the trust for its fair market value. The amount of the resulting gain or loss would be the difference between that fair market value and the beneficiary's basis in the interest. Presumably, the fair market value would be what a willing buyer would pay for such interest. The beneficiary's basis typically would be determined under the uniform basis rules (see above). If the interest that is being marked to market is an income interest, term interest or life estate, section 1001(e) would prevent the use of any of that basis in determining the gain realized on the deemed sale. Any resulting tax liability would be that of the expatriating beneficiary; the trust itself would not pay the tax.

The deemed realization by the expatriating beneficiary generally would result in double taxation of the gain inherent in trust assets once on the gain resulting from the deemed sale of the trust interest and again when the trust actually disposes of the trust assets.276 This is because the deemed realization by the beneficiary with respect to his trust interest does not result in a basis adjustment to the trust's “inside” basis in its assets.277 To eliminate this double taxation, the proposal could be amended to permit a basis adjustment upon a deemed realization (i.e., the trust would be permitted to increase its basis in the trust assets by the amount of gain recognized by the expatriating beneficiary). Such an adjustment, if permitted, would cause less taxable gain (or more taxable loss) when the trust subsequently sells trust assets. The individual who would benefit (in the case of an increase in basis from a gain) or negatively affected (in the case of a decrease in basis from a loss) would depend upon the allocation of the gain under the terms of the trust instrument.278 In the typical case, undistributed gains from a sale are taxed to the trust, and the tax typically is allocated to the residual interest in the trust. As a result, any increased basis from the deemed sale by the expatriating beneficiary would reduce the tax borne by the residuary beneficiary or beneficiaries of the trust. The effect of these rules may be illustrated by the following examples:

Example 1 (one income beneficiary who expatriates and one remainderman).—Assume that F created a trust into which he transferred stock of M Corporation with a basis of $1,000 279 that is to pay the income from the trust for a 20-year period to S, remainder to GS. Also assume that S expatriates five years later, when the discount rate is 10 percent, the value of the M stock is $2,000, and that the M Corporation is expected to pay dividends of $100 a year.

Under the Administration proposal, S would be deemed to have sold his interest in the trust for its market value when S expatriates. Assume that the value of S's interest at that time is $500 (which is less than the present value of the income stream of

276 This domestic double tax is in addition to any potential double tax that may arise on trust distributions as a result of the expatriate moving to another country. (For a discussion of these issues, see Part V.F.)

277 Put another way, the double tax arises because the beneficiary's basis in the trust (the "outside" basis) is not coordinated with the trust's basis in its assets (the "inside" basis).

278 Any adjustment to the trust's basis for Federal income tax purposes also may not extend to the determination of the amount of gain or loss under applicable local law in determining beneficiaries' interests in the trust.

279 The basis could be either what F paid for the stock in the case of an intervivos trust or the value of the stock in the case of a testamentary trust.

$760.61 because of the difficulty in selling an interest in a trust). Under the uniform basis rules, S's basis in the income interest would be $380.31 ($1,000 × $760.61 $2,000). Nonetheless, under section 1001(e), S cannot use that basis in determining the gain on the deemed sale of the income interest. As a result, S would recognize a gain of $500. The tax on this gain may be viewed as an acceleration of the taxes on income for which S would have been liable had he not expatriated; the subsequent distributions to S of the actual income of the trust also may be subject to withholding taxes and hence double taxed, but otherwise will be exempt from U.S. taxation, because S will be a nonresident alien at that time.

Next assume that the trust subsequently sells the stock in M Corporation for $2,000. Because the deemed sale by S does not affect the trust's basis in its assets, the resulting gain on the sale will be $1,000 (amount realized of $2,000 minus basis of $1,000) the tax on which will be borne entirely by GS.280 Even though the tax on an expatriating income beneficiary and the tax on the trust on the disposition of trust assets are determined both by reference to the amount of gain in the trust's corpus, it is not clear that there is double taxation of that gain. Since the tax that arises by reason of expatriation will be borne entirely by a beneficiary who is entitled only to income, the tax may be viewed as acceleration of tax that the income beneficiary would have paid on the trust income had he not expatriated. This result arguably is consistent with the second purpose articulated by the Administration for the proposal.281 The tax on the actual disposition of M Corporation stock that will be borne by the remainderman would be the same as occurs under present law.

If the proposal is amended to allow the gain on the deemed sale to result in an upward adjustment of the trust's basis in the trust assets to $1,119.69 ($619.69 basis in the remainder interest plus the $500 realized on the deemed sale of the income interest), there will be gain only on $880.31 on the subsequent disposition of the trust assets for $2,000. Thus, adopting such an amendment would transfer the tax on a portion of the gain from the remainderman to the income beneficiary (i.e., the proposal would exempt some of the tax normally borne by the remainderman).28

282

Example 2 (one income beneficiary and one remainderman who expatriates).-Assume the same facts as Example 1, except that it is GS, not S, who expatriates 5 years after the trust was created and that the value of the remainder interest is $1,100 (which is less than present value of the remainder interest of

280 If the resulting gain is not distributable to GS at that time, the trust will pay tax on the $1,000 gain and allocate the tax to GS's residuary interest in the trust. If the resulting gain is distributable at the time of the sale, the resulting gain will be included in the distributable net income (DNI) of the trust which DNI will be distributed to, and therefore taxable to, GS. 281 If this is the purpose of the proposal, however, other future income streams (e.g., interest on bonds or dividends on stock) also should be subject to tax. As discussed above, these income streams are not expressly subject to tax under the proposal (but may be subject to tax under regulatory authority granted to the Treasury Secretary); thus, the proposal may be inconsistent in its treatment of income interests held in trust and other future income streams. Taxing future income streams, including income interests held in trust, arguably would be inconsistent with the first purpose articulated by the Administration for the proposal.

282 In some jurisdictions, S may have an action to collect the amount of the tax from GS under the doctrine of equitable recoupment. In addition, the proposal could be modified to provide a Federal right of contribution, similar to the rights provided under sections 2207 and 2207A.

$1,239.39 ($2,000 - $760.61) because of the difficulty in selling an interest in a trust).

Under the Administration proposal, GS would be deemed to have sold his interest in the trust for its market value when GS expatriates. Under the uniform basis rules, GS's basis would be $619.69 ($1,000 × $1,239.39 $2,000). As a result, GS would recognize a gain of $480.30 ($1,100 - $619.70).283

As indicated above, present law does not permit a basis adjustment to the trust's basis in its assets upon the deemed sale of a trust interest. Without such an adjustment, there may be a double tax borne by the remainderman-a tax borne directly by him on the deemed sale under the proposal and then an additional tax that typically is imposed at the trust level when the trust sells the property.284 However, unlike Example 1, both taxes will be borne in this case by the same individual-the remainderman.

If the proposal were amended to allow a basis adjustment for the gain on the deemed sale, the trust's basis in the trust assets after the deemed sale would be $1,480.31 ($380.31 basis in the income interest plus the $1,100 realized on the deemed sale of the income interest). As a result, there would be gain of only $519.70 on the subsequent disposition of the trust assets for $2,000. The total gain recognized would still be $1,000 ($480.30 plus $519.70); the net effect of the Administration proposal with a basis adjustment would be to accelerate part of the gain to the time of expatriation.

If, instead of selling the stock in M Corporation, the trust makes an in-kind distribution to the expatriate, there will be no additional tax. On the other hand, if the trust makes an in-kind distribution of the M Corporation stock to a foreign corporation, partnership, or trust, an additional 35-percent excise tax generally would be imposed under section 1491.

b. Senate bill and modified bills

Under the Senate bill and the modified bills, the following transactions would be deemed to occur when a trust beneficiary expatriates: (1) the interest shall be separated into a separate share within the trust; (2) the separate trust then is treated as selling the newly segregated assets; (3) the separate trust distributes the sales proceeds from the deemed sale to the expatriated beneficiary; and (4) the expatriated beneficiary contributes the deemed distributed assets back to the trust with a stepped-up basis.285 Thus, one effect

283 Note that section 1001(e) does not apply to the sale of a remainder interest.

284 If the trust requires that the proceeds be distributed to GS in the year of sale, the gain on the sale would be included in the distributable net income (DNI) of the trust and, therefore, generally would be taxable to GS instead of the trust. However, because GS will be a nonresident alien at that time, he or she would avoid the double tax on the distribution of proceeds in this case. This is because withholding tax is only imposed on distributions from trusts with U.S. trustees to foreign beneficiaries generally to the extent that the trust distribution comprises income that would be subject to U.S. withholding tax if paid directly from the U.S. payor to the foreign beneficiary (e.g., trust distributions of U.S.-source dividends, rents, royalties, and certain interest), but withholding does not apply to trust distributions of U.S.-source capital gains, foreign-source income of any type, or corpus (sec. 1441).

285 It is unclear under the proposal whether the deemed recontribution causes the trust to be treated as a grantor trust with respect to the recontributed assets. The question of whether the deemed recontribution gives rise to a grantor trust should be clarified. Treatment as a grantor trust may have the apparently unintended consequence of treating the separate trust as a foreign grantor trust. (See Part V.H.2.c., below.)

The recontribution treatment may have other unintended consequences (e.g., the effect on other beneficiaries with respect to trust distributions, the application of the generation-skipping

of this treatment is to provide effectively for the basis adjustment not permitted under the treatment of the Administration proposal. Moreover, as discussed with respect to valuation above, a second effect of this treatment is to impose the tax on the value of the trust's underlying assets, as opposed to the Administration proposal's approach of valuing the trust interest. Thus, any potential discount that arises from a deemed sale of an interest in a trust would be eliminated. These rules may be illustrated by the following examples.

Example 3.-The facts are the same as Example 1. Under the Senate bill and the modified bills, a separate trust 286 is deemed created out of the original trust's assets in an amount equal to the value of S's income interest in the original trust.287 Presumably, after the deemed segregation, the separate trust would have assets with a value of $760.61 and a basis of $380.31. That trust would be deemed to sell those assets and to distribute the sales proceeds to S. As a result, the separate trust would recognize a gain of $380.30 288 which gain would be included in the separate trust's distributable net income (DNI) that is distributed and, therefore, taxable to S prior to his expatriation.289 Finally, S would be deemed to have contributed the $760.61 of distributed sales proceeds to the original trust.

The proposal is somewhat unclear as to the proper method of determining what the tax effect of a subsequent sale by the trust. Assume the trust sells the M Corporation stock for $2,000. Presumably, under these bills, the basis of the assets would be at least the $619.69 ($1,000 less $380.31) left in the remainder interest in the original trust. It is unclear, however, whether the original trust would have any additional basis in the deemed contribution by S since it is unclear whether that deemed contribution created a grantor trust in which S is treated as its owner. If the trust received no basis in the deemed contribution because the deemed

transfer tax, and cases where the expatriate had interests in a charitable remainder trust or a pooled income fund).

286 The deemed transaction under the bills is somewhat unclear since the bills state that the beneficiary's interest is .treated as a separate share in the trust and such separate share shall be treated as a separate trust consisting of the assets allocable to such share...." Separate shares within a trust are not the same as a separate trust. In general, the effect of the special rules for separate shares (sec. 663(c)) is to prevent income allocable to the separate share from affecting the taxability of distributions to other beneficiaries of the trust through allocating distributable net income of the separate share to other beneficiaries.

287 While both the language of the Senate bill and the modified bills, as well as any legislative history (see page 24 of S. Rept. 104-16, 104th Cong. 1st Sess., on the Senate amendment to H.R. 831) are, at best, ambiguous on what occurs upon the deemed creation of the new trust, the staff has been given to understand that the intent of the provision is that a portion of the trust's assets would be deemed transferred from the original trust to a new trust. If, instead of individual assets being deemed transferred to a new trust, a life estate was deemed transferred to a new trust, the tax results would be similar except that section 1001(e) would apply so that the gain on the deemed sale by the new trust would be determined without regard to any basis the new trust would have in the life estate.

288 Since the separate trust is deemed to have sold trust assets and not an income interest, section 1001(e) would not apply.

289 As discussed above, beneficiaries of trusts generally are taxable on distributions from a trust to the extent of the trust's DNI for taxable years ending with, or within, the taxable year of the beneficiary. However, present law is unclear as to whether income from a complex trust is includible in a beneficiary's income under the "with or within rule" as the distributions from the trust are made or at the beneficiary's year end. If income is includible only at the beneficiary's year end, the United States will have lost jurisdiction to impose a tax in the case of expatriation since the deemed second trust under the various bills would be a complex trust and the beneficiary typically would be a nonresident alien at the close of his taxable year (except in the unusual event that the expatriation occurs on the last day of the beneficiary's taxable year).

contribution created a grantor trust, there would be a gain of $619.70 on the sale of the M Corporation stock (amount realized of $1,239.39 ($2,000 less $760.61) less basis of $619.69. As a result, there would be total taxable gain of $1,000 (gain of $380.31 on the deemed sale on expatriation plus additional gain of $619.70 on the actual sale by the original trust). If, on the other hand, the deemed contribution did not create a separate grantor trust and the original trust thus did receive additional basis in its assets by reason of the deemed contribution by S of $761.61 (i.e., the amount realized on the deemed sale of the assets of the deemed separate trust), the trust's total basis in its assets would be $1,380.31 ($619.69 of basis in the remainder interest plus $761.62 in the deemed contribution) and the resulting gain to the original trust on an sale of its assets would be $619.69 ($2,000 less $1,380.31) for total gain of $1,000 ($380.31 plus $619.69).

Example 4.-The facts are the same as Example 2. Under the Senate bill and the modified bills, a separate trust is created for GS's remainder interest in the M Corporation stock. Thus, the separate trust has assets with a basis of $620.69 and a value of $1,241.38. The separate trust then is deemed to have sold that interest for $1,241.38 with a resulting gain of $620.69. The separate trust would be deemed to distribute all of its assets ($1,241.38) to the expatriating beneficiary which would result in gain of $620.69 being included in the separate trust's distributable net income that is distributed and therefore, taxable to the expatriating beneficiary. While the proposal is unclear what the tax results would occur on the deemed distribution and recontibution upon expatriation under these bills if the trust subsequently were to sell the M Corporation stock for $2,000, presumably the basis of the assets in the original trust would be $1,621.69 (i.e., $380.31 in the income interest plus $1,241.38 in the deemed contribution by GS). If the trust were subsequently to sell that asset for $2,000, there would be a gain of $378.31 ($2,000 less $1,621.69). As a result, there would be total taxable gain of $1,000.00 ($479.31 + $519.69).

c. Technical issues

Closest in kinship rules; Intestate succession rules

If the ownership of trust interests cannot be determined under the facts and circumstances test, the Administration proposal and the Senate bill apply "closest in kinship" rules and the modified bills rely on intestate succession rules to determine trust ownership. In either case, these rules could permit tax planning to avoid or reduce imposition of the expatriation tax and could also have arbitrary results. For example, assume a grandfather wants to establish a discretionary trust for a granddaughter who plans to expatriate in the future. To avoid the expatriation tax, he may include his daughter (i.e., the granddaughter's mother) as a potential beneficiary in the hopes that the facts and circumstances test will not apply and the interest in the trust will therefore be attributed completely to the daughter under the closest in kinship rules or intestate succession rules. Similarly, even if the daughter is truly an intended beneficiary, attributing the entire trust to her under either the closest in kinship rules or the intestate succession rules seems