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 advisors should be aware of these new rules, released February 23, which apply to taxable years beginning after December 31, 2015.
Overview
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 about their “specified foreign financial assets” (SFFAs) if the aggregate value of the SFFAs exceeds a specified monetary threshold. However, Congress was also concerned that domestic entities might be used to hold SFFAs, so section 6038D(f) provides that, to the extent provided in regulations or other guidance, the same reporting obligations apply to any domestic entity that is “formed or availed of” to hold, directly or indirectly, specified foreign financial assets.
In December 2011 the Treasury Department issued temporary regulations to implement the reporting rules of section 6038D for individuals. The temporary regulations introduced the definition of a “specified individual” (i.e., any US citizen or resident of the United States or any of certain specified possessions) and required each specified individual owning SFFAs with a value in excess of a specified monetary threshold to disclose such SFFAs on IRS Form 8938. At the same time, the Treasury Department issued proposed regulations with respect to reporting by “specified domestic entities” (SDEs) under section 6038D(f). The temporary regulations took effect for individuals starting with the 2011 taxable year and were subsequently finalized in 2014, but the proposed regulations were merely a warning of things to come.
The final regulations
Under the final regulations, an SDE generally includes any domestic corporation, domestic partnership, or domestic trust that is considered to be “formed or availed of” for purposes of holding, directly or indirectly, SFFAs. In the case of a corporation or partnership, the “formed or availed of test” is met if the entity satisfies a closely held test and a passive income or assets test.
The closely held test is met if an 80 percent interest in the entity — based on voting stock, in the case of a corporation, and on capital or profits interests, in the case of a partnership — is owned directly, indirectly, or under constructive ownership rules by a specified individual on the last day of the entity’s taxable year.
The passive income or assets test is met if either 50 percent or more of the entity’s gross income is considered to be “passive income” or 50 percent or more of the entity’s assets produce or are held for the production of passive income.
Consolidation rule
Pursuant to a “consolidation rule,” the passive income or assets test is applied on a consolidated basis to all domestic corporations and domestic partnerships that are closely held by the same specified individual and connected through equity ownership with a common parent corporation or partnership.
For example, suppose that a US individual X owns all of the stock 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 active. B has gross income of $3,000,000 and assets of $30,000,000, all of which are passive. Solely for purposes of applying the passive income or assets test, A and B are consolidated. Therefore, 75 percent of A’s gross income and assets are considered to be passive; and the same holds true for B. Accordingly, each satisfies the passive income or assets test and each will be an SDE (since the closely held test is satisfied as well).
Definition of passive income
The final regulations include a number of clarifications and changes from the proposed regulations 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 regulations clarify that “dividends” include certain substitute dividends; add a new category of passive income for income “equivalent to interest,” such as substitute interest; add a new exception for certain active business gains or losses from sales of commodities; and add a new exception for certain income earned by an entity that regularly acts as a dealer in certain types of property.
The final regulations also modify an exclusion from passive income for certain rents and royalties derived in the active conduct of a trade or business conducted by employees of the corporation or partnership. A comment submitted to the government in response to the proposed regulations expressed concern that the exception might apply only in circumstances where the trade or business is conducted exclusively by the entity’s own employees and might therefore be unduly restrictive. The final regulations address this concern by modifying the exception to apply where the active trade or business is conducted “at least in part” by employees of the entity.
Measurement of passive assets, principal purpose test
The proposed regulations did not explain how to determine whether 50 percent or more of a domestic corporation or partnership’s assets are passive assets. The final regulations offer further guidance, providing that the passive asset percentage is a weighted average percentage, based on quarterly measurements. The final regulations further provide that the value of a domestic corporation or partnership’s assets may be based on either fair market value or book value, as reflected on the entity’s balance sheet determined under either a US or international financial accounting standard.
The final regulations also eliminate the proposed regulations’ principal purpose test, which was an alternative to the income or assets test. Purpose tests are, by their nature, extremely subjective, so this change is extremely helpful. However, the preamble to the final regulations warns that “the Treasury Department and the IRS will continue to monitor whether domestic corporations and partnerships not required to report under these final regulations are being used inappropriately by specified individuals to avoid reporting under section 6038D.” The preamble adds that, if necessary, the definition of SDE may be expanded in future guidance.
Monetary threshold, aggregation rule
An SDE 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 taxable year, or $75,000 at any time during the year. In the case of domestic corporations and partnerships, an “aggregation rule” applies. Pursuant to the aggregation rule, all domestic corporations and partnerships that have an interest in SFFAs and that are closely held by the same specified individual are treated as a group, and each member of the group is considered to own all of the assets of the group for purposes of determining if such member’s SFFAs exceed the applicable monetary threshold.
Rules for domestic trusts
A domestic trust meets the formed or availed of test, and is therefore an SDE, if it has one or more specified persons as a “current beneficiary.” The proposed regulations provided that the term current beneficiary means, with respect to the taxable year, any person who at any time during such taxable year is entitled to, or at the discretion of any person may receive, a distribution from the principal or income of the trust (determined without regard to any power of appointment to the extent that such power remains unexercised at the end of the taxable year).
However, the Treasury Department and the IRS were concerned that this definition might not apply to a specified person who holds an immediately exercisable power of appointment but who is not technically a beneficiary. Accordingly, the final regulations clarify that the term “current beneficiary” also includes any holder of a general power of appointment, whether or not exercised, that was exercisable at any time during the taxable year.
–– Michael J. Miller is a partner with Roberts & Holland LLP, New York. He can be reached at [email protected].
© 2016 Michael J. Miller. All rights reserved.
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