otherwise classified as U.S.-situs property for estate taxation.2 The result is to transform the U.S.-situs into foreign-situs property such that exposure to the estate tax is avoided on the grantor’s demise.3
Due to the Tax Cuts and Jobs Act,4 this approach must now be assiduously refined, due to the repeal of the 30-day rule as previously set forth in the controlled foreign corporation provisions.5 More specifically, if the foreign corporation is indeed extant on the grantor’s demise, CFC classification will now automatically occur.6 The result will be the imputation of Subpart F income consistent with the CFC provisions to the U.S. shareholders of the foreign corporation.7
contrast, if the foreign corporation is eliminated prior to the date of the grantor’s death, CFC considerations are avoided. Yet, adopting this approach must be balanced against and considered in light of the potential estate tax consequences.
If the foreign corporation holds and is to continue to hold only foreign-situs property, elimination on or prior to the date of death is appropriate. This may be accomplished through exercise of the election. More specifically, on exercise of the election, the foreign corporation is deemed to have distributed all of its assets to the trust as its sole owner in liquidation.8 Accordingly, the existence of the foreign corporation is treated as having been terminated through its deemed liquidation and dissolution under the check-the-box regulations. The result is essentially elimination of the impact of the CFC provisions.
This approach requires that the foreign corporation be appropriately formed as a foreign eligible entity.9 This means that on formation the foreign corporation must not constitute a foreign entity, which is automatically classified as a corporation.10 Otherwise, the check-the-box election will, in general, be unavailable.
Notably, the regulations authorize exercise of the election retroactively for a period of up to 75 days prior to its intended effective date.11 In this context, the election should be exercised within such 75-day period but with an effective date on or preceding the date of the grantor’s death.
Consistent with this approach, with exercise of the election, the foreign corporation will be deemed to have been liquidated and dissolved on the designated effective date with the foreign situs property treated as having been distributed to the trust in liquidation.12 Resulting tax effects include the following:
1) The bases of the underlying assets as contained within the investment portfolio will have been adjusted to their fair market values as of the date of liquidation.13
2) The U.S. estate tax will be avoided on the subsequent death of the foreign grantor since only foreign, and not U.S.-situs property will have been held by the foreign corporation within the portfolio.
3) With the foreign corporation’s being treated as having been eliminated prior to the death of the grantor, the CFC provisions will be inapplicable subsequent to the grantor’s demise.
Even so, if the foreign corporation owns or is expected to own U.S.-situs property on the demise of the grantor, CFC considerations will then be present, and this approach is generally not viable. Instead, with repeal of the 30-day rule, alternative strategies should be considered. One of these is to retain the wholly owned foreign corporation-trust structure even where U.S.-situs assets are present, but to go an important step further. This approach, euphemistically referred to as “cleansing,” is predicated on the existence of the foreign corporation and resulting CFC status on the date of the grantor’s demise. It requires closely monitoring the level of appreciation inherent in the underlying foreign corporate assets and periodically realizing and recognizing the gain therein, e.g., through outright sales.14 The intended effect is to diminish the level of potential Subpart F income such that, on the grantor’s demise, the foreign corporation is in position to be liquidated and dissolved expeditiously with negative income-tax consequences being minimized.
Under this approach, the election is exercised to be effective subsequent, but in close proximity, to the date of the grantor’s demise.15 This approach is subject to a number of risks, including the volatility of the financial markets over a condensed time frame and issues relating to substance over form in connection with the disposition of the appreciated assets and the reinvestment of the realized gain as inherent therein.16 Yet, with appropriate investment and tax-related advice, this approach may well prove viable.
While other potential strategies remain available, each is necessarily predicated on significant revision of the basic investment structure. The result is enhanced complexity and potentially even more resulting considerations relating to substance over form.
One such strategy is the use of dual upper-tier foreign corporate owners of a lower-tier foreign corporation as previously utilized in the foreign corporate trust structure. To enhance the level of substance, the shareholders of the upper-tier foreign corporate parents should be separate and distinct.17 To illustrate, rather than a single trust as owner of both upper-tier foreign corporations, two distinguishable trusts, e.g., with differing trustees, dispositive provisions, governing law, and/or beneficiaries, etc., could be interposed. Under this scenario, the basic steps and the tax and estate planning effects would include the following.
1) The lower-tier foreign corporation will exercise the election to be treated as a partnership with an effective date as of the grantor’s death.
2) The bases of the underlying assets as contained within the investment portfolio will be adjusted to their fair-market values as of such date due to the deemed liquidation and dissolution of the lower foreign corporation.18
3) The upper-tier foreign corporations will each likewise exercise the election but to be treated as disregarded entities and with the election exercised such that their deemed liquidation is treated as occurring subsequent to the date of the grantor’s demise.
4) Due to the existence of the upper-tier foreign corporations, as of the date of the of the grantor’s demise, the estate tax is avoided.
5) Correspondingly, while the upper-tier foreign corporations because of being extant on the date of the grantor’s death will be classified as CFCs, their shares will nevertheless attain an adjustment in basis to fair-market value as of the date of the grantor’s death.19
6) Accordingly, the respective shareholders of the upper-tier foreign corporations should realize de minimis gain as a result of their exercise of the elections since the bases of the assets distributed in liquidation will have previously been adjusted as of the date of the grantor’s death due to the deemed liquidation of the lower-tier foreign corporation.
A further alternative approach is to avoid the use of a foreign corporation altogether. Instead, an alternative investment structure is utilized, e.g., that of an underlying foreign partnership. For this purpose, a number of criteria must be satisfied:
1) The partnership must not be engaged in the conduct of a U.S. trade or business.20
2) Its partners and the partnership itself must be foreign and not U.S. persons.21
3) Partnership ownership certificates must be retained outside the U.S.22
4) The entity serving as a foreign partnership must constitute a foreign eligible entity, and the election must be duly submitted electing partnership status.23
The concept as based on assiduous application of the above principles is that the partnership and its ownership interests should give rise to foreign-situs treatment for estate taxation irrespective of U.S.-situs property as held within the investment portfolio.
To be valid and effective, the election must also be authorized and executed by the appropriate person(s). This is particularly important when the 75-day lookback period is being utilized. The reason is that if the election is retroactively effective at any point within the 75-day period, each person who was an “owner” between the date the election is effective and the date it is filed, but who was not an owner when filed, must nevertheless execute the election.24
In the case of a trust, satisfaction of this requirement presents interesting considerations, but considerations not entirely resolved. In part, this conundrum rests on the distinctive nature of title as held in the underlying trust assets, i.e., legal title as held by the trustee and equitable title by the trust beneficiaries. In terms of satisfaction of the literal requirement that each “owner” must execute the election, the issue becomes whether legal and equitable title must coalesce or would execution by the trustee, as legal titleholder, standing alone suffice.25
Correspondingly, if only foreign-situs property was held by the foreign corporation, the intended effective date would be that preceding the date of the grantor’s death. Even so, at that point, the grantor would still have been alive with the trust correspondingly being a grantor trust. Yet when the election is to be executed and effectuated, the holder of equitable title, i.e., the grantor, will have been deceased, and if the grantor was also serving as sole trustee, the same would be equally true even of the then legal titleholder.
Despite these open issues, resolution may potentially be achieved through inclusion of an express, appropriately focused trust provision.
The provision would specifically extend to the trustee as serving the full and complete authority to exercise the election on behalf of all trust beneficiaries, whether vested or contingent. This would be so irrespective of grantor versus nongrantor trust status. While not entirely free from doubt, this approach is reasonable and does potentially offer the likelihood of favorable resolution.26
1 All references are to the Internal Revenue Code of 1986, as amended. Treas. Reg. 301.7701-2 and 301.7701-3.
2 Treas. Reg. 20.2105-1(f).
3 Treas. Reg. 20.2104-1(a)(5). See, e.g., Estate of Charania v. Commissioner, 133 T.C. 122, aff’d in part, rev’d in part on other grounds, 608 F. 3d 67 (1st Cir. 2010) (domestic corporate shares, i.e., in Citigroup, subjected to estate taxation on demise of nondomiciliary alien).
4 H.R.1-115th Cong. (2017-2018).
5 See 14215 (amending I.R.C. 951(a)(1) by striking “for an uninterrupted period of 30 days or more” and inserting “at any time”).
6 virtue of the power to revoke, the trust is a grantor trust with the grantor being treated as owner of the underlying foreign corporation during the grantor’s lifetime. I.R.C. 672(f)(2)(A)(i). Thus, result will arise either due to constructive attribution to the United States beneficiaries of the trust under I.R.C. 958 or a situs shift from foreign to domestic on the grantor’s demise. See Treas. Reg. 7701-7(a)(1)(ii) (setting forth control test as a requirement for activating domestic trust situs).
7 See I.R.C. 951(a)(1)(A) (addressing imputation of Subpart F income) and I.R.C. 957(c) (U.S. shareholder requirement). Notably, where the foreign corporation has at all times been classified as a CFC, the passive foreign investment company provisions will in general be inapplicable. I.R.C. 1297(d).
8 Treas. Reg. 301.7701-3(g)(1)(iii) (treating foreign corporation on deemed liquidation to single owner as disregarded entity). Exercise of the election, while applicable for federal tax, does not override local law otherwise providing for entity treatment, a result which may be important under the tax-related laws (including death tax) of foreign jurisdictions.
9 Treas. Reg. 301.7701-3(a) and (b).
10 Treas. Reg. 301.7701-2(b)(8). See also Form 8832 Instructions at 7 (updating tabulation of entities reflected in regulations).
11 Treas. Reg. 301.7701-3 (c)(1)(iii).
12 Treas. Reg. 301.7701-3(g)(1)(iii).
13 I.R.C. 331. Income taxation in general will not result at the corporate or shareholder levels due to the absence of a U.S. trade or business, or U.S.-source fixed or determinable annual or periodic income (FDAPI). See I.R.C. 882, 871(a)(1)(A).
14 Due to the absence of a U.S. trade or business, or FDAPI, the foreign corporation will not incur U.S. income taxation.
15 Even so, caution regarding the effective date of the election is particularly appropriate. Specifically, the literal language of the check-the-box regulations provides that the deemed liquidation of the foreign corporation is treated as occurring “immediately” before the close of the day selected as the effective date of the election. Treas. Reg. 301.7701-3(g)(3). Accordingly, if exercised to be effective on the initial day after the grantor’s death, the election would be treated as having an effective date immediately before the close of the day of the grantor’s death. If U.S.-situs property is held by the foreign corporation within the investment portfolio the effect would be to activate the estate tax as of the precise date of the grantor’s death. To avoid this literal but unintended result, consideration should be given to exercising the election such that its effective date is not the initial day after but instead the succeeding day, i.e., the second day, following the date of the grantor’s death.
16 The reinvestment could be affected through the purchase of assets readily distinguishable from those which resulted in the realization and recognition of the inherent gain. To illustrate, the proceeds from the sale of publicly traded stock could be reinvested into bonds or potentially into the stock of separate and distinct publicly traded companies.
17 Notably the preamble to the “check-the-box regulations” emphasizes that “whether an organization has more than one owner is based on all the facts and circumstances …” and that “…whether subsidiaries are associates continues to be an issue….” See 61 Fed. Reg. 66, 584, B. Discussion of Comments on the General Approach and Scope of the Regulations. In so doing, the preamble cites Rev. Rul. 93-41, 1993-1 C.B. 225, which modified and superceded Rev. Rul. 77-214, 1977-1 C.B. 408 (substance lacking due to common control in structure where domestic corporate parent was sole owner of two domestic subsidiaries which in turn were equal owners of foreign entity). While Rev. Rul. 98-37, 1998-1 C.B. 133 declared the rulings cited in the preamble to be obsolete, the perception that its doing so was based on the prior criteria, e.g., continuity of life, free transferability of interests, etc., as no longer being applicable or relevant in distinguishing between corporations and partnerships. Nevertheless, it is submitted that substance over from continues to be a most material tax consideration under the check-the-box regulations. See, e.g., I.R.C. 7701(o)(economic substance doctrine).
18 See note 13 and accompanying text.
19 This will result when the power to revoke is coupled with either the right or the authority to pay income for life. I.R.C. 1014(b)(2).
20 The absence of a U.S. trade or business precludes application of Rev. Rul. 55-701, 1955-2 C.B. 836, which held that the situs of a partnership interest is where the partnership business is conducted. Moreover, though the estate tax and the income tax are in any event not in pari materia, due to the absence of a U.S. trade or business, new I.R.C. 864(c)(8), which effectively codified Rev. Rul. 91-32, 1991-1 C.B. 107, likewise is inapplicable.
21 The effect should in any event avoid application of Treas. Reg. 20.2104-1(a)(4), which defines intangible personal property, e.g., a partnership interest, the written evidence of which is not treated as the property itself, as U.S.-situs property if issued by or enforceable against a U.S. resident. See, e.g., Chase National Bank v. Commissioner, B.T.A.M. (P-H) 3301 7 (1993) (rights in annuity contract enforceable against U.S. person are U.S.-situs property).
22 As the certificates constitute written evidence of the partnership interests, retention outside the U.S. should further avoid if not preclude outright application of Treas. Reg. 20.2104-1(a). See note 21 and accompanying text.
23 See Treas. Reg. 301.7701-3(a) and (b). See also note 9 and accompanying text.
24 Treas. Reg. 301.7701-3(c)(2)(ii).
25 See, e.g., Treas. Reg. 301.7701-4(a) (emphasis added) (referring to trust as “an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries…”).
26 For this purpose, an appropriately drafted provision could include the following: Authority to Exercise Check-the-Box Election — The trustee shall be vested with the full and complete authority to exercise the check-the-box election (the “Election”) as provided in United States Treasury Regulation 301.7701-3(c) through the filing of Form 8832 by and on behalf of any and all beneficiaries whether vested or contingent of this trust with the trustee’s exercise of the Election not being subject to question by any such beneficiary or any third person or party. Other variations thereof could likewise be utilized as dependent on the underlying facts and circumstances.
WILLIAM H. NEWTON III is an author of the two-volume treatise, International Income Tax and Estate Planning, published by Thomson Reuters, a practicing attorney in Miami, an adjunct professor of law in the graduate tax program at the University of Miami College of Law for over 25 years, author of numerous articles regarding international tax and international estate planning, and a graduate of the Massachusetts Institute of Technology and Southern Methodist University.
This column is submitted on behalf of the Tax Law Section, Michael D. Minton, chair, and Benjamin A. Jablow and Christine Concepcion, editors.