Final Rules Govern Sec. 6038D Reporting by Specified Domestic Entities

The IRS issued final regulations requiring specified domestic entities to report specified foreign financial assets in which they have interests (T.D. 9752). The rules generally apply to tax years beginning after Dec. 31, 2015.

Sec. 6038D, enacted as part of the Foreign Account Tax Compliance Act (FATCA), requires individuals to report interests in specified foreign financial assets (SFFAs) when filing their federal income tax returns for tax years beginning after March 18, 2010, using Form 8938, Statement of Specified Foreign Financial Assets.

Until now, the requirement to report SFFAs applied only to individuals, but the IRS is also authorized to apply the reporting requirement to any domestic entity that is formed or availed of principally to avoid reporting (a specified domestic entity). In 2011, the IRS issued Prop. Regs. Sec. 1.6038D-6, under which specified domestic entities would be required to report SFFAs. The IRS adopted the proposed regulations with only a few changes.

The most significant change is the elimination of the “principal purpose” test. Prop. Regs. Sec. 1.6038D-6(b)(1)(iii) provided that a corporation or partnership would be treated as formed or availed of for purposes of holding, directly or indirectly, SFFAs if either: (1) at least 50% of the corporation or partnership’s gross income or assets is passive; or (2) at least 10% of the corporation or partnership’s gross income or assets is passive and the corporation or partnership is formed or availed of by a specified individual with a principal purpose of avoiding Sec. 6038D (the principal purpose test).

“Principal purpose” in turn is determined by all the facts and circumstances. Because the IRS has decided that the 50% passive income or assets test is adequate to deter abuse and that taxpayers should be allowed to determine their reporting requirements by relying on objective, rather than subjective, criteria, the final regulations eliminate the principal purpose test.

Another significant change to the proposed regulations is to the definition of passive income. The final rules align this definition with the definition of passive income under Sec. 1472, because the definitions under both Code sections serve a similar function, which is to identify entities that have a high risk of being used for tax evasion and to reduce compliance burdens for active entities. The final regulations (1) clarify that “dividends” include substitute dividends and expand “interest” to cover income equivalent to interest, including substitute interest; (2) add a new exception for certain active business gains or losses from the sale of commodities; and (3) define notional principal contracts by adding a reference to Regs. Sec. 1.446-3(c)(1). In addition, these final regulations add the exception for dealers in financial instruments that are described in Regs. Sec. 1.1472-1(c)(1)(iv)(B)(2).

A change made in response to comments was to the definition of passive income rents or royalties derived in the active conduct of a trade or business conducted by employees of the relevant entity. The commenters were concerned that few businesses would be able to meet the requirement and requested a change that the IRS adopted. The final regulations provide that the trade or business must be conducted “at least in part” by the employees to not be considered passive income.

The proposed regulations did not clarify how to determine whether 50% of an entity’s assets are passive. The final regulations adopt the same test used to determine the passive asset percentage for NFFEs, the weighted average test found in Regs. Sec. 1.1472-1(c)(1)(iv).

Under the proposed regulations, a trust is a specified domestic entity only if the trust has one or more specified persons as a current beneficiary. A current beneficiary is any person who at any time during the tax year is entitled to, or at the discretion of any person may receive, a distribution from the principal or income of the trust (determined without regard to any power of appointment to the extent that such power remains unexercised at the end of the tax year).

The preamble to the final regulations states that the IRS intended that a specified domestic entity include a trust whereby a specified person has an immediately exercisable general power of appointment, even if such specified person is not technically a beneficiary. Under the final rules, a current beneficiary includes any holder of a general power of appointment, whether or not exercised, that was exercisable at any time during the tax year, but does not include any holder of a general power of appointment that is exercisable only on the holder’s death.

—Sally P. Schreiber (sschreiber@aicpa.org) is a Tax Adviser senior editor.