Those of us who practice international tax and deal with the intricacies of FATCA, including the disclosure of “specified foreign financial assets” (SFFAs)and Form 8938, have found at least some solace in the fact that Form 8938 has only applied to individual taxpayers. Entities were not considered. But there were proposed regulations issued back in December of 2011 (and some early 2012 corrections and clarifications) that have remained on the back burner.
Until now.
Effective for the 2016 tax year, certain entities will have a Form 8938 filing requirement along with individuals who meet the filing requirements for this form. As if navigating the various components of the definition of SFFAs and valuation of certain SFFAs was not difficult enough, these new entity rules add an additional layer of complication to an already highly complex area of compliance.
However, for the 2016 tax preparation season coming up in early 2017, tax practitioners need to be aware of these rules and advise affected entity clients accordingly.
Definition of a Specified Domestic Entity
Under Treas. Reg. §1.6038D-6, an SDE is a corporation, partnership or trust that is “formed or availed of” for purposes of directly or indirectly holding SFFAs. Generally, the litmus test used to determine whether an entity meets this “formed or availed of” test has two parts:
- It must be closely held by a specified individual, (closely held test), and
- It must be used to generate passive income, (passive test)
Each of the above two subparts to the “formed or availed of” test has some special rules used for the practitioner to make a definitive determination as to whether the entity is, in fact, an SDE. These special rules are as follows. Note that the rules below should be separately applied to the entity each year (since this is an annual determination).
In addition, there are SDE tests for corporations and partnerships, while the SDE determination test for trusts is different.
Corporations and Partnerships
Closely Held Test
The entity must be closely held by a specified individual. Treas. Reg. §1.6038D-1(a)(2) tells us that a specified individual is a U.S. citizen, a U.S. resident alien (for any part of a tax year), or a nonresident alien who makes an election to become subject to U.S. taxation. (For example, it is common for a nonresident alien and their U.S. citizen spouse to elect under IRC §6013(g) to subject the nonresident alien spouse to U.S. tax law so that a joint return may be filed). Generally, a specified individual is a person that is subject to U.S. tax law. Nonresident aliens who are residents of Puerto Rico or other U.S. possession are also generally included in this definition.
A corporation is closely held if the specified individual owns at least 80% of either the total combined voting power or value of corporation on the last day of the corporation’s tax year. A similar rule applies to partnerships: if the specified individual owns at least 80% of a capital or profits interest, that partnership is considered to be closely held.
Note that the above corporation and partnership 80% tests are subject to a slightly modified version of constructive ownership rules found in IRC §267. These corporation and partnership 80% tests, and the details of the modified constructive ownership rules that apply are found at Treas. Reg. §1.6038D-6(b)(2).
Passive Test
Corporations and partnerships will meet the passive test if either of the following is true:
- At least 50% of gross income is passive, or
- At least 50% of the assets of the corporation or partnership are held to produce passive income.
To determine whether a corporation or partnership meets either of the above prongs of the passive test, the tax practitioner will need some details about how to calculate the appropriate percentage, and how to value the entity’s assets. Guidance is provided at Treas. Reg. §1.6038D-6(b)(ii). For the appropriate percentage, the weighted average percentage of passive assets, weighted by total assets measured quarterly, is used. Moreover, the book value or fair market value of the assets, as reflected on the entity’s balance sheet, is used. This assumes the use of U.S. or international financial accounting standards.
The new guidance also provides an enumerated list of what is considered to be passive income under these rules. Treas. Reg. §1.6038D-6(b)(3)(i) provides a lengthy list which includes dividends, interest or interest equivalents (such as substitute interest), rents, royalties, annuities, and foreign currency gains under §988, among other items.
In addition, the passive income and asset prongs of the passive test are subject to an entity aggregation rule where more than one entity has common ownership through a stock or partnership interest with a common corporate parent or partnership. Sufficient nexus exists for aggregate ownership if an 80% ownership test (80% of stock voting power or value, or an 80% partnership profits or capital interest) exists. In essence, the aggregated entities are considered to be a single entity for application of the two prongs of the passive test. Each entity within the aggregated group is considered to own the combined group assets and considered to receive the combined passive income of the group for purposes of the passive income and asset prongs of the passive test. However inter-aggregate assets or debts (that are exclusively among the aggregated entities, such as intercompany debts or common stock ownership), are not considered in the asset valuation.
Trusts
Trusts are also entities covered under these new rules, but the test for whether a trust is “formed or availed of for purposes of holding specified foreign financial assets” isn’t based on the closely held and passive tests used for corporations and partnerships. Instead, a trust is an SDE if it has one or more specified persons as a current beneficiary (making this test rather broad).
A “current beneficiary” is generally any person who is entitled to receive a distribution (even at the discretion of the trustee) from either income or principal (without regard to any unexercised power of appointment). In addition, a power of appointment holder of a power that may be exercised at any time during the year is also considered a current beneficiary, even if the power is unexercised. However, such a power, if only exercisable upon death of the holder, is excepted from this rule.
While this rule for trusts on its face appears rather broad, there are significant exceptions, though some of these exceptions have not been made entirely clear without a close reading of the new regulatory language. Under Treas. Reg. §1.6038D-6(d)(1), a trust is not considered to be an SDE if the trust is excluded under the definition of “specified United States person” as found in IRC §1473(3). The list of excepted trusts under §1473(3) include REITs, IRA accounts, §403(b) and §457(g) plans, among others (which are not surprisingly the types of trusts outside the focal point of foreign asset disclosure).
Under Treas. Reg. §1.6038D-6(d)(2), a trust generally will not be an SDE is a regulated bank or financial institution that has supervisory authority or fiduciary obligations over the trust investments and timely files returns and extensions for the trust.
Grantor Trusts
In addition, Treas. Reg. §1.6038D-6(d)(3), a trust “owned by one or more persons under sections §671 through §678” and underlying regulations is also exempt . Code sections §671 through §678 are the grantor trust rules.
After the proposed regulations were issued on December 19, 2011 and later, corrections issued on February 21, 2012, a comment period followed. One commenter recommended that the list of excepted trusts be expanded to include trusts not required to file Form 1041. The Treasury Department declined to expand the rules, because the Department felt the rules already provided such an exception for grantor trusts. The Treasury Department reasoned, in the preamble to the final rules in TD 9752, that under Treas. Reg. §1.638D-2(a)(7), a specified person, including an SDE, that is not required to file an annual return is not under a Form 8938 reporting requirement either. The Treasury Department makes clear that a Form 1041 is an “annual return” under these rules.
Accordingly, as a general rule, grantor trusts that are SDEs by virtue of the “specified-person-as-current-beneficiary” test are exempt from Form 8938 reporting requirements.
Publicly Traded Partnerships
Moreover, the Treasury Department flatly refused the notion of creating a wholesale exception for publicly traded partnerships (again, there is discussion of this in the TD 9752 preamble). However, given the applicable 80% ownership “closely held” test, most PTPs would not fall under the definition of an SDE to begin with.
Threshold for Entities
Once the above rules have been applied to determine whether the entity is an SDE, the next step is to determine whether that SDE has a reporting requirement. An entity that is not an SDE is not subject to any reporting requirement.
The appropriate threshold for an SDE is found in Treas. Reg. §1.6038D-2(a). A reporting requirement exists if the SDE has aggregate specified foreign financial assets in excess of either $50,000 on the last day of the tax year, or $75,000 at any time during the year.
Conclusion
During the 2016 tax preparation season coming up in early 2017, tax preparers will need to advise affected clients on foreign asset disclosure compliance. This now includes certain entities under these new rules. The penalty for failure to file a required Form 8938 is generally $10,000. If notified by the IRS of the noncompliance, an additional $10,000 for each subsequent month of noncompliance (after 90 days from the notice), up to a maximum of $50,000, can be assessed.