The classification of private foundations for US federal income tax purposes

Professionals providing cross-border estate planning advice need to know whether a private foundation will be treated as a foreign corporation, partnership or trust for US federal income tax purposes. The present article contains a detailed evaluation of the classification possibilities of private foundations under US tax law. Introduction Private foundations are not commonly used by estate planning professionals advising citizens or residents of the United States. However, subsequent changes in the residence or citizenship of the founders or beneficiaries of foreign private foundations or investments made by private foundations in US situs assets can cause these entities to be subject to US federal income tax. Professionals providing cross-border estate planning advice thus need to know whether a private foundation, which is considered to be a legal entity in the jurisdiction where it is established and domiciled, will be treated as a foreign corporation, partnership or trust for US federal income tax purposes. If private foundations are classified as corporations, then the US tax and reporting obligations associated with foreign corporations, including the controlled foreign corporation, foreign personal holding company, and/or passive foreign investment company rules, apply, if the private foundation has an actual or deemed owner who is a ‘United States person’. If, however, private foundations are treated as trusts, then the rules governing the income taxation of foreign trusts created by US persons (outbound trusts) and trusts created by non-US persons for US beneficiaries (inbound trusts) will have to be applied. By analysing the leading case on the classification of private foundations and assessing the Entity Classification Regulations, the following article provides guidance on the classification of private foundations pursuant to the provisions of the US Internal Revenue Code. A brief analysis of the leading case on the classification of private foundations: Oei Tjong Swan’s Estate v C.I.R The issue, how a private foundation should be classified, has been addressed by the United States Court of Appeals Second Circuit in the case ‘Oei Tjong Swan’s Estate v. C.I.R.’ in 1957. The Court of Appeals decision and the appealed Tax Court decision, which was upheld by the Court of Appeals with regard to the classification of a foundation as a trust, are no longer decisive for the classification of private foundations, as the Entity Classification Regulations under section 7701 I.R.C. now define what constitutes a ‘trust’ for US tax law. A non-resident non-citizen making a revocable lifetime transfer of US situs assets to a foreign private foundation will, however, still face the same tax consequences and insofar the decision is very illustrative and the merits are to be briefly discussed: (i) The principle issue The principle issue presented for consideration by the court was whether deposits of cash and securities in a US bank by a non-resident alien, not engaged in business in the United States at the time of his death, in the * Patrick Schmutz, LLM (Taxation) is a Swiss Attorney at Law practising at Niederer Kraft & Frey in Zurich, Switzerland. He is also admitted as a Solicitor of the Supreme Court of England and Wales, The above article is based on a paper the author wrote while attending the graduate tax program of the University of Florida. It is an attempt by a civil law practitioner to shed light on the US tax consequences of this interesting legal entity, which is little known in the US. 1 The term ‘private foundation’ refers to foundations established in Liechtenstein, Panama, Curacao or in other low-tax jurisdictions for non-charitable purposes. Despite their identical name, the private foundations discussed in this article are not the equivalent of the ‘private foundation’ of s509 Internal Revenue Code since private foundations can be used for the benefit of the founder, family members and other beneficiaries, whereas the ‘private foundation’ of s509 must meet the requirements of s501(c)(3), requiring strict public purposes. 2 Unless otherwise stated, all statutory references are to the US Internal Revenue Code. 3 247 F.2d 144. 4 Estate of Swan v C.I.R., 24 T.C. 829, 1955 WL 627 (Tax Ct.). 5 Section 301.7701-4(a), which came into effect on 1 January 1961. The Author (2007). Published by Oxford University Press. All rights reserved. accounts of two family foundations established by him were includible in his gross estate for federal estate tax purposes. (ii) Tax consequences of revocable lifetime transfers under current law Upon death of a non-resident non-citizen, only the part of that decedent’s gross estate that is situated in the United States is included in the value of the noncitizen’s gross estate. However, any property of which the decedent has made a transfer, by trust or otherwise, within the meaning of sections 2035 to 2038, is deemed to be situated in the United States, if so situated either at the time of the transfer or at the time of the decedent’s death. By reference to section 2038, this provision provides that the value of a non-resident non-citizen’s gross estate shall include the value of all property transferred by the decedent by trust or otherwise where the decedent up to the date of his death retained the power, ‘to alter, amend, revoke, or terminate’, (iii) Arguments of the taxpayer The taxpayer argued that the foundations should be treated as foreign corporations and that transfers to them do therefore not fall within section 811(d) (now Internal Revenue Code of 1954 section 2038). He pointed to such characteristics, inter alia, as (a) perpetual existence; (b) the capacity to engage in business; (c) treatment as a separate legal entity under the applicable foreign law; and (d) being taxed solely on their own income. Furthermore, the taxpayer contended that the US assets of the foundations were not includible in the decedent’s gross estate on the theory that the foundations would have to be considered foreign corporations, and that the instruments representing the decedent’s interest in the foundations (the articles of foundation) were at the date of the decedent’s death physically situated outside the United States. The taxpayer argued that although stock was not issued by the foundations, these incorporated entities should be treated as foreign corporations and consequently the instrument of organization (the articles of the foundation) received by the decedent should be considered as stock. Thus, the taxpayer argued that the transfers of the decedent’s property to the foundations had been for valuable consideration and thus outside of the scope of sections 811(d) or 862(b). (iv) Decisions of the courts The tax court considered the respective foundations to be very much like private trusts and held that the transfers of property by the decedent to the foundations subject to the power of revocation should not be treated any differently than transfers to a private trust. In the court’s view, it was relatively insignificant for federal estate tax purposes that the decedent, a non-resident alien, carried out his purposes within the particular legal means and juridical concepts which were recognized in his own country (and which create particular and definite legal effect there). The tax court stated that it was more important to consider the method and technique that the decedent would have had available in the United States in order to accomplish his basic purposes and concluded that the foundations should be treated as revocable trusts because they were created by the decedent in order to provide for his children. Moreover, it held that in any event, regardless of the classification of the foundations, taxability followed from the decedent’s power to alter, amend and to revoke the transfer. The Court of Appeals agreed with the conclusion of the Tax Court and held that sections 862(b) and 811(d) are not limited to trust arrangements but expressly refer to the broad category of all ‘revocable transfers’, as shown by the specific references to ‘a transfer . . . by trust or otherwise’. Agreeing with the decision of the Tax Court it held that section 811(d) is directed at transfers which are valid under state law but in which the taxpayer has retained control over the ultimate enjoyment of the property up to the date of his death. Where this control exists, the value of the property is includible in the estate regardless of any unique or unusual mode of transfer that may have been