In final regulations (TD 9752), the IRS extended the requirement to report ownership of certain specified "foreign financial assets" on Form 8938, Statement of Foreign Financial Assets, to certain "specified domestic entities" effective for years beginning after 2015. Under prior law, only individuals were required to perform Form 8938 reporting under Section 6038D.

Background

Section 6038D requires certain taxpayers to report with their tax returns on Form 8938 ownership of certain foreign financial assets in excess of specified minimum threshold amounts. This reporting is in addition to, and not in lieu of, foreign bank account reporting on FinCEN Form 114. Individuals have been required to perform this reporting for tax years beginning after March 18, 2010 (see Tax Alerts 2011-2148 and 2014-2280). Although the statute gives the government authority to extend this reporting requirement to domestic entities, the proposed regulations on this point (Prop. Reg. Section 1.6038D-6) issued in 2011 were not issued in temporary or final form until now, so no entity has been required to perform Form 8938 reporting. In addition, there were (and continue to be) no constructive ownership rules to attribute ownership of foreign financial assets from a domestic entity to an individual owner, except when the domestic entity is a "grantor" trust and the individual is treated as owning any portion of the trust under Sections 671-679 or when the domestic entity is a disregarded entity.

The final regulations (Treas. Reg. Section 1.6038D-6) promulgated by TD 9752 extend the reporting requirement to certain domestic entities. The final regulations, including differences from the temporary regulations, are discussed below. These final regulations do not change the prior-law definition of foreign financial assets (including exceptions therefrom) and how they are to be measured.

Readers of the final regulations will note a family resemblance between some of the concepts under these rules and concepts contained in the FATCA rules of Sections 1471 et seq.

The final regulations

Who must file

The final regulations clarify that determining whether a domestic entity must file Form 8938 is a two-step process. (The proposed regulations partially conflated the two steps.) First, one must determine whether the domestic entity at hand is a "specified domestic entity" that potentially is in scope to file. Second, one must determine whether the domestic entity owns specified foreign financial assets in excess of the minimum threshold for reporting.

Specified domestic entity

Corporations and partnerships. A domestic corporation or partnership is a specified domestic entity for a year if both (a) it is closely held by a specified individual and (b) either (i) at least 50% of its gross income for the year is passive or (ii) at least 50% of its assets produce, or are held for the production of, passive income. The final regulations do not contain the provision in the proposed regulations that would have treated domestic entities with a lower amount of passive assets or income as specified domestic entities if they were formed or availed of for a principal purpose of avoiding Section 6038D.

Specified individuals. Specified individuals are individuals who already are within scope for reporting foreign financial assets on Form 8938 under existing law: US citizens, resident aliens (who held this status at any time during the tax year), persons who elected to be treated as US residents for tax purposes under Sections 6013(g) or 6013(h) because they were married to US individuals, and bona fide residents of possessions.

Closely held. A domestic corporation is closely held by a specified individual if on the last day of the corporation's taxable year either (i) at least 80% of the total voting power of all classes of stock entitled to vote or (ii) at least 80% of the value of the stock of the corporation is directly, indirectly, or constructively held by a specified individual. A partnership is closely held by a specified individual if on the last day of the partnership's taxable year either (i) at least 80% of the partnership's capital or (ii) 80% of the partnership's "profits interest" is directly, indirectly or constructively held by a specified individual. The IRS brushed aside comments that it can be difficult to determine the profits interest of a partner when the partnership has complex allocations, on the grounds that this is a pervasive issue in Subchapter K and is not limited to Section 6038D. In both cases, a modified version of the rules of Sections 267(c) and 267(e)(3) are used to determine when an individual has a constructive ownership interest in an entity.

Passive income. The definition of passive income is modified from the proposed regulations. Under the final regulations, passive income comprises:

— Dividends, including substitute dividends

— Interest

— "Income equivalent to interest," including substitute interest

— Rents and royalties, other than rents and royalties derived in the active conduct of a trade or business conducted, at least in part, by employees of the corporation or partnership (the relation between this definition and the definition of active rents and royalties under the Subpart F rules is not entirely clear)

— Annuities

— The excess of gains over losses from the sale or exchange of property that gives rise to any of the foregoing categories of passive income

— The excess of gains over losses from transactions (including futures, forwards and similar transactions) in any commodity, but not including income from certain hedges or income from certain transactions in dealer property

— The excess of foreign currency gains over foreign currency losses as determined under Section 988 and

— Net income from notional principal contracts.

Certain income derived by dealers, as defined, is excluded for this purpose.

Assets may be measured by either book basis (under US GAAP or IFRS) or fair market value, but in either case the asset figure for a year is a weighted average, weighted by assets and measured quarterly.

Aggregation. For purposes of the income and asset tests, all domestic corporations and partnerships that are closely held by the same specified individual are aggregated if they are held through a common parent corporation or partnership (as defined). But the provision of the proposed regulations that would have gone on to treat all such entities as a single entity has been deleted from the final regulations. An example in the final regulations makes it clear that even if two or more entities must be aggregated for the purposes of the income and asset tests, and, as a result, all of them are specified domestic entities, the reporting threshold, discussed below, will be applied to each entity on a separate-entity basis.

Unlike the proposed regulations, the concept of the reporting threshold has nothing to do with determining whether an entity is a specified domestic entity.

Trusts. A domestic trust, including a charitable remainder trust, is a specified domestic entity for a year if, at any time during the trust's taxable year, the trust is required to or may in the trustee's discretion make distributions to any specified individual or specified domestic entity, whether or not the trust actually makes any distributions. A holder of a general power of appointment that could be exercised at any time during the year is also treated as a current beneficiary for this purpose, unless the general power can only be exercised on the death of the holder. (As noted above, if a specified individual or specified domestic entity is treated as owning some or all of a trust under the grantor trust rules, reporting is done by the deemed owner, not the trust.) Certain exceptions for trusts are discussed below.

Exceptions. The following entities are excluded from the definition of specified domestic entities:

— Publicly traded corporations and their affiliates (as defined under the FATCA rules) — there is no corresponding exception for publicly traded partnerships

— Tax-exempt entities under Section 501(a), including qualified pension plans described in Section 401(a)¹

— Individual retirement accounts

— Banks

— REITs

— RICs

— Common trust funds (as described in Section 584(a))

— Nonexempt charitable trusts (as defined in Section 4947(a)(1)) and

— Certain trusts in which the trustee is a domestic bank, credit union, SEC-regulated entity (such as a registered broker/dealer), publicly traded corporation or affiliate thereof.

Reporting threshold

Once it has been determined that an entity is a specified domestic entity, it is then necessary to determine whether the entity holds specified foreign financial assets in excess of the threshold amount. The threshold, as under current law for single individuals not residing abroad, is: either $50,000 on the last day of the taxable year or $75,000 at any time during the taxable year. Unlike the current law applicable to individuals, in determining whether a corporation, partnership or trust meets this threshold, the value of assets excepted from reporting on Form 8938 under Reg. Section 1.6038D-7(a) because they are already reported on Form 3520, 5471, 8621, or 8865 is not included in calculating the total value of the entity's foreign financial assets.

Effective date

The final regulations apply to taxable years beginning after December 31, 2015.

Implications

Domestic corporations, partnerships, and trusts need to begin analyzing whether they will have to file Form 8938 as part of their tax returns for years beginning after 2015. The elimination of the principal purpose test from the definition of a specified domestic entity is a welcome change. This, coupled with the "closely held" requirement, should reduce the number of managed fund entities subject to reporting. But the Preamble states that the IRS will continue to monitor the situation to see if the definition of a specified domestic entity needs to be expanded.

The testing to determine specified domestic entities must be done annually. Therefore, there is the potential that filing Form 8938 may be required in some years, but not others. The Form 8938 is included with the annual tax returns, so care must be taken to analyze specified domestic entity status when structural changes of business entities cause short-year returns, such as mid-year partnership technical terminations and electing or terminating S corporation status. Due to the attribution rules used to determine if a specified individual owned more than 80% of the stock, profits or capital, many corporations and partnerships may not conclusively know if they are specified domestic entities in a given year. In these cases, these entities may choose to file Form 8938 as a protective measure.

In the case of trusts, there are several wrinkles:

— The Preamble points out that because Form 8938 reporting only applies to persons and entities otherwise required to file tax returns, a domestic trust that is not required to file a return on Form 1041, U.S. Income Tax Return for Estates and Trusts, is not required to Form 8938.

— To determine whether the trust is a specified domestic entity, an annual review of the status of its beneficiaries must be conducted. In the case of trusts where corporations or partnerships are beneficiaries, the determination of whether the trust is specified domestic entity may turn on whether the corporation or partnership is a specified domestic entity for that year. The trustee of a trust should reevaluate the specified domestic entity of the trust following any change in beneficiary classes (for example, following birth, death, marriage and divorce of a beneficiary).

— The final regulations do not require decedents' estates to file Form 8938, although a trust formed pursuant to a will or one that becomes nongrantor at a decedent's death must be tested for specified domestic entity status.

— The exception for trusts in which the trustee is a bank or a certain financial institution is welcome. This should relieve a large number of trusts from having to file Form 8938.

Finally, it must be emphasized that Form 8938 reporting is in addition to, and not in lieu of, foreign bank account reporting on FinCEN Form 114.

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ENDNOTES

¹ It is understood that the statement in the Preamble that there is not meant to be a per se exemption for pension plans was meant to cover pension plans that do not qualify under Section 401(a).