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Considerations for Underlying Foreign Corporations

by Sanford H. Goldberg
Published: April 30, 2001
Source: ALI-ABA Estate Planning Course Materials Journal

Unless otherwise indicated, all section references are to the Internal Revenue Code ("IRC"). "ABA" refers to the American Bar Association; "Act," to the Investment Company Act of 1940, 15 U.S.C. Search7RH80a-1 et seq.; "ALI," to The American Law Institute; "CFC," to controlled foreign corporation; "E&P," to earnings and profits; "FIC," to foreign investment company; "FPHC" to foreign personal holding company; "FPHCI," to foreign personal holding company income; "IRS," to Internal Revenue Service; "NYSBA Report" to the New York State Bar Association, Tax Section, Special Comm. on Attribution Rules, Report on Proposal for the Simplification of Stock Attribution Rules (1980)); "PFIC" to passive foreign investment company; and "QEF" to qualified electing fund.

  1. Summary of Antideferral Regimes

1. The United States taxes U.S. persons on their worldwide income (i.e., their combined foreign and U.S. source taxable income), granting a foreign tax credit that generally allows U.S. taxpayers to reduce the U.S. tax on their foreign income by the foreign income taxes they pay on that income. IRC Search7RHSearch7RH61 and 901. U.S. persons owning stock in corporations are generally not subject to U.S. tax on the income of the corporation until dividends are paid to them. However, the income of certain types of foreign corporations is taxed to its U.S. shareholders when the corporation earns the income, regardless of whether and when dividends are actually paid. These provisions ("antideferral regimes") usually eliminate deferral of tax for passive types of income and income from certain related party transactions provided that a shareholder requirement and an income requirement are satisfied. This outline will focus principally on the shareholder requirements. An additional antideferral regime applies to U.S. shareholders of certain foreign corporations that satisfy an income requirement, regardless of the aggregate amount of U.S. ownership. U.S. shareholders of a foreign corporation subject to this regime generally must either elect to be taxed currently on all of the foreign corporation’s income or pay an interest charge when they receive certain dividends on, or dispose of shares of the foreign corporation.

2. A 10 percent U.S. shareholder of a CFC must include in gross income for each year that U.S. shareholder’s pro rata share of the CFC’s "subpart F income," whether the income is repatriated or not. Search7RH951. A foreign corporation is a CFC if over half the company is owned by a few U.S. persons. Even if a foreign corporation is a CFC, the U.S. shareholder will not be subject to current adverse tax consequences if the foreign corporation does not earn any "subpart F income."

a. A foreign corporation is a CFC if more than 50 percent (by vote or value) of the stock of the corporation is directly or indirectly owned by "United States shareholders." Indirect ownership may result from "constructive ownership" or "attribution" rules. These rules operate to prohibit taxpayers from transferring stock to family members or closely-held entities ("relatives"), to avoid various ownership thresholds that trigger adverse tax consequences, by treating stock owned by another as though it were actually owned by the taxpayer. They provide that stock owned directly by a foreign corporation, foreign partnership, or foreign trust is treated as actually owned by its shareholders, partners, or beneficiaries in proportion to their respective ownership interests in the entity. A "United States shareholder" is a United States person who owns (or is considered as owning by applying the attribution rules) 10 percent or more of the total combined voting power of all classes of stock entitled to vote. A United States person is a citizen or resident of the United States, a domestic partnership, a domestic corporation, and any estate or trust other than a foreign estate or trust.

b. Subpart F income includes certain insurance income and "foreign base company income," which is defined to include FPHCI, "foreign base company sales income," "foreign base company services income," "foreign base company shipping income," and "foreign base company oil related income."

c. A shareholder’s pro rata share of subpart F income is the amount that would have been distributed as a dividend with respect to the stock that the shareholder directly or indirectly owns if, on the last day of the taxable year, the CFC distributed all of its subpart F income pro rata to its shareholders. However, the subpart F income of any CFC for any taxable year cannot exceed the earnings and profits of the CFC for that taxable year.

d. If an amount would be included in the gross income of a United States shareholder under subpart F and under the rules relating to taxation of a foreign personal holding company, that amount is included in the gross income of the shareholder under subpart F only. If an amount would be included in the gross income of a United States shareholder under subpart F and under the rules relating to taxation of a passive foreign investment company, that amount is taxable only under subpart F. In other words, the subpart F rules take precedence over the FPHC rules and the PFIC rules.

e. Section 1248 provides that if a U.S. person sells or exchanges stock in a foreign corporation (or if a U.S. person receives a distribution from a foreign corporation treated as in exchange for stock); and that person owns, or is considered as owning, 10 percent or more of the voting power at any time during the five-year period ending on the date of the sale or exchange when the corporation was a CFC, then the gain recognized on the sale or exchange of the stock is included in the gross income of that person as a dividend, to the extent of E&P of the foreign corporation attributable to that stock, that was accumulated in taxable years of such foreign corporation during the period the stock sold or exchanged was held by such person while such foreign corporation was a CFC. If E&P of a foreign corporation is attributable to any amount previously included in the gross income of a United States person under subpart F, that amount is excluded in determining the amount of the section 1248 deemed dividend upon the sale or exchange of the stock.

3. A United States shareholder of a FPHC must include in gross income a share of the undistributed FPHCI of the FPHC whether distributed or not. Search7RH551. Undistributed FPHCI is the taxable income of a FPHC (subject to certain adjustments) reduced by the amount of dividends paid for the taxable year. A "United States shareholder" is defined broadly without regard to the percentage of vote or value of the FPHC stock held by such shareholder.

a. Generally, a foreign corporation is a FPHC if the majority of its stock is owned by a few U.S. persons and most of its income is passive. A FPHC is any foreign corporation if at least 60 percent (50 percent after the first taxable year for which the corporation is a FPHC) of its gross income for the taxable year is FPHCI; and at any time during the taxable year more than 50 percent (by vote or value) of the stock is owned (directly or indirectly) by five or fewer individuals who are citizens or residents of the United States (a "U.S. group"). Gross income of a foreign corporation for purposes of classification as a FPHC includes income from foreign sources as well as United States sources. Again, constructive ownership rules apply for purposes of determining whether a foreign corporation is a FPHC. They provide that stock owned by a corporation, partnership, estate, or trust is considered as owned proportionately by its shareholders, partners or beneficiaries. An individual is considered as owning the stock owned by or for his family or by his partner. The family of an individual includes only his brothers and sisters (whether by the whole or half-blood), spouse, ancestors, and lineal descendants. For purposes of determining whether a U.S. person will be required to include a share of the foreign corporation’s undistributed FPHCI in its income, stock of a FPHC owned (directly or through the application of the constructive ownership rules) by a second foreign corporation which is not a FPHC or by a foreign partnership, foreign estate, or foreign trust is considered as owned proportionately by its shareholders, partners, or beneficiaries.

b. FPHCI for purposes of the FPHC regime is similar, but not identical to, FPHCI for subpart F purposes. FPHCI includes passive income items such as dividends, interest, royalties, annuities, the excess of gains over losses from the sale by a nondealer of stock and securities, rents (unless constituting 50 percent or more of gross income), and personal services income from services performed by a shareholder.

c. Each United States shareholder of a FPHC must include in its gross income, as a dividend, the amount it would have received if, on the last day of the taxable year, there had been distributed by the FPHC and received by the shareholders the undistributed FPHCI of the FPHC for the taxable year. Undistributed amounts included in income by a shareholder are treated as a reinvestment of capital, and result in an upward adjustment to the shareholder’s basis in the stock of the FPHC. Even if a foreign corporation escapes treatment under the FPHC rules, its U.S. shareholders are still subject to taxation on any income that constitutes FPHCI under the CFC/subpart F income rules.

d. The FPHC rules are relevant when a foreign corporation is also a CFC if a member of the FPHC’s U.S. group owns less than 10 percent, and therefore does not constitute a "United States shareholder" under the CFC rules. In such a case, U.S. shareholders with less than the requisite 10 percent ownership are taxed under the FPHC rules; the rest are similarly taxed under subpart F.

4. A United States shareholder who is not subject to current taxation under the subpart F rules or the FPHC rules may still be subject to adverse tax consequences under the rules applicable to a PFIC. Search7RH1291.

a. A PFIC is any foreign corporation if 75 percent or more of the gross income of such corporation for the taxable year is passive; or the average percentage of assets (by value) held by such corporation during the taxable year which produce passive income is 50 percent or more. In the case of nonpublicly traded CFC (or nonpublicly traded CFC making an election), this determination is based on the adjusted bases of the assets in lieu of their value.

    1. "Passive income" generally means income which would be FPHCI under subpart F. If a foreign corporation owns 25 percent or more (by value) of the stock of a second corporation, for purposes of determining whether the first corporation is a PFIC, the first corporation is treated as if it held its proportionate share of the assets, and received directly its proportionate share of the income, of the second corporation. The 25 percent "look-through" rule may work to exempt foreign corporations owning the stock of subsidiaries engaged in active businesses from classification as a PFIC, since active assets and income of such subsidiaries will dilute the passive assets of the parent so that the PFIC thresholds are not met. This rule may also operate to treat a foreign parent with an active business as a PFIC if it owns stock in a subsidiary owning passive assets or earning passive income.
    2. Constructive ownership rules apply for purposes of determining a PFIC’s U.S. shareholders but only to the extent that the effect is to treat stock of a PFIC as owned by a United States person. Once the attribution rules attribute constructive ownership of PFIC stock to a U.S. person, they stop (as opposed to causing a second U.S. person to own the stock because of its relationship with the first U.S. person).

b. A U.S. person owning any interest in a PFIC, no matter how small, is subject to the PFIC anti-deferral provisions applicable to the income earned by the PFIC (not just the passive income) attributed to his shares. These provisions consist of three taxing regimes that depend on whether or not the U.S. owner of the PFIC makes a QEF election or a mark to market election.

i. A U.S. owner that does not make a QEF election is not taxed on the PFIC’s income until he actually receives a distribution from the PFIC or sells shares in the PFIC. Although the PFIC rules technically do not eliminate deferral on income earned through a PFIC, an interest charge is added to the tax imposed when the PFIC’s income is distributed through an "excess distribution," or stock in the PFIC is sold or exchanged. The effect of these rules is to treat such distributions and gains as though they were received evenly throughout the U.S. shareholder’s holding period of the PFIC stock. Any distributions from a PFIC that are not "excess distributions" are taxed as normal dividends. "Excess distributions" are subject to tax under rules that impose an interest charge as the price for deferral. An "excess distribution" is the excess of distributions received from the PFIC in a taxable year over an amount equal to 125 percent of the average of all distributions received by the taxpayer during the three preceding taxable years (or, if shorter, the portion of the taxpayer’s holding period before the taxable year). Thus, there can be no excess distributions for the first year a PFIC is in existence. For these purposes, an amount already included in gross income of a United States shareholder as subpart F income is treated as a distribution received with respect to the PFIC stock. After the amount of the excess distribution is determined, this amount is allocated ratably to each day of the shareholder’s holding period. Amounts allocated to the current year and any pre-PFIC years are treated as current income. The remainder of the excess distribution is subject to a tax which equals the "deferred tax amount." The "deferred tax amount" is composed of an aggregate tax amount and an aggregate interest amount. The aggregate tax amount is computed by allocating the remaining portion of the excess distribution to each "applicable" tax year in the shareholder’s holding period (i.e., all years except the current year and non-PFIC years) and multiplying the amount of the distribution allocable to each such tax year by the highest tax rate in effect for such year. The aggregate interest amount is determined by using the rate and method applicable for underpayments of tax with respect to the amount of taxes calculated above. This rate is generally above market.

ii. A shareholder that elects to treat its PFIC as a QEF must include in income its pro rata share of the QEF’s ordinary income and capital gains for the taxable year even though no cash is actually distributed. This treatment mirrors the treatment of United States shareholders of CFCs which earn subpart F income, except that shareholders of a QEF must currently include ALL income, not just tainted income. Amounts included in a QEF shareholder’s income are not treated as a dividend when actually distributed to the shareholder. Finally, a shareholder who has made a QEF election can make a second annual election to extend the time for payment of tax on a deemed income inclusion. Interest is imposed on the amount of the tax liability subject to the extension. Generally, the interest rate imposed on this "underpayment" is the Federal short-term rate plus three percentage points. If a U.S. shareholder of a PFIC makes a QEF election, but does so after the PFIC year, the PFIC rules described above generally will continue to apply.

iii. A U.S. shareholder of a PFIC that is publicly traded can elect to be taxed annually on the increase in the fair market value of his shares. Conversely, a U.S. shareholder can elect to deduct a decrease in the market value of his or her shares, limited to the extent of prior inclusions of market increases. If a U.S. shareholder of a PFIC makes a mark to market election, the deemed disposition for the year of the election may be subject to the PFIC rules described above (unless the election is made for the first PFIC year), but such rules will not apply thereafter.

c. A U.S. shareholder of a FIC treats any gain on a sale or exchange of such stock as ordinary income to the extent of the U.S. shareholder’s ratable share of the E&P of the FIC.The seller’s ratable share of E&P includes only his or her ratable share of the accumulated E&P for the period the seller owned the stock, reduced by E&P attributable to (i) any amount previously included in the gross income of the seller as subpart F income; and generally (ii) any taxable year during which the corporation was not a FIC. This rule does not apply to the extent gain on a FIC stock sale is treated as ordinary income under section 1248. Generally, gain from the sale of FIC shares by 10 percent shareholders is treated as ordinary income under section 1248; and all other shareholders take such amounts into ordinary income under the above FIC rules. A foreign corporation that is a FIC can avoid the application of the above rule, if it elects to distribute to its shareholders 90 percent or more of its taxable income (calculated as if the FIC were a domestic corporation) and to provide certain written information to its shareholders and the IRS.

i. A FIC is any foreign corporation that is registered under the Act, either as a management company or as a unit investment trust; or engaged (or holding itself out as being engaged) primarily in the business of investing, reinvesting, or trading in: (A) securities; (B) commodities; or (C) any interest (including a futures or forward contract or option) in property described in (A) or (B) above, at a time when 50 percent or more of the total voting power or the total value of all stock, is owned (directly or constructively) by United States persons. Search7RH1246. Under the Act, the term "security" is defined broadly.

ii. If a foreign corporation escapes classification as a FIC, but invests the cash proceeds of its business into its own portfolio or a mutual fund, that entity itself may be subject to classification as a FIC. The result would be that the foreign corporation is a foreign shareholder of a FIC. The U.S. shareholders of the foreign corporation would be treated as constructively owning any stock that the foreign corporation owns in proportion to their interests in the foreign corporation. Ultimately, the U.S. shareholders of the foreign corporation would constitute U.S. shareholders of the FIC into which the foreign corporation invests.

d. A tax equal to 39.6 percent is imposed on the undistributed PHCI of every PHC. Search7RH541. Undistributed PHCI is defined as the taxable income of a PHC as adjusted, less dividends paid for the taxable year. Unlike the subpart F provisions and the FPHC provisions, which require an amount to be included in the gross income of a shareholder, the PHC provisions impose a penalty tax on the corporation.

i. A PHC is any corporation, excluding FPHCs, if at least 60 percent of that corporation’s adjusted ordinary gross income is PHCI; and at any time during the last half of the taxable year more than 50 percent in value of that corporation’s outstanding stock is owned, directly or indirectly, by five or fewer (U.S. or foreign) individuals. Constructive ownership rules similar to those described above with respect to a FPHC apply for purposes of the stock ownership test. Stock owned by a corporation, partnership, estate, or trust is considered as owned proportionately by its shareholders, partners, or beneficiaries. An individual is considered as owning the stock owned by his or her family or by his or her partner. The family of an individual includes only his or her brothers and sisters (whether by the whole or half-blood), spouse, ancestors, and lineal descendants. A foreign corporation, other than a foreign corporation that has personal service contracts income, will not be a PHC if all of its outstanding stock during the last half of the taxable year is owned by nonresident alien individuals (directly or indirectly through foreign corporations, partnerships, trusts, or estates).

ii. PHCI generally includes the types of passive income that are considered FPHCI under the FPHC rules (as opposed to FPHCI under the subpart F rules).

  1. Avoidance of Shareholder Requirement for CFCs
  2. 1. Avoiding "U.S. Shareholders," i.e., 10 percent owners of vote, for example, 11 owners of nine percent.

    2. Introducing foreign shareholders to own 50 percent of vote or value:

    a. Foreign distributors own fifty percent (50 percent) of worldwide distributor;

    b. Foreign charitable interest.

    3. Synthetic ownership of shares:

    a. Variable annuities;

    b. Variable life insurance; and

    c. Derivatives.

    4. Avoiding calculable ownership through:

    a. Discretionary trusts U.S. person is treated as owner of property he transfers directly or indirectly to a foreign trust if for such year there is a U.S. beneficiary. IRC Search7RH679.

    b. Transfer by will;

    c. Foreign transferor with U.S. beneficiaries.

  3. Attribution of Ownership Between Discretionary Trusts and Their Beneficiaries
  4. 1. The IRC has a number of provisions that may cause a trust’s ownership of property (normally, stock) to be attributed, in whole or in part, to its beneficiaries. In some instances, these provisions may also cause a beneficiary’s ownership of property to be attributed to the trust.

    2. Unfortunately, these attribution rules generally have not been drafted in a manner that permits their easy application to a discretionary trust (i.e., a trust that endows its trustee with a "sprinkle" or "spray" power, which permits the trustee to distribute income and/or principal to beneficiaries at his or her discretion).

    3. Compounding this problem is the dearth of judicial and administrative guidance concerning the attribution of ownership between a discretionary trust and its beneficiaries. See generally Zolman Cavitch, Problems Arising from the Attribution Rules, N.Y.U. 35th Ann. Ins. on Fed. Tax’n 801, 813-14 (1977); Armand Drexler, Some Unresolved Problems Resulting from the Rules of Attribution, N.Y.U. 25th Ann. Ins. on Fed. Tax’n 281, 285, 293 (1967); Fred M. Ringel et al., Attribution of Stock Ownership in the Internal Revenue Code, 72 Harv. L. Rev. 209, 214 n. 17 (1958).

    4. This outline summarizes below:

    a. The nature of the guidance that is provided under selected IRC sections concerning the attribution of ownership between a discretionary trust and its beneficiaries;

    b. The treatment of discretionary trusts in several past proposals for the simplification of the attribution rules; and

    c. Recent administrative guidance and legislative proposals concerning the attribution of ownership between a discretionary trust and its beneficiaries.

    5. In reading this outline, bear in mind that application of the attribution rules in most sections discussed below, although possibly triggering the taxation of other taxpayers, will generally not cause a beneficiary of a discretionary trust who does not actually own stock in a corporation to be subject to tax on income that he or she has not received.

    a. For example, application of the attribution rules in section 544 to a discretionary trust may cause a corporation to be treated as a personal holding company; however, the resulting personal holding company tax is levied on the corporation, not on its shareholders (whether actual or constructive). See Search7RH541.

    b. In addition, application of the attribution rules in section 1298 may cause a beneficiary of a discretionary trust to become subject to tax under the passive foreign investment company regime; however, the beneficiary could defer payment of this tax by not electing to treat the foreign corporation as a qualified electing fund under section 1295; and to defer taxation under the qualified electing fund regime under section 1294 until the happening of certain prescribed events (e.g., transfer of the stock of the foreign corporation or a direct or indirect loan by the foreign corporation to the beneficiary).

    c. Nonetheless, the attribution rules in sections 551(f) and 958(a) will cause certain beneficiaries of discretionary foreign trusts that own (directly or indirectly, but not constructively) the stock of certain foreign corporations to be subject to current taxation under the foreign personal holding company and controlled foreign corporation regimes, respectively, regardless of whether the beneficiaries actually own stock of such foreign corporations. See Search7RH551(a); Search7RH551(f); Search7RH951(a)(1); Search7RH958(a).

  5. Selected Attribution Rules

1. Each of the sections discussed below contains a general rule that stock owned, directly or indirectly, by a trust shall be considered as owned either proportionately by its beneficiaries or by its beneficiaries in proportion to their actuarial interests in the trust.

a. With regard to the application of these general rules to discretionary trusts, the IRC sections discussed below can generally be divided into three categories:

i. Those that provide relatively definite guidance;

ii. Those that provide general guidance; and

iii. Those that provide no guidance at all.

b. Each of these categories is discussed separately below.

2. Section 318(a)(3)(B) (concerning constructive ownership of stock), section 1563 (concerning consolidated returns), section 883 (excluding from gross income the income derived by a foreign corporation from the international operation of ships or aircraft), section 884 (concerning the branch profits tax), section 897 (concerning dispositions of U.S. real property interests), and section 367 (concerning transfers to foreign corporations) each contain relatively definite rules concerning the attribution of ownership from (and, in the case of section 318(a)(3)(B), to) a discretionary trust.

a. To address the difficulty inherent in determining a beneficiary’s interest in a discretionary trust, sections 318(a)(3)(B) and 1563 adopt a "maximum exercise of discretion" standard under which a beneficiary’s actuarial interest in a trust is computed by assuming that the trustee of the trust will exercise the maximum discretion in favor of the beneficiary. Section 318(a)(3)(B) does not contain either of the general rules mentioned above because it concerns attribution of ownership to (rather than from) a trust.

b. Section 318(a)(3)(B) contains rules for determining a beneficiary’s actuarial interest in a trust because a beneficiary’s ownership of stock will not be attributed to the trust if, on an actuarial basis, the beneficiary has only a remote contingent interest in the trust. This maximum exercise of discretion standard is also found in attribution rules in certain Treasury Regulations. See Treas. Reg. Search7RH1.414(c)-4(b)(3)(i); Treas. Reg. Search7RH1.451-3(b)(3)(iii)(C)(3)(iii)(B) and (iv)(B) (to be superseded on finalization of proposed regulations promulgated on May 5, 1999, under section 460); Treas. Reg. Search7RH1.460-3(b)(3)(iii); Treas. Reg. Search7RH1.958-2(d)(1)(ii)(a); Treas. Reg. Search7RH25.2701-6(a)(4)(i). In some instances, use of the maximum exercise of discretion standard in these Treasury Regulations naturally results from the incorporation by reference of the attribution rules of either section 318 or section 1563 in the operative IRC section. See Search7RH414(b) and (c); Search7RH958(b).Search7RH318(a)(3)(B). It may also be of some interest to note that section 318(a)(2)(B), which provides for attribution from a trust to its beneficiaries and is discussed in the text below, as originally proposed by the House of Representatives, also incorporated the maximum exercise of discretion standard; however, this standard was deleted in conference. Compare H.R. Rep. No. 1337, 83rd Cong., 2d Sess. A97 (1954) with S. Rep. No. 1622, 83rd Cong., 2d Sess. 253 (1954) and H.R. Conf. Rep. No. 2543, 83rd Cong., 2d Sess. 34-35 (1954).) Search7RH1563(e)(3)(A). Section 1563 takes this approach one step further by providing that the actuarial interest of each beneficiary will be determined by also assuming the "maximum use of such stock to satisfy his rights as a beneficiary." Search7RH1563(e)(3)(A).

i. The maximum exercise of discretion standard has been described by commentators as the "worst of all worlds approach" because it may potentially result in each beneficiary being attributed 100 percent of the stock of the trust, even though some (or even most) of the beneficiaries may never, in fact, receive either the stock, the income from the stock, or the proceeds from the disposition of the stock. See Burton W. Kanter and Sheldon I. Banoff, editors, IRS Takes Novel Approach to Trust Attribution, 73 J. Tax’n 420 (1990).

ii. Section 1563 does, however, ameliorate the harshness identified by these commentators by providing that a beneficiary of a trust will not be considered as having an actuarial interest in stock held by the trust if the beneficiary cannot, under any circumstances, receive any interest in the stock held by the trust, including income from the stock and proceeds from the disposition of the stock. Treas. Reg. Search7RH1.1563-3(b)(3)(i).

3. The Proposed Treasury Regulations interpreting section 883 and the Treasury Regulations under section 884 adopt the attribution rule of section 318(a)(2)(B) (discussed below), and provide that an individual will be treated as having an interest in the stock of a foreign corporation owned by a trust in proportion to the individual’s actuarial interest in the trust. Prop. Treas. Reg. Search7RH1.883-4(c)(3)(i); Treas. Reg. Search7RH1.884-5(b)(2)(iii)(A).

    1. In determining an income beneficiary’s actuarial interest in the trust, the trust will be treated as if its only asset were the stock of the foreign corporation. Id.
    2. A remainder beneficiary’s actuarial interest in the trust will be equal to 100 percent minus the sum of the actuarial interests of the income beneficiaries. Id.
    3. The ownership of an interest in stock owned by a trust will generally not, however, be attributed to any beneficiary whose interest cannot be determined under the foregoing rules, unless all potential beneficiaries with respect to the stock are qualified shareholders for purposes of section 883 and section 884, respectively. Id.

4. The Treasury Regulations promulgated under section 897 contain a rule that specifically addresses attribution from discretionary trusts.

a. This rule provides that if the net assets of a trust exceed the sum of the definitely ascertainable actuarial values of interests in the trust, the total amount of such excess will be considered to be owned by each beneficiary:

i. Who is in existence on the relevant date;

ii. Whose interest in the excess is not definitely ascertainable; and

iii. Who is potentially entitled to that excess. Treas. Reg. Search7RH1.897-1(e)(3)(ii)(B).

b. Application of this rule may cause the sum of the beneficiaries’ percentage ownership interests in the trust to exceed 100 percent. See Notice of Proposed Rulemaking, 1983-2 C.B. 741, 744 ("The possibility exists in some instances, therefore, that the value of assets held by a trust...may be required to be attributed to more than one beneficiary in determining proportionate shares of the trust’s...assets.").

c. The Treasury Regulations illustrate the operation of this rule (and the potential for the rule to cause more than 100 percent ownership of the assets of the trust) with the following example:

i. A establishes a trust and contributes real property with a fair market value of $10,000 to the trust. The terms of the trust provide that the trustee, at its discretion, may retain trust income or may distribute it to X or to the head of state of any country other than the United States. The remainder upon the death of X is to go in equal shares to such of Y and Z as survive X.

ii. On the date of contribution, the actuarial values of the remainder interests of Y and Z in the corpus of the trust are definitely ascertainable. These remainder interests are $1,000 and $500, respectively.

iii. Neither the income interest of X nor of the head of state of any country other than the United States has a definitely ascertainable actuarial value.

iv. The interests of Y and Z in the income portion of the trust similarly have no definitely ascertainable actuarial values because the income may be distributed rather than retained by the trust.

v. Since the sum of the actuarial values of the definitely ascertainable interests of persons in existence on the date of contribution ($1,500) is less than the net assets of the trust ($10,000), the difference ($8,500) is treated as owned by each beneficiary who is in existence on the date of contribution, whose interest in the excess is not definitely ascertainable, and who is potentially entitled to such excess.

vi. Therefore, X, Y, Z, and the head of state of any country other than the United States are each considered as owning the entire $8,500 income interest in the trust.

vii. Accordingly, on the date of contribution, the total actuarial value of X’s interest in the trust is $8,500, and his percentage ownership interest is 85 percent. The total actuarial value of Y’s interest in the trust is $9,500 ($1,000 plus $8,500), and his percentage ownership interest is 95 percent. The total actuarial value of Z’s interest in the trust is $9,000 ($500 plus $8,500), and his percentage ownership interest is 90 percent. The total actuarial value of the interest in the trust of the head of state of each country other than the United States is $8,500, and his or her percentage ownership interest is 85 percent. See Treas. Reg. Search7RH1.897-1(e)(3)(ii)(B), Example.

5. The Treasury Regulations promulgated under section 367 contain the general rule that stock or securities owned by or for a trust shall be considered as being owned by the trust’s beneficiaries in proportion to their actuarial interests in the trust. See Treas. Reg. Search7RH1.367(e)-1(b)(2) (incorporating the standard in section 318(a)(2)(B), which is discussed below, by reference). However, these Treasury Regulations also contain an exception to this general rule that appears to be designed to prevent abuse of the general rule through the use of a discretionary trust.

a. This exception provides that "if a trust includes interests that are not actuarially ascertainable, all such interests shall be considered to be owned by foreign persons." Id.

b. Application of this exception causes a distribution that would otherwise qualify for nonrecognition of gain or loss under section 355 to be a taxable event.

6. Section 958 (concerning controlled foreign corporations), section 1298 (concerning passive foreign investment companies), and section 544 (concerning personal holding companies) each provide (through administrative and/or judicial interpretation) general guidance on the application of its attribution rules to trusts. This general guidance is in the form of a "facts and circumstances" standard.

a. Section 958(a)(2) provides that stock owned, directly or indirectly, by or for a foreign trust will be considered as being owned "proportionately" by its beneficiaries. The Treasury Regulations promulgated under section 958 indicate that "[t]he determination of a person’s proportionate interest in a...foreign trust...will be made on the basis of all the facts and circumstances in each case." Treas. Reg. Search7RH1.958-1(c)(2).

b. In Field Service Advice 1999-52-014, the IRS concluded that, where all of the income of a trust was to be distributed to one beneficiary during his lifetime:

i. Remainder beneficiaries (whether vested or contingent) would be disregarded in determining the attribution of ownership under section 958(a); and

ii. The income beneficiary’s power to direct the distribution of income to other persons, if exercised, would need to be evaluated to determine whether it constituted an arrangement that artificially decreases a U.S. shareholder’s proportionate interest in a foreign corporation (such an arrangement would be disregarded in determining the attribution of ownership under Treasury Regulation Search7RH1.958-1(c)(2)). F.S.A. 1999-52-014 (Sept. 23, 1999).

7. Section 1298 and the Proposed Treasury Regulations promulgated under section 1291 indicate that a beneficiary of a trust will be considered as owning a proportionate amount of the stock that is owned, directly or indirectly, by the trust. Search7RH1298(a)(3); Prop. Treas. Reg. Search7RH1.1291-1(b)(8)(iii)(C). The Proposed Treasury Regulations further provide that "the determination of a person’s indirect ownership is made on the basis of all the facts and circumstances in each case; the substance rather than the form of ownership is controlling, taking into account the purpose of section 1291. Cf. Search7RH1.958-1(c)(2)." Prop. Treas. Reg. Search7RH1.1291-1(b)(8)(i). Note, however, that the preamble to these Proposed Treasury Regulations solicited comments as to whether the foregoing standard for attributing ownership of stock from a trust to a beneficiary should be replaced with "different attribution rules, such as the indirect ownership rules in Search7RH25.2701-6" (which contain a maximum exercise of discretion standard similar to that found in section 1563). Notice of Proposed Rulemaking, 1992-1 C.B. 1124, 1125.

8. Section 544(a)(1) also provides that stock owned, directly or indirectly, by or for a trust shall be considered as being owned "proportionately" by its beneficiaries. The authorities under section 544(a)(1) have gradually evolved toward a facts and circumstances approach to the attribution of ownership from a discretionary trust to its beneficiaries. This evolution is described below.

a. In Steuben Securities Corp. v. Commissioner, 1 T.C. 395, 399(1943), the Tax Court held, in interpreting a predecessor of current Section 544, that the term "beneficiaries," as used in that section, referred only to "those who have a direct present interest in the shares and income in the taxable year and not those whose interest, whether vested or contingent, will or may become effective at a later time." This rule should have prevented the application of section 544(a)(1) to those beneficiaries of a discretionary trust who received no distributions from the trust during a given taxable year.

b. In Revenue Ruling 58-325, 1958-1 C.B. 212, 213, revoked by Rev. Rul. 62-155, 1962-2 C.B. 132, the IRS followed Steuben Securities in interpreting the attribution rule in section 421(d)(1)(C) (the predecessor of current section 424(d)), which contained language similar to that found in section 544(a)(1), and concluded that stock held by a trust would not be attributed to beneficiaries who could only receive distributions after the expiration of a 10-year period because "present actual enjoyment [is]the controlling factor in determining who is the beneficiary of the trust."

c. In Phinney v. Tuboscope Co., 268 F.2d 233 (5th Cir. 1959), the Fifth Circuit, in interpreting a predecessor of current section 544 for purposes of determining whether a corporation constituted a "new" corporation under the Korean Excess Profits Tax Statute (and without making any express negative reference to the Tax Court’s decision in Steuben Securities), held that the rule regarding attribution of ownership from trusts in section 544(a)(1) "does not confine itself to beneficiaries having an immediate and enforceable right." Id. at 238. Thus, the court concluded that stock held by a series of spendthrift trusts could be attributed to the trusts’ respective minor beneficiaries, who had vested interests in the trusts, even though such beneficiaries were entitled to no income from the trusts until age 21 (unless the trustee in its sole discretion elected to make a distribution) and none of the trusts could be terminated or its corpus distributed until its respective beneficiary reached age 25.

d. In Revenue Ruling 62-155, 1962-2 C.B. 132, the IRS reconsidered and revoked its position in Revenue Ruling 58-325, 1958-1 C.B. 212 (discussed above), in light of the decision in Tuboscope. The IRS concluded that "in determining stock ownership for the purposes of section 421(d)(1)(C) and section 544(a)(1) , the shares held by a trust are considered to be owned by its present or future beneficiaries in proportion to their actuarial interests." Id. at 133.

e. More recently, in Private Letter Ruling 90-24-076 (Mar. 21, 1990), the IRS addressed the manner in which the actuarial interest of a beneficiary of a discretionary trust should be calculated for purposes of section 544(a)(1), as interpreted by Revenue Ruling 62-155, 1962-2 C.B. 132. In Private Letter Ruling 90-24-076, the IRS acknowledged that, where "the trustees of the Trust have unrestricted discretion in selecting the recipients of income and principal, the Trust’s beneficiaries do not have actuarial interests in the Trust that can be computed pursuant to the guidelines contained in Rev. Rul. 62-155 and section 1.318-3(b) of the regulations." The IRS also acknowledged that "it is possible to postulate various methods to accomplish this allocation." However, the IRS chose the "facts and circumstances method" as the most appropriate method for determining the actuarial interest of a beneficiary in a discretionary trust. The IRS included the following in its non-exhaustive list of relevant facts and circumstances to be considered in determining the actuarial interest of a beneficiary in a discretionary trust:

i. The patterns of past distributions;

ii. Appropriate mortality assumptions;

iii. The trustee’s fiduciary duties; and

iv. The relationships among the trustees and beneficiaries.

f. Because of the existence of a pattern of distributions over a period of years, the IRS concluded that, under the facts and circumstances presented in Private Letter Ruling 90-24-076, a "methodology" based on this pattern would "most accurately reflect the beneficiaries’ proportionate interest [sic]in the Trust." Id. Thus, each beneficiary was considered as owning an income interest in the trust in the same proportion that the amount of distributions that he or she received bore to the total amount of distributions made by the trustee. Each beneficiary’s income interest could then be determined on an actuarial basis with reference to appropriate mortality tables as if the trustee were required to distribute the income to the beneficiary over the remainder of his or her life. Although this facts and circumstances standard sheds some light on the manner in which ownership may be attributed from a discretionary trust to its beneficiaries, it has been criticized due to its vague nature. Some of the questions that have been raised by commentators include:

i. How long must a pattern of distributions continue before this "methodology" is considered the most appropriate basis for determining actuarial interests?

ii. Is a minimum level of distributions required to be made each year?

iii. What may cause a pattern of distributions to be considered as having changed? See Burton W. Kanter and Sheldon I. Banoff, editors, IRS Takes Novel Approach to Trust Attribution, 73 J. Tax’n 420 (1990).

9. Section 267 (concerning the disallowance of losses in transactions between related taxpayers), section 318(a)(2)(B) (concerning constructive ownership of stock), and sections 551(f) and 554 (concerning foreign personal holding companies), among others, simply contain, without further elaboration, a general rule that stock owned, directly or indirectly, by a trust shall be considered as being owned either proportionately by its beneficiaries or by its beneficiaries in proportion to their actuarial interests in the trust. In a recently released Field Service Advice, the IRS avoided a truly substantive interpretation of section 318(a)(2)(B) by concluding that a life tenant of a discretionary trust who also held a general power of appointment with respect to the trust would be treated as owning a 100 percent interest in the trust, despite the fact that the trust’s assets would pass to her heirs in the event that she failed to exercise the general power of appointment. F.S.A. 1998-343 (Feb. 22, 1993). The IRS disregarded the potential remainder interest in the life tenant’s heirs on the ground that the class of eligible heirs could change at any time under local intestacy laws. Whether the general rules in these IRC sections may be interpreted in light of experience with the attribution rules in other IRC sections is not altogether clear. Compare Hickman v. Commissioner, 31 T.C.M. (CCH) 1030 (1972) with Rev. Rul. 62-155, 1962-2 C.B. 132 and Rev. Rul. 58-325, 1958-1 C.B. 212. See also F.S.A. 1999-52-014 (Sept. 23, 1999).

a. In Hickman, the court considered this issue in construing the trust attribution rule in section 267(c)(1).

i. Section 267(c)(1) provides that stock owned, directly or indirectly, by or for a trust shall be considered as being owned "proportionately" by or for its beneficiaries.

ii. The taxpayer in Hickman urged the court to interpret section 267(c)(1) in light of Revenue Ruling 62-155, which had clarified that the term "proportionately" in former section 421(d)(1)(C) and current section 544(a)(1) meant "in proportion to [the]actuarial interests" of the beneficiaries. Rev. Rul. 62-155, 1962-2 C.B. 132. The taxpayer argued that Revenue Ruling 62-155 was an appropriate source of guidance because sections 421(d)(1)(C) and 544(a)(1) contained language identical to that of section 267(c)(1).

iii. The court in Hickman rejected the application of Revenue Ruling 62-155 by analogy. The court held that the value of stock attributed from a trust to its beneficiaries under section 267(c)(1) should not be calculated on an actuarial basis because, even though the language of sections 421(d)(1)(C) and 544(a)(1) was identical to that of section 267(c)(1), there was no indication in the case law or in the legislative history that section 267(c)(1) was "intended to have a meaning other than that normally implied by the words employed" or "that a cross-reference of interpretation to section 267 [from former section 421(d)(1)(C) or current section 544]was intended." Id. at 1037. Accord Wyly v. United States, 662 F.2d 397 (5th Cir. 1981).

b. By way of contrast, in Revenue Ruling 58-325, 1958-1 C.B. 212, the IRS followed the Tax Court’s decision in Steuben Securities Corp. v. Commissioner, 1 T.C. 395 (1943), which involved the attribution rule under a predecessor of current section 544(a)(1), in interpreting the attribution rule in section 421(d)(1)(C) (the predecessor of current section 424(d)) . The IRS gave no indication in Revenue Ruling 58-325 that there was any issue concerning the interpretation of one attribution rule in light of authorities decided under another, similarly-worded attribution rule.

c. The IRS continued interpreting the attribution rule of section 421(d)(1)(C) in light of authorities construing predecessors of section 544(a)(1) when it revoked Revenue Ruling 58-325 based on the decision in Phinney v. Tuboscope, 268 F.2d 233 (5th Cir. 1959). See Rev. Rul. 62-155, 1962-2 C.B. 132. As discussed above, the decision in Tuboscope involved a predecessor of section 544(a)(1), which the Fifth Circuit interpreted in a manner contrary to the Tax Court’s interpretation of another (identically-worded) predecessor of that section in Steuben Securities.

  1. Simplification Proposals

1. From the late 1950s until the early 1980s, several proposals were made to simplify and consolidate the attribution rules in the IRC. In addressing the issue of attribution of ownership between a discretionary trust and its beneficiaries, each of these proposals adopted some form of the maximum exercise of discretion standard currently found in sections 318(a)(3)(B) and 1563 (discussed above).

2. In 1958, the ALI, in considering the income tax problems of corporations and shareholders, issued a report in which it expressed its "working view" that "[i]t is feasible and desirable to formulate a single set of uniform rules of stock attribution to be utilized throughout the entire IRC." See Stanley S. Surrey, Income Tax Problems of Corporations and Shareholders: American Law Institute Tax Project—American Bar Association Committee Study on Legislative Revision, 14 Tax L. Rev. 1, 51 (1958). Although the ALI report did not itself address in detail the manner in which stock should be attributed from a discretionary trust to its beneficiaries, a discussion draft of the ALI report contained a proposal that included, for purposes of calculating the actuarial interest of a beneficiary in a trust, an "assumption that there will be a maximum exercise of any discretion of the fiduciary in [the beneficiary’s]favor." American Law Inst. Tax Project, Discussion Draft No. 16D: Attribution of Stock Ownership 29 (1958).

3. In 1968, the American Bar Association’s Committee on Affiliated and Related Corporations issued a proposal for simplifying and consolidating the attribution rules in the IRC. The ABA proposal contained a rule similar to that found in the ALI discussion draft, under which a beneficiary’s actuarial interest in a trust would be calculated "on the assumption that there will be a maximum exercise of any power in the fiduciary in [the beneficiary’s]favor." American Bar Ass’n, Tax Section, Comm. on Affiliated and Related Corps., Committee Recommendations, 21 Tax Law. 921, 932 (1968). However, the ABA proposal differed from the ALI proposal in two respects:

    1. The ABA proposal modified the maximum exercise of discretion standard by disregarding any power limited by an ascertainable standard relating to the health, education, support, or maintenance of the beneficiary. Id.
    2. Like section 1563, the ABA proposal also ameliorated the harshness of the maximum exercise of discretion standard by providing that stock owned by a trust would not be attributed to a beneficiary who could not, under any circumstances, receive from the trust any interest in the stock, the proceeds of the disposition of the stock, or the income from the stock. Id.

4. In 1980, the staff of the Senate Committee on Finance issued a proposal for the simplification of the attribution rules in the IRC. Senate Comm. on Fin., Proposal for the Simplification of Stock Attribution Rules (1980). The description of the Senate Finance Committee proposal in this outline is based on a summary and critique of that proposal by the Tax Section of the New York State Bar Association. See the NYSBA Report. The Senate Finance Committee proposal also adopted the maximum exercise of discretion standard, which had been found in the ALI and ABA proposals, for purposes of determining a beneficiary’s actuarial interest in a discretionary trust. See NYSBA Report at 18.

a. Like the ABA proposal, the Senate Finance Committee proposal modified the maximum exercise of discretion standard by disregarding any power limited by an ascertainable standard relating to the health, education, support, or maintenance of the beneficiary. See id.

b. The Senate Finance Committee proposal also ameliorated the harshness of the maximum exercise of discretion standard by providing that if a beneficiary’s interest in the relevant stock held by the trust differed from the beneficiary’s interest in the trust as a whole, then attribution would be based on the beneficiary’s interest in the relevant stock. See id. at 17.

c. The Senate Finance Committee further included in its proposal a rule providing that if the beneficiaries of a discretionary trust included descendants of the grantor, then attribution would be determined as if all distributions were required to be made to the descendants per stirpes. See id. at 16. The New York State Bar Association criticized this per stirpes rule on the ground that it was ripe for abuse. See id. at 18-19.

i. For example, stock owned by a grandfather would be attributed in full to his grandchildren under general family attribution rules; however, if the grandfather were to contribute the same stock to a discretionary trust, then the stock would be attributed to the grandchildren only on a per stirpes basis, "even though the transfer to the trust arguably increased the interests of the children and grandchildren." Id. at 19.

ii. In addition, the per stirpes rule included in the Senate Finance Committee proposal was apparently susceptible to abuse when the intended beneficiary of the discretionary trust was not a descendant of the grantor. In such a situation, it appears that if an "irrelevant" descendant of the grantor were added as a beneficiary of the trust, the application of the attribution rules to the intended beneficiary could be "avoided." Id.

  1. Recent Administrative Guidance and Legislative Proposals

1. Recent guidance from the IRS as well as recent legislative proposals in Congress have not adopted the maximum exercise of discretion standard that was a mainstay of the earlier simplification proposals (discussed above). Instead, recent guidance and proposals have adopted the facts and circumstances approach applied by the IRS in Private Letter Ruling 90-24-076 (discussed above in connection with section 544), and have generally clarified the facts and circumstances standard by providing that any interest not allocated under this standard should be allocated on the basis of the beneficiaries’ familial relationship to the grantor of the trust (the "modified facts and circumstances approach").

2. In 1995, the Clinton Administration’s revenue proposals contained an amendment to section 679 (concerning foreign trusts with U.S. beneficiaries), which provided that the determination of a beneficiary’s interest in a trust would be based on all relevant facts and circumstances, including the terms of the trust instrument, any letter of wishes or similar document, historical patterns of trust distributions, and the existence of and functions performed by a trust protector or any similar advisor. If a beneficiary’s interest in a discretionary trust could not be determined under the rule described above, then the proposal provided that the beneficiary having the closest degree of kinship with the grantor would be treated as holding the remaining interests in the trust, and, if two or more beneficiaries had the same degree of kinship with the grantor, they each would be treated as holding the remaining interests equally. See H.R. 981, 104th Cong., 1st Sess. (1995); S. 453, 104th Cong., 1st Sess. (1995).

3. In 1995 and 1996, before the revision of the tax regime applicable to expatriates by the Health Insurance Portability and Accountability Act of 1996, Pub. L. No. 104-191, 110 Stat. 1936, a number of bills circulating in Congress proposed the addition to the IRC of section 877A, which generally would have caused, upon expatriation, a deemed sale for fair market value of all of an expatriate’s assets.

  1. All of the bills proposing the addition of section 877A to the IRC contained rules concerning the determination of a beneficiary’s interest in a trust, which rules were necessary for purposes of determining the extent of the assets held (and deemed sold) by an individual at the time of expatriation.
  2. Each of the bills contained a general rule that a beneficiary’s interest in a trust would be based upon all relevant facts and circumstances, including the terms of the trust instrument, any letter of wishes or similar document, historical patterns of trust distributions, and the existence of and functions performed by a trust protector or any similar advisor. See, e.g., H.R. 3185, 104th Cong., 2d Sess. (1996); S. 1637, 104th Cong., 2d Sess. (1996); H.R. 4122, 104th Cong., 2d Sess. (1996); H.R. 1535, 104th Cong., 1st Sess. (1995); S. 700, 104th Cong., 1st Sess. (1995); H.R. 1748, 104th Cong., 1st Sess. (1995); H.R. 981, 104th Cong., 1st Sess. (1995); S. 453, 104th Cong., 1st Sess. (1995).

i. Certain of the bills did not contain anything more than this general rule. See, e.g., H.R. 3185, 104th Cong., 2d Sess. (1996); S. 1637, 104th Cong., 2d Sess. (1996).

ii. Other bills provided that the remaining interests in the trust not determined under the general rule would be allocated first to the grantor, if a beneficiary, and then to other beneficiaries under rules prescribed by the Department of the Treasury similar to the rules of intestate succession. See, e.g., H.R. 4122, 104th Cong., 2d Sess. (1996); H.R. 1535, 104th Cong., 1st Sess. (1995); S. 700, 104th Cong., 1st Sess. (1995).

iii. The final group of bills provided that, in the case of beneficiaries whose interests in a trust could not be determined under the general rule, the beneficiary having the closest degree of kinship to the grantor would be treated as holding the remaining interests in the trust, and, if two or more beneficiaries had the same degree of kinship to the grantor, the remaining interests would be treated as held equally by such beneficiaries. See, e.g., H.R. 1748, 104th Cong., 1st Sess. (1995); H.R. 981, 104th Cong., 1st Sess. (1995) (incorporating by reference the proposed amendment to section 679 discussed above); S. 453, 104th Cong., 1st Sess. (1995) (incorporating by reference the proposed amendment to section 679 discussed above).

4. In 1997, a bill containing new section 877A was once again introduced in Congress. See H.R. 1015, 105th Cong., 1st Sess. (1997). This bill provided that a beneficiary’s interest in a trust would be based upon all relevant facts and circumstances, including the terms of the trust instrument, any letter of wishes or similar document, historical patterns of trust distributions, and the existence of and functions performed by a trust protector or any similar advisor. Like certain of the bills introduced in 1995 and 1996, this bill further provided that any interests in the trust not determined under this general rule would be allocated first to the grantor, if a beneficiary of the trust, and then to the other beneficiaries under rules prescribed by the Department of the Treasury similar to the rules of intestate succession.

5. In March 1997, the IRS issued Notice 97-19, 1997-1 C.B. 394, modified by Notice 98-34, 1998-2 C.B. 29, which contains guidance concerning the application of the expatriate provisions (sections 877, 2107, and 2501), as those provisions were amended by the Health Insurance Portability and Accountability Act of 1996 Pub. L. No. 104-191, 110 Stat. 1936. As a part of this guidance, the IRS included "[s]pecial rules for determining beneficial interests in trusts." Id. In keeping with certain of the proposed versions of new section 877A discussed above, these special rules provide that "all interests in property held by [a]trust must be allocated to beneficiaries (or potential beneficiaries) of the trust based on all relevant facts and circumstances, including the terms of the trust instrument, letter of wishes (and any similar document), historical patterns of trust distributions, and any functions performed by a trust protector or similar advisor. Interests in property held by the trust that cannot be allocated based on the factors described in the previous sentence shall be allocated to the beneficiaries of the trust under the principles of intestate succession (determined by reference to the settlor’s intestacy) as contained in the Uniform Probate Code, as amended." Id.

  1. Conclusion

1. As currently constituted, the attribution rules in the IRC are generally lacking in guidance concerning the attribution of ownership between a discretionary trust and its beneficiaries.

2. Early proposals to simplify and consolidate the attribution rules in the IRC advocated the general adoption of the maximum exercise of discretion standard currently found in sections 318(a)(3)(B) and 1563. This standard has rightfully been criticized by commentators as a worst of all worlds approach because it may produce results that are completely divorced from reality.

3. More recently, the IRS and Congress have demonstrated a trend toward adopting a facts and circumstances approach, which appears to have its roots in Private Letter Ruling 90-24-076 (discussed above).

4. However, to avoid the problems that may arise from application of the facts and circumstances standard alone, the IRS, the Clinton Administration, and Congress have generally modified this standard by incorporating a "back-stop" rule under which interests in a trust that cannot be determined under the general facts and circumstances standard will be allocated based on familial relationships with the grantor of the trust.

5. This modified facts and circumstances approach, while logical and providing guidance with respect to many situations that will arise, will by no means prove to be a panacea, and, in fact, may give rise to several problems of its own, for example:

a. The modified facts and circumstances approach will still not bring certainty to taxpayers in applying the general facts and circumstances standard in practice because, in a somewhat circular fashion, the "back-stop" rule will only apply if the beneficiary’s interest in the trust cannot be determi