The Tax Cuts and Jobs Act (TCJA),1 signed into law on Dec. 22, 2017, is the largest piece of tax reform legislation enacted in the United States since 1986. Included in the TCJA are a host of changes to the Internal Revenue Code, including significant changes to the international tax provisions.
Of particular relevance to cross-border estate planning, the TCJA included amendments to the rules on controlled foreign corporations (CFCs) under subpart F of the IRC. These changes have broadened the application of the tax on U.S. shareholders of CFCs and have created a wrinkle in certain check-the-box (CTB) planning techniques for heirs of non-U.S. grantors of grantor trusts following the grantor’s death.
With the upcoming 2020 elections, there remains uncertainty whether there will be another overhaul of the IRC or, at least, legislation to address the international tax rules that were impacted by the TCJA. I’ll address the rules adopted under the TCJA and possible solutions to minimize one’s overall U.S. tax exposure under current law.
CFC Rules
Taxation under IRC subpart F. If a foreign corporation is a CFC at any time during the year, the U.S. shareholders of the CFC who own stock on the last day of the tax year or on the last day in which the corporation is a CFC are required to report their pro rata share of the CFC’s subpart F income for that year.2 Prior to the TCJA, this tax on U.S. shareholders would only apply if the foreign corporation was a CFC for an uninterrupted period of at least 30 days in the year. Therefore, prior to the TCJA, if a foreign corporation was liquidated or deemed to have liquidated within 30 days of becoming a CFC, its U.S. shareholders weren’t required to report their share of the CFC’s subpart F income.
Definition of CFC. A CFC is a foreign corporation in which more than 50% of the vote or value of the corporation is owned directly or indirectly by U.S. shareholders.3 A U.S. shareholder is a U.S. person (for example, a U.S. citizen or U.S. resident) that directly or indirectly owns 10% or more of the vote or value of the foreign corporation.4 Furthermore, shares that are held by a foreign non-grantor trust are deemed to be owned proportionately by the trust’s beneficiaries.5
Determination of a U.S. shareholder’s pro rata share of a CFC’s subpart F income. A U.S. shareholder’s pro rata share of the subpart F income of a CFC is determined by taking the CFC’s entire subpart F income earned in the tax year and allocating such income on a percentage basis based on the number of days in the year in which the corporation wasn’t a CFC and the number of days in which it was a CFC. That is, the U.S. shareholder’s subpart F income inclusion is calculated on a purely fractional basis and doesn’t attribute specific items of subpart F income to the specific period in which it was generated.6 Therefore, a portion of the subpart F income generated by a foreign corporation in the current year during the period prior to becoming a CFC would be included as subpart F income to the U.S. shareholders if the foreign corporation becomes a CFC in such year.7
CTB Planning Pre-TCJA
CTB planning provides a method for non-U.S. grantors of grantor trusts with U.S. remainder beneficiaries to protect against U.S. federal estate tax and, if otherwise unavailable under IRC Section 1014, to potentially obtain a tax-free step-up in basis in the trust’s assets on the grantor’s death.
Prior to the TCJA, many non-U.S. grantors with U.S. beneficiaries would create a grantor trust and place a foreign blocker corporation between the trust and its U.S. situs assets so that the grantor wouldn’t be subject to U.S. federal estate tax on such underlying assets. On the grantor’s death, the trust would no longer be a grantor trust, and the foreign corporation would often become a CFC because it would be beneficially owned, at least in part, by beneficiaries who were U.S. persons. Therefore, often the corporation was either liquidated, or a CTB election was made within 30 days of the grantor’s death to prevent a subpart F inclusion to the trust or its U.S. beneficiaries.8
In addition, if the trust assets weren’t entitled to a step-up in basis on the grantor’s death under Section 1014,9 an additional foreign corporation could be interposed, creating a two-tier corporate structure, whereby the trust owns one foreign corporation, which owns another foreign corporation, which owns the U.S. situs assets, provided that there’s a business purpose in adding an additional corporation. On the grantor’s death, a CTB election would be made with respect to the top-tier foreign corporation, effective the day prior to the grantor’s death. Because this would be a recognition event under U.S. tax law, it would result in the grantor obtaining a fair market value (FMV) basis in the trust’s assets just before the date of death. Neither the grantor nor the corporation are U.S. persons, so neither would be subject to U.S. income tax on the deemed exchange.10 Moreover, let’s assume that the election wouldn’t result in tax in the grantor’s home country because a CTB election is only a U.S. tax concept and shouldn’t be treated as a deemed transaction in other countries (but always consult local counsel in assessing the worldwide tax consequences of any plan).11 The lower tier foreign corporation would continue to serve as a U.S. federal estate tax blocker through the date of death. A CTB election would be made with respect to the lower tier corporation within 30 days following the grantor’s death to prevent subpart F inclusion.
A key element to either of these strategies was to make a CTB election on all of the foreign corporations effective within 30 days of the grantor’s death to prevent subpart F inclusion. As will be illustrated below, the enactment of the TCJA may require additional structuring or other measures to mitigate adverse U.S. tax consequences that could now result from the election. Even so, it’s often unlikely, if not impossible, to prevent at least nominal subpart F inclusion following the grantor’s death.
CTB Planning Post-TCJA
The conventional method of planning described above doesn’t work as effectively in some cases under the TCJA. As will be illustrated below, when a CTB election is made on a foreign blocker corporation following a grantor’s death under the new legislation, it will generate subpart F income and will likely be taxed against the trust or its U.S. beneficiaries, no matter how soon after the grantor’s death the CTB election is made.
The following section illustrates four alternative planning structures, their U.S. tax consequences in light of the TCJA and each of their benefits and drawbacks given the circumstances. The structures are: (1) one-entity, one-tier, (2) two-entity, two-tier, (3) three-entity, two-tier, and (4) four-entity, three-tier. But first, let’s review some threshold matters:
Corporation formalities and business purpose. For each entity to be respected as a separate entity, it’s important that corporate formalities are followed with respect to each such entity, including, for example, the maintenance of records, meeting minutes and separate financial statements. Therefore, administrative (in)convenience and costs, including annual service company fees, must be taken into account in weighing the suitability of each structure for a given taxpayer.
It’s also important to consider business purpose, as the Internal Revenue Service may not respect the structure if it can’t be shown to have a business purpose independent of tax planning. In a multi-tier structure, as in the examples in this article, each individual entity in the structure must exist for some business purpose. Therefore, in considering the various structuring options, it’s important to determine what the business purpose would be for each entity in the desired structure and not simply to create entities for no purpose other than post-death planning. It may be easier, for example, to demonstrate a significant non-tax business purpose for one or two entities than for a four-entity structure. Further, a taxpayer who already has a single entity structure in place and who’s considering one of the multi-tier structures will want to consider his business purpose for modifying the existing structure.
Relevance. Furthermore, as a threshold matter, for a CTB election with respect to a foreign entity to be treated as a liquidation, which is necessary for the planning contemplated in this article, the entity’s classification as a corporation compared to a partnership or disregarded entity must have some “relevance” on the liability of at least one person for U.S. tax or information reporting purposes.12 That is, if the CTB election doesn’t result in a change in who’s responsible for U.S. tax or who must file U.S. information reporting forms with respect to the entity, the election likely wouldn’t be treated as a liquidation.13
One way to address the issue of relevance has been to have the entity in question directly hold dividend-paying stock in one or more U.S. companies. The thought is that when a CTB election is made at some point with respect to the entity, and the entity is then treated as a disregarded entity or a partnership, the entity is no longer responsible for U.S. tax on the dividends and is no longer required to file Form W-8BEN-E; the responsibility for the tax and the reporting forms transfers to the entity’s owner. Additionally, the classification of the entity would inform whether it must furnish a Form W-8BEN-E or a Form W-8IMY (and other withholding certificates). The issue of relevance must be considered and accounted for with respect to every entity when incorporating any of the structures discussed below.
Four Structures
One-entity, one-tier structure. This structure is most viable when both: (1) the trust is entitled to a step-up in basis on the grantor’s death under Section 1014, and (2) the underlying trust assets have a relatively high basis, whether due to active trading or recent sales and purchases, so as to minimize subpart F income.
To illustrate the one-entity, one-tier structure, assume that Grantor George, a non-U.S. person, creates a foreign grantor trust (the trust) that wholly owns FC1, a foreign corporation, which holds a portfolio of U.S. stocks and securities. The trust is for Grantor George’s benefit during his lifetime. Following his death, the beneficiary of the trust will be Beneficiary Ben, a U.S. person. In this case, FC1 would become a CFC on Grantor George’s death. The plan is to make a CTB election with respect to FC1 immediately following Grantor George’s death.
Assume that on Jan. 1 of the current year (Day 1), the trust has a $10 million basis in the stock of FC1, which has a value of $100 million. FC1 has a $50 million basis in the U.S. portfolio, also worth $100 million. On Day 150, Grantor George dies, when FC1 stock and the underlying U.S. portfolio are worth $108 million. Effective Day 155, a CTB election is made with respect to FC1, when FC1 stock and the underlying U.S. portfolio are worth $110 million each. The following summarizes the U.S. income tax consequences of this hypothetical scenario.
A CTB election on a corporation is treated as a liquidation of the corporation for U.S. federal income tax purposes.14 On the election, two things are deemed to occur: (1) FC1 will be deemed to exchange its interest in the U.S. portfolio for its own shares and then liquidate, which would be a recognition event in this case;15 and (2) the trust will be deemed to sell its interest in FC1 in exchange for an interest in the U.S. portfolio, which would also be a recognition event.
Gains to FC1 and subpart F inclusion to Beneficiary Ben.On its deemed exchange, FC1 would realize a gain of $60 million. I’ve assumed for this article that the U.S. assets don’t consist of real property located in the United States (or stock in any U.S. real property holding corporations) or that FC1 is engaged in a U.S. trade or business, such that FC1 itself wouldn’t be subject to U.S. federal income tax. Prior to the TCJA, the analysis with respect to FC1 would end here because the CTB election was made within 30 days of FC1 becoming a CFC, thereby preventing any of the gain from being taxed as subpart F income.
Under the TCJA, however, Beneficiary Ben would be taxed on his pro rata share of this $60 million gain, which is subpart F income.16 Because FC1 was a CFC for five days out of its 155-day tax year (before it was deemed to liquidate), Beneficiary Ben would be required to report approximately 3% of the $60 million of subpart F income, or approximately $1.8 million.17 This income would be taxed at ordinary income tax rates. However, this would still be preferable to paying a 40% estate tax on the U.S. stock. Furthermore, as a result of this $1.8 million inclusion, the trust’s basis in FC1 will increase by $1.8 million.18
If FC1 in this example more actively traded its investments, such that its basis in the U.S. investments were closer to the FMV of the investments, the gains to FC1 on the CTB election and, therefore, the subpart F inclusion to Beneficiary Ben would be reduced, making this structure more effective. On the other hand, if FC1’s basis in its investments was lower than $50 million, there would be greater subpart F inclusion, making this structure less effective.
Gains to trust. The gains to the trust would depend on whether its basis in FC1 was increased to FMV at the time of Grantor George’s death under Section 1014. If the assets in the trust were entitled to a basis step-up, then the trust’s basis at the time of the CTB election would be $109.8 million (the FMV of FC1 at Grantor George’s death, plus the subpart F inclusion to Beneficiary Ben). Therefore, the deemed exchange on the liquidation would result in a total gain of $200,000.
If, however, the trust isn’t entitled to a basis step-up with respect to FC1 under Section 1014, its basis at the time of the CTB election would be $11.8 million (its historic basis in FC1, plus the subpart F inclusion to Beneficiary Ben). Therefore, the deemed exchange on the CTB election would result in a total gain of $98.2 million.
Summary of results. As illustrated, it’s impossible to avoid subpart F inclusion under the one-entity, one-tier structure unless FC1 has a basis in its assets equal to their FMV at the time of the CTB election. Furthermore, the earlier in the year that Grantor George dies, the larger Beneficiary Ben’s pro rata share of the subpart F income would be. For example, if Grantor George dies on Jan. 1 and the CTB election is made effective Jan. 2, Beneficiary Ben would be required to include one-half of FC1’s gain, or $25 million, as subpart F income.19 While this would result in a commensurate increase in the trust’s basis in its interest in FC1 and potentially generate a capital loss to the trust, the capital loss couldn’t be used to offset more than $3,000 of the subpart F income because the latter would be ordinary income. It’s unclear whether the trust could carryforward or otherwise use the capital loss to mitigate the tax exposure. The U.S. tax consequences are exacerbated if the trust isn’t entitled to a basis step-up under Section 1014. These consequences may be mitigated if lower basis investments are sold in advance so as to minimize FC1’s gain on the CTB election, but it may be difficult to mitigate exposure if the underlying portfolio includes illiquid assets.
Two-entity, two-tier structure. This structure is essentially a variation on the first structure for situations in which the inside gain can be managed by regular sales and purchases of the underlying assets, but the trust isn’t entitled to a step-up in basis on the grantor’s death under Section 1014.
The two-entity, two-tier structure may generate a step-up in the trust’s basis when not otherwise available under Section 1014. There may, however, be a large subpart F inclusion, as in the case of the one-entity, one-tier structure, if the underlying investments have a relatively low basis and/or if the grantor dies earlier in the year.
To illustrate the two-entity, two-tier structure, now assume that the trust in the example above wholly owns FC1, which wholly owns FC2, another foreign corporation, which holds the U.S. portfolio. The plan is to make a CTB election with respect to FC1 effective the day prior to Grantor George’s death and a CTB election on FC2 effective for a day following Grantor George’s death.
Assume that on Jan. 1 of the current year (Day 1), the trust has a $10 million basis in the stock of FC1, which has a value of $100 million. In addition, FC1 has a $10 million basis in the stock of FC2, which has a value of $100 million. Lastly FC2 has a $50 million basis in the U.S. portfolio, worth $100 million. Effective Day 149, a CTB election is made with respect to FC1, when FC1, FC2 and the U.S. portfolio are worth $108 million. On Day 150, Grantor George dies, and the assets haven’t increased in value.20 Effective Day 155, a CTB election is made with respect to FC2, when FC2 and the U.S. portfolio are worth $110 million. The following summarizes the U.S. income tax consequences of this hypothetical scenario:
Gains to FC1 and the trust on the first CTB election. The gains on the first CTB election wouldn’t result in any U.S. income tax for either Grantor George or FC1.21 Furthermore, there would be no subpart F inclusion to Beneficiary Ben or the trust on the first CTB election because FC1 is deemed to liquidate during Grantor George’s life, when the trust is a grantor trust, and before FC1 becomes a CFC. As mentioned above, however, because the trust wholly owns FC1, the CTB election would be treated as a “taxable” liquidation for U.S. income tax purposes. Therefore, for U.S. tax purposes, the trust would be deemed to receive the shares of FC2 with a basis equal to their then FMV of $108 million.
Gains to FC2 on the second CTB election and subpart F inclusion to Beneficiary Ben. As was the case for FC1 in the one-entity, one-tier structure, FC2 realizes a gain of $60 million on the second CTB election. While FC2 wouldn’t be subject to tax, Beneficiary Ben would be required to report his pro rata share of this gain, which is subpart F income. Therefore, as in the one-entity, one-tier structure, Beneficiary Ben must report $1.8 million of subpart F income.
Also, as was the case in the one-entity, one-tier structure, the higher the basis in the underlying investments, the less gains there will be to FC2 on the CTB election, and Beneficiary Ben’s subpart F inclusion would be reduced. The lower the basis of such underlying investments, however, the greater the subpart F inclusion will be, particularly if Grantor George dies earlier in the year.
Gains to trust on the second CTB election. Due to the first CTB election and the subpart F inclusion to Beneficiary Ben on the second CTB election, the trust would have a basis of $109.8 million in FC2. This would result in a $200,000 gain to the trust, whether or not the trust was entitled to a basis step-up under Section 1014 on its assets.
Summary of results. As illustrated, it wouldn’t be possible to avoid subpart F inclusion under the two-entity, two-tier structure, as was the case in the one-entity, two-tier structure, unless FC2 had a basis in its U.S. investments equal to their FMV. Furthermore, the earlier in the year that Grantor George dies, the larger Beneficiary Ben’s pro rata share of the subpart F income would be.
A benefit of the two-entity, two-tier structure compared to the one-entity, one-tier structure is that it allows the trust to obtain a step-up in basis of its holdings on the grantor’s death, even when otherwise unavailable under Section 1014. Furthermore, if underlying investments have a relatively high basis to minimize subpart F inclusion, the two-entity, two-tier structure provides a potential simple solution.
However, if the underlying investments have a relatively low basis, the problem may be exacerbated. For example, if FC2 has only a $10 million basis, and further assuming Grantor George dies on Jan. 1, making a CTB election on FC2 effective on Jan. 2 would result in total gains to FC2 of $90 million, 50% of which, or $45 million, would be Beneficiary Ben’s pro rata share of the subpart F income. This would be the worst case, disastrous, scenario under the two-entity, two-tier structure (and as discussed above, the one-entity, one-tier structure) and illustrates the importance of there being sufficient basis in the underlying investments when using these structures, particularly to hedge against the risk of the grantor dying earlier in the year.
Note that the order of the two elections is critical to preventing a significant gain recognition event for the trust. If an election is filed for FC2 before one is filed for FC1, then FC2 will be deemed to have been liquidated into FC1 in a tax-free liquidation (preventing an outside basis step-up), and the parties will be no better off than if they had adopted a one-entity, one-tier structure.
Three-entity, two-tier structure. This structure is most viable when the trust is entitled to a step-up in basis on the grantor’s death under Section 1014, but the underlying U.S. assets have a low basis.
The three-entity, two-tier structure could significantly reduce, or even eliminate, subpart F inclusion if the grantor dies within the first 75 days of the year. This structure minimizes a U.S. shareholder’s pro rata share of the subpart F income on the CTB elections. If there’s adequate basis in the underlying investments, however, the one-entity, one-tier structure may be preferable.
To illustrate the three-entity, two-tier structure, now assume that the trust in the example above wholly owns both FC1 and FC2, each of which owns 50% of FC3, another foreign corporation, which holds the U.S. portfolio. The plan is to make a CTB election with respect to FC3 effective the day prior to Grantor George’s death if he dies after the 74th day of the year or effective in the prior year if he dies before the 75th day of the year. Then, a CTB election on FC1 and FC2 is made effective following Grantor George’s death.
Assume that on Jan. 1 of the current year (Day 1), the trust has a $5 million basis in each of the stock of FC1 and the stock of FC2 ($10 million combined as in the first two structures), each of which has a value of $50 million ($100 million combined). In addition, FC1 and FC2 have a combined $10 million basis in the stock of FC3, which has a value of $100 million. Lastly, FC3 has a $50 million basis in the U.S. portfolio, worth $100 million as of Day 1. Effective Day 149, a CTB election is made with respect to FC3, when FC3 and the U.S. portfolio are worth $108 million. On Day 150, Grantor George dies, and the assets haven’t increased in value. Effective Day 155, a CTB election is made with respect to FC1 and FC2, when FC1 and FC2 are worth $55 million each, and the U.S. portfolio is worth $110 million. The following summarizes the U.S. income tax consequences of this hypothetical scenario:
Gains to FC1, FC2 and FC3 on the first CTB election. Because a CTB election is made on FC3 before Grantor George’s death, it doesn’t become a CFC, and therefore, there’s no subpart F inclusion as a result of its realized gains from the deemed liquidation.
FC1 and FC2, however, will continue to exist following Grantor George’s death. Therefore, their combined realized gain of $98 million at the time of the first CTB election would be subpart F income. Approximately 3% of this gain would flow up to Beneficiary Ben as subpart F income. Furthermore, no amount of trading activity by FC3 would increase the respective basis of FC1 and FC2 in their shares in FC3. Therefore, the amount of gain potentially subject to subpart F income under the three-entity, two-tier structure is generally fixed, regardless of the basis of the underlying investments, although the amount that’s taxable to Beneficiary Ben as subpart F income is dependent on when Grantor George dies. Going forward, FC1 and FC2 will have a combined basis of $108 million in the now deemed partnership FC3, and indirectly, in the underlying assets.
If, Grantor George died within the first 74 days of the year, however, the first CTB election could be made effective on Dec. 31 of the prior year. As a result, none of this subpart F income would be taxable to Beneficiary Ben because it was generated in the previous year, when Beneficiary Ben had no interest in FC1 and FC2.
Gains to FC1 and FC2 on the second CTB election and subpart F inclusion to Beneficiary Ben. On the second CTB election, the value of FC3 and the underlying assets have increased to $110 million, generating an additional $2 million of gain, which would be subpart F income. Therefore, there would be a total of $100 million of subpart F income in the current year (including the $98 million from the previous election). Of this amount, Beneficiary Ben would be responsible for his pro rata share, 3% of $100 million, or $3 million. As mentioned, no amount of trading activity by FC3 prior to the elections would change this result.
If Grantor George dies within the first 74 days of the year and the first CTB election was made in the prior year, Beneficiary Ben would only be responsible for the subpart F income generated as a result of the appreciation of FC3 and the underlying assets since the first CTB election. Therefore, Beneficiary Ben wouldn’t be required to report his pro rata share of the $98 million of appreciation and gain prior to the first CTB election.
Gains to trust on the second CTB election. The gain to the trust would depend on whether its basis in FC1 and FC2 were increased to FMV at the time of Grantor George’s death under Section 1014.
If the trust was entitled to a basis step-up, its basis on the second CTB election would be $111 million, the FMV of FC1 and FC2 at the time of Grantor George’s death, plus the $3 million of subpart F inclusion to Beneficiary Ben. Therefore, the deemed exchange on the liquidation would result in a $1 million capital loss to the trust. As mentioned above, however, it’s unclear whether this capital loss could be used.
If, however, the trust isn’t entitled to a basis step-up under Section 1014, its combined basis in FC1 and FC2 on the CTB election would be $13 million, its original combined basis in FC1 and FC2, plus the $3 million of subpart F inclusion to Beneficiary Ben. Therefore, the deemed exchange on the second CTB election would result in a total gain of $97 million to the trust.
Summary of results.As illustrated, the three-entity, two-tier structure provides an opportunity to significantly reduce subpart F inclusion if Grantor George dies earlier in the year, unlike in the prior two structures, in which Beneficiary Ben’s pro rata share of the subpart F income only increases the earlier in the year Grantor George dies.
This structure, however, may not be optimal if the underlying investments have sufficient basis or if the trust isn’t entitled to a step-up in basis of its holdings on the grantor’s death. If there’s adequate basis in the underlying investments, it may be preferable to use the one-entity or the two-entity structure to take advantage of the higher basis in the investments, with the risk that a larger portion of the gains, if any, would be attributed to Beneficiary Ben if Grantor George dies earlier in the year. As the basis of the underlying investment approaches FMV, the less this gain would be under the one-entity or the two-entity structure, which isn’t the case under the three-entity structure. This structure may be more useful when there are low basis illiquid assets in the portfolio that can’t be sold prior to death, in which case it could offer some protection against the risk of a large percentage of the gain being taxed as subpart F income if Grantor George dies early in the year.
Furthermore, confirming that a business purpose exists for each entity is more difficult as more entities are added to the structure. This issue would have to be considered more carefully when adopting the three-entity, two-tier structure.
Four-entity, three-tier structure. This structure is most viable when both: (1) the trust isn’t entitled to a step-up in basis on the grantor’s death under Section 1014, and (2) the underlying assets have a low basis.
The four-entity, three-tier structure combines the benefits of the two-entity, two-tier structure and the three-entity, two-tier structure because it provides the opportunity to date the bulk of the subpart F income to the prior year and provides a basis step-up to the trust when not otherwise available under Section 1014. If there’s adequate basis in the underlying investment, however, as was the case in the three-entity, two-tier structure, it may be preferable to adopt the two-entity, two-tier structure to take advantage of such higher basis.
To illustrate the four-entity, three-tier structure, now assume that the trust in the example above wholly owns FC1, which wholly owns both FC2 and FC3, each of which owns 50% of FC4, another foreign corporation, which holds the U.S. portfolio. The plan is to make a CTB election with respect to FC1 effective the day prior to Grantor George’s death and, with respect to FC4, effective the day prior to Grantor George’s death if he dies after the 74th day of the year or effective in the prior year if he dies before the 75th day of the year. Then, a CTB election on FC1 and FC2 is made effective following Grantor George’s death. In a nutshell, the goal is to trigger recognition events at the top level to step up the outside basis and the bottom level to step up the basis of the underlying assets prior to death.
Assume that on Jan. 1 of the current year (Day 1), the trust has a $10 million basis in FC1, which has a value of $100 million. FC1 has a $5 million basis in each of the stock of FC2 and the stock of FC3, each of which has a value of $50 million. In addition, FC2 and FC3 have a combined $10 million basis in the stock of FC4, which has a value of $100 million. Lastly, FC4 has a $50 million basis in the U.S. portfolio, worth $100 million. Effective Day 149, a CTB election is made with respect to FC1 and FC4, when the U.S. portfolio is worth $108 million. On Day 150, Grantor George dies, and the assets haven’t increased in value. Effective Day 155, a CTB election is made with respect to FC2 and FC3, when they’re worth $55 million each, and the U.S. portfolio is worth $110 million. The following summarizes the U.S. income tax consequences of this hypothetical scenario:
Gains to FC1 and the trust on CTB election of FC1. This step is identical to the first step in the two-entity, two-tier structure. It doesn’t result in any tax because FC1 is deemed to liquidate prior to becoming a CFC. As a result of the deemed liquidation, the trust’s combined basis in FC2 and FC3 increases to $108 million.
Gains to FC2, FC3 and FC4 on the CTB election of FC4. This step is identical to the first step in the three-entity, two-tier structure. FC4 will be deemed to liquidate prior to becoming a CFC, and therefore, its realized gains wouldn’t be includible as subpart F income. However, the combined gain of $98 million between FC2 and FC3 at the time of this CTB election would be subpart F income. As before, no amount of trading activity by FC4 would change this result. Going forward, FC2 and FC3 will have a combined basis of $108 million in the deemed partnership FC4, and indirectly, in the underlying assets.
As before, if Grantor George dies within the first 74 days of the year, the CTB election on FC4 could be made effective on Dec. 31 of the prior year, eliminating this subpart F income altogether.
Gains to FC2 and FC3 on the CTB election of FC2 and FC3 and subpart F inclusion to Beneficiary Ben. This step is identical to the second step in the three-entity, two-tier structure. On this CTB election, the value of the assets has increased to $110 million, generating an additional $2 million of gain between FC2 and FC3, which would be subpart F income. This would result in a total of $100 million of subpart F income, $3 million of which is attributable to Beneficiary Ben. As before, if Grantor George dies within the first 74 days of the year, the appreciation prior to, and gains realized on, the CTB election on FC4 wouldn’t be attributed to Beneficiary Ben for U.S. tax purposes.
Gains to trust on the CTB election of FC2 and FC3. Unlike under the three-entity, two-tier structure, it’s irrelevant here whether the trust is entitled to a basis step-up under Section 1014. In all circumstances, its basis would be equal to $111 million or its original basis of $108 million (as a result of the CTB election of FC1 or as a result of Section 1014), plus the $3 million of subpart F inclusion. Therefore, on this final CTB election, the trust would realize a $1 million capital loss.
Summary of results. As illustrated, the four-entity, three-tier structure, similar to the three-entity structure, provides an opportunity to significantly reduce subpart F inclusion if Grantor George dies earlier in the year. It also, similar to the two-entity structure, provides for a step-up in basis when not otherwise available under Section 1014.
As was the case in the three-entity structure, however, if there’s adequate basis in the underlying investments, it may be preferable to adopt the two-entity structure to take advantage of such high basis and reduce the subpart F inclusion. In the four-entity structure, the subpart F income is determined based on the gains of the middle tier entities, whose bases aren’t increased as a result of the activities of the underlying investments. Therefore, unless Grantor George dies within the first 75 days of the year, the subpart F inclusion under the four-entity structure may be greater than under the two-entity structure if there’s adequate basis in the underlying investments. As with the three-entity structure, this structure may be most viable when the underlying assets are illiquid and selling the investment in advance isn’t a viable mitigation strategy.
Furthermore, it may be difficult to establish that there’s a business purpose for a fourth entity in such a structure. This issue must be given greater consideration than when adopting the structures involving fewer entities.
Comparing the Alternatives
As illustrated in this article, the TCJA threw a wrench into the prior planning strategies for non-U.S. grantors of trusts with U.S. remainder beneficiaries. No longer could a non-U.S. individual protect against U.S. federal estate tax exposure without facing subpart F issues.
There are four alternative structures that may be used to address this subpart F issue:
If the trust in question is entitled to a step-up in basis under Section 1014 and there’s sufficient basis in the underlying assets, the one-entity, one-tier structure may be most appropriate; it’s administratively convenient and provides U.S. federal estate tax protection without significant risk that there will be much subpart F inclusion to the U.S. beneficiaries.
If, however, the trust isn’t entitled to a basis step-up at the grantor’s death, but there’s sufficient basis in the underlying assets, the two-entity, two-tier structure may be most appropriate to generate this step-up in basis at the grantor’s death. So long as there’s sufficient basis in the underlying assets, there’s little risk of substantial subpart F inclusion.
On the other hand, if the trust is entitled to a basis step-up at the grantor’s death, but there isn’t sufficient basis in the underlying assets, the three-entity, two-tier structure would likely be preferable, particularly to address the risk of a large subpart F inclusion if the grantor dies earlier in the year.
Lastly, if the trust isn’t entitled to a step-up in basis at the grantor’s death and there isn’t sufficient basis in the underlying assets, the four-entity, three-tier structure may be best. This would allow the trust to receive a step-up in basis on the grantor’s death when not otherwise available and would protect against a larger subpart F inclusion if the grantor dies earlier in the year.
As more entities are added to the structure, however, one may face a difficult time devising a non-tax business purpose that would withstand IRS scrutiny. Therefore, the viability of any of the plans would depend on having such a purpose in place. Furthermore, future changes to U.S. tax laws could render these options obsolete, which is important to consider in light of the 2020 elections.
—Thank you to Carl A. Merino of Day Pitney LLP in New York City and Rachel J. Harris of Loeb & Loeb LLP in Los Angeles for their comments.
Endnotes
1. Tax Cuts and Jobs Act (TCJA), Pub. L. No. 115-97 (2017).
2. Internal Revenue Code Section 951(a)(1)(A).
3. IRC Section 957(a).
4. Prior to the TCJA, U.S. shareholder status was determined based on ownership (or deemed ownership) of voting stock. The TCJA eliminated the distinction between voting and non-voting stock.
5. See Treasury Regulations Section 1.958-1(b), (c)(2), (d), Ex. 3.
6. See IRC Section 951(a)(2)(A); Treas. Regs. Section 1.951-1(f). The holding period of stock in a controlled foreign corporation (CFC) is determined by excluding the day when the stock is acquired and including the day when the stock is disposed of.
7. A U.S. shareholder’s pro rata share of global intangible low-taxed income (GILTI) is determined in a similar manner under IRC Section 951A and the proposed regulations thereunder. Unlike subpart F income, which is determined on a CFC-by-CFC basis, GILTI is determined on an aggregate basis, taking into account all of the CFCs with respect to which a U.S. person is a U.S. shareholder. However, the GILTI regime incorporates the same fractional inclusion rule. This article focuses more on the subpart F rules, as GILTI is more likely to come into play with a closely held business, the income of which wouldn’t otherwise be picked up under the subpart F rules.
8. See, e.g., Curtis, Mallet-Prevost, Colt & Mosle LLP, Insight, “Tax Planning for Non-U.S. Individuals May Be Thwarted by Recent Tax Reform” (April 30, 2018), www.curtis.com/our-firm/news/tax-planning-for-non-u-s-individuals-may-be-thwarted-by-recent-tax-reform.
9. A trust’s basis in property is adjusted to its fair market value as of a decedent’s death if the decedent transferred property to the trust during his lifetime and the trust pays income for life “to or on the order or direction of the decedent, with the right reserved to the decedent at all times before his death to revoke the trust.” Treas. Regs. Section 1.1014-2(a)(2). Therefore, a basis step-up (or step-down) under IRC Section 1014 wouldn’t be available if trust income isn’t distributed to, or on the order of, the grantor, or if the trust isn’t revocable, or otherwise amendable, by the grantor, even if the trust is a grantor trust with respect to a foreign grantor under IRC Section 672(f).
10. This is on the assumption that the foreign corporation didn’t hold real property located in the United States.
11. This article doesn’t address the tax consequences of any jurisdiction outside of the United States.
12. Treas. Regs. Section 301.7701-3(d).
13. While there’s some ambiguity under the entity classification regulations as to whether a classification of an entity must be relevant for a check-the-box election to result in the entity being treated as liquidating, it’s recommended to always take measures to ensure that relevancy exists when an election is made. See Treas. Regs. Section 301.7701-3(d) and Treas. Regs. Section 301.7701-3(g)(1).
14. Treas. Regs. Section 301.7701-3(g)(1)(ii)-(iii).
15. This is the case because FC1 is wholly owned by the trust as opposed to another corporation. See IRC Section 331 and IRC Section 336, compared to IRC Section 332 and IRC Section 337 (providing generally for nonrecognition treatment when an 80% owned subsidiary is liquidated into its parent corporation).
16. If the trust is deemed to be a U.S. person, then the trust would be subject to the tax on the subpart F income instead of Beneficiary Ben. This article assumes, however, that the trust is a foreign trust and that ownership of the CFC is attributed to the U.S. beneficiaries.
17. I’ve assumed for purposes of this example and the following examples that the foreign corporations in question hold only investment assets and thus that the gain would be picked up under the subpart F rules, rather than under the GILTI regime, which is more likely to apply in the case of active business income and gain not otherwise picked up as subpart F income. However, the same fractional inclusion rule would apply in either case.
18. IRC Section 961; Treas. Regs. Section 1.961-1(a), (b)(1)(iii).
19. This is on the assumption that the U.S. investments are worth $100 million on Jan. 2.
20. The election is filed post-mortem, but with an effective date prior to the date of death. Elections generally may be filed up to 75 days after the effective date designated on Form 8832. See Treas. Regs. Section 301.7701-3(c)(1)(iii).
21. This assumes that neither Grantor George nor FC1 is engaged in a U.S. trade or business to which the income is effectively connected and that the gains aren’t attributable to U.S. real property holdings.