Rost v. United States: Each Stiftung Must Be Analyzed on Its Own Facts and Circumstances

By: Halley Hu1

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Are stiftungs foreign trusts? The Fifth Circuit’s recent decision in Rost v. United States provides helpful considerations for practi tioners when advising clients with stiftungs

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On August 11, 2022, the Fifth Circuit in Rost v. United States (“Rost”)2 ruled in favor of the government, holding that (1) the Liechtenstein stiftung3 at issue was correctly classified as a foreign trust based on the facts and circumstances, and (2) the existing legal framework for determining whether an arrangement is a for eign trust is sufficiently precise and provides ample notice to the taxpayer. The overall framework and specific factors laid out in Rost provide helpful considerations for practitioners when advis ing clients with stiftungs

How We Got Here

The taxpayer was a US citizen who formed a stiftung under the laws of Liechtenstein in 2005 (“Stiftung”). He made transfers of $2 million and $1 million to the Stiftung in 2005 and 2007, respec tively, but did not report to the IRS the creation of the Stiftung or the subsequent transfers until 2013.

In 2014, the IRS assessed $1,380,252 in penalties against the tax payer for his late filing of Form 35204 and Form 3520-A.5 The penalty for failure to file a timely and complete Form 3520 is the greater of $10,000 or 35% of the “gross reportable amount.”6 The penalty for failure to file a timely and complete Form 3520-A is the greater of $10,000 or 5% of the gross value of the portion of the trust for which the taxpayer is the deemed owner.7

The taxpayer contested the penalties, and the IRS Appeals Office reduced the penalties by half. The taxpayer paid the penalties, as adjusted, and then filed an administrative refund claim with the IRS in 2018. In 2019, the taxpayer filed a refund action in the appropriate district court, claiming that the Stiftung was not a trust and that the penalties imposed violated the Due Process Clause under the Administrative Procedure Act (APA).8 When the taxpayer passed away in late 2019, his executor, Daphne Jeanette Rost, was substituted as plaintiff. The district court granted sum mary judgment for the government; the plaintiff appealed, and the Fifth Circuit ultimately affirmed the district court’s decision.

The Decision

The questions presented to the district court, and reviewed de novo by the Fifth Circuit, were (1) whether the Stiftung was cor rectly classified as a foreign trust and (2) whether the taxpayer had sufficient notice of the classification and the related penalties. The Fifth Circuit concluded that (1) the district court correctly classified the Stiftung as a foreign trust, and (2) the plaintiff’s argu ment of insufficient notice was without merit.

Classification of a foreign trust is a two-part inquiry. The first part determines whether the entity is a trust9 or a business enti ty.10 Morrissey v. Commissioner is the seminal case setting out the facts-and-circumstances approach to determining whether an arrangement constitutes a trust or a business association.11 In Morrissey, the Supreme Court found that the “trust” at issue was “analogous to a corporate organization” because it had distinctly corporate features, such as centralized management and limita tion of personal liability for participants. Based on the corporate features of the arrangement, the Supreme Court in Morrissey con cluded that the arrangement qualified as an “association” rather than a trust. Other courts have since followed a similar approach in applying the facts-and-circumstances analysis when classifying entities.12

The Fifth Circuit adopted the approach set out in Morrissey and other cases and focused on the “nature, purpose, and operations” of the Stiftung when determining whether it qualified as a trust. In applying the facts-and-circumstances test, the Fifth Circuit looked specifically to the Stiftung’s organizing documents and found the Stiftung had numerous characteristics of a trust, including:

• Presence of familial purpose – the Stiftung was organized with the specific purpose of supporting its beneficiaries (who were the taxpayer’s family members)

• Lack of business objective – the Stiftung was prohibited from conducting commercial trade

• Bar on commercial activity – the Stiftung’s organizing documents specifically prohibited it from conducting commercial trade

• Form of organization, including

• • Governed by Liechtenstein’s “Act on Trust Enterprises”

• • Board members functioned as independent trustees

• • Presence of beneficiaries

• • Beneficiaries’ lack of involvement with, and knowl edge of, the Stiftung

• • Lack of profit-sharing provision

Based on these factors, the Fifth Circuit concluded that both the Stiftung’s purpose and its form of organization supported its clas sification as a trust.

If the entity is a trust, the second part of an inquiry considers whether the trust is domestic or foreign. To determine whether the Stiftung was a domestic or foreign trust, the Fifth Circuit applied the court test and the control test.13 A trust is domestic if it passes both the court test and the control test. The court test looks at whether a US court may “exercise primary supervision over the administration of the trust.” The Stiftung failed the court test because it was exclusively governed under Liechtensteinian law. The control test looks at whether one or more US persons “have the authority to control all substantial decisions of the trust.” The Stiftung also failed the control test because its board, which consisted entirely of foreign persons, had decision-mak ing authority. The Fifth Circuit concluded the Stiftung was “not a domestic trust and so qualifie[d] as a foreign trust.”

The Fifth Circuit further concluded that the plaintiff’s notice arguments were without merit. Building on the facts-and-circum stances test, the court rejected the plaintiff’s argument that there was “insufficient notice” for the Stiftung classification and that the penalties “violate the duty of clarity for tax laws.” The plaintiff first argued that there is no “notice and comment that [stiftungs] are foreign trusts for tax purposes.” The plaintiff further argued that the penalties imposed “violated the duty of clarity” because there was no “clear description of the prohibited circumstances, facts or status.” Both arguments, the Fifth Circuit explained, were predicated upon the “false presumption” that the Stiftung is auto matically treated as a foreign trust. The Fifth Circuit emphasized that there is no such specific “rule”; rather, “under certain facts and circumstances” a stiftung could be classified as something other than a trust. However, the evidence in Rost did not support such a conclusion.

Addressing the plaintiff’s final argument, the Fifth Circuit noted that the IRS “is not obligated to promulgate a regulation listing all foreign entities that are or may be classified as a foreign trust.” The case law on the facts-and-circumstances approach, combined with the existing legal framework, “are sufficiently precise,” the Fifth Circuit concluded. On September 26, 2022, the plaintiff filed a petition for rehearing en banc, which was subsequently denied on October 12, 2022.

Takeaways

Rost is the latest development on the classification of stiftungs for US tax purposes. The landmark case involving classification of stiftungs is Estate of Swan v. Commissioner, 14 in which the Tax Court examined whether stiftungs created by a US decedent were sub ject to US estate tax. The Tax Court in Estate of Swan took a similar facts-and-circumstances approach and focused on the “essence of the foreign organization, [and] its functional features.” Since 1955 when Estate of Swan was decided, stiftungs have been examined on several other occasions.15 In each case, a facts-and-circumstances approach was followed, focusing on the purpose, organization and function of the stiftungs. The Fifth Circuit’s analysis and ulti mate holding in Rost further supports the groundwork laid by Estate of Swan.

Rost serves as a reminder that timely and accurate entity classi fications are critical, especially for clients with foreign entities. Foreign entities, such as stiftungs, may be subject to US reporting obligations, regardless of whether they constitute trusts or asso ciations. As noted in Rost, an interest in a foreign trust is subject to US information reporting (and is sometimes subject to US income tax). Likewise, interests in foreign associations may be reportable. In some instances, foreign associations may be treated as foreign corporations.16 US persons holding interests in for eign corporations may be impacted by anti-deferral tax regimes (e.g., controlled foreign corporation and passive foreign invest ment company considerations) and face additional reporting obligations. Failure to identify and comply with such reporting requirements, timely and accurately, could result in significant penalties to the taxpayers.

Acknowledgement

I would like to thank my colleagues from Ernst & Young for their generous support in making this article possible: Caryn Friedman, Dianne Mehany, Anthony Nitti, and Justin Ransome.

Endnotes

1.Halley Hu is a manager in the Private Client Services department, National Tax, at Ernst & Young LLP. The views expressed in this article are those of the author and do not necessarily represent the views of Ernst & Young LLP or other members of the global EY organization.

2. Rost v. United States, 44 F.4th 294 (5th Cir. 2022)

3. Stiftung is a German word that translates to “foundation, establishment, donation, [or] endowment.” https://www.collinsdictionary.com/ us/dictionary/german-english/stiftung.

4. Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts

5. Annual Information Return of Foreign Trust With a U.S. Owner

6. § 6677(a), as amended by the Hiring Incentives to Restore Employment (HIRE) Act of 2010, Pub. L. No. 111-147, § 535, to add the minimum dollar amount, effective for notices and returns required to be filed after 2009. Additional penalties may apply if failure persists after the IRS notifies the taxpayer by mail.

7. § 6677(b), § 6677(c)(2), as amended by the HIRE Act, Pub. L. No. 111-147, § 535, to add the minimum dollar amount, effective for notices and returns required to be filed after 2009. Additional penalties may apply if failure persists after the IRS notifies the taxpayer by mail. Criminal penalties may also be imposed if the failure to file or false failing was due to fraud.

8. 5 USC § 551 et seq. (1946)

9. See § 7701(a)(30)(e), (31)(B); Treas. Reg. § 301.7701-4

10. See Treas. Reg. § 301.7701-2, § 301.7701-3

11. Morrissey v. Commissioner, 296 U.S. 344 (1935)

12. See Swanson v. Comm’r, 296 U.S. 362 (1935); Helvering v. Cole man-Gilbert Assocs., 296 U.S. 369 (1935); Helvering v. Combs, 296 U.S. 365 (1935)

13. See § 7701(a)(30)(E)

14. Estate of Swan v. Commissioner, 24 T.C. 829 (1955)

15. See Berik Stiftung v. Plains Marketing, LP, 603 F.3d 295 (5th Cir. 2010); United States v. Garrity, 121 AFTR 2d 2018-1976 (D.C. Conn. 2018); Kraus v. Commissioner, 59 T.C. 681 (1973); PLR 200226012, PLR 200302005, and 200901023; Chief Counsel Advice AM-2009-012 (2009)

16. Treas. Reg. § 301.7701-3(b)(2)(i)(B)

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