eReport 2023 Winter - ABA Section of Real Property, Trust and Estate Law

REAL PROPERTY

3 Buyer Beware — The Foreign Investment in Real Property Tax Act

By: Eric D. Oberer, and Gil O. Acevedo

7 2022 Developments in Real Estate Finance

By: Brook Boyd

14 New York Court Holds a Pledge Agreement Does Not “Clog” a Borrower’s Equity of Redemption

By: Jose A. Fernandez

17 Destroying Charitable Conservation Easements Is Not Within Congressional Intent

By: Nancy Ortmeyer Kuhn

20 New Proposed Regulations Would Affect the Taxation of US Real Estate for Foreign Investors

By: Nickolas Gianou, Victor Hollender, David Polster and Sarah Beth Rizzo

TRUST AND ESTATE

23 Why GST Tax is Relevant for Non-US Trusts

By: Jennie Cherry and Lindsey Bronstein

26 Planning for the Massachusetts Millionaire Tax— Individuals and Trusts

Editor

Robert Steele (TE)

Articles Editor for Real Property

Cheryl Kelly (RP)

Assistant Real Property Editors

Articles Editor for Trust and Estate

Ray Prather (TE)

Assistant Trust and Estate Editors

By: Ropes & Gray LLP

29 Form 3520-A, Foreign Trust Return with US Owner

Explained

By: Sean M. Golding

33 Taxation of US Beneficiary Foreign Trust Income: an Overview

By: Sean M. Golding

John Trott (RP)

Katie Williams (RP)

Sarah Cline (RP)

Technology/Practice Editor for Trust and Estate

Martin Shenkman (TE)

The materials contained herein represent the opinions of the authors and editors and should not be construed to be those of either the American Bar Association or the Section of Real Property, Trust and Estate Law unless adopted pursuant to the bylaws of the Association. Nothing contained herein is to be considered the rendering of legal or ethical advice for specific cases, and readers are responsible for obtaining such advice from their own legal counsel. These materials and any forms and agreements herein are intended for educational and informational purposes only.

© 2023 American Bar Association. All rights reserved.

Keri Brown (TE) Brandon Ross (TE) WINTER

Buyer Beware — The Foreign Investment in Real Property Tax Act

By: Eric D. Oberer, Esq. (CLTP), and Gil O. Acevedo, Esq.1

Liability for tax withholdings on real property sales rest with buyers under the Foreign Investment in Real Property Tax Act — and it’s not always immediately clear when the Act applies. Buyers beware!

Synopsis

The Foreign Investment in Real Property Tax Act (27 U.S.C. §1445) (“FIRPTA”) requires and obligates a buyer who purchases real property in the United States (U.S.) from a foreign seller to withhold from seller’s proceeds and submit to the Internal

Revenue Service (IRS.) 15% (or 10% for qualifying transactions) of the sales price of the U.S. real property.

A foreign seller is an entity not organized in the U.S., or an individual person not born in the U.S., not admitted in the U.S. for permanent residence (e.g., issued a Green Card) or who has not met the IRS’s “substantial presence test” for the calendar year in which the property is sold. Determination of the foreign status of a given seller can be complicated, particularly when the seller is an entity. This is when the flow chart incorporated herein below can be useful.

Legal liability for compliance with FIRPTA and its withholding requirements rests with the buyer, because a foreign seller will often flee and be out of the U.S. government’s arm’s reach for recouping the withholding amount. A buyer’s and the settlement and/or closing agent’s liability under FIRPTA can be avoided by their reasonable reliance on a domestic seller’s certification or affidavit of non-foreign status. Where the seller is a foreign person, liability is avoided through compliance with the withholding requirements or meeting an exception to the withholding

requirements (e.g., a sale for $300,000 or less, where an individual buyer will acquire the property and use it as his/her principal residence).

FIRPTA Generally

• Real estate dispositions by a foreign person are subject to income tax withholdings.

• Buyers must determine and confirm whether the seller is a foreign person.

• Buyer’s failure to withhold creates tax liability to the IRS for noncompliance with FIRPTA and its withholding requirements.

• FIRPTA applies to residential and commercial transactions.

• The main analysis under FIRPTA is to determine whether the seller is a foreigner, and, if so, whether the foreign seller falls within an exception, or qualifies for a reduction, to the required tax withholding.

Foreign Person

• A “foreign person” is an individual not born in the U.S. or nonresident alien.

• It does not include a resident alien individual, which is an individual:

m admitted in the U.S. for permanent residence (e.g., issued a Green Card); or

m who meets the “substantial presence test.”

Substantial Presence Test

The IRS’s “substantial presence test” is a complex formula. To meet the test, the seller has to be physically present in the U.S. on for at least 183 days during the current year and two preceding years, with a minimum of 31 days in the current year. The days of physical presence are counted as follows: (a) each day of presence in the current year is counted as one full day, (b) each day of presence within the year before the current year is counted as one-third of a day, and (c) each day of presence two years before the current year is counted as one-sixth of a day.

• Pro tip: Retain the services of an attorney or accounting/tax specialist to make this determination.

Liability

The buyer is responsible and required to deduct and withhold the tax, and, thus, liable to the IRS for buyer’s failure to do so. Liability can also rest with the settlement/closing agent if such agent accepts the seller’s certification of non-foreign status, where the agent knew or reasonably should have known it was false.

• Pro tip: Circulate an affidavit in which all parties swear, under oath and penalties of perjury, that they reasonably believe seller is not subject to FIRPTA.

Amount to Withhold

If the seller is indeed foreign, or if the status of seller cannot determine with certainty, then the buyer must withhold the required (or reduced) amount and submit such amount to the IRS using the correct form.

Exceptions

• Personal Residence: The property involved is residential property, the buyer is an individual and acquiring the property for use as residence, and the sales price is equal to $300,000 or less.

• Reduced Rate of Withholding: The property involved is residential property, the buyer is an individual and acquiring the property for use as residence, but instead, the sales price is greater than $300,000 but less than or equal to $1,000,000. This exception allows the buyer to reduce the withholding from 15% to 10%. (This exception arose from the Protecting America from Tax Hikes (PATH) Act of 2015.)

• Seller Certification: The seller delivers a certification (or affidavit) stating that seller is not a foreign person under the laws of the U.S. The certification must include the seller’s name, taxpayer identifying number (social security number), physical home address and a statement, under penalties of perjury, as to its truth and correctness.

• IRS Withholding Certificate: The buyer may request a withholding certificate from the IRS prior to sale of the property under certain circumstances using the applicable form, where the IRS makes the determination whether withholding is reduced or not required.

Reporting and Paying the Tax

• The buyer must use Forms 8288 and 8288-A to report and pay the tax required to be withheld.

• Forms and funds must be received by the IRS within twenty days after the date of the transfer of the property.

• The buyer’s and foreign seller’s tax identification numbers are required. If foreign seller (individual) and does not have a tax identification number but is eligible, such seller can apply for one.

Caution: It’s Not Always Immediately Clear If FIRPTA Applies

It is not always immediately clear whether the seller is foreign, that is, whether FIRPTA applies. The property may have multiple owners, where one of those owners is foreigner. Under

these circumstances, the withholding is prorated according to the foreigner’s ownership interest in the property. In a different scenario, the seller may be a single-member limited liability company, where the single member is an individual U.S. citizen, but the entity was organized outside the U.S. Under these circumstances, FIRPTA would apply.

The message is that due diligence is required to determine whether or not FIRPTA applies, as it may not always an easy task. Hiring a professional in this area is advisable. The Paradigms below can serve as tool in determining the applicability of a FIRPTA withholding. Part A aids in analyzing the seller’s status and Part B in analyzing which exception, if any, apply.

[Link to Florida Bar Journal Article: https://www.floridabar.org/ the-florida-bar-journal/to-withhold-or-not-to-withhold-that-isthe-question-a-step-by-step-approach-to-the-firpta-income-taxwithholding/ ]

Endnotes

1. Eric D. Oberer is Senior Underwriting Counsel at First American Title Insurance Company’s Maryland and Washington, D.C. offices. Eric is able to provide IRS forms, transaction templates and copies of paradigms that can help navigate FIRPTA.

Gil O. Acevedo is Counsel at Hunton Andrews Kurth LLP in Miami, Florida. He represents clients in acquisition and disposition of retail property, hotels, office buildings, multi-family apartment buildings and residential luxury residences, as well as financing and leasing transactions.

2022 Developments in Real Estate Finance

By: Brook Boyd1

1.THE IMPACT OF TECHNOLOGY ON REAL ESTATE FINANCE

1.1 Current Status of eDocuments Authorized By E-SIGN Act, UETA & UCC

1.11.

E-SIGN Act

The federal Electronic Signatures in Global and National Commerce Act (“ E-SIGN Act ”), enacted in 2000,2 authorized a new type of electronic document, called a “transferable record.” Pursuant to the E-SIGN Act, a “transferable record” must meet the following conditions: (1) it must be an electronic equivalent to a “note” under Article 3 of the UCC, (2) the “issuer of the electronic record expressly has agreed [it] is a transferable record” pursuant to the E-SIGN Act,3 and (3) the transferable record must relate “to a loan secured by real property.”4

1.1.2. UETA

The Uniform Electronic Transactions Act (“ UETA”) contains similar rules regarding “transferable records.”5 UETA was introduced in 1999, and has been adopted by all states except New York.6

1.1.3. UCC

The 1999 version of the Uniform Commercial Code (“ UCC ”) defined “record” to include “information . . . which is stored in an electronic or other medium and is retrievable in perceivable form.”7 The 2010 amendments to the Uniform Commercial Code (“ UCC ”) (1) authorized electronic signatures,8 (2) enabled secured parties to have “control” of “electronic chattel paper” if a “system”9 was used to store the related electronic “records,” (3) protected buyers of intangible collateral who gave value and were unaware of claims by secured parties,10 and (4) authorized electronic notices of UCC sales.11

1.1.4. Control of e-Notes by Holder in Due Course

The E-SIGN Act provides that a person (including a lender) has “control” of an electronic note (“eNote”) if “a system employed for evidencing the transfer of interests in the [eNote] reliably establishes that person as the person to which the [eNote] was issued or transferred.”12 The person with “control” of such eNote is generally deemed to be the “holder” of it.13 Such person will also qualify as a “holder in due course” or “purchaser,” as applicable, if the relevant requirements are satisfied under

the UCC, except that delivery, possession and endorsement are not required.14 Similar rules apply under the Uniform Electronic Transactions Act (“ UETA”).15

1.1.5. Current Fannie Mae Rules for Its Purchases of eNotes and eMortgages

Registration of eNotes & eMortgages: The Federal National Mortgage Association (“ Fannie Mae”) has issued detailed rules for its purchases of eNotes and eMortgages.16 For example, Fannie Mae’s rules provide that “Lenders must . . . ensure eNotes are registered in the MERS eRegistry as soon as possible after the tamper-evident seal has been applied [to the eNote], but no later than one (1) business day of signing. All eMortgages delivered to Fannie Mae must also be registered on the MERS Residential System prior to delivery to Fannie Mae.”17 This registry is intended to comply with the requirements under UETA and the E-SIGN Act for a central registration system.18

Transmitting eNotes to Fannie Mae through MERS eDelivery: A lender that is selling an eNote to Fannie Mae must actually deliver it to Fannie Mae through MERS eDelivery, and then must transmit a request to the MERS eRegistry to begin the process of transferring “Control” and “Location” of the eNote to Fannie Mae.19

1.1.6. Recording of Paper Mortgages & Other Documents May Still Be Required

Even if an originating lender or a loan purchaser would prefer to accept only electronic documents, however, in some jurisdictions only paper mortgages (and other related recordable paper loan documents) are accepted for recording.20

1.2. Impact of Cryptocurrencies & Other Digital Assets on Finance

Cryptocurrencies and other digital assets are held by many investors, and may be required by lenders as additional collateral, even if the primary collateral is real estate or another traditional form of security. As of January 1, 2023, several U.S. states have enacted various types of laws governing security interests in, as well as purchase or sale of, cryptocurrencies and other digital assets. However, there are also many bills, under consideration by various U.S. state legislatures, that, if enacted, would provide ground rules, and a regulatory structure, for such assets.21

1.2.1. Current Practices for Loans Secured by Digital Collateral.

The following practices are customary in jurisdictions in which the proposed 2022 UCC amendments (or similar provisions) have not yet been enacted. In such jurisdictions, secured parties that are relying on digital assets, at least in part, will generally

follow at least one of the following procedures:

(1) (a) the transfer of such digital assets to a securities intermediary,22 (b) the securities intermediary consents to hold the digital assets as financial assets,23 which are credited to the debtor’s securities account, creating a security entitlement24 and (c) control25 by the secured party of the security entitlement pursuant to Article 8 of the UCC, perfecting the secured party’s security interest in the securities account;26 or

(2) (a) delivery by the debtor to the secured party of a private key for a blockchain asset, (b) the secured party transfers such asset to the secured party’s crypto wallet, and (c) perfection of the secured party’s security interest by filing the applicable financing statements.

However, in each case specified in (1) and (2) above, there is no guarantee that the debtor actually owns the digital asset, or that the securities intermediary will get title to the digital asset free from other property claims.27

1.2.2. Proposed 2022 UCC Amendments for Cryptocurrencies & Other Digital Assets.

The American Law Institute and the Uniform Law Commission approved in 2022, and recommended for adoption by all U.S. states, various proposed amendments to the UCC covering cryptocurrencies and other digital assets (the “2022 UCC Amendments”). These proposed amendments include changes to the existing Articles 1-9 of the UCC, as well as a new Article 12 of the UCC.28 However, as of January 1, 2023, according to the “Enactment Map” appearing on the website of the Uniform Law Commission, no state has adopted these amendments.29

The following are new or revised types of assets that are covered in the 2022 UCC Amendments:

Controllable Electronic Records (CERs): The proposed 2022 UCC Amendments define various new types of digital assets that are covered by such 2022 UCC amendments. Probably the most important new type of digital assets are “controllable electronic records (‘CERs’).”30 According to the 2022 UCC Amendments, a CER “is a record that is stored in an electronic medium [such as the blockchain] and that can be subjected to control.”31 The comments in the 2022 UCC Amendments say, “think of bitcoin and other virtual currencies as prototypical controllable electronic records.”32 Another example is that J.P. Morgan has proposed “adapting decentralized finance (DeFi) protocols in the finance industry using tokenized real-world assets. DeFi protocols are self-executing applications on a blockchain that can automate financial services such as lending and borrowing, trading, and asset management while reducing manual involvement from intermediaries.”33

Controllable Assets: CERs “also provide a mechanism for evidencing certain rights to payment—controllable accounts and controllable payment intangibles. An account debtor (obligor) on such a right to payment agrees to make payments to the person that has control of the [CER] that evidences the right to payment.”34

Payment Intangible: “Payment intangibles” were defined in the 1999 UCC as “a general intangible under which the account debtor’s principal obligation is a monetary obligation.”35 The 2022 UCC Amendments add the following to such definition: “The term includes a controllable payment intangible.”36 Courts have ruled, for example, that payment intangibles include (1) payment streams that are stripped from equipment leases,37 and (2) settled tort claims.38

Account: “Account” is a traditional UCC category that similarly has been broadened by inclusion of “controllable account” under the 2022 UCC Amendments. “Account” includes, for example, “a right to payment of a monetary obligation, whether or not earned by performance, (i) for property that has been or is to be sold, leased, licensed, assigned, or otherwise disposed of, (ii) for services rendered or to be rendered,” and certain other rights of payment, subject to various exclusions.39

Controllable Account and Controllable Payment Intangible: A “controllable account” or “controllable payment intangible” means, respectively, an account (in the case of a controllable account), or a payment intangible (in the case of a controllable payment intangible) “evidenced by a controllable electronic record that provides that the account debtor undertakes to pay the person that has control under Section 12-105 of the controllable electronic record.”40

Advantages of Control: If a party (1) acquires a CER by purchase,41 for value, in good faith and without notice of a competing claim of a property right in the CER, and (2) has control of the CER,42 then such party will be a “qualifying purchaser” of the CER. “Article 12 confers an attribute of negotiability on controllable electronic records because a qualifying purchaser takes its interest free of conflicting property claims to the record.”43

Recommendations for Lenders Secured by Digital Assets: A lender that intends to be secured, in whole or in part, by digital assets, pursuant to the proposed 2022 UCC Amendments, should (1) design closing procedures, with the borrower’s acknowledgment and consent, in order to enable the lender to have “control” over such assets from the closing date (or such other date that is designated by the lender) until the lender is repaid, (2) require the borrower not only to pay the lender (or the person designated by the lender), but also to acknowledge that the lender is the person in “control” (as defined in the proposed 2022 UCC Amendments) of the digital asset, (3) include a ”choice of law” provision in each CER, and (4) obtain the consents of trading

parties, and the borrower, to provide further assurances to the lender confirming that the lender is a first priority perfected secured party with control over the digital assets and other related collateral.44

1.2.3 Regulatory & Other Legal Issues Relating to Cryptocurrencies & Other Digital Assets

Bank Secrecy Act/Anti-Money Laundering (BSA/AML) & Combating the Financing of Terrorism (CFT). Because money laundering has been facilitated, and other crimes and terrorism have been funded, by cryptocurrencies and other digital assets, therefore the U.S. Treasury Department is devoting substantial resources to preventing this in the future.45 Accordingly, parties should expect a high level of regulatory scrutiny, if they are involved in transactions involving significant amounts of cryptocurrencies and other digital assets.

U.S. SEC & CFTC. The U.S. Securities and Exchange Commission (“SEC ”) and the U.S. Commodity Futures Trading Commission (“CFTC ”) have aggressively asserted their jurisdiction over cryptocurrencies. For example, the SEC charged that BlockFi Lending LLC both (1) failed to register, with the SEC, BlockFi’s offers and sales of its interest accounts under the Securities Act of 1933, and (2) failed to register as an investment company under the Investment Company Act of 1940. BlockFi then paid a $50 million penalty to the SEC. Also, the CFTC charged BitMEX with (1) illegally operating a cryptocurrency derivatives trading platform and (2) anti-money laundering (AML) violations. BitMEX then entered into a consent order, pursuant to which it paid a $100 million penalty to the CFTC and a $50 million penalty to FinCEN.46

U.S. IRS & Other State Tax Agencies. The U.S. Internal Revenue Service (“ IRS”) states that, in the case of the typical owner of virtual currency such as bitcoin (who purchases the virtual currency as a long-term investment and is not a dealer), the sale by such owner of such virtual currency results in long or short term capital gain. Therefore, spending bitcoin is not like spending U.S. currency, which is tax-free. Similarly, if you receive bitcoin for services rendered, that must be reported to the IRS as income.47

Money Transmitter Licenses. The District of Columbia now requires a money transmitter license to be obtained by any person who engages in any money transmission involving bitcoin or other virtual currency “used as a medium of exchange, method of payment or store of value in the District.”48

2. BENEFITS FOR PROPERTY OWNERS UNDER THE INFLATION REDUCTION ACT OF 2022

You, or some of your clients, may be entitled to benefits under the federal Inflation Reduction Act of 2022 (the “ IRA”).49 Here are some examples of the available programs that apply to

residential property, but there are many other benefits that apply to commercial property as well.50

The IRA extends, through 2032, the existing tax credit to individuals for residential energy property costs. The IRA also increases the rate of such credit for individuals to 30%, and permits a credit of up to $1,200 per annum for various “energy” improvements, except that such credit will be: (1) up to $2,000 per annum with respect to certain heat pump and heat pump water heaters, and biomass stoves and boilers,51 and (2) up to $150, for home energy audits.52

The IRA extends, through 2034, the residential clean energy tax credit, revises the phased reduction of such credit, and extends the credit to include qualified battery storage technology expenditures.53

The IRA continues the new “energy efficient home tax credit” through 2032, and permits (1) a $2,500 credit for new homes that meet various Energy Star efficiency standards and (2) a $5,000 credit for new homes that are certified as zero-energy ready homes. The IRA also authorizes a credit for energy efficient multifamily dwellings.54

The IRA appropriates funds for the U.S. Department of Energy (“ DOE”) for a HOMES rebate program that provides grants to state energy offices. States must then provide rebates to homeowners, aggregators, and contractors, for certain whole-house energy saving retrofits, inclding enhanced rebates for low-income and moderate-income households. A rebate provided under this program may not be combined with any other federal grant or rebate for the same single upgrade.55

Also, the IRA funds a DOE high-efficiency electric home rebate program that awards grants to state energy offices and Indian tribes. Pursuant to this program, rebates are available for qualified electrification projects in low-income or moderate-income households. Qualified electrification projects include the purchase and installation of certain heat pumps, electric stoves, electric ovens, electric load service centers, insulation, materials to improve ventilation, or electric wiring.56

3. TAX CODE LIMITS ON BUSINESS INTEREST, AND EXCEPTIONS THERETO

As interest rates rise, and as the aggregate amount of business interest continues to increase, borrowers and their attorneys should carefully monitor the amount of each borrower’s “business interest.” For taxable years beginning after December 31, 2017, “business interest” means any “interest paid or accrued on indebtedness properly allocable to a trade or business.” However, a deduction for “business interest” shall not exceed the sum of—

(A) the business interest income of such taxpayer for such taxable year,

(B) 30% of the adjusted taxable income of such taxpayer for such taxable year, plus

(C) the floor plan financing interest (e.g., loans to finance the acquisition of motor vehicles) of such taxpayer for such taxable year.

Any disallowed business interest deduction is carried forward to the next tax year.57 However, the above limit on deduction of business interest is not applicable to a corporation or partnership with average annual gross receipts not exceeding $25 million.58 Further, a “trade or business” does not include “any electing real property trade or business.”59

It is necessary to clearly distinguish “business interest” from other types of interest. For example, “business interest” does not include investment interest. “Investment interest” includes interest that “is paid or accrued on indebtedness properly allocable to property held for investment.”60 However, “investment interest” excludes both (A) “qualified residence interest”61 and “any interest which is taken into account under Section 469 in computing income or loss from a passive activity of the taxpayer.”62 Deduction of investment interest is limited to the extent of net investment income,63 which is calculated in a less generous way to taxpayers than the above deduction for business interest.

The line between a “trade or business,” and an “investment,” is not always clear-cut. It may be possible for taxpayers in some transactions to achieve a preferred tax result based on how the transaction is structured and sized.64

Other provisions of the Internal Revenue Code that may restrict excessive leverage in real estate financings include (1) restrictions on “excess business losses” (which are not allowed and are instead treated as part of the taxpayer’s net operating loss carryforward in subsequent taxable years) for taxpayers other than corporations,65 and (2) a requirement that net operating loss deductions cannot exceed 80% of taxable income.66

4. WHEN REAL ESTATE LENDERS SHOULD BE REITS

What is the most efficient deal structure for a real estate investor that collects interest? This becomes more and more relevant as interest rates continue to increase.

In some cases, a real estate investment trust (“ REIT ”) should be used (rather than a partnership or C corporation) to provide financing for income-producing real estate by purchasing or originating residential and commercial mortgage loans, and mortgage-backed securities (“ MBS”). A mortgage REIT can be formed as a corporation under Subchapter M of the U.S. Tax Code, or as an unincorporated entity that has made a “checkthe-box election” to be taxed as a corporation. A mortgage REIT, unlike a C corporation, generally does not pay entity tax on its net earnings if it distributes all of its current-year taxable

income to its shareholders, since a mortgage REIT is entitled to a deduction for dividends paid. Further, under Sec. 199A of the U.S. Tax Code, a U.S. individual can claim a 20% deduction for dividends received from a mortgage REIT that collects interest income. In contrast, interest income allocated to a U.S. individual partner is not eligible for this deduction.67

5. WHEN A LOAN WILL BE RECHARACTERIZED AS EQUITY FOR TAX PURPOSES

In the Tribune Media case,68 Tribune Media Co. (“ Tribune”), was the publisher of the Chicago Tribune, and the owner of the Chicago Cubs. Both were controlled by Sam Zell.

In 2009, the Tribune, and the Ricketts family (the founders of TD Ameritrade), formed Chicago Baseball Holdings, LLC (the “ LLC ”). The LLC obtained 2 loans, (1) a senior loan funded by a commercial lender, and (2) a subordinate loan (“sub loan”) funded by the Ricketts. Tribune guaranteed collection of the loans.69

The Tax Court ruled that the “sub loan” was actually not bona fide debt for tax purposes, and would be recharacterized as equity.70 The Tax Court stated that the main factors, indicating that the “sub loan” was actually equity, were: (1) there was no fixed maturity date for repayment of the “sub loan,”71 (2) the terms of the “sub loan,” and the subordination agreement, prevented any meaningful right to enforce payments of the “sub loan” as they became due,72 (3) the intent of the parties was to treat the “sub loan” as equity,73 (4) because of the interests of the Ricketts family in both the LLC and the sub lender, it was unlikely that the “sub loan” would ever be enforced,74 (5) the LLC did not meet its burden of proving that it could have obtained a similar loan from an unrelated third party,75 (6) the “sub loan” proceeds were used by the Ricketts family to purchase their equity interest (rather than funding operating expenses),76 and (7) repayment of the “sub loan” was uncertain.77

6. ENFORCEABILITY OF MAKE-WHOLE PREMIUMS IN BANKRUPTCY

When Ultra Petroleum Corp. and its affiliates (collectively “ Ultra”) obtained various loans, it agreed, if it prepaid the loans, to pay a “make-whole” premium to each lender equal to the present value of the interest payments such lender would have received if its loan had been paid at its maturity. However, when natural gas prices plummeted, Ultra became insolvent, and it filed for bankruptcy. But during the Ultra bankruptcy proceeding, natural gas prices roared back, and Ultra became solvent again. Nonetheless, Ultra proposed a plan that would not pay its lenders the agreed make-whole premium. Instead, Ultra proposed, pursuant to Section 502(b)(2) of the Bankruptcy Code (which disallows payment of unmatured interest), to pay only the sum of (1) the outstanding principal owed to its lenders, (2) all interest that had accrued before Ultra’s bankruptcy,

and (3) interest on both such amounts at the Federal Judgment Rate (which was much lower than the contractual interest rate) only for the duration of the bankruptcy proceeding.78 The lenders objected, because Ultra’s proposed payments were $387 million less than their calculation of the contractually required payments.

The Fifth Circuit recently ruled that Ultra’s lenders are entitled to their full make-whole premiums, at the agreed contractual rate, based upon existing case law to the effect that solvent debtors in bankruptcy must nonetheless pay interest at the rate they originally agreed to pay to their lenders. The Fifth Circuit decision is in accord with decisions by the U.S. Supreme Court and some other federal courts, but technically conflicts with the literal provisions of the Bankruptcy Code.79

Similarly, in an unrelated case involving Pacific Gas & Electric Company (“ PG&E”), the Ninth Circuit held that since PG&E had a net worth of almost $20 billion, and clearly was solvent, therefore PG&E was obligated to pay post-petition interest to its unsecured trade creditors, at the applicable contractual or legal rate, even though PG&E had filed under Chapter 11 of the Bankruptcy Code.80

7. STRUCTURING OF BANKRUPTCY REMOTE ENTITIES

The ABA Committee on Securitization and Structured Finance has published an article, summarizing the issues involved in structuring a borrowing entity, in order to enable it to be “bankruptcy remote” (i.e., it will be unlikely to file for bankruptcy). Such article includes discussions of topics including “special purpose vehicles,” “substantive consolidation,” “true sale,” and related case law.81 This ABA committee has also proposed a model form of “Delaware Limited Liability Company Agreement,” which is extensively annotated with comments.82 For new lawyers, or those who have not been closely following the cases in this area, these ABA articles will be invaluable. Lawyers should also be familiar with the specific requirements of the rating agencies (regarding the borrower’s structure and powers), which are available online.83

This article should not be construed as legal advice, and readers should not act upon information in this article without legal counsel.

Endnotes

1. Brook Boyd is Counsel to Meister, Seelig & Fein, LLP in their New York office. He is a member of the Connecticut, Florida, New Jersey and New York bars. He is the author of Real Estate Finance (Law Journal Press, 51st ed.) and has published many articles in legal and professional journals.

2. Pub. L. No. 106-229, 114 Stat. 464 (June 30, 2000).

3. 15 U.S.C. § 7021(a)(1). One commentator took the position that it is not clear who is the “issuer” of a “transferable record.” He stated, “to qualify as a transferable record, the issuer of the electronic record must agree to the treatment of the record as a transferable record under the UETA [Uniform Electronic Transactions Act]. . . . The obligor on a paper promissory note is not the issuer of an electronic record.” Whitaker, “Rules Under the Uniform Electronic Transactions Act for an Electronic Equivalent to a Negotiable Promissory Note,” 55 Bus. Law. 437, 448 n.46 (Nov. 1999).

4. 15 U.S.C. 7021(a)(1). Note that Section 16 of UETA does not require that the transferable record relate “to a loan secured by real property.”

5. However, UETA is not limited to “transferable records” that are secured by real property, since, for example, it also applies to “transferable records” that are secured by documents of title. UETA § 16(d).

6. Uniform Electronic Transactions Act § 16 (1999), available at https:// higherlogicdownload.s3-external-1.amazonaws.com/UNIFORMLAWS/21c366b3-b11c-d774-f34d-7901ab76e9a5_file.pdf?AWSAccessKeyId=AKIAVRDO7IEREB57R7MT&Expires=1673126463&Signature=XIAG9qPNXX0kWXQMeFjEMySapAM%3D (last visited Jan. 7, 2023).

7. UCC § 9-102(a)(69) (ULC 1999).

8. UCC § 9-102(a)(7)(B) (ULC 2010).

9. UCC § 9-105(a-b) (ULC 2010).

10. UCC § 9-317(d) & cmt. n. 6 (ULC 2010).

11. UCC § 9-613, cmt. 2 (ULC 2010).

12. 15 U.S.C. § 7021(b).

13. Id. § 7021(b-d).

14. 15 U.S.C. § 7021(d).

15. UETA § 16 (1999).

16. Fannie Mae, Selling Guide (Dec. 14, 2022), available at https://singlefamily.fanniemae.com/media/33041/display (last visited Jan. 8, 2023).

17. See generally, Fannie Mae, “Guide to Delivering eMortgages to Fannie Mae,” § 3.5 (June 22, 2022), available at https://singlefamily.fanniemae. com/media/4601/display (last visited Jan. 8, 2023).

18. 15 U.S.C. § 7021(b); UETA § 16(b-c) (1999).

19. See generally, Fannie Mae, “Guide to Delivering eMortgages to Fannie Mae,” § 4 (June 22, 2022), available at https://singlefamily.fanniemae. com/media/4601/display (last visited Jan. 8, 2023).

20. “State-by-State Recording and Notarization Guidance” (Blackwell April 26, 2020), available at https://hbfiles.blob.core.windows.net/webfiles/HB_State-by-State%20Recording%20and%20Notarization%20 Guidance_Responding%20to%20COVID19_April%2030%202020.pdf (last visited Dec. 3, 2022).

21. The following states enacted their own laws that facilitate the ownership and financing of cryptocurrencies and other digital assets (but are not identical with the final proposed 2022 amendments to the UCC approved by the American Law Institute, and then by the Uniform Law Commission at its July 2022 meeting):

Idaho enacted Chapter 284 of 2022 regarding the purchase and sale of digital assets, and perfection by possession or control of digital assets.

Indiana enacted Public Law 110 of 2022 adding a new chapter to the Uniform Commercial Code that applies to “controllable electronic records” such as cryptocurrencies.

New Hampshire similarly enacted Chapter 281 of 2022 based on a draft version of the 2022 amendments to the UCC.

See also Wyo. Stat. Ann. § 34-29-101 et seq.

Iowa and Nebraska adopted a preliminary version of the UCC “controllable electronic record” proposal.

Arkansas and Texas adopted the “controllable electronic record” rules only for virtual currency.

Utah enacted comparable laws for virtual currency.

22. UCC § 8-102(a)(14) (1994).

23. UCC § 8-102(a)(9) (1994).

24. UCC § 8-102(a)(17) (1994).

25. UCC §§ 8-106 (1994 & 2022) & 8-501, comments 1 & 4 (1994 & 2022).

26. UCC § 8-102, comment 9 (2022) & § 12-102, comment 2 (2022).

27. See generally “TriBar Report on Opinions Under 2022 Amendments to the Uniform Commercial Code Regarding Emerging Technologies” § II at 2-4 (Aug. 3, 2022 draft report not yet considered or approved by TriBar but presented for discussion at the 9/16/22 ABA Bus. Law Annual Meeting presentation entitled “Legal Opinion Letters on Digital Assets”) (K.A. Desmarais, S.M. Rocks, L. Safran & S. Weise, speakers) (hereinafter called “Draft TriBar Report on Opinions Under 2022 UCC Amendments”).

28. A copy of such 2022 proposed amendments to the UCC is available at https://www.uniformlaws.org (last visited Jan. 8, 2023).

29. “2022 Amendments to UCC” (Enactment Map), available at https:// www.uniformlaws.org/committees/community-home?communitykey= 1457c422-ddb7-40b0-8c76-39a1991651ac (last visited Jan. 7, 2023).

30. UCC § 12-102(a)(1) (ULC 2022).

31. Id.

32. UCC Article 12, Prefatory Note to Article 12, § 2 (ULC 2022).

33. “Institutional DeFi: The Next Generation of Finance?” (J.P. Morgan et al. 2022), available at https://www.jpmorgan.com/onyx/documents/ Institutional-DeFi-The-Next-Generation-of-Finance.pdf (last visited Jan. 11, 2023).

34. “Prefatory Note to Uniform Commercial Code Amendments (2022)” § 2(a) (ULC 2022).

35. UCC § 9-102(a)(61) (1999).

36. UCC § 9-102(a)(61) (ULC 2022).

37 In re Commercial Money Center, Inc., 350 Bankr. 465, 469, 488-489 (9th Cir. B.A.P. 2006), modified In re Commercial Money Center, Inc., 392 Bankr. 814, 824-825, 832 (9th Cir. B.A.P. 2008). In this case, Commercial Money Center, Inc. (the debtor), leased equipment to lessees, and then (1) pooled groups of leases and assigned its contractual rights (to future lease payments) to NetBank, (2) obtained surety bonds guaranteeing the lease payments, and assigned its interest in the surety bonds to NetBank, and (3) granted to NetBank a separate security interest in the leases and other property). The court ruled that the debtor’s rights (to such future lease payments) were payment intangibles.

38 In re Wiersma, 324 Bankr. 92, 106-107, 109-110 (9th Cir. B.A.P. 2005) aff’d in part, rev’d in part on other grounds, 483 F.3d 933 (9th Cir. 2007).

But see In re S-Tek 1, LLC, 635 Bankr. 860, 869 (Bankr. D. N. Mex. 2021) (“a secured party cannot have a security interest in the proceeds of a commercial tort claim under grants of collateral other than a grant of a security interest in a commercial tort claim”).

39. UCC § 9-102(a)(2) (ULC 2022).

40. UCC § 9-102(a)(27A & 27B) (ULC 2022).

41. UCC § 1-201(b)(29) and (30) (ULC 2001).

42. UCC § 12-102(a)(2) (ULC 2022).

43. “Prefatory Note to Uniform Commercial Code Amendments” § 2(a) (ULC 2022).

44 See T. Harmon, J. Moringiello, S. Sepinuck & S. Weise, “Commercial Law Developments: 2021-2022” at 34, 44 (ABA Bus. Law Sec. Annual Meet. Sept. 2022) (Powerpoint).

45. “Action Plan to Address Illicit Financing Risks of Digital Assets” (U.S.

Treasury Dept. Sept. 12, 2022), available at https://home.treasury.gov/ system/files/136/Digital-Asset-Action-Plan.pdf (last visited Jan. 9, 2023).

46. S. M. Humenik, C. L. Isaac, K. E. Riemer and C. Mikhael, “CFTC and SEC Perspectives on Cryptocurrency and Digital Assets -Volume I: A Jurisdictional Overview,” ABA RPTE eReport at 8-10 (Spring 2022), available at https://www.americanbar.org/groups/real_property_trust_estate/publications/ereport/ (last visited Jan. 9, 2023).

47. “Frequently Asked Questions on Virtual Currency Transactions” (IRS Dec. 1, 2022), available at https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions (last visited Jan. 9, 2023).

48. “Bulletin 22-BB-001-08/04: Certain Bitcoin Activity Subject to DC Money Transmission Laws” (Banking Bureau of the Department of Insurance, Securities and Banking of Washington, D.C. Aug. 8, 2022), available at https://content.govdelivery.com/accounts/DCWASH/bulletins/326e069 (last visited Jan. 9, 2023).

49. Inflation Reduction Act of 2022, Pub. L. No. 117-169 (2022), available at https://www.congress.gov/bill/117th-congress/house-bill/5376/text (last visited Jan. 9, 2023).

50. See the summary of benefits, under the Inflation Reduction Act of 2022, that appears at https://www.congress.gov/bill/117th-congress/ house-bill/5376 (last visited at Jan. 9, 2023).

51. Id. § 13301.

52. Id.

53. Id. § 13302.

54. Id. § 13304.

55. Id. § 50121.

56. Id. § 50122.

57. An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018, Pub. L. No. 115-97 (2017) (“Tax Cuts and Jobs Act”), § 13301 (codified as 26 U.S.C. § 163(j)); H.R. Rep. 115-466 (2017) (“Tax Cuts and Jobs Act Conference Report”), at 385-392, available at http://docs.house.gov/billsthisweek/20171218/CRPT-115HRPT-%20466.pdf (last visited Jan. 2, 2023).

58. Tax Cuts and Jobs Act, § 13102 (codified as 26 U.S.C. § 448(c)) and § 13301 (codified as 26 U.S.C. § 163(j)(3)); Tax Cuts and Jobs Act Conference Report at 385-392.

59. Tax Cuts and Jobs Act, § 13301 (codified as 26 U.S.C. § 163(j)(7)(A)(ii)); Tax Cuts and Jobs Act Conference Report at 391-392.

60. 26 U.S.C. § 163(d)(3)(A) (2022).

61. Tax Cuts and Jobs Act, Pub. L. No. 115-97 (2017), § 11043 (codified as 26 U.S.C. §§ 163(d)(3)(B)(i) & 163(h)(3)) (applicable to tax years beginning before 1/1/26); Tax Cuts and Jobs Act Conference Report, at 256-258.

62. 26 USC § 163(d)(3)(B)(ii).

63. 26 U.S.C. § 163(d)(1).

64. See generally Vandenberg, Brignall, & Richard Schneible, “A strategy to raise a business’s interest limitation,” Tax Adviser (June 2022), available at https://www.thetaxadviser.com/issues/2022/jun/strategy-to-raise-business-interest-limitation.html (last visited Jan. 10, 2023).

65. Tax Cuts and Jobs Act, § 11012 (codified as 26 U.S.C. § 461(l)); Tax Cuts and Jobs Act Conference Report at 238-239.

66. Tax Cuts and Jobs Act, § 13302 (codified as 26 U.S.C. § 172(a) and other miscellaneous sections); Tax Cuts and Jobs Act Conference Report at 393-394.

67. Stern, “Mortgage REITs: When should one be used?,” Tax Adviser (Dec. 2021), available at https://www.thetaxadviser.com/newsletters/2021/dec/mortgage-reits.html (last visited Jan. 10, 2023). See also 26 U.S.C. § 199A.

68 Tribune Media Co. v. Comm’r, T.C.M. 2021-122, action on dec., 2022-Docket No. 20940-16. See generally R. Lipton, “Tribune Media: A Split Decision for the Chicago Cubs’ Leveraged Partnership Transaction,”

J. of Tax. at 6-16 (Feb. 2022).

69 Tribune Media Co. v. Comm’r, T.C.M. 2021-122 at 2.

70. Id at 3.

71 Tribune Media Co. v. Comm’r, T.C.M. 2021-122 at 60-63. Although the subordinate debt (“sub debt”) had a stated maturity of 15 years, however, the sub debt could not be repaid before the senior debt, and the senior lenders had the right to extend the maturity date of the senior debt. Id. pps. 60-61

72. Id at 67-70

73. Id at 74-78.

74. Id at 78-80.

75. Id at 83-86.

76. Id at 86-87.

77. Id at 89-90.

78. Ultra also argued that its lenders were “unimpaired” under 11 U.S.C. §§ 1123(a)(2) & 1124, and were therefore “conclusively presumed to have accepted the plan” per 11 U.S.C. § 1126(f).

79 In re Ultra Petroleum Corporation, 51 F.4th 138 (5th Cir. 2022).

80. In re PG&E Corporation, 46 F. 4th 1047 (9th Cir. 2022). Technically, PG&E was obligated to pay interest to its trade creditors, at the applicable contractual or legal rates, so that its creditors would be “unimpaired” by PG&E’s reorganization plan, pursuant to 11 U.S.C. § 1124(1). California generally provides for a default interest rate of ten percent on contractual obligations. Cal. Civ. § 3289(b). In contrast, the court in In re Latam Airlines Group S.A., Docket No. 22-1940 (2d Cir. Dec. 14, 2022), ruled that trade creditors were not entitled to post-petition interest since (1) the debtor was insolvent, and (2) the trade creditors’ claims were not impaired under Section 1124(1) of the Bankruptcy Code.

81. ABA Comm. On Securitization & Structured Fin., “Bankruptcy Remoteness: A Summary Analysis,” 77 Bus. Law. 1105 (ABA Bus. Law Sec. Fall 2022).

82. ABA Comm. On Securitization & Structured Fin., “Model Form of Limited Liability Company Agreement,” 77 Bus. Law. 1131 (ABA Bus. Law Sec. Fall 2022).

83 E.g., “U.S. Structured Finance Asset Isolation And Special Purpose Entity Criteria,” (Standard & Poor May 15, 2019), available at https:// disclosure.spglobal.com/ratings/en/regulatory/article/-/view/type/ HTML/id/2818845 (last visited Jan. 3, 2023); and “U.S. and Canadian Multiborrower CMBS Rating Criteria: Discussion Paper (Potential Changes to CMBS Methodology in Advance of a Likely Exposure Draft),” (Fitch Ratings Dec. 6, 2022), available at https://www.fitchratings.com/ research/structured-finance/us-canadian-multiborrower-cmbs-rating-criteria-discussion-paper-potential-changes-to-cmbs-methodology-in-advance-of-likely-exposure-draft-06-12-2022?FR_Web-Validation=true&mkt_tok=NzMyLUNLSC03NjcAAAGJKSE0qixv2I5kzWJhoBI472Ugtpt_ q7iBJEcnfGo_gdc8LweYVkzPy_im3LHR9Q5YpYRf-LkKjeCfg9rtrNvMOsrqW4H7Vv1xFjFC3zMgMRmqR_s5TpY (last visited Jan. 6, 2023).

New York Court Holds a Pledge Agreement Does Not “Clog” a Borrower’s Equity of Redemption

By: Jose A. Fernandez1

This article discusses Atlas Brookview Mezzanine LLC v. DB Brookview LLC, the first New York court decision to directly hold that enforcing a mezzanine pledge taken in conjunction with a mortgage as security does not violate a borrower’s equity of redemption.

Over the last decade, commercial lenders have increasingly relied on “accommodation” pledges to obtain additional security in connection with mortgage loans. The typical structure involves a property-owning borrower entity obtaining financing secured by a mortgage, while the borrower’s sole member or parent entity—often referred to as the “mezzanine entity”—

guaranties the mortgage loan. The mezzanine entity’s guaranty is separately secured by a pledge of its 100% ownership interests in the borrower.

If a borrower defaults, a mortgage lender must typically pursue a lengthy judicial foreclosure process. Armed with an accommodation pledge, however, the lender can pursue a more expeditious Uniform Commercial Code (“UCC”) sale of the mezzanine’s 100% equity interests in the borrower. Article 9 of the New York UCC requires the lender to market and conduct the public auction of the equity interests in a commercially reasonable manner. Upon consummation of the auction, the winning bidder will own 100% of the membership interests in the borrower entity, and thus control the underlying property. If the lender’s credit bid is the highest bid, the lender has effectively obtained control of the property in as little as a few months.

Unlike a mortgage foreclosure, a UCC sale of a borrower’s equity under a pledge does not extinguish subordinate liens against the assets of the borrower itself, and the lender takes ownership of the borrower via a UCC sale of the borrower’s equity subject to the obligations of the borrower and all liens on the borrower’s assets.

As accommodation pledges have become more prevalent, commercial real estate practitioners have debated whether they vio -

late the centuries-old equitable doctrine that prohibits lenders from “clogging” a borrower’s right to pay off its mortgage loan and redeem the property at any time prior to the foreclosure sale. This right, known as the borrower’s “equity of redemption,” generally cannot be waived by an unsophisticated borrower under New York law. But even sophisticated commercial borrowers have argued that accommodation pledges clog their redemption right, as the UCC sale process shortens the amount of time they have to redeem the debt and is not always subject to judicial oversight. “Where the redemption right is lawfully waived, or where it is not actually impaired, courts will hopefully feel comfortable ruling for the lender and rejecting “clogging” claims, which will, in turn, provide a high level of reliability in structuring multi-tiered real estate financings,” as noted by Zachary G. Newman, Co-Chair of the American Bar Association’s Section of Litigation Commercial and Business Litigation Committee, and lead counsel in the Atlas Brookview case.

The Atlas Brookview Borrower’s “Clogging” Claim

Until recently, no New York court had squarely addressed whether enforcing a mezzanine pledge taken in conjunction with a mortgage as security violates a borrower’s equity of redemption. At least one New York court had previously declined to enjoin a UCC sale based on a borrower’s clogging challenge and expressed doubt about the claim. HH Cincinnati Textile L.P. v. Acres Capital Servicing LLC, 2018 WL 3056919, at *3-4 (Sup. Ct. N.Y. Cnty. June 20, 2018) (Ostrager, J.). But the court later held that the denial of injunctive relief did not constitute a ruling on the merits.

In November 2021, the first New York court to address the issue on the merits dismissed a commercial borrower’s claim that the collateral pledge granted by its parent entity violated the equity of redemption. Atlas Brookview Mezzanine LLC v. DB Brookview LLC (Index No. 653986/2020; entered on Nov. 18, 2021). In Atlas Brookview, the borrower obtained a $64.9 million mortgage loan secured by a multifamily development in Illinois. The mortgage was governed by Illinois law, and the rest of the loan documents were governed by New York law. As additional security for the loan, Atlas Brookview Mezzanine LLC (“Atlas Mezzanine”), which owned 100% of the borrower entity, guaranteed the entire loan and entered into a pledge agreement securing the guaranty.

Following pre-maturity defaults in June, 2020, the lender scheduled a UCC foreclosure sale scheduled for August 25, 2020. The day before the scheduled auction, the court granted temporary injunctive relief delaying the sale. However, on October 15, 2020, Justice Andrew Borrok denied injunctive relief and noted that no New York court had sustained a “clogging the equity” challenge. The court also recognized that granting relief “would be upending the entire mezzanine lending business.” Following the denial of injunctive relief, the UCC foreclosure sale was rescheduled and consummated on February 17, 2021, and the lender became the owner of the borrower entity and gained control of the property.

The Motion to Dismiss

Atlas Mezzanine’s other challenges to the UCC sale procedures were rendered moot by the consummated sale, but it continued to pursue its declaratory judgment claim arguing that the pledge agreement clogged the borrower’s equity of redemption and was void ab initio, thus requiring an unwind of the sale.

The lender moved to dismiss the declaratory judgment claim and argued that upholding the claim would seriously disrupt billions of dollars of mezzanine financing in New York state. In addition, the lender argued that a borrower retains a right to redeem the debt under Section 9-623 of the UCC until the auction is conducted. Moreover, the lender noted that the borrower was a sophisticated developer represented by competent counsel of its choice and that it expressly endorsed and benefitted from the collateral pledge structure. Further, the lender pointed to Illinois statutes that explicitly allow sophisticated mortgage borrowers to waive the right of redemption.

The borrower argued that the equity pledge structure had never been sanctioned by a New York court, and that it clearly violated its equity of redemption by cutting short the time to redeem the debt. The borrower argued that New York law does not permit any borrower to waive the redemption right, and that “the market effect if the motion [to dismiss] is granted, is that the structure will be viewed as sanctioned … and mortgage lenders everywhere will slap an equities pledge on top of every mortgage loan.” The borrower also argued that the streamlined UCC sale process could allow a lender to foreclose in as little as 30 days.

The Court’s Decision

The Court did not rely on the Illinois law provisions that permit a borrower to waive its right of redemption. Nevertheless, the court rejected the borrower’s argument that the UCC sale had been conducted as a fire sale, and noted that the borrower had months to redeem the debt. Accordingly, the court appeared to recognize that mezzanine pledges do not clog a mortgage borrower’s equity of redemption because the borrower retains the right of redemption provided by UCC § 9-623.

Separately, the Court noted that “commercially sophisticated people represented by able counsel agree[d] that the collateral is sufficient to support the loan and voluntarily enter[ed] into a loan agreement that contemplates additional collateral.” Consistent with well-settled New York principles that seek to afford certainty to sophisticated commercial real estate parties, the court recognized that the borrower “entered into this structure voluntarily with the advice of good counsel” in connection with a $65 million loan. Accordingly, the court dismissed the declaratory judgment claim with prejudice.

The Court’s decision on the motion to dismiss, issued from the bench, recognized that the prior ruling in the HH Mark Twain case did not dismiss the equity-clogging claim on the merits.

However, the Court found that prior decision merely stood for the proposition that the denial of a preliminary injunction “didn’t foreclose the issue at the motion to dismiss stage.”

Conclusion

Justice Borrok’s decision recognized that equity pledges are regularly negotiated and consented to by commercial parties, and that they constitute consensual “business terms” that are not foisted upon unsophisticated borrowers. Because the decision relied on the principle that agreements between sophisticated parties are generally enforceable, it provides comfort to commercial lenders that continue to obtain accommodation pledges in commercial real estate transactions. Nevertheless, the decision was issued from the bench and remains unreported, and no appellate court has addressed the issue. Accordingly, borrowers may continue to lodge challenges to accommodation pledges and the case law may continue to evolve until an appeals court settles the issue.

Endnotes

1. Jose A. Fernandez is an Associate in the New York office of Thompson Coburn LLP. Zachary G. Newman , Robert Rabin , and Jose A. Fernandez at Thompson Coburn LLP were counsel of record to the lender in the Atlas Brookview case.

Destroying Charitable Conservation Easements Is Not Within Congressional Intent

By: Nancy Ortmeyer Kuhn1*

Charitable conservation easements have been a target for examination by the IRS for many years, resulting in the disallowance of millions of dollars of charitable deductions. Learn what the IRS is doing wrong, and in the process acting contrary to the legislative intent behind the incentives afforded to taxpayers to conserve natural resources.

The U.S. Tax Court, in Green Valley Investors, LLC v. Commissioner, 159 T.C. No. 5 (Nov. 9, 2022), analyzed whether the syndicated conservation easements at issue in the case were subject to the §6662A2 penalty, which is an additional penalty on “listed” and “reportable” transactions. The IRS in Notice 2017-10 had added syndicated conservation easements to the definition of transactions considered to be “listed” — i.e., tax

shelters. If a transaction fits within the definition, there are IRS reporting requirements with substantial penalties for a failure to report. The taxpayers argued that the IRS did not follow the procedures outlined in the Administrative Procedures Act (APA) in issuing the Notice, because they did not follow the required notice-and-comment opportunity afforded to taxpayers. The Tax Court agreed. The court held that the taxpayers were not liable for the §6662A penalties. In an apparent response to this opinion, the IRS issued proposed Treasury Regulations to, in effect, replace Notice 2017-10.3 This time the IRS is providing a Notice and Comment period, as required, before finalizing the new Treasury Regulation.

In Green Valley, a reviewed opinion, the Tax Court extensively analyzed the legislative history behind the penalty provision applicable to listed transactions, and did not find the exceptions relied upon by the Commissioner as particularly convincing. The court held: “…we remain unconvinced that Congress expressly authorized the IRS to identify a syndicated conservation easement transaction as a listed transaction without the APA’s notice-and-comment procedures, as it did in Notice 2017-10.”4

Charitable Easements After ‘Green Valley’ Reliance on Legislative History Should Apply to the Core Incentive as Well

Similarly as with the penalty provision, the Tax Court and other courts should rely upon legislative history to further protect

the advantages afforded taxpayers who donate conservation easements to qualified charities. Section 170(h) provides incentives for property owners to protect disappearing species, to protect open vistas, and to preserve natural habitats and scenic views. Taxpayers receive charitable deductions offsetting up to 50% of adjusted gross income for said donations. However, the IRS has been erecting roadblocks so that taxpayers are unable to take advantage of these tax incentives. By doing so, the IRS is arguably frustrating congressional intent. Notice 2017-10 classifying syndicated easements as listed transactions, the new Proposed Regulations to replace the Notice, and the IRS’s litigating posture for the hundreds of cases pending have substantially crippled the conservation easement space. Instead of focusing on the valuations of the conservation easements, the IRS and Tax Court have acted to completely eliminate these incentives — contrary to legislative intent.

Earlier courts analyzing conservation easements ---before the line of cases in which easements were completely disallowed in reliance on the Proceeds Clause in the Treasury Regulations5 — were a bit more lenient in allowing the charitable deduction. In Glass v. Commissioner6 (2005), both the Tax Court and the Sixth Circuit Court of Appeals allowed the conservation easement charitable deductions claimed by the taxpayers, with valuation reserved as a subsequent issue. The Tax Court relied upon legislative history and the intent of Congress in allowing the charitable deductions. The court noted that in promulgating §170(h), Congress stated as follows:

It is intended that a contribution of a conservation easement …qualify for a deduction only if the holding of the easement…is related to the purpose or function constituting the donee’s purpose for exemption… and the donee is able to enforce its rights as holder of the easement…and protect the conservation purposes which the contribution is intended to advance. The requirement that the contribution be exclusively for conservation purposes is also intended to limit deductible contributions to those transfers which require that the donee hold the easement…exclusively for conservation purposes (i.e. that they not be transferable by the donee in exchange for money, other property, or services). H. Conf. Rept. 95-263.7

While Congress stated strong support for protecting conservation purposes, it also indicated that the deduction was not without limits and qualifying requirements. However, there is not one word in this legislative history about the distribution of proceeds in the unlikely event of a judicial extinguishment. By turning this hypothetical event into a “make or break” criterion for purposes of qualification, the IRS and affirming courts have frustrated the intent of Congress and §170(h).

As discussed in my previous article8 the Eleventh Circuit Court of Appeals recently reversed the position of the IRS and Tax Court in favor of allowing taxpayers a deduction.9 The Sixth Circuit, on the other hand, has affirmed the IRS’s and Tax

Court’s positions completely disallowing the deductions and declaring the easements invalid. The IRS and courts rely upon language in the easement document as it relates to the Proceeds Clause.10 The Sixth Circuit taxpayers filed a Petition for Writ of Certiorari with the Supreme Court11 to gain clarity on the issues, but that Petition was denied. The split in the Circuits remains with differing outcomes for taxpayers depending upon the location of the property and taxpayers.

The Tax Court in its majority opinion in Oakbrook12 discussed that the Treasury Regulations interpreting §170(h) were promulgated in January 1986 and have never been amended. The court also relied upon its observation that Congress has amended the statutory provisions of §170 without any indication that the Treasury Regulations interpreting §170(h) were problematic.13 However, these statutory amendments do not address the extinguishment provisions and the Proceeds Clause14 which has the effect of disallowing the entire deduction. Instead, Congress has focused on whether there is actually a conservation purpose and a reasonable value. It has been easier for the IRS and the Tax Court to disallow the entire easement in contravention of the legislative history, rather than follow prior precedent that focused on charitable qualifications and valuation issues.

A Matter of Language

One solution to this quagmire would be for the IRS to offer a settlement initiative in which the taxpayers are allowed to amend the language in their easements, assuming there has not been a judicial extinguishment action and proceeds have not yet been distributed. The charitable qualification and valuation issues could be separately negotiated, with valuation limited to 2.5 times the fair market value of the property, as recently enacted in the 2023 Omnibus Legislation.15 This new law only applies prospectively and does not impact all of the cases in the Federal courts, or any of the ongoing IRS examinations. An interpretation of a Treasury Regulation regarding the distribution of proceeds of a judicial sale (that is very unlikely to happen) is also not impacted by this new statutory amendment to IRC §170.

The goal of §170(h) is for the easement to be perpetual. The standard language in easement documents specifies that the easement is perpetual. The extinguishment is hypothetical. My review of case law does not reveal a single case among the hundreds of cases pending and decided in which a judicial extinguishment has occurred and proceeds from the sale distributed. It seems there is an argument that the IRS cannot base an examination on a hypothetical set of facts that has not occurred. Nothing has happened. The easement is perpetual. Instead, the IRS finds the prototype language in the easement, used by hundreds or thousands of projects, and says “gotcha.”

The taxpayer used the wrong language and so the entire easement fails, even though the easement is perpetually valid and there will be nothing to disrupt that easement until there is a judicial extinguishment such as an eminent domain action.

There has been no harm, other than arguable harm to the federal fisc if the valuation of the easement is not reasonable. That loss is better dealt with in an examination of valuation of the easement. As Tax Court Judge Holmes stated in his dissenting opinion in Oakbrook: “Our holding today will likely deny any charitable deduction to hundreds or thousands of taxpayers who donated conservation easements that protect perhaps millions of acres.”16

Conclusion

Now that the Supreme Court has denied review of Oakbrook Land Holdings and thus declined to resolve the conflict between the Sixth Circuit Court of Appeals17 and the Eleventh Circuit Court of Appeals,18 the tax treatment of conservation easements will vary widely depending upon where the property is located. Property in the Eleventh Circuit, i.e., Alabama, Florida, and Georgia, will be conserved, while there will be little incentive for taxpayers in the Sixth Circuit to donate to qualified conservation charities to preserve the birds, trees, and animals of Kentucky, Michigan, Ohio, and Tennessee. This divisiveness was not envisioned by Congress when originally enacting §170(h). Moreover, the statutory requirements recently enacted19 will not prevent the IRS and courts from dealing the “gotcha” card. The IRS and courts will presumably continue to completely disallow conservation easements without regard to value everywhere except the Eleventh Circuit, based upon a technicality. These actions continue to frustrate longstanding Congressional intent. Although Congress limited the valuation of easements in its recent amendments, it did not limit the validity of conservation easements themselves. By doing so, Congress signaled that using a technicality to completely invalidate conservation easements is outside the intent of the statute. More focus should be trained on furthering legislative intent, rather than frustrating legitimate conservation activities.

Endnotes

1.* Nancy O. Kuhn is currently a shareholder at Shulman Rogers, where her practice focuses on tax controversy work. Nancy was a law clerk at the U.S. Tax Court for two years and then worked as a litigator for the IRS for approximately 10 years, handling litigation for exempt organizations the final five years. She is now in private practice and represents taxpayers before the IRS, Tax Court, and district courts. She has served as an expert witness on several matters, including charitable conservation easements.

Reproduced with permission from Tax Management Estates, Gifts, and Trusts Journal, Volume 48, Issue No. 01, 1/12/23. Copyright

©2023 by The Bureau of National Affairs, Inc. (800-372- 1033) http:// www.bna.com

2. All section references are to the Internal Revenue Code, as amended, or the Treasury Regulations thereunder.

3. Prop. Reg. §1.6011-9, REG-106134-22, 87 Fed. Reg. 75,185 (Dec. 8, 2022).

4. Green Valley, slip. op. at 23.

5. Reg. §1.170A-14(g)(6). See Kuhn, Insight: Charitable Conservation Easements — IRS and Tax Court Act to Shut Them Down, Bloomberg Tax Insights, July 22, 2020.

6. Glass v. Commissioner, 124 T.C. 258 (2005), aff’d, 471 F.3d 698 (6th Cir. 2006).

7. 124 T.C. 258 at 283.

8. Kuhn, A Split in the Circuits: Will the Supreme Court Take Up the Easement Challenge? Bloomberg Tax Insights, Apr. 4, 2022.

9. Hewitt v. Commissioner, 21 F.4th 1336 (11th Cir. 2021), rev’g and rem’g T.C. Memo. 2020-89.

10. Oakbrook Land Holdings v. Commissioner, 28 F.4th 700 (6th Cir. 2022) aff’g 154 T.C. 180 (2020).

11. Oakbrook Land Holdings, LLC v. Commissioner, Petition for Writ of Certiorari, S. Ct. No. 22-323 (Oct. 4, 2022). “Brief for the Respondent in Opposition” filed December 7, 2022. Petition denied: 598 U.S. _____ (Jan. 10, 2023).

12. Oakbrook v. Commissioner, 154 T.C. 180 (2020).

13. “… these amendments have never suggested any disagreement with the construction of the statute that Treasury adopted in section 1.170A-14(g)(6), Income Tax Regs. This ‘strongly suggests that * * * [Congress] did not view Treasury’s construction * * * as unreasonable or contrary to the law’s purpose.”

14. Reg. §1.170A-14(g)(6).

15. Consolidated Appropriations Act, 2023 (H.R. 2617)(Dec. 29, 2022).

16. Oakbrook, 154 T.C. 180 *230.

17. Oakbrook Land Holdings, LLC, supra.

18. Hewitt, supra.

19. Consolidated Appropriations Act, 2023, supra.

New Proposed Regulations Would Affect the Taxation of US Real Estate for Foreign Investors

By: Nickolas Gianou, Victor Hollender, David Polster and Sarah Beth Rizzo1

This article discusses the Treasury Department’s recent release of a set of proposed regulations that, if finalized, would alter key rules affecting many real estate funds, sovereign wealth funds and other foreign investors in U.S. real estate.

On December 28, 2022, the Treasury Department released a set of proposed regulations that, if finalized, would alter key rules affecting many real estate funds, sovereign wealth funds and other foreign investors in U.S. real estate.1 The proposed regulations are likely to be met with a mixed reception from market participants. On the one hand, the regulations provide a helpful rule that would give foreign government investors increased flexibility in structuring their investments. On the other hand, they contain a controversial new rule for determining whether a real estate investment trust (REIT) is “domestically controlled,” threatening to disrupt the tax planning of many real estate funds, private equity funds,

real estate joint venture (JV) participants and other non-U.S. investors in U.S. real estate.

Background

The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), contained principally in Section 897 of the Internal Revenue Code (the Code), created an important exception to the general rule that a foreign investor is not subject to U.S. taxation on capital gains. Under FIRPTA, a foreign investor that recognizes gain on a “United States real property interest” (USRPI) is subject to tax on that gain at regular U.S. tax rates as if they were a U.S. person. The term USRPI includes direct interests in real property as well as equity interests in a domestic “U.S. real property holding corporation” (USRPHC). The term USRPHC generally includes any corporation if a majority of its assets consists of USRPIs. A foreign corporation may be a USRPHC if it meets the asset test (though interests in the foreign USRPHC will generally be treated as USRPIs only for purposes of determining whether an owner of such interests is itself a USRPHC).

Importantly, equity interests in a “domestically controlled REIT” are not USRPIs, regardless of the quantum of real estate owned by the REIT. Thus, a foreign investor generally may sell shares in a domestically controlled REIT without being subject to U.S. taxation. If, on the other hand, the REIT ceased to be domestically controlled, a foreign investor would generally be subject to full U.S. taxation on any gain from selling the REIT’s stock.

A REIT is domestically controlled if less than 50% of its stock is held “directly or indirectly” by foreign persons at all times during a testing period (generally, the five-year period pre -

ceding the sale of the REIT’s stock). The Code and existing regulations generally do not specify what “indirect” ownership encompasses for this purpose and, in particular, whether and to what extent a REIT must look through a domestic C corporation to the C corporation’s shareholders. For example, if 60% of a REIT is owned by a domestic corporation but the corporation’s shareholders are entirely foreign, is the REIT domestically controlled because the majority of its stock is held directly by a U.S. corporation, or is it foreign controlled because foreign shareholders of the U.S. corporation indirectly own more than 50% of the REIT?

Although the answer is not explicit in the Code or current regulations, it appears that taxpayers are not required to look through domestic corporations under current law. This interpretation is supported by the current regulations, which state that for purposes of determining domestic control, the “the actual owners of stock, as determined under [Treasury Regulation Section] 1.857-8, must be taken into account.” Importantly, under Treasury Regulation Section 1.857-8, the “actual owner” of REIT stock is the person who is required to include the dividends on that REIT stock in their income, which, in the case of REIT stock owned by a domestic corporation, would be only the corporation itself and not the corporation’s shareholders.

Moreover, in the Protecting Americans From Tax Hikes (PATH) Act of 2015, Congress expressly included certain look-through (and modified look-through) rules for REIT stock that is held by an upper-tier REIT, but those rules do not apply to regular C corporations. The clear implication of the PATH Act rules is that Congress did not intend similar rules to apply to regular C corporations. For these reasons, most practitioners believe that current law does not require look-through of domestic corporations. Indeed, even before the PATH Act, the Internal Revenue Service (IRS) concluded as much in Private Letter Ruling 200923001.

The general FIRPTA rules described above are modified for entities that qualify as “foreign governments” under Section 892 of the Code. Such an entity is generally exempt from U.S. taxation on income from investments in securities, including, in general, stock of a USRPHC, whether or not the USRPHC is a domestically controlled REIT. The Section 892 exception does not, however, apply if either the foreign government investor or the USRPHC in whose stock it has invested is a “controlled commercial entity” of the foreign government.

A “controlled commercial entity” is, in general, any entity that is both engaged in “commercial activities” (which includes most business or profit-making activities other than investments in securities) and is “controlled” by the foreign government.2 Thus, if the foreign government investor is itself engaged in commercial activity, it will generally not qualify for the Section 892 exemption on any of its investments, and even if it is not so engaged, the exemption will not apply to income or gain recognized from a USRPHC or other

corporation that is engaged in commercial activity and that the foreign government investor controls.

Existing temporary regulations provide that an entity will be deemed to be engaged in commercial activities if it is a USRPHC. Thus, if a sufficient portion of a foreign government investor’s assets consists of stock of USRPHCs that are not domestically controlled REITs, it would lose its Section 892 exemption even though its only activity is investing in securities (which otherwise does not constitute commercial activity).

New Proposed Regulations

Section 892: Deemed Commercial Activity

In a helpful clarification of the existing temporary regulations, the new proposed regulations create an exception to the rule that a USRPHC is deemed to be engaged in commercial activity. In particular, the proposed regulations provide that the rule does not apply to an entity that is a USRPHC solely by reason of its direct or indirect ownership interest in one or more other corporations that are not controlled by the foreign government.2 Thus, a foreign government investor that owns solely minority, noncontrolling interests in USRPHCs would not be deemed to be engaged in commercial activity even if those interests caused the foreign government investor itself to be a USRPHC. This rule would be effective for taxable years ending on or after the date the regulations are finalized, though taxpayers may rely on the rule prior to finalization.

This is a welcome change that would provide significant flexibility to many foreign government investors. Very often, such an investor would prefer to hold an investment in a special purpose vehicle (SPV) that owns no assets other than that investment. Doing so would prevent any inadvertent commercial activity generated by the investment from tainting the Section 892 exemption for other investments held by other entities in the foreign government’s structure and also may have nontax benefits in terms of liability insulation, accounting/tracking and financing.

Unfortunately, though, under the existing temporary regulations, such an SPV would lose its eligibility for the Section 892 exemption if its investment is stock in a USRPHC (other than a domestically controlled REIT) or any other USRPI. Moreover, even when a foreign government holds USRPIs through an entity that also owns non-USRPIs sufficient to outweigh the USRPIs, it must continually monitor the balance of USRPIs and non-USRPIs to avoid USRPHC status. This can be burdensome due to the difficulty of getting the information necessary to reliably run the tests and the need to adjust the portfolio as portfolio composition and asset values change.

The new proposed regulations would alleviate these issues by allowing an SPV to maintain its Section 892 exemption while holding noncontrolling interests in USRPHCs and by removing the burden of having to balance USRPIs and non-USRPIs. This would provide foreign governments with significantly more flexibility to segregate U.S. real estate investments in different

legal entities and to otherwise hold investments based on business or nontax legal objectives rather than tax considerations. Given that taxpayers may rely on the proposed regulations prior to finalization, they may also consider implementing favored structures now. The existing deemed commercial activity rule would, however, continue to apply in the case of a foreign government investor that is a USRPHC because of its investment in USRPIs other than stock of noncontrolled USRPHCs — for example, direct interests in U.S. real estate or majority interests in corporations that own U.S. real estate.

Section 897: Domestic Control ‘Look-Through’

As noted above, it appears that existing law does not require a REIT to look through a domestic C corporation to its shareholders in determining whether the REIT is domestically controlled. In a reversal of this position — the position taken by the IRS in a prior private ruling — the new proposed regulations would require a REIT to look through any nonpublic domestic corporation if 25% or more of the corporation’s stock (by value) is owned by foreign persons. Domestic corporations that are either publicly traded or whose foreign ownership is less than 25% would not be subject to the look-through rule and thus would be treated as U.S. persons for purposes of testing domestic control of the underlying REIT.

In addition, consistent with the views of most practitioners, the regulations clarify that a REIT must look through partnerships that are not publicly traded partnerships. The new lookthrough rules would be effective for transactions occurring on or after the date the regulations are finalized. The reference to “transactions” presumably means REIT share sales or other transactions for which the status of a REIT as domestically controlled is relevant, and there is no provision grandfathering ownership structures that have been established prior to finalization under current law.

Moreover, given that domestic control must be satisfied for the entirety of the backward-looking testing period, the look-through rule could cause a REIT to lose its domestically controlled status based on current ownership even if that ownership is changed prior to finalization of the proposed regulations. Finally, Treasury noted in the preamble that it may challenge positions contrary to the look-through rule even before finalization.

The rule requiring look-through of domestic corporations with 25% or greater foreign ownership is controversial and likely to affect many private equity funds, real estate funds and JVs, and other investors in private REITs, many of which have created domestic corporate “blockers” through which certain foreign investors hold REIT interests. In situations where the blocker and other U.S. ownership of the REIT aggregates to exceed 50%, these investors generally would have expected that the REIT would be domestically controlled such that a sale of the REIT stock by any foreign investors that owned the REIT shares “unblocked” would be exempt from U.S. tax. Fund

sponsors may have provided tax covenants to investors based on these expectations.

These investors and sponsors will now have to reevaluate their expectations — including with respect to existing structures, given the lack of grandfathering — and determine whether any alternative structuring is appropriate. We anticipate that Treasury will receive significant comments opposing its proposed look-through rule for domestic corporations.

1 On the same date, Treasury issued final regulations concerning the special rules for “qualified foreign pension funds.” Those regulations are outside the scope of this discussion.

2 The proposed regulations also clarify that certain entities that are eligible for the FIRPTA exemption for “qualified foreign pension funds” (and entities wholly owned by qualified foreign pension funds) are not subject to the deemed commercial activity rule.

This memorandum is provided by Skadden, Arps, Slate, Meagher & Flom LLP and its affiliates for educational and informational purposes only and is not intended and should not be construed as legal advice. This memorandum is considered advertising under applicable state laws.

Endnotes

1. Nickolas Gianou Nick Gianou is a partner in the tax group at Skadden, Arps, Slate, Meagher & Flom LLP. He represents clients on a wide range of tax matters, including real estate investment trusts (REITs), private equity and hedge fund transactions, foreign investment in the United States, sovereign wealth funds, public and private mergers and acquisitions, initial public and other debt and equity offerings, regulated investment companies (RICs) and restructuring transactions.

David Polster David Polster is head of the Chicago office tax group and co-head of the firm’s REIT group at Skadden, Arps, Slate, Meagher & Flom LLP. He represents clients on a wide range of tax matters, including partnership transactions, mergers and acquisitions, initial public offerings, real estate investment trusts (REITs), regulated investment companies (RICs) and outbound investment in foreign jurisdictions.

Victor Hollender Victor Hollender is a partner in the tax group at Skadden, Arps, Slate, Meagher & Flom LLP. He advises on a wide range of U.S. and international tax matters, including public and private mergers and acquisitions, divestitures, joint ventures, cross-border financings, restructurings, spin-offs, initial public offerings and complex capital markets transactions.

Sarah Beth Rizzo Sarah Beth Rizzo is a partner in the tax group at Skadden, Arps, Slate, Meagher & Flom LLP. She advises clients on a wide range of federal income tax planning matters, including REIT transactions, mergers, acquisitions and dispositions, reorganizations, partnership transactions, private and public securities offerings, financings, private equity transactions and foreign investments in the U.S.

Why GST Tax is Relevant for Non-US Trusts

By: Jennie Cherry and Lindsey Bronstein1

Jennie Cherry and Lindsey Bronstein discuss the importance of the US generation-skipping transfer tax for non-US families planning trusts for their US relatives.

Introduction

Non-US families establishing succession planning structures rarely think about the US generation-skipping transfer (GST) tax. Nevertheless, when a foreign trust becomes a US domestic trust so that distributions can be made in a tax-efficient manner to the settlor’s US grandchildren and more remote descendants, US trustees or tax return preparers may raise questions about whether those distributions are subject to the GST tax. Advisers to these families should become familiar with the application of the GST tax rules in order to bring clarity to the situation.

Background

For details regarding US gift and estate taxes in general, please

see “Overview (August 2022)”. In addition to these transfer taxes, the United States has a third type of tax known as the GST tax. As its name implies, the GST tax is aimed at transfers that skip a generation. There are three GST transfers on which GST tax may be imposed – namely, “direct skips, “taxable terminations” and “taxable distributions”:

• A “direct skip” is a transfer which is subject to US gift or estate tax and which is made to a person two or more generations below that of the transferor (a skip person). A trust is a skip person if all persons who have an interest in the trust are skip persons. For example, an outright transfer to a grandchild or to a trust for the benefit of a grandchild is a direct skip.

• A “taxable termination” is a termination of a person’s interest in a trust if, after termination of that interest, only skip persons have interests in the trust. For example, in the case of a trust held for the benefit of the settlor’s child, there is a taxable termination when the child dies and the trust is now held for the benefit of the settlor’s grandchild.

• A “taxable distribution” is a distribution from a trust to a skip person that is neither a direct skip nor a taxable termination – for example, when the trust is for the benefit of the settlor’s children and more remote descendants and the trustee makes a discretionary distribution to the settlor’s grandchild.

US citizens and residents subject to tax on transfers that skip a generation

When a US citizen or a non-US citizen who is resident in the United States for transfer tax purposes (a US person) makes a transfer to a skip person, whether such transfer is made during life or at death, a GST tax is imposed in addition to any gift or estate tax that may be due. The GST tax is calculated at a flat rate equal to the top transfer tax rate of 40%.

For tax year 2022, an exemption amount of $12,060,000 is available to shelter gifts or bequests from GST tax. If a US person does not affirmatively allocate this exemption amount to specific transfers, automatic allocation rules apply.

Non-resident aliens subject to GST tax only when also subject to gift or estate tax

The reach of the GST tax for transfers made by a non-resident alien (NRA) matches the reach of the estate and gift tax on the underlying transfer. Thus, a transfer by an NRA of non-US situs property is not subject to the GST tax, since it is not subject to estate or gift tax, but the GST tax applies when an NRA transfers US property (other than intangibles transferred by gift) to a skip person. For further details on when property has a US situs for tax purposes, please see “ Estate and gift tax situs of assets – basic rules” and “ Estate and gift tax situs of assets –specific examples”.

The NRA transferor is entitled to the same $12,060,000 (for tax year 2022) exemption from GST tax as a US person. Schedules to the federal estate and gift tax returns (Forms 706 and 709) are used to report generation-skipping transfers.

Application of GST tax to gifts and bequests of NRAs to skip persons

The key principle to keep in mind is that GST tax is determined by applying estate and gift tax rules. Specifically:

• GST tax applies to transfers to a skip person by an NRA during lifetime to the extent that the transferred property is US situs property for purposes of the gift tax, and therefore subject to US gift tax.

• GST tax applies to transfers to a skip person by an NRA at death to the extent that the transferred property is US situs property for purposes of the estate tax, and therefore subject to US estate tax.

• Trust distributions to skip persons and taxable terminations are subject to GST tax to the extent that the initial transfer to the trust by the NRA was a transfer at death or during life that was initially funded with US situs property, and therefore subject to US gift or estate tax.

The time for testing whether the tax applies is the same time as under the estate or gift tax rules, even though the “skip” transfer would often occur later. Specifically, the character of

the property and the non-resident alien status of the transferor are tested only at the time of the initial transfer as determined for estate tax purposes (at death) or for gift tax purposes (when the gift is complete).

Thus, the GST tax generally does not apply to transfers by NRAs of property situated outside of the United States as of the time of the initial transfer.

However, the converse is also true. If US situs property is transferred by an NRA to a trust, and that property is later reinvested in non-US situs property, GST tax will still apply on a taxable distribution or termination.

Allocation of GST exemption

As mentioned above, the NRA transferor is entitled to the same $12,060,000 (for tax year 2022) exemption from GST tax as a US citizen or resident. This is true even though the NRA’s estate tax exemption is limited to $60,000 and there is no exemption amount for gift tax purposes.

When the transfer by the NRA is fully subject to the GST tax or when a trust is being funded with US situs property and may in the future have taxable terminations or taxable distributions, the same principles apply as for US transferors, so the NRA transferor can allocate their exemption on a timely filed Form 709, gift tax return, or Form 706-NR, estate tax return. Similarly, if the NRA does not affirmatively allocate their exemption, the automatic allocation rules will apply to certain transfers. In the case of a trust to which the NRA transferor has allocated GST exemption, the trust will thereafter have a GST “inclusion ratio” as discussed further below.

When the transfer by the NRA is not subject to the GST tax at all, or will not be subject to GST tax in the future, the exemption is not allocated.

As discussed further below, when an NRA funds a trust with US situs property, during life or at death, consideration should be given to allocating GST exemption to that trust if the transfer is a direct skip or if there could be a taxable termination or taxable distributions subject to GST tax in the future.

It is important to keep in mind that when an NRA transfers US corporation stock (an intangible) by gift during life, that transfer is not subject to US gift tax. But when an NRA dies owning US corporation stock the value of that stock is subject to US estate tax (absent an applicable treaty provision). If the NRA has bequeathed the stock to a grandchild whose parent survives the NRA decedent, GST tax will be due in addition to US estate tax.

Thus, NRAs need not consider the GST tax implications of their transfers unless the transfer otherwise requires the filing of a US gift or estate tax return. For example:

• An NRA grandmother gives non-US property or intangibles worth $1 million to her US granddaughter. The NRA

grandmother is not subject to US gift tax and need not file a US gift tax return, nor does she need to allocate any GST tax exemption to the gift because the GST tax simply does not apply. The US granddaughter will report the receipt of the gift on Form 3520 (for further details please see “Preparing US tax and information returns: Forms 3520 and 3520-A”).

• If that same NRA grandmother gives artwork located in the United States worth $1 million to her non-US grandson, she files a US gift tax return and pays gift tax. The gift tax return includes a schedule calculating GST tax and allocating her GST exemption amount.

• The NRA grandmother later dies and her will bequeaths her estate in equal shares to her US granddaughter and non-US grandson. At the time of her death, the grandmother owns stock of US corporations valued in excess of $60,000. Her estate files a US estate tax return reporting the date of death value of the US stock and includes a schedule calculating GST tax and allocating her remaining GST exemption amount.

GST tax and trusts

In the domestic context, a US settlor can give property to a trust to be held for the benefit of the settlor’s child and then to the settlor’s grandchildren. When the child dies and the trust property is distributed to the grandchildren, this triggers a taxable termination subject to GST tax. However, the settlor can allocate GST exemption to the trust, which will reduce or eliminate the GST tax. The amount of GST tax imposed will be determined by reference to a formula known as the “inclusion ratio”. An inclusion ratio of zero means none of the termination distribution will be subject to GST tax. An inclusion ratio of one means the entire distribution will be subject to GST tax. An inclusion ratio between zero and one means the distribution will be partially subject to GST tax.

Suppose that prior to her death, the NRA grandmother establishes a Bermuda trust and retains the right to revoke the trust. On her death, the trust holds US stock, the value of which is subject to US estate tax. Following her death, the trust will be moved to the United States and continue for the benefit of her US daughter and US granddaughter. The NRA grandmother’s estate files a US estate tax return and allocates her remaining GST exemption amount. The successor US trustee will need to know the trust’s GST inclusion ratio in order to determine whether distributions to the US granddaughter will be subject to GST tax.

If NRA grandmother’s trust was only partially subject to the US estate tax, a special rule for non-resident aliens applies to calculate the GST inclusion ratio of the transfer so that the GST tax can be calculated in the future. The effect of this rule, as in the domestic context, is to encourage the creation of a separate

trust in the amount of the allocated exemption, easing administration and minimising taxes.

Suppose that, as is more often the case, the NRA grandmother transfers non-US situs assets to her Bermuda trust and at her death the trust owns only the shares of a foreign corporation which has invested in US stock, so that no US estate tax is due (see “ Tax planning for US equities owned in a non-US trust structure”). In that case, no US estate tax return need be filed and the trust is exempt from GST tax. The successor US trustee can be provided with an explanation of the tax analysis so that when distributions are made in the future to skip persons there is no question as to whether GST tax is due.

Comment

The purpose of the GST tax is to discourage multi-generational tax planning so that the Internal Revenue Service collects estate tax from every generation. The goal of GST trust planning is to allocate, to the extent possible, the transferor’s GST exemption so that trusts have an inclusion ratio of zero. A trust established by an NRA settlor will not be subject to GST tax so long as property transferred to the trust during lifetime or held in the trust at death is not subject to US gift or estate tax. Where the NRA settlor’s children and grandchildren are US persons, ensuring that distributions from a trust lasting in perpetuity will never be subject to GST tax is an important consideration.

For further information on this topic please contact Jennie Cherry or Lindsey Bronstein at Kozusko Harris Duncan by telephone (+1 212 980 0010) or email ( jcherry@kozlaw.com or lbronstein@ kozlaw.com ). Please note that the authors are unable to provide legal advice to non-clients. The Kozusko Harris Duncan website can be accessed at www.kozlaw.com .

Endnotes

1 For further information on this topic please contact Jennie Cherry or Lindsey Bronstein at Kozusko Harris Duncan by telephone (+1 212 980 0010) or email (jcherry@kozlaw.com or lbronstein@kozlaw. com). Please note that the authors are unable to provide legal advice to non-clients. The Kozusko Harris Duncan website can be accessed at www.kozlaw.com .

Planning for the Massachusetts Millionaire Tax— Individuals and Trusts

By: Ropes & Gray LLP1

The Private Client Group at Ropes & Gray LLP in Boston explains the new Massachusetts tax of 4% on annual taxable income in excess of $1,000,000, which applies to individuals and trusts.

The first part of the Private Client Group’s October Update summarizes the inflation adjustments to the estate and gift tax exemption, the annual exclusion amount and other related tax thresholds that are expected in 2023. The second part explains the key provisions of the Corporate Transparency Act, following the issuance of final regulations by FinCEN on September 30, 2022.

On November 8, 2022, Massachusetts voters approved a measure placed on the ballot by initiative petition that amends the state’s Constitution to impose an additional 4% tax on

that portion of annual taxable income in excess of $1,000,000 reported on any income tax return. The $1,000,000 figure is to be adjusted annually to reflect any increases in the cost of living. This additional tax becomes effective on January 1, 2023.

The effect of the additional tax can be significant. For example, the income tax liability of a Massachusetts resident individual (or a resident non-grantor trust) with taxable income of $1,500,000 would increase by $20,000. If instead the taxable income were $10,000,000, the increase resulting from the additional tax would be $360,000.

In simplest terms, there are three main strategies to minimize or avoid the additional tax:

1. Accelerate income into 2022, before the additional tax becomes effective;

2. Spread income across multiple taxpayers or multiple years; and

3. Avoid Massachusetts income tax altogether on non-Massachusetts-source income by moving out of Massachusetts.

These strategies should be considered in planning for both individuals and trusts. However, in determining whether to implement any strategy to mitigate the additional tax, the expected tax reduction should be weighed against the cost of the strategy being considered.

Basic planning for individuals—spreading and accelerating income

The language in the constitutional amendment specifying that the additional tax is based on the excess over $1,000,000 per tax return makes it likely that spouses filing separately will each be able to shelter the first $1,000,000 of their individual income from the additional tax. This leads to some basic planning opportunities. If a couple has substantial unearned income, that income could be spread between the spouses to ensure that each makes full use of the first $1,000,000 of income that is free of the additional tax. Therefore, if one spouse earns income in excess of $1,000,000 and the other does not, it would make sense to consider shifting investment assets into the name of the other spouse. If, after shifting income to the spouse who earns less, filing separately returns results in tax savings for Massachusetts tax purposes, but not for federal purposes, you could also consider filing separately for Massachusetts purposes and filing jointly for federal purposes.

Another strategy for individuals is to accelerate income realization before the additional tax goes into effect on January 1, 2023. For example, individuals who were considering converting their traditional IRA to a Roth IRA may want to do so before year-end. Similar considerations apply to individuals who are considering the sale of real estate or the sale of a business. Spreading income over multiple years is another way of minimizing or avoiding the additional tax. For example, if you are selling an asset with significant unrealized appreciation, consider an installment sale that would spread the gain over multiple years. The same concept applies to multiple assets within a portfolio. Staggering the sale of portfolio assets over multiple calendar years (even by simply postponing certain sales from December to January) could lead to tax savings. Of course, this technique should be considered only after the additional tax comes into effect. As discussed in the previous paragraph, one should generally try to accelerate income in 2022, rather than postpone it to a future year.

Asset selection and tax-advantaged financial products may also help mitigate the additional tax. For example, investment in assets that generate income that is exempt from state tax, such as many Massachusetts municipal bonds, may become more attractive. Private placement life insurance (PPLI) and private placement variable annuities (PPVA), may also become more attractive simply because the income tax deferral, and in some cases tax elimination, that they provide will become more valuable.

Planning for individuals—moving out of Massachusetts

Massachusetts taxes the worldwide income of any individual who is either domiciled in Massachusetts or who is a resident of the state. In contrast, Massachusetts taxes income of an individual who is neither domiciled in Massachusetts nor a resident of Massachusetts only to the extent the income derives

from a Massachusetts source. An individual could therefore escape the taxing authority of Massachusetts over non-Massachusetts source income by changing his or her domicile and ending his or her residency in the Commonwealth.

For most, this is a drastic step that would not make sense. However, for individuals who are not employed in Massachusetts and already spend considerable time in one or more other states, this may not be such a dramatic change.

“Domicile” is a subjective concept that means the place an individual considers to be his or her home. If a person leaves Massachusetts but intends to return, that person’s domicile remains in Massachusetts. There are several objective manifestations of the intention to change one’s domicile, which generally revolve around establishing new roots in a new place. A domicile determination requires an analysis of all facts and circumstances, and no single fact or circumstance is determinative. Owing to the inherently factual and complex nature of the domicile issue, it is often the subject of contention between taxpayers and the Massachusetts Department of Revenue. Claiming that one is no longer domiciled in Massachusetts therefore comes with inevitable risk, especially if connections with Massachusetts remain.

“Residency” is a simpler concept. It merely requires maintaining a permanent place of abode in Massachusetts (which could even be a hotel room) and spending at least 183 days in the Commonwealth during a particular calendar year.

If you are considering leaving Massachusetts, we would be happy to talk with you about your particular circumstances.

Trust planning—existing trusts

Many individuals have either created trusts or are beneficiaries of trusts. There are two types of trusts from an income tax perspective – grantor trusts and non-grantor trusts.

Grantor trusts include revocable trusts and irrevocable trusts over which the funder of the trust (the “grantor”) has retained some level of control that causes all trust income to be taxed to the grantor on his or her individual income tax returns. Income that is distributed to beneficiaries of grantor trusts is tax-free to the beneficiaries.

Non-grantor trusts are trusts that file their own tax returns and pay their own taxes on capital gains and undistributed income. Income that is distributed to beneficiaries of non-grantor trusts is taxed in the beneficiaries’ hands.

Grantor Trust Planning. Because the income of grantor trusts is taxed to the grantor and reported on his or her own income tax returns, that income will be subject to the additional Massachusetts income tax if the grantor is subject to that tax, which should be taken into consideration in the grantor’s planning. With respect to irrevocable grantor trusts, an additional planning consideration is whether grantor trust status should be ended, which is possible in most cases. At

that point the trust becomes a non-grantor trust and the planning considerations set out below become relevant. A variant of this technique is to first divide the grantor trust into multiple trusts (with different beneficiaries) and then end grantor-trust status with respect to some or all of the resulting trusts, thus spreading the trust income among multiple taxpayers (as further discussed below).

Non-Grantor-Trust Planning. With respect to nonMassachusetts-source income, the Massachusetts income tax, including the additional tax, applies to (1) all trusts created under the will of a Massachusetts decedent and (2) all trusts created by a Massachusetts resident during lifetime, but only while at least one trustee of the trust is a Massachusetts resident. Most trusts fall into the second category, and there is an opportunity to remove such trusts from the taxing authority of Massachusetts altogether by changing the trustees to non-residents of Massachusetts.

Another strategy for an existing non-grantor trust is to consider dividing the trust. For example, if the trust is currently a pooled trust for the benefit of the grantor’s children, the trust could be divided into multiple non-grantor trusts, one for the benefit of each child. This could allow the income to be spread across multiple taxpayers and multiple returns to potentially alleviate or eliminate the additional tax. Whether it is possible to divide the trust depends on the terms of the trust. And whether a trust division will be respected for tax purposes depends on complex rules that should be consulted carefully before embarking on a division plan. Just as dividing an existing non-grantor trust could mitigate the additional tax, so could establishing multiple nongrantor trusts from the outset.

Trust planning— “ING” trusts

Some taxpayers have sought to avoid Massachusetts income tax on unearned income by transferring income-producing assets to a so-called incomplete gift non-grantor trust, or ING trust. Because of the additional tax, ING trusts may experience increased popularity, although they are a relatively rare and risky technique.

The main idea behind an ING trust is to establish an irrevocable trust that accomplishes two goals. The first goal is for the trust to qualify as a non-grantor trust, so that as long as it does not have Massachusetts resident trustees, it will not be subject to Massachusetts income tax on non-Massachusetts source income. To accomplish this goal, the grantor must have limited rights and control over the trust property and income. The second goal is for the transfers to the trust to qualify as an “incomplete gift” because the grantor of the trust does not want the funding of the trust to be treated as a taxable gift for federal gift tax purposes. This goal can be achieved by the grantor retaining a minimum degree of control over the disposition of the trust property. To be successful, ING trusts therefore require that the grantor have sufficient control over the trust assets to avoid causing completed gifts, but not so much control that the trust will be treated as a grantor trust.

This task is fraught with technical and factual questions that make ING trusts a technique that is often touted but whose complexity is often overlooked.

Starting in 2021, the IRS no longer issues rulings on ING trusts, which means there is no way to obtain advance assurance on the key federal gift tax and grantor trust aspects of the arrangement. In addition, certain states have attacked ING trusts and nullified their tax benefits (e.g., New York). It is conceivable that one day Massachusetts might follow suit. In most cases, an ING trust is too aggressive a technique, and we do not generally recommend it. Nevertheless, if you are interested in learning more about ING trusts, we would be happy to help you determine whether an ING trust can be right for your situation.

Endnotes

1. Ropes & Gray is a preeminent global law firm with more than 1,200 lawyers and legal professionals serving clients in major centers of business, finance, technology and government. The firm has consistently been recognized for its leading practices in many areas, including private equity, M&A, finance, investment management, hedge funds, real estate, tax, life sciences, health care, intellectual property, business & securities litigation, government enforcement, privacy & cybersecurity, and business restructuring.

Form 3520-A, Foreign Trust Return with US Owner Explained

By: Sean M. Golding1

Golding & Golding explains the importance and application of US Form 3520-A to US taxpayers with interests in foreign accounts, assets, investments, entities, and trusts.

Foreign Trust Information Return with US Owner

There are many different types of international information reporting forms that a US Person may have to file when they have ownership over foreign accounts, assets, investments, entities, and trusts. For the US Owner of a Foreign Trust, one of the main forms (but not only form) they have to file is Form 3520-A. Form 3520-A is the Annual Information Return of Foreign Trust with a U.S. Owner (under section 6048(b)). The form is one of the more complicated reporting vehicles for overseas assets. That is because unlike the FBAR or Form 8938 (FATCA), which focuses more on just reporting the high-balance and associated income,

Form 3520-A is a tax return for the trust – similar in concept to IRS Form 1041 – and therefore it has several moving parts associated with the annual foreign trust reporting requirements.

Is It a Foreign Trust?

The first and most important aspect of foreign trust reporting is to determine whether or not you even have a foreign trust in the first place – which can be harder than it seems. Different countries have different rules and requirements as to what qualifies as a trust. For example, in some countries, a person may use a structure such as a Sociedad Anonima for asset protection — and while it was created for trust-like purposes — from a US tax perspective, it may be considered a corporation and not a trust and require different reporting on Form 5471. Likewise, a Stiftung that is not considered a foreign trust per se, can be deemed a foreign trust for US tax and reporting purposes.

26 USC 6048(b)

The starting point with foreign trust reporting, as with any type of international information reporting, should determine what the statute is and what corresponding IRS form(s) must be filed. Which foreign trust reporting, taxpayers should refer to Internal Revenue Code section 6048. The code section breaks down who is required to report, what is required to be included in the reporting form, and what happens when taxpayers fail to report timely.

• (b) United States owner of foreign trust

o (1) In general

 If, at any time during any taxable year of a United States person, such person is treated as the owner of any portion of a foreign trust under the rules of subpart E of part I of subchapter J of chapter 1, such person shall submit such information as the Secretary may prescribe with respect to such trust for such year and shall be responsible to ensure that—

 (A) such trust makes a return for such year which sets forth a full and complete accounting of all trust activities and operations for the year, the name of the United States agent for such trust, and such other information as the Secretary may prescribe, and

 (B) such trust furnishes such information as the Secretary may prescribe to each United States person

 (i) who is treated as the owner of any portion of such trust or

 (ii) who receives (directly or indirectly) any distribution from the trust. (2)Trusts not having United States agent

 (A) In general

 If the rules of this paragraph apply to any foreign trust, the determination of amounts required to be taken into account with respect to such trust by a United States person under the rules of subpart E of part I of subchapter J of chapter 1 shall be determined by the Secretary.

 (B) United States agent required

 The rules of this paragraph shall apply to any foreign trust to which paragraph (1) applies unless such trust agrees (in such manner, subject to such conditions, and at such time as the Secretary shall prescribe) to authorize a United States person to act as such trust’s limited agent solely for purposes of applying sections 7602, 7603, and 7604 with respect to—

 (i) any request by the Secretary to examine records or produce testimony related to the proper treatment of amounts required to be taken into account under the rules referred to in subparagraph (A), or

 (ii) any summons by the Secretary for such records or testimony. The appearance of persons or production of records by reason of a United States person being such an agent shall not subject such persons or records to legal process for any purpose other than determining the correct treatment under this title of the amounts required to be taken into account under the rules referred to in subparagraph (A). A foreign trust which appoints an agent described in this subparagraph shall not be considered to have an office or a permanent establishment in the United States, or to be engaged in a trade or business in the United States, solely because of the activities of such agent pursuant to this subsection.

 (C) Other rules to apply

 Rules similar to the rules of paragraphs (2) and (4) of section 6038A(e) shall apply for purposes of this paragraph.

IRS Form 1041

By way of comparison, for a US-based trust, taxpayers file Form 1041 instead of Form 3520-A. Depending on the complexity of an estate plan, there may be some overlap so taxpayers should be aware of whether or not their trust is actually a US trust or a foreign trust. Oftentimes, nuances within the trust language can take what looks like a US-based trust and transmute it into a foreign trust.

Form 3520-A Breakdown

Let’s go through the basics of the Form 3520-A content to get a baseline understanding of the type of information that needs to be reported:

General Information (Part I)

As with most international information reporting forms, the first part of Form 3520-A refers to general information about the name of the trust, the location of the trust, and the day that the trust is formed. There is also additional information about whether or not a US agent was appointed. Oftentimes having a US agent is a benefit to a foreign trust because it can minimize the amount of reporting and documentation that needs to be provided to the IRS.

Foreign Trust Income Statement (Part II)

The next portion of the reporting involves the foreign trust income statement. This is where taxpayers will have to roll up their sleeves and dive into the more complex aspect of foreign trust reported. Depending on the type of foreign trust and whether this information is even available, taxpayers must do their best to provide information about the income generated in the foreign trust. As you can see from the form, the usual cast of income characters is included – such as interest, dividends, rent, gains, and other income. In addition, the taxpayer must also provide information regarding expenses and other distributions from the trust.

Foreign Trust Balance Sheet (Part III)

The third part of Form 3520-A is the balance sheet. This is important, to show that the assets equal liabilities plus equity. Again, depending on how much information is actually available from the foreign trust will dictate how thorough the taxpayer is when preparing this form. One very important concept to keep in mind is the idea of diligence. Completing Form 3520-A — or any other international information reporting form for that matter — is not a test and you are not graded on the outcome. The idea is to do a diligent and reasonable search sufficient to obtain as much information you can to prepare the form as accurately as possible so that if the IRS was ever to come knocking on your door, you can explain what you did to try to obtain the information to the best of your abilities.

Additional Form 3520-A Forms

In addition to completing the main Form 3520-A, there are also other ancillary forms that taxpayers may have to file depending on what their relationship is to the trust, the type of trust (grantor

versus non-grantor), and other related issues. Let’s take a look at some of these other forms.

Foreign Grantor Trust Owner Statement

When a taxpayer is a grantor of a foreign trust, they are required to complete an additional form submitted with Form 3520-A referred to as a Foreign Grantor Trust Owner Statement. The form requires each US person owner of the trust to prepare their own statement unless the trustee already prepared a statement for them. They must identify information regarding the trust: if an agent was appointed, the portion of the trust deemed owned by the specific US person, and how much cash or other fair market value property was distributed to the owner.

Foreign Grantor Trust Beneficiary Statement

The trustee or the owner must also prepare a separate statement for each specific US beneficiary that had received a distribution from the trust. This form is similar to the foreign grantor trust owner statement, aside from the fact that it does not require as detailed an income breakdown that it does for the owner.

Exceptions to Filing Form 3520-A

Some taxpayers may be able to sidestep or circumvent the reporting requirements on Form 3520-A. The two main exceptions involve Revenue Procedure 2020–17 and Revenue Procedure 2014–55.

Revenue Procedure 2020-17

Revenue Procedure 2020–17 refers specifically to pension and other tax-deferred retirement and non-retirement savings. In reality, the IRS is not really seeking taxpayers who have an ownership interest in foreign pension plans or other deferred investments (that may technically qualify as a trust) to report the asset on Form 3520-A. Especially since these types of accounts are usually already reported on FATCA Form 8938 and the FBAR – and the IRS is seeking to minimize the heavy burden of duplicative reporting when possible.

Revenue Procedure 2014-55

Revenue Procedure 2014-55 deals specifically with RRSPs and RRIFs from Canada and specifically exempts these two types of retirement savings from having to be reported on Form 3520 or 3520-A as a foreign trust.

Current Year vs. Prior Year Non-Compliance

Once a taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist that specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs. Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain Streamlined Procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead of the Streamlined Procedures. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties

Endnotes

1. Golding & Golding, International Tax Lawyers - Sean M. Golding

Taxation of US Beneficiary Foreign Trust Income: an Overview

By: Sean M. Golding1

Golding & Golding explains the taxation and reporting requirements for US tax payers who are beneficiaries of foreign trusts, and focuses on non-Grantor non-US trusts.

Does a US Beneficiary of a Foreign Non-Grantor Trust Pay Taxes?

In general, the tax rules involving trusts are very complicated. That is because there are many different types of trusts — and depending on the specific type of trust, there may be complex tax rules at play. For example, when dealing with foreign trusts, there is an initial concern about the tax implications in the country where the trust was formed and/or where it is legally obligated to report. Then, taxpayers next have to determine if a US person is considered an owner, trustee, or beneficiary of the foreign trust. If so, the next issue is to evaluate whether or not the foreign trust is a grantor trust or non-grantor trust — and if any income is associated with the trust that could become subject to US tax. Let’s focus for the moment on a US beneficiary of a foreign non-grantor trust.

Common Foreign Non-Grantor Trust Scenario

A US person is originally from a foreign country in which one of their wealthy relatives created a foreign non-grantor trust to protect their foreign assets. The US person is named as one of the beneficiaries of the foreign trust and receives distributions from the trust. The question for US tax purposes is whether or not the beneficiary of the trust has to pay tax on the income distributions he received from the foreign non-grantor trust.

Non-Grantor vs. Grantor Trust Tax Implications

With a grantor trust, the grantor is still considered the owner of the trust for tax purposes — and any income of the trust is attributed to the grantor. Conversely, with a non-grantor trust, the initial settlor is no longer the owner of the trust, and therefore it is the trust/beneficiaries who receive the distributions that are required to pay tax on the income. This can come as a shock to many US beneficiaries of a foreign trust, because when they were residing overseas, they may have not been taxed at all on the income — since different countries operate differently when it comes to trust income and many countries have their own set of exceptions, exclusions, and limitations for taxing beneficiaries under a particular trust scheme.

Beneficiary Non-Grantor Trust Tax

When a US beneficiary receives a distribution from a foreign trust, it is reported on the individual’s own personal Form 1040 tax return . In a perfect world, the foreign trust will provide the US beneficiary with a K-1 or equivalent so that the taxpayer can report the income properly (and avoid various penalty situations in which the lack of a Foreign Non-Grantor Trust Beneficiary Statement can impact how the income is

treated for US tax purposes). The US beneficiary of a foreign non-grantor trust will also have to contend with the throwback rule and difference between DNI and UNI in their US tax return.

Forms 3520/3520-A Reporting

In addition to the tax implications of being a beneficiary of a foreign trust, the beneficiary must also file a Form 3520 in any year they receive a trust distribution. If they are considered an owner of the trust, more detailed Form 3520 and 3520A requirements may be necessary.

Current Year vs. Prior Year Non-Compliance

Once a taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist that specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs. Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain Streamlined Procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead of the Streamlined Procedures. But, if a willful taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties.

Endnotes

1. Golding & Golding, International Tax Lawyers - Sean M. Golding

HECKERLING REPORTS

The 57th annual Heckerling Institute on Estate Planning was held in January, 2023, presented by the University of Miami School of Law. Reports of each day’s sessions prepared by members of our Section are available here:

https://www.americanbar.org/content/dam/aba/events/ real_property_trust_estate/heckerling/heckerlinkg-reports-2023.pdf

SAVE THE DATE

August 10-11, 2023

Join the ABA Section of Real Property, Trust and Estate Law as we present a consolidated take on the ideal estate planning CLE program for both new and experienced lawyers. Young and transitioning lawyers new to the practice will receive an educational experience focused on the “how-to” of estate planning. The outstanding faculty includes experts in all aspects of estate planning and will cover a wide range of topics.

August 10-11, 2023 Chicago, IL

www.rpteskillstraining.com

Sponsored by the American Bar Association Section of Real Property, Trust & Estate Law

FELLOWSHIP OPPORTUNITY

The ABA Section of Real Property, Trust and Estate Law Fellows Program encourages the active involvement and participation of young lawyers in Section activities. The goal of the program is to give young lawyers an opportunity to become involved in the substantive work of the RPTE Section while developing into future leaders.

Each RPTE Fellow is assigned to work with a substantive committee chair, who serves as a mentor and helps expose the Fellow to all aspects of committee membership. Fellows get involved in substantive projects, which can include writing for an RPTE publication, becoming Section liaisons to the ABA Young Lawyers Division or local bar associations, becoming active members of the Membership Committee, and attending important Section leadership meetings.

www.americanbar.org/groups/real_property_trust_estate/ fellowships-and-awards/fellows/

Applications due June 23, 2023.

How to Ensure Your Estate Planning Practice Can Never Be Replaced by AI

By: Ali Katz1 NEW LAW BUSINESS MODEL

As we all know by now, AI is getting more and more powerful every day. Up until recently, it didn’t seem like a real threat. However, today chatGPT is creating content that’s sometimes even better than human created content, and certainly much faster. This is a problem for Estate Planning Lawyers, who generate much of their revenue from document preparation, at least if you do estate planning the traditional way. In a year or two, a client will be able to go online, interact with their AI, and say: “Draft me a trust.” The AI will ask a series of questions and put together everything the client needs.

Within the next 3-5 years, most clients won’t need an Attorney who only provides documents or even an attorney who sells documents plus financial products. Clients will be able to run numbers, create documents and buy insurance and make investments on their own. So, what can the smart and savvy Estate Planning Lawyer do to ensure they can never be replaced by AI? The solution is to provide an innovative, high-value service that can never be replaced by technology, but that uses technology to create so much efficiency for you that you can focus on the parts of your law practice that rely on your heart and soul to deliver.

Don’t Compete with DIY Solutions - Do This Instead

You do not need to compete with DIY solutions. Instead, you can become the go to authority for your ideal clients by helping them decide what they can do themselves, and what they should rely on a lawyer (like you) to do for them. And here’s how you can actually benefit from the online DIY services and even get referrals from them. First, become the authority for everyone in your market who needs estate planning help by offering regular educational talks on estate planning, and what people can do themselves, and what they need a lawyer to do for them. Then, leverage the search terms of people in your community searching for DIY solutions and run paid ads to your target market based on those search terms, promoting your educational presentation.

Your job is to become known as the authority, expert, educator and to focus your authority, expertise, and education on giving as much as you can freely to those who do not need or want intimate access and support from you.

By doing this, you’ll scoop up the clients who want the professional help of a trusted authority who is knowledgeable enough to offer education. Through the education of your community, you will make it clear that the next step for those who cannot or should not DIY is to move into more connection with you, leading into your intake and engagement system. When your engagement and enrollment process is easeful, it will show clients just how much stress you’ll take off their plate when they work with you.

Focus on Providing the Human Connection That AI Can’t Provide

People want an emotional connection with a personal lawyer who is going to help them with the most intimate family and financial matters during life and be there for their family when they can’t be. They want a lawyer who cares about them and their needs. If you want to keep, and grow, your book of business, you must provide your clients with the connection they want, expand your emotional IQ and offer a lifetime of relational support that can never be replaced by robots. Do this and you’ll never have to worry about AI replacing you.

Your humanity is the only non-replaceable technology you have, and you can invest in cultivating your next level relational skills. It’s very likely the best investment you can make in your law practice—use technology to get extremely efficient so you can have the time to create more connection with your clients.

“Your humanity is the only non-replaceable technology you have, and you can invest in cultivating your next level relational skills.”

Create a Revenue Model That Isn’t Dependent on Commissions, AUM or Legal Documents

Along with developing your relational skills, you need to get ready to shift your income model. If you’ve been operating as a “trust mill” style estate planning lawyer, selling wills and trusts or even insurance or investments, you’re going to be hardpressed to get clients who are willing to pay for any of that in the future, even if you’re only charging $1500 or $2000 per plan. Why would they do with you what they can do themselves online?

Many websites like FreeWill.com and LifeLegacy.io already provide free legal documents. So what will you provide that’s different? When you return to the heart and soul of “lawyer as trusted advisor,” and have a financial model for your law practice that pays you to guide your clients throughout life and guide their family beyond their lifetime, your clients will happily pay you $4k-$6k up front on average. Then, when you set your practice up with systems you can receive hundreds to thousands a year per client throughout their life to maintain their plan, and then their family will hire you to provide guidance after their death.

This is what we guide our Personal Family Lawyer (PFL) law firms to do. If you become a PFL, you’ll discover a better revenue model, better service deliverables, better engagement strategies, and very likely, a whole new way of being YOU. The great news is, once you decide to embrace this change, you’re going to love your life and law practice a whole lot more. It’s the true fulfillment of why you went to law school in the first place. And you’ll discover a way to be a lawyer that is truly fulfilling, financially, emotionally, and spiritually, and can never be replaced by robots.

Endnotes

1. Ali Katz (former name, Alexis Martin Neely) is the Founder/ CEO of New Law Business Model, and the author of two bestselling books, Wear Clean Underwear: A Fast, Fun, Friendly - and Essential - Guide to Legal Planning for Busy Parents, and The New Law Business Model Revealed: Build a Lucrative Law Practice That You (and Your Clients) Love

Learn more at www.NewLawBusinessModel.com

Business Planning Group

The Business Planning Group (BPG) addresses trust and estate planning and administration for closely held entity owners via its three committees. The Investment Entities Committee focuses on investment vehicles, including family limited partnerships, family LLCs and private investment funds—such as hedge funds, private equity and venture capital. The Farmers, Ranchers and Natural Resources Committee focuses on the planning and administration issues specifically associated with those asset classes. The Operating Businesses Committee focuses on the challenges that are unique to business owners including business succession planning, liquidity planning, and entity taxation.

BPG members contribute to RPTE’s National CLE Conference, eCLEs and publications. In addition, BPG members monitor proposed legislation, regulations, and guidance, and offers comments on changes that may affect entity owners—including with respect to the Corporate Transparency Act taking effect at the beginning of next year. We discuss these topics and more on BPG’s monthly open Zoom meetings. Join the Business Planning Group to receive calendar invitations for monthly calls and other outreach from the group.

https://www.americanbar.org/groups/real_property_trust_estate/committees/ trust-estate-committees/

Charitable Planning and Organizations Group

The Charitable Planning and Organizations Group is an active and diverse group of private practitioners (including both specialists and trust and estate attorneys who enjoy advising the charitably inclined client), counsel for trustees, foundations, and other charitable organizations, and law professors. The Group sponsors educational quarterly calls and in September the Group heard from Jane Zhao, who spoke to the group about the planning opportunities presented in the Patagonia founder’s gift of his entire interest in the company to a 501(c)(4) organization and a purpose trust. For its January call the Group hosted a panel of experts from the National Association of Charitable Gift Planners and the American Council on Gift Annuities to discuss the Secure Act 2.0 and charitable gift planning in the new year.

The Group is presenting a panel at the Spring National CLE Conference on related party transactions in private foundation. In conjunction with the Spring Conference in Washington, D.C, the leaders of the Group are also organizing its annual meeting with the Department of Treasury to discuss legal and regulatory issues of interest to the Group. Group members are also busy writing articles on charitable planning and charitable organizations topics for RPTE publications as well as a new edition of the book “Charitable Gift Planning: A Practical Guide for the Estate Planner.”

https://www.americanbar.org/groups/real_property_trust_estate/committees/ trust-estate-committees/

Committee Calls March 2023

REAL ESTATE FINANCE GROUP

March 1, 1p.m. CT

Join Zoom Meeting

https://americanbar.zoom.us/j/95318709145?pwd=U1NldVlGNUpycnQrQWxPeGlDeHRXdz09

Meeting ID: 953 1870 9145

Passcode: 694404

888 475 4499 US Toll-free

877 853 5257 US Toll-free

JOINT LAW PRACTICE MANAGEMENT GROUP

March 7, 12p.m. CT

Join Zoom Meeting

https://americanbar.zoom.us/j/97678334395?pwd=OGV1TWx1SHBtVnRUVkl1Uyt2VUViUT09

Meeting ID: 976 7833 4395

Passcode: 005551

888 475 4499 US Toll-free

877 853 5257 US Toll-free

MORTGAGE LENDING COMMITTEE

March 14, 9a.m CT

Join Zoom Meeting

https://americanbar.zoom.us/j/98806692494?pwd=VjBsN24xYXBjSlNqSkczaE1XaUFXQT09

Meeting ID: 988 0669 2494

Passcode: 686641

877 853 5257 US Toll-free

888 475 4499 US Toll-free

BUSINESS PLANNING GROUP

March 15, 11a.m. CT

Join Zoom Meeting

https://schiffhardin.zoom.us/j/3122585522

Meeting ID: 312 258 5522

877 853 5257 US Toll-free

888 475 4499 US Toll-free

ELDER LAW AND SPECIAL NEEDS PLANNING GROUP

March 21, 3p.m. CT

Join Zoom Meeting

https://americanbar.zoom.us/j/97982863270?pwd=OVNBQXpQZnIwSnA0bkR6U0lGVTRyQT09

Meeting ID: 979 8286 3270

Passcode: 220818

877 853 5257 US Toll-free

888 475 4499 US Toll-free

LAND USE AND ENVIRONMENTAL GROUP

March 23, 2p.m. CT

Join Zoom Meeting

https://americanbar.zoom.us/j/97968854761?pwd=WWg0MEJoTjhSOGQzUEpjSW1LQXhkQT09

Meeting ID: 979 6885 4761

Passcode: 956923

888 475 4499 US Toll-free

877 853 5257 US Toll-free

Legal Education and Uniform Laws Group

The Legal Education and Uniform Laws Group works across the spectrum of property law on subjects of interest to either the Real Property Division or the Trusts and Estates Division that involve the teaching of property law or the development of uniform state laws. The Legal Education Committee informs law professors of current practices in real property, trusts and estates; advises practitioners on real property, trusts and estates law scholarship issues; and provides opportunities for members to participate in publication projects. The Uniform Laws Committee is responsible for monitoring, reviewing, and promoting uniform state laws involving the law of real property, trusts and estates. The committee reports to the RPTE section council on current projects of the Uniform Law Commission (ULC), and provides recommendations and assistance to the two boards that monitor and review uniform laws. This committee also often sponsors CLE programming on uniform laws in development or recently approved. The Group welcomes a wide range of involvement, including in the classroom and in the promotion of uniform laws where appropriate.

https://www.americanbar.org/groups/real_property_trust_estate/committees/jointgroups/

Real Estate Financing Group

The Real Estate Financing Group is devoted to assisting attorneys in financing techniques involving real estate as collateral. To this end, this group presents educational programs and produces written materials to educate lawyers in all aspects of real estate finance. Separate committees within this group are dedicated to mortgage lending, construction lending, securitizations and legal opinions issued in connection with these financings, as well as legal issues and developments in real estate workouts, foreclosures and bankruptcies.

https://www.americanbar.org/groups/real_property_trust_estate/committees/real-property-committees/real-estate-financing-group/

35TH ANNIVERSARY CELEBRATION AT THE NATIONAL MUSEUM OF AFRICAN

AMERICAN HISTORY AND CULTURE

Conference attendees will have private access to the only national museum devoted exclusively to the documentation of African American life, history, and culture, with over 40,000 artifacts.

35th Annual RPTE National CLE Conference

www.rptecleconference.com

CALLING ALL LAW STUDENTS!

The Section of Real Property, Trust and Estate Law is now accepting entries for the 2023 Law Student Writing Contest. This contest is open to all J.D. and LL.M students currently attending an ABA-accredited law school. It is designed to encourage and reward law student writing on real property or trust and estate law subjects of general and current interest.

1st Place

$2,500 award

2nd Place

$1,500 award

3rd Place

$1,000 award

n Free round-trip economy-class airfare and accommodations to attend the RPTE National CLE Conference. This is an excellent meeting at which to network with RPTE leadership! (First place only.)

n A full-tuition scholarship to the University of Miami School of Law’s Heckerling Graduate Program in Estate Planning OR Robert Traurig-Greenberg Traurig Graduate Program in Real Property Development for the 2023-2024 or 20242025 academic year.* (First place only.)

n Consideration for publication in The Real Property, Trust and Estate Law Journal, the Section’s law review journal.

n One-year free RPTE membership.

n Name and essay title will be published in the eReport, the Section’s electronic newsletter, and Probate & Property, the Section’s flagship magazine.

Contest deadline: May 31, 2023

Visit the RPTE Law School Writing Competition webpage at ambar.org/rptewriting.

*Students must apply and be admitted to the graduate program of their choice to be considered for the scholarship. Applicants to the Heckerling Graduate Program in Estate Planning must hold a J.D. degree from an ABA accredited law school and must have completed the equivalent of both a J.D. trusts and estates and federal income tax course. Applicants to the Robert Traurig-Greenberg Traurig Graduate Program in Real Property Development must hold a degree from an ABA accredited law school or a foreign equivalent non-US school.

https://ambar.org/taxationfundingrpte

Learn about Section of Real Property, Trust and Estate Law’s eReport

The eReport is the quarterly electronic publication of the American Bar Association Real Property, Trust and Estate Law Section. It includes practical information for lawyers working in the real property and estate planning fields, together with news on Section activities and upcoming events. The eReport also provides resources for seasoned and young lawyers and law students to succeed in the practice of law.

For further information on the eReport or to submit an article for publication, please contact Robert Steele(Editor), Cheryl Kelly (Real Property Editor), Raymond Prather (Trust and Estate Editor), or RPTE staff members Bryan Lambert or Monica Larys. Are you interested in reading FAQs on how to get published in the eReport? Download the FAQs here. We welcome your suggestions and submissions!

FREQUENTLY ASKED QUESTIONS BY PROSPECTIVE AUTHORS RTPE eReport

What makes eReport different from the other Section publications? The most important distinction is that eReport is electronic. It is delivered by email only (see below) and consists of links to electronic versions of articles and other items of interest. Since eReport is electronic, it is flexible in many ways.

How is eReport delivered and to whom?

eReport is delivered quarterly via email to all Section members with valid email addresses. At the ABA website, www.americanbar.org, click myABA and then navigate to Email, Lists and Subscriptions. You have the option of receiving eReport. Currently almost 17,000 Section members receive eReport.

What kind of articles are you looking for?

We are looking for timely articles on almost any topic of interest to real estate or trust and estate lawyers. This covers anything from recent case decisions, whether federal or state, if of general interest, administrative rulings, statutory changes, new techniques with practical tips, etc.

How long should my article be?

Since eReport is electronic and therefore very flexible, we can publish a two page case or ruling summary, and we can publish a 150 page article. eReport is able to do this since the main page consists of links to the underlying article, therefore imposing no page restraints. This is a unique feature of eReport.

How do I submit an article for consideration?

Email either a paragraph on a potential topic or a polished draft – the choice is yours – to the Editor, Robert Steele, at rsteele@ssrga.com , and either our Real Estate Editor, Cheryl Kelly, at ckelly@thompsoncoburn.com , or our Trust and Estate Editor, Raymond Prather, at ray@pratherebner.com

Do I need to have my topic pre-approved before I write my submission?

Not required, but the choice is yours. We welcome topic suggestions and can give guidance at that stage, or you may submit a detailed outline or even a full draft. You may even submit an article previously published (discussed below) for our consideration.

Do citations need to be in formal Bluebook style?

eReport is the most informal publication of the Section. We do not publish with heavy footnotes and all references are in endnotes. If there are citations, however, whether to the case you are writing about, or in endnotes, they should be in proper Bluebook format to allow the reader to find the material. Certainly you may include hyperlinks to materials as well.

Can I revise my article after it is accepted for publication?

While we do not encourage last minute changes, it is possible to make changes since we work on Word documents until right before publication when all articles are converted to pdf format for publication.

What is your editing process?

Our Editor and either the Trust and Estate Editor or the Real Estate Editor work together to finalize your article. The article and the style are yours, however, and you are solely responsible for the content and accuracy. We will just help to polish the article, not re-write it. Our authors have a huge variety of styles and we embrace all variety in our publication.

Do I get to provide feedback on any changes that you make to my article?

Yes. We will email a final draft to you unless we have only made very minor typographical or grammatical changes.

Will you accept an article for publication if I previously published it elsewhere?

YES! This is another unique feature of eReport. We bring almost 17,000 new readers to your material. Therefore, something substantive published on your firm’s or company’s website or elsewhere may be accepted for publication if we believe that our readers will benefit from your analysis and insight. In some cases, articles are updated or refreshed for eReport. In other cases, we re-publish essentially unchanged, but logos and biographical information is either eliminated or moved to the end of the article.

How quickly can you publish my article?

Since we publish quarterly, the lead time is rarely more than two months. If you have a submission on a very timely topic, we can publish in under a month and present your insights on a new topic in a matter of weeks.