18 October 2019 - Article
The IRS has issued final regulations requiring certain domestic corporations, partnerships, and trusts to file Form 8938 to report specified foreign financial assets. The regulations went into effect on February 23, 2016, and apply to taxable years beginning after December 31, 2015. Failure to timely file Form 8938 may result in a maximum penalty of up to $60,000.
Section 6038D of the Internal Revenue Code, which was enacted in 2010 as part of the Foreign Account Tax Compliance Act (FATCA), requires individuals to report to the IRS interests in specified foreign financial assets by attaching Form 8938 to their annually filed federal income tax returns. Under § 6038D(f), the Department of Treasury and IRS are authorized to extend the Form 8938 filing requirements to “any domestic entity which is formed or availed of for purposes of holding, directly or indirectly, specified foreign financial assets.” Proposed regulations were published in December 2011, however, until now, only individuals were required to file Form 8938.
After consideration of various comments from practitioners, the Treasury Department and the IRS adopted proposed Reg. § 1.6038D-6 with few modifications. Most significantly, the final regulations simplify the process for determining which domestic entities must report specified foreign financial assets on a Form 8938. A brief summary of the changes adopted in the final regulations is provided below:
Clarification of Application of Reporting Threshold
Under the proposed regulations, a multi-prong test was used to determine if an entity was a “specified domestic entity” subject to a potential filing obligation. Under the test, in addition to satisfying other factors, an entity must have an interest in certain specified foreign assets that exceeded a reporting threshold. Once it was determined that an entity satisfied the definition of specified domestic entity, the same reporting threshold was applied to determine whether the entity had a filing obligation. That is, the reporting threshold was applied twice in determining an entity's § 6038D reporting responsibilities. The final regulations eliminate the application of the reporting threshold in determining whether an entity is treated as a specified domestic entity.
Elimination of the Principal Purpose Test
The proposed regulations provided that a corporation or partnership is treated as formed or availed of for purposes of holding, directly or indirectly, specified foreign financial assets if either: 1) At least 50% of its gross income or assets is passive; or 2) At least 10% of its gross income or assets is passive and the entity is formed or availed of by a specified individual with a principal purpose of avoiding § 6038D.
The new rules make it simpler to determine if an entity is a specified domestic entity by eliminating the principal purpose test for determining whether a corporation or partnership is a specified domestic entity. The “principal purpose” was a subjective test determined by the facts and circumstances. The final regulations allow taxpayers to rely on the objective 50% passive income or assets test to determine their reporting requirements under § 6038D.
Defining Passive Income
The final regulations also clarify the definition of passive income. The proposed regulations listed specific items that were defined as passive income for purposes of § 6038D. The final regulations are intended to define passive income consistent with the definition found in IRC § 1472, which was also enacted as part of FATCA. Both § 1472 and § 6038D use the definition of passive income to identify entities that have a high risk of being used for tax evasion and to reduce the compliance burden for active entities. Accordingly, the final regulations found in Reg. § 1.6038D-6(b)(2) largely mirror the definition of passive income set forth in Reg. § 1.1472-1©(1)(iv).
More specifically, final Reg. § 1.6038D-6(b)(2) adopts the following modifications of the definition of “passive income” from the § 1472 regulations:
1) Clarifies that “dividends” includes substitute dividends, and expands “interest” to cover income equivalent to interest, including substitute interest;
2) Adds a new exception for certain active business gains or losses for the sale of commodities;
3) Defines notional principal contracts by adding a reference to Reg. § 1.446-3©(1); and
4) Excludes from the definition of passive income rents or royalties derived in the active conduct of a trade or business conducted at least in part by employees of the entity.
Additionally, the final regulations adopt a rule found in the § 1472 regulations to provide guidance concerning how to determine whether 50% of an entity's assets are passive assets. Under the regulations, a weighted average test is used, and an entity may use the fair market value or of book value to determine the value of its assets.
Under the final regulations, a trust is a specified domestic entity if the trust has one or more specified persons as a current beneficiary. A current beneficiary is defined as any person who at any time during the taxable year is entitled to, or may receive, a distribution from the principal or income of the trust. The final regulations clarify that the term current beneficiary also includes any holder of a general power of appointment, whether or not exercised, that was exercisable at any time during the taxable year, but does not include any holder of a general power of appointment that is exercisable only on the death of the holder.