puted without regard to personal exemptions, the distribution deduction, capital gains that are allocated to corpus and not distributed to any beneficiary during the taxable year or set aside for charitable purposes, capital losses other than capital losses taken into account in determining the amount of capital gains which are paid to beneficiaries, and (with respect to simple trusts) extraordinary dividends which are not distributed to beneficiaries. In the case of a foreign trust,42 DNI also includes foreign-source income less related deductions, income that is exempt under treaties, and capital gains reduced (but not below zero) by capital losses. Also, to determine DNI, the exclusion for small business capital gains under section 1202 is not taken into account. DNI has the following three functions: (1) it measures the amount of the deduction to the trust or estate for distributions to beneficiaries, (2) it measures the amount of distributions that is taxable to the beneficiaries, and (3) it determines the character of the income to the beneficiaries. In effect, DNI is allocated to distributions in the following order: first, to distributions that are required to be made out of income for the year; second, to distributions of income made to charities; and lastly, to all other distributions. The character of the amounts includible in gross income is the same proportion of each class of items includible in distributable net income as the total of each class bears to total distributable net income. There are two exceptions to these rules. First, distributions as a gift or bequest of specific property or a specific sum of money that is paid in not more than 3 installments are not includible in the gross income of the beneficiary. Second, distributions from a separate and independent share of a trust to a beneficiary of that trust share is treated as a distribution from a separate trust. Existing Treasury regulations (Treas. Reg. sec. 1.663(c)-3) provide that "[t]he application of the separate share rule...will generally depend upon whether distributions of the trust are to be made in substantially the same manner as if separate trusts had been created.... Separate share treatment will not be applied to a trust or portion of a trust subject to a power to distribute, apportion, or accumulate income or distribute corpus to or for the use of one or more beneficiaries within a group or class of beneficiaries, unless the payment of income, accumulated income, or corpus of a share of one beneficiary cannot affect the proportionate share of income, accumulated income, or corpus of any shares of the other beneficiaries, or unless substantially proper adjustment must thereafter be made under the governing instrument so that substantially separate and independent shares exist." Distributions to beneficiaries of trusts (but not estates) out of previously accumulated income are taxed to the beneficiaries under a throwback rule. The effect of the throwback rule is to impose an additional tax on the distribution of previously accumulated income in the year of distribution at the average marginal rate of the beneficiary in the previous five years. The amount of the distribution is grossed-up by the amount of the taxes paid by the trust on the 42 A foreign trust is a trust whose income from sources outside the United States, which is not effectively connected with the conduct of a trade or business within the United States, is not included in gross income for U.S. income tax purposes. Section 7701(a)(31). accumulated income and a nonrefundable credit is allowed to the beneficiary for such taxes. In order to prevent trusts from accumulating income for a year, the fiduciary of a trust may elect to treat distributions within the first 65 days after the close of its taxable year as having occurred at the end of the preceding taxable year. c. Grantor trust rules Under the grantor trust rules,43 the grantor of a trust will continue to be taxed as the owner of the trust (or a portion thereof) if certain rights or powers are retained by the grantor. A grantor of a trust generally is treated as the owner of any portion of a trust when the following circumstances exist: (1) the grantor has a reversionary interest that has more than (3) the grantor retains any of the following administrative pow- (4) the grantor has a power to revoke, unless such power may not be exercised any time before an event that has a 5-percent probability or less of occurring. (5) the income is or may be distributed to, held for the future benefit of, or used to pay for life insurance on the lives of, the grantor or the grantor's spouse, unless such power may not be exercised any time before an event that has a 5-percent probability or less of occurring. (An exception is provided for income that may be used to discharge an obligation of support, unless the income is so used.) If the grantor is not treated as the owner of any portion of a trust, another person generally will be treated as the owner of that portion of the trust if he or she has the power to revoke that portion of the trust or gave up a power to revoke and retained any of 43 Sections 671-679. the powers set forth above, unless the retained power is disclaimed within a reasonable time. A U.S. person who transfers property to a foreign trust generally is treated as the owner, under the grantor trust rules, of the portion of the trust comprising that property for any taxable year in which there is a U.S. beneficiary of any portion of the trust. This treatment generally does not apply, however, to transfers by reason of death; to sales or exchanges of property at fair market value, where gain is recognized to the transferor; or to transfers made before the transferor became a U.S. person. d. Taxation on disposition of interests in trusts In general, the gain or loss on the sale or other disposition of an asset is the difference between the amount realized on the sale or disposition of the asset and the taxpayer's adjusted basis in that property.44 A trust's basis in an asset contributed to the trust is the same as the contributor's basis in that asset increased by any gain or decreased by any loss recognized on the transfer. A beneficiary's basis in his interest in a trust generally is the same as the trust's basis in the asset.45 "If the [trust] property is an investment made by the fiduciary (as, for example, in the case of a sale by the fiduciary of property transferred by the grantor, and reinvestment of the proceeds), the cost or other basis to the fiduciary is taken in lieu of the [grantor's basis]." 46 When a life estate and remainder interest in property are acquired by gift, bequest, or inheritance, a so-called "uniform basis" rule is applied with the basis of the property being divided between the life estate and the remainder interest. As the life estate is used up each year, its basis is reduced, and the basis of the remainder interest increases in the same amount; hence, the combined basis of the life estate and the remainder interest remains the same from year to year. Under a special rule applicable in determining gain or loss from the sale or other disposition of a “term interest" in property, that portion of the adjusted basis of such interest which is determined as a carryover basis as a result of a transfer of the property by gift (section 1015) or a stepped-up basis as a result of the property being transferred at death (section 1014) generally is disregarded.47 For purposes of the rule, a "term interest" includes a life estate, an interest for a term of years, or an income interest.4 A "term interest" includes an interest which will terminate upon the happening of an event, but does not include a remainder or reversionary interest or an interest that will ripen into ownership upon the termination of a preceding interest.49 e. Residence of trusts 48 An estate or trust is treated as foreign if it is not subject to U.S. income taxation on its income that is neither derived from U.S. 44 Section 1001(a). 45 Treas. Reg. section 1.1015-2(a). 46 Treas. Reg. section 1.1015-2(b). See also Treas. Reg. section 1.1014-5(c). 47 Section 1001(e). This special rule does not apply to a sale or disposition of the life estate as part of a transaction in which the entire interest in property is transferred to any person or persons (sec. 1001(e)(3)). 48 Section 1001(b)(2). 49 Treas. Reg. section 1.1001-1(f)(2). sources nor effectively connected with the conduct of a trade or business within the United States.50 Thus, if a trust is taxed in a manner similar to a nonresident alien individual, it is considered to be a foreign trust. Any other estate or trust is treated as domestic.51 The Code does not specify what characteristics must exist before a trust is treated as being comparable to a nonresident alien individual. IRS rulings and court cases, however, indicate that this status depends on various factors, such as the residence of the trustee, the location of the trust assets, the country under whose laws the trust is created, the nationality of the grantor, and the nationality of the beneficiaries.52 If an examination of these factors indicates that a trust has sufficient foreign contacts, it is deemed comparable to a nonresident alien individual and, thus, is a foreign trust. 4. Special tax rules with respect to the movement of persons and property into or out of the United States a. Individuals who relinquish U.S. citizenship with a principal purpose of avoiding U.S. tax An individual who relinquishes his U.S. citizenship with a principal purpose of avoiding U.S. taxes is subject to an alternative method of income taxation for 10 years after expatriation under section 877 of the Code.53 Under this provision, if the Treasury Department establishes that it is reasonable to believe that the expatriate's loss of U.S. citizenship would, but for the application of this provision, result in a substantial reduction in U.S. tax based on the expatriate's probable income for the taxable year, then the expatriate has the burden of proving that the loss of citizenship did not have as one of its principal purposes the avoidance of U.S. income, estate or gift taxes. Section 877 does not apply to resident aliens who terminate their U.S. residency. The alternative method modifies the rules generally applicable to the taxation of nonresident aliens in two ways. First, the expatriate is subject to tax on his or her U.S. source income at the rates applicable to U.S. citizens rather than the rates applicable to other nonresident aliens. (Unlike U.S. citizens, however, individuals subject to section 877 are not taxed on any foreign source income.) Second, the scope of items treated as U.S. source income for section 877 purposes is broader than those items generally considered to be U.S. source income under the Code. For example, gains on the sale of personal property located in the United States, and gains on the sale or exchange of stocks and securities issued by U.S. persons, generally are not considered to be U.S. source income under the Code. However, if an individual is subject to the alternative taxing 50 Section 7701(a)(31). 51 Section 7701(a)(30). 52 For example, see Rev. Rul. 87-61, 1987-2 C.B. 219, Rev. Rul. 81-112, 1981-1 C.B. 598, Rev. Rul. 60-181, 1960-1 C.B. 257, and B. W. Jones Trust v. Commissioner, 46 B.T.A. 531 (1942), aff'd, 132 F.2d 914 (4th Cir. 1943). 53 Treasury regulations provide that an individual's citizenship status is governed by the provisions of the Immigration and Nationality Act, specifically referring to the "rules governing loss of citizenship [set forth in] sections 349 to 357, inclusive, of such Act (8 U.S.C. 1481-1489)." Treas. Reg. section 1.1-1(c). Under the Immigration and Nationality Act, an individual is generally considered to lose U.S. citizenship on the date that an expatriating act is committed. The present law rules governing the loss of citizenship, and a description of the types of expatriating acts that lead to a loss of citizenship, are discussed more fully in Part B.1., below. method of section 877, such gains are treated as U.S. source income with respect to that individual. The alternative method applies only if it results in a higher U.S. tax liability than would otherwise be determined if the individual were taxed as a nonresident alien. Because section 877 alters the sourcing rules generally used to determine the country having primary taxing jurisdiction over certain items of income, there is an increased potential for such items to be subject to double taxation. For example, a former U.S. citizen subject to the section 877 rules may have capital gains derived from stock in a U.S. corporation. Under section 877, such gains are treated as U.S. source income, and, therefore, are subject to U.S. tax. Under the internal laws of the individual's new country of residence, however, that country may provide that all capital gains realized by a resident of that country are subject to taxation in that country, and thus the individual's gain from the sale of U.S. stock also would be taxable in his country of residence. If the individual's new country of residence has an income tax treaty with the United States, the treaty may provide for the amelioration of this potential double tax. (See Part V.F. for a more detailed discussion of the double taxation issues and their treatment under existing U.S. tax treaties.) Similar rules apply in the context of estate and gift taxation if the transferor relinquished U.S. citizenship with a principal purpose of avoiding U.S. taxes within the 10-year period ending on the date of the transfer. A special rule applies to the estate tax treatment of any decedent who relinquished his U.S. citizenship within 10 years of death, if the decedent's loss of U.S. citizenship had as one of its principal purposes a tax avoidance motive.54 Once the Secretary of the Treasury establishes a reasonable belief that the expatriate's loss of U.S. citizenship would result in a substantial reduction in estate, inheritance, legacy and succession taxes, the burden of proving that one of the principal purposes of the loss of U.S. citizenship was not avoidance of U.S. income or estate tax is on the executor of the decedent's estate. In general, the estates of such individuals are taxed in accordance with the rules generally applicable to the estates of nonresident aliens (i.e., the gross estate includes all U.S.-situs property held by the decedent at death, is subject to U.S. estate tax at the rates generally applicable to the estates of U.S. citizens, and is allowed a unified credit of $13,000, as well as credits for State death taxes, gift taxes, and prior transfers). However, a special rule provides that the individual's gross estate also includes his pro-rata share of any U.S.-situs property held through a foreign corporation in which the decedent had a 10-percent or greater interest, provided that the decedent and related parties together owned more than 50 percent of the voting power of the corporation. Similarly, gifts of intangible property having a situs within the United States (e.g., stocks and bonds) made by a nonresident alien who relinquished his U.S. citizenship within the 10-year period ending on the date of transfer are subject to U.S. gift tax, if the loss of U.S. 54 Section 2107. |