by Michael J. Miller
The US Treasury has issued final regulations that require certain domestic corporations, partnerships, and trusts to report their foreign financial assets to the IRS. Taxpayers and their advisers should be aware of these new rules, released February 23, which apply to tax years beginning after December 31, 2015.
Section 6038D of the tax code, enacted in 2010 as part of the Hiring Incentives to Restore Employment (HIRE) Act, requires individuals to report certain information to the IRS regarding their “specified foreign financial assets” (SFFA) if the total value of SFFA exceeds a specified monetary threshold. However, Congress was also concerned that domestic entities could be used to hold SFFAs, so Section 6038D(f) provides that, to the extent provided by regulations or other guidance, the same reporting obligations are apply to any national entity that is “formed or used”. of” to hold, directly or indirectly, specified foreign financial assets.
In December 2011, the Treasury Department issued temporary regulations to implement Section 6038D reporting rules for individuals. The temporary regulations introduced the definition of a “specified person” (meaning any U.S. citizen or resident of the United States or any of certain specified assets) and required that each specified individual holding SFFAs with a value greater than a specified monetary threshold disclose those SFFAs on IRS Form 8938. At the same time, the Treasury Department issued proposed regulations regarding reporting by “domestic specified entities” (SDEs) under Section 6038D(f). The temporary regulations came into effect for individuals from the 2011 tax year and were later finalized in 2014, but the proposed regulations were only a warning of things to come.
The final settlement
Under the final rule, an SDE generally includes any domestic corporation, domestic partnership or domestic trust that is deemed to be “formed or operated” for the purpose of holding, directly or indirectly, SFFAs. In the case of a corporation or partnership, the “formed or utilized test” is met if the entity satisfies a restricted ownership test and a passive income or asset test.
The restricted ownership test is met if an 80% ownership interest in the entity – based on voting shares, in the case of a corporation, and capital or earnings, in the case of a partnership – is owned directly, indirectly or under ownership rules by a specified individual on the last day of the entity’s taxation year.
The passive income or asset test is met if 50% or more of the entity’s gross income qualifies as “passive income” or if 50% or more of the entity’s assets produce or are held for the production of passive income.
Pursuant to a “consolidation rule”, the income or passive asset test is applied on a consolidated basis to all domestic corporations and partnerships that are closely owned by the same specified person and related by ownership of shares to a parent corporation or a common partnership.
For example, suppose a US individual X owns all of the shares of two domestic corporations, A and B. A has gross income of $1,000,000 and assets of $10,000,000, all of which are assets. B has gross income of $3,000,000 and assets of $30,000,000, all of which are liabilities. For the sole purpose of applying the income or passive asset test, A and B are consolidated. Therefore, 75% of A’s gross income and assets are considered liabilities; and so does B. Accordingly, each satisfies the passive income or asset test and each will be a BDS (since the restricted ownership test is also satisfied).
Definition of Passive Income
The final settlement includes a number of clarifications and changes from the proposed settlement with respect to the definition of passive income, which generally includes, among other things, dividends, interest, rents, royalties and capital gains. .
For example, the Final Rule clarifies that “dividends” include certain replacement dividends; add a new category of passive income for “interest equivalent” income, such as substitute interest; add a new exception for certain active business gains or losses from the sale of commodities; and adding a new exception for certain income earned by an entity that regularly acts as a merchant of certain types of goods.
The final settlement also amends a passive income exclusion for certain rents and royalties from the active conduct of a trade or business carried on by employees of the corporation or partnership. A comment submitted to the government in response to the proposed regulations expressed concern that the exception only applies where the trade or business is carried on exclusively by the entity’s own employees and could therefore be unduly restrictive. The final rule addresses this concern by amending the exception to apply where the trade or active business is carried on “at least in part” by employees of the entity.
Valuation of Passive Assets, Primary Purpose Test
The proposed regulations did not explain how to determine whether 50% or more of the assets of a domestic corporation or partnership are passive assets. The final regulations offer additional guidance, namely that the percentage of passive assets is a weighted average percentage, based on quarterly measurements. The final rule further provides that the value of assets of a domestic corporation or partnership may be based on either fair market value or book value, as reflected in the entity’s balance sheet determined according to a US or international accounting standard.
The final settlement also eliminates the primary purpose test of the proposed settlement, which was an alternative to the income or asset test. Finality tests are, by their nature, extremely subjective, so this change is extremely helpful. However, the preamble to the final settlement warns that “the Treasury Department and the IRS will continue to monitor whether corporations and domestic partnerships that are not required to report under this final settlement are being used inappropriately by specified persons. to avoid reporting under section 6038D”. The preamble adds that, if necessary, the definition of BDS can be expanded in future guidance.
Monetary threshold, aggregation rule
A BDS is required to report its SFFAs on Form 8938 only if the value of its SFFAs exceeds a specified monetary threshold, i.e. $50,000 on the last day of the tax year or $75,000 at any time of the year. In the case of domestic corporations and partnerships, an “aggregation rule” applies. Under the aggregation rule, all domestic corporations and partnerships that have an interest in SFFAs and that are closely owned by the same specified person are treated as a group, and each member of the group is considered the owner of all group assets. for the purpose of determining whether that member’s SFFA exceeds the applicable monetary threshold.
Rules for domestic trusts
A domestic trust satisfies the criterion formed or used, and is therefore a BDS, if it has one or more persons specified as the “current beneficiary”. The proposed Regulations provided that the current term beneficiary means, in relation to the taxation year, any person who at any time during such taxation year is entitled or, at the discretion of a person , may receive a distribution of principal or income from the trust (determined independently of any power of appointment to the extent that such power has not been exercised at the end of the tax year).
However, the Treasury Department and the IRS were concerned that this definition would apply to a specified person who holds an appointing authority exercisable immediately but who is technically not a beneficiary. Thus, the final regulations specify that the term “current beneficiary” also includes any holder of a general power of appointment, whether exercised or not, which may have been exercised at any time during the tax year.
–– Michael J. Miller is a partner at Roberts & Holland LLP, New York. He can be reached at [email protected].
© 2016 Michael J. Miller. All rights reserved.