Trusts are often treated as a conduit, with income flowing through the trust to the beneficiaries. (see generally Subchapter J of Chapter 1 of the Internal Revenue Code and specifically Code §§651 thru 662). The income received by a beneficiary retains the same character in the hands of the beneficiary as in the hands of the trust. Code §§652(b) and 662(b). Attribution rules often apply to treat the beneficiaries of the trust as the owners of certain types of assets of the trust (e.g., Code §§318(a)(2)(B) and 958(b)).
A trust may own shares in a passive foreign investment company (“PFIC”). A PFIC is generally defined as a foreign corporation if 75% or more of its gross income for the taxable year consists of passive income, or 50% or more of its assets consists of assets that produce, or are held for the production of, passive income. Code §1297(a).
Code §1298(a)(3) states:
Stock [of a PFIC] owned, directly or indirectly, by or for a partnership, estate, or trust shall be considered as being owned proportionately by its partners or beneficiaries.
Under this general rule, the beneficiary of a trust that owns PFIC stock will be treated as though he or she owns the PFIC stock directly. This is consistent with the general treatment of trusts, where the character of trust income flows through to the beneficiary.
“Opaque” Doctrine for Employee Trusts
As stated above, Code §§652(b) and 662(b) generally provide that income received by a beneficiary retains the same character in the hands of the beneficiary as in the hands of the trust. Beneficiaries of employees’ trusts are not subject to this general rule.
Treas. Reg. §1.641(a)-0(b) provides in part:
Subparts A, B, C, and D (section 641 and following), Part I, Subchapter J, Chapter 1 of the Code, relate to the taxation of estates and trusts and their beneficiaries. * * * These subparts have no application to beneficiaries of nonexempt employees' trusts. See section 402(b) and the regulations thereunder.
Under this regulation, Code §§652(b) and 662(b) do not apply to beneficiaries of nonexempt employees’ trusts, because those sections are included in Subparts B and C, respectively, of Subchapter J. Thus, the character of any income earned by a nonexempt employees’ trust does not flow through to the beneficiary upon distribution from the trust. Instead, the income is taxed to the beneficiary under the rules of Code §402(b).
Rev. Rul. 74-299 is also consistent with Treas. Reg. §1.641(a)-0(b), noting:
For the purpose of determining the taxability of beneficiaries of employees’ trusts that are not exempt from tax under section 501(a) of the Code, the specific provisions of section 402(b) apply, rather than the general provisions of section 662(a). In the instant case, the fact that the provisions of section 662(a) do not apply to the employee, as beneficiary of the trust, does not preclude the application of the provisions of section 661(a) to the trust itself.
Code §661(a) applies to the trust in this revenue ruling, because Treas. Reg. §1.641(a)-0(b) only removes the applicability of Subparts A, B, C, and D for the beneficiaries of nonexempt employees’ trusts. Thus, when such an employees’ trust makes a distribution, the trust itself is able to claim a deduction for the distribution under Code §661(a).
In reaching its conclusion, Rev. Rul. 74-299 used one of the basic rules of statutory interpretation, i.e., a general rule will govern when there is no more specific rule. Using the same rationale, the general rule in Code §1298(a)(3), which attributes PFIC stock owned by a trust to the trust’s beneficiaries, should not apply when there are more specific rules in Code §402(b) and Treas. Reg. §1.641(a)-0(b) for employees’ trusts.
Code §1298(a)(3) is written very generally. It is titled “Partnerships, Etc.,” and states that there is attribution of ownership of PFIC stock from a partnership, estate, or trust to its partners or beneficiaries. However, an employees’ trust is not the typical trust. As stated above, there is a specific rule that governs how a beneficiary of an employees’ trust is taxed. The same rule effectively renders nearly all of Subchapter J (which governs trusts) inapplicable to beneficiaries of employees’ trusts. Treas. Reg. §1.641(a)-0(b). Consequently, Code §1298(a)(3), which very generally addresses trusts, likely does not apply to an employees’ trust. PFIC stock owned by an employees’ trust, therefore, is likely not treated as being owned by the beneficiary of the employees’ trust.
For convenience purposes, we will refer to the non-flow through nature of employees’ trusts together with the inapplicability of Code §1298(a)(3) as the “Opaque Doctrine” of employee trusts.
Foreign Pensions as Employees’ Trusts
Most foreign pension plans are likely characterized as trusts for U.S. tax purposes. Neither the statute nor the regulations define the term “employees’ trust.” However, if a foreign pension (i.e., the trust): (i) was created by a foreign employer, (ii) is administered by the foreign employer, and (iii) is more than half funded by the foreign employer, it seems likely that the foreign pension/trust would be considered an “employees’ trust.” Code §402(b).
Note that a portion of the trust may not be treated as an employees’ trust if the employee contributions have been more than the employer contributions. Treas. Reg. §1.402(b)-1(b)(6). In this case, the trust is bifurcated and the portion related to the employee contributions is treated as a grantor trust and the portion related to the employer contributions is treated as an employees’ trust. Id.
As described above, the character of income earned by an employees’ trust does not pass from the trustee to the beneficiary upon distribution. Instead, Code §402(b)(2) provides that distributions from employees’ trusts are taxable under Code §72 (relating to annuities). Code §1298(a)(3) likely does not apply to an employees’ trust, so a beneficiary of an employees’ trust is likely not treated as owning any PFICs that are owned by the trust. As a result, a beneficiary of an employees’ trust likely does not have to file a Form 8621 either under the annual filing requirements (Code §1298(f)) or for any other reason, i.e., indirect disposition of the PFIC, excess distribution, etc.
Of course, the Opaque Doctrine would not apply to the extent that the employees’ trust was treated as a grantor trust under Treas. Reg. §1.402(b)-1(b)(6). Under the grantor trust rules, the income earned by the trust is treated as directly earned by the grantor and the assets held by the trust are treated as held directly by the grantor. When a foreign pension that holds PFICs is either partially or wholly treated as a grantor trust, Form 8621 must generally be filed on an annual basis.