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Navigating Pandora’s Hallelujah Mountains: Civil Law Foundations, U.S. Tax Classification and Related Penalty Issues

Shawn P. Wolf

Blog ImageOne of the most challenging aspects of assisting clients with international tax planning is determining the right entity to use for that client’s situation. Although the Internal Revenue Service (the “IRS”) simplified the process of determining the classification of business entities by issuing the so-called Check-the-Box Regulations in 19971, an issue that remains as difficult to navigate as flying through the misty Hallelujah Mountains of Pandora2 is determining when a foreign entity is properly classified as a business entity versus a trust.  Making this even more challenging is the fact that an incorrect determination can lead to potentially significant penalties being imposed by the IRS based on the non-filing (or late filing) of certain U.S.-based information returns.  This difficulty with classification, and the related penalties, is at the heart of Daphne Jeanette Rost, Executor of the Estate of John H. Rebold, Deceased v. United States (“The Estate of  Rebold”).3

The main issue in The Estate of Rebold was the imposition of penalties for the failure to file Forms 35204 and 3520-A5 in relation to the tax ownership of, and transactions with respect to, a foreign trust. In this  case, the decedent, a U.S. taxpayer, established during his lifetime a Civil Law Foundation, known as a Stiftung, under the laws of Liechtenstein. In this regard, the U.S. Federal District Court was faced with determining if the Stiftung was a foreign trust for purposes of the Forms 3520 and 3520-A.

A trust is generally defined for U.S. tax purposes as an arrangement whereby the trustee of the trust takes title to property for the purpose of protecting or conserving it for the trust beneficiaries. From a practical perspective, an arrangement will be treated as a trust for U.S. tax purposes if it can be shown that the purpose of the arrangement is to vest in the trustee the responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.  

On the other hand, the fact that any organization is technically cast in the trust form, by conveying title to property to trustees for the benefit of persons designated as beneficiaries, will not change the real character of the organization if the organization is more properly classified as a business entity.7 If a trust is reclassified as a business entity, its tax classification will be governed by the Check-the-Box Regulations.  If a reclassified foreign trust fails to make an election to be treated as a corporation or partnership, its default treatment would depend on the existence, or lack thereof, of limited liability to its associates.  Generally, a foreign trust subject to reclassification would most often offer limited liability to its “associates” (a.k.a. the beneficiaries) and, thus, its default classification after reclassification could be that of an association taxable as a corporation.  

This said, trust type vehicles created pursuant to the laws of Civil Law jurisdictions (e.g., Panama or Liechetenstein) often have characteristics of both a trust and a business entity.  Consider, for example, that many trust type vehicles created pursuant to the laws of Civil Law jurisdictions are created through “Articles of Incorporation” and have “By-Laws” (both of which are documents generally associated with corporate entities) but have language in those same documents that discuss the administration of assets in terms of the lifetime and death of the Founder and reference how such assets are to be held or distributed to beneficiaries (these terms being more consistent with a Will or a trust).  

Some case law exists in the U.S. regarding Stiftungs created under the laws of Liechtenstein (which are similar in concept to Panamanian Foundations and other Civil Law trust type vehicles).  The Second Circuit Court of Appeals in Swan v. Commissioner (“Swan”) believed that Stiftungs should be treated more in the nature of revocable trusts for estate taxation.8  The Second Circuit Court of Appeals in Aramo Stiftung v. Commissioner9  treated a Liechtenstein Foundation as a corporation even though this was not an issue in question. 

In light of the above, it is easy to understand that there is confusion regarding the classification of Civil Law jurisdiction trust type vehicles (e.g., Panama or Liechetenstein Foundations) as trusts or as corporations for U.S. tax purposes.   

Turning to The Estate of Rebold, the U.S. Federal District Court analyzed the facts and circumstances applicable to the decedent’s  Stiftung and determined that it was a foreign trust for U.S. tax purposes.  The U.S. Federal District Court considered that the Stiftung: (a) had a purpose, as stated in its formation documents, to defray the costs of education, support, training, and general maintenance of its beneficiaries; (b) does not involve business associates and is not a joint enterprise that conducts business; (c)  was settled with assets by the decedent as a grantor, and the Stiftung pays Trustee fees; (d) does not provide for the allocation of profits of a business to its beneficiaries; and (e) has formation documents that provide it shall not engage in or conduct business in any commercial manner. 

What may be even more interesting to some is the fact that the U.S. Federal District Court in The Estate Rebold addressed several arguments about the nature and extent of the Form 3520 and Form 3520-A penalties from certain reasonable cause and constitutional perspectives (e.g., Due Process and Eighth Amendment).  Although this is not intended to be the primary focus of the discussion herein, it is important to note that the U.S. Federal District Court’s interpretation of these issues appears to be consistent with the IRS’ continued imposition of penalties on U.S. taxpayers who fail to file the Form 3520 and/or Form 3520-A (or otherwise file these Forms late).11

As you can see, and unfortunately, the classification of a Civil Law trust type vehicle (such as a Stiftung as discussed in The Estate of Rebold) as a trust or a business entity for U.S. tax purposes is based on a facts and circumstances standard.  Thus, it is possible that a Civil Law trust type vehicle that has similar characteristics to that of a trust (as opposed to a corporation or other business entity), as explained above, could be classified as a trust for U.S. tax purposes. Of course, the terms of any such Civil Law trust type vehicle should be reviewed and, if necessary, revised and coordinated with U.S. tax law concepts to be drafted in a manner to clearly indicate the intention to qualify as a trust for U.S. tax purposes.  Nevertheless, and because this is a facts and circumstances intensive analysis, the search for a clear test by which one may determine that a Civil Law trust type vehicle will always be considered to be a trust for U.S. tax purposes is about as easy to find as Unobtainium is to mine on Pandora.  Of course, all of this must be considered while navigating the risks relating to the wild creatures and dangerous flora of Pandora on the ground and the mountain banshees in the skies (i.e., the risks of the potentially severe penalties, such as those at issue in The Estate of Rebold). As such, clients and their advisors would be prudent to involve the RDA's SecOps (i.e., competent U.S. tax professionals, such as the tax advisors at Bilzin Sumberg) to guide them through this complex landscape. 

1) See Treas. Reg. §301.7701-2 and Treas. Reg. §301.7701-3.
2) In the movie Avatar, Pandora is the fifth moon of the gas giant Polyphemus (both names reference figures in Greek mythology), which orbits Alpha Centauri A in the Alpha Centauri System, the closest star system to our own sun. The Hallelujah Mountains are gravitationally floating islands on Pandora.
3) 130 AFTR 2d 2022-XXXX, (DC TX), 09/22/2021; aff’d Rost v. U.S., 130 AFTR 2d 2022-XXXX, (CA5), 08/11/2022.
4) Although a detailed discussion of the Form 3520 is beyond the scope of this overview of The Estate of Rebold, suffice it to say that a Form 3520 is required to be filed with respect to various transactions between a U.S. person and a foreign trust, as well as to report the receipt of certain large gifts by a U.S. person from foreign persons. A minimum penalty of $10,000 for a failure to file (or to timely file) may be imposed by the IRS and, in certain circumstances, the penalty can be as high as: (a) 35% of the gross value of any property transferred to, or received from, a foreign trust; or (b) 5% of the gross value of the portion of the foreign trust's assets treated as owned by a U.S. person under the U.S. tax law. 
5) Similarly, a detailed discussion of the Form 3520-A is beyond the scope of this overview of The Estate of Rebold.  Nevertheless, a Form 3520-A is required to be filed with respect to a foreign trust that has one or more U.S. persons treated as the owner thereof under the U.S. tax law. For a failure to file (or to timely file) the Form 3520-A the IRS may impose a minimum penalty of $10,000 or, if higher, a penalty of 5% of the gross value of the portion of the foreign trust's assets treated as owned by a U.S. person under the U.S. tax law.
6) Treas. Reg. §301.7701-4(a).
7) Consider Treas. Reg. §301.7701-4(b).  Also, consider investment trusts under Treas. Reg. §301.7701-4(c). 
8) 247 F.2d 144 (2d Cir. 1957), rev’d in part & aff’d in part 24 TC 829 (1955).
9) 172 F.2d 896 (2d Cir. 1949), aff’g as modified 9 TC 947 (1947).
10) An understanding of the distinction between a domestic and a foreign trust is, of course, crucial.  In this regard, a trust is foreign for tax purposes if it is not classified as a domestic trust.  §7701(a)(31)(B).  A trust is considered a domestic if two factors are present:  (a) a court within the U.S. is able to exercise primary supervision over the administration of the trust; and (b) one or more U.S. persons (e.g., a U.S. citizen or income tax resident alien) have the authority to control all substantial decisions of the trust.  §7701(a)(30)(E).  The U.S. Federal District Court in The Estate of Rebold did not fully analyze this issue as the Plaintiff did not meet the necessary burden of proof. For further discussion on this issue, please consider:
11) For a discussion of recent of a recent IRS Form 3520 and Form 3520-A case, please see:

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