U.S. Tax and Reporting Issues Related to the Use of Foreign Usufructs

A typical European or Latin American estate plan involves a usufruct. A usufruct grants, by contractual arrangement, the right of use or enjoyment of property from one person to another for a specified period. The usufructuary is the person who has the right to use the person who has the right to use the property and is generally entitled to income from the property. The benefits from a foreign tax law perspective is typically that the value of the gift on which foreign gift tax will be paid is reduced based on the age of the donor. At the donor’s subsequent death, the usufruct interest terminates by operation of law and is automatically recovered by the bare ownership holder who then owns the property in full.

Usufructs are often utilized in France. In France the inheritance and gift taxes between parents and children can reach up to 60%. A usufruct can potentially eliminate or reduce French inheritance and gift taxes. A usufruct involves the gifting of bare ownership interest in property. The usufructuary’s interest is generally similar to a life estate under common law. The “naked” or “bare” owner (equivalent to a remainderman) is the legal owner of the property. The property is included in the usufructuary’s estate to be taxed at death for French tax purposes. However, the appreciated value of the property passes to the donor’s children. The usufructuary or grantor has the right to use the property and is entitled to income from the property during his or her lifetime. The gifted bare ownership interest of the property is valued on a scale that benefits the donor. In addition, gifts in France result in a stepped-up basis to the fair value of the gifted property at the time of the gift. Thus, the French gift tax could be eliminated or mitigated  on the bare ownership portion of the bare ownership after the ususfructuary’s death.

How Tax and Reporting Considerations of a Usufruct

With the exception of Louisiana, the concept of a usufruct is not well known in the United States. The Internal Revenue Service (“IRS”) has issued a number of private letter rulings (“PLR”) regarding the characterization of a usufruct for U.S. tax purposes.

In PLR 9121035, the IRS concluded that a usufruct was classified as a trust for U.S. tax purposes. In the ruling, the usufructuary, in addition to his usufruct rights, had administrative powers over the assets subject to the usufruct (similar to the role of a trustee). Thus, if a U.S. person makes a gift of a bare ownership interest and retains a usufruct, there is an initial threshold question of whether the gift establishes a foreign trust for U.S. tax purposes. If the usufruct is considered a foreign trust for U.S. purposes, the usufructuary may be required to file a Form 3520 with the IRS.

A transfer involving a usufruct interest or a bare ownership interest could trigger a U.S. gift tax or estate tax consequence. Depending on the nature of rights retained by the usufruct holder and other factors, a completed gift for U.S. transfer tax purposes. This is the case even if the transfer may be considered a gift for French tax purposes. Treasury Regulation Section 25.2511-2(b) provides as follows:

“As to any property, or part thereof or interest thereof, of which the donor has so parted with dominion and control as to leave in him no power to change its disposition, whether for his own benefit or for the benefit of another, the gift is complete. But if upon a transfer of property (whether in trust or otherwise) the donor reserves any power over its disposition, the gift may be wholly incomplete, or may be partially complete and partially incomplete, depending upon all the facts in the particular case. Accordingly, in every case of a transfer of property subject to reserved power, the terms of the power must be examined and its scope determined.”

For U.S. estate planning purposes, specific trusts like grantor-retained annuity trusts are used to enable the donor to make a gift to family members with a gift tax base of less than the value of the property. This retained interest in the case of a grantor-retained annuity trust is a fixed amount and is permitted as a “qualified interest” for which Section 7520 valuation principles may be used to value the gift. Section 2036 of the Internal Revenue Code may cause gifted property with a retained life interest to be included in the gross estate of the donor upon death as a transfer of property with a retained interest.

Applying these concepts to a usufruct, should a U.S. person (that is a dual U.S. French tax resident) make a completed gift of a bare ownership interest and retain a usufruct, the usufruct holder may reserve powers that could cause the transfer of the bare ownership to be incomplete for U.S. gift purposes. Thus, the property could remain in the usufruct holder’s estate resulting in an estate tax equal to the full value of the property at the date of death.

Reporting Requirements

If a usufruct established in a foreign country can be classified as a foreign trust, the U.S. bare ownership holder will have a number reporting requirements with the IRS. U.S. persons who own, are beneficiaries of, or interact with, a foreign trust, generally must file Form 3520-A and/or Form 3520. If a U.S. person holds bare ownership of property in a usufruct in France or any other foreign country, the IRS PLRs may treat the usufruct as a foreign trust for U.S. tax purposes and require the usufructuary (and a U.S. beneficiary) to file a Form 3520-A and Form 3520 with the IRS.

Form 3520-A is used to report information on a foreign trust with at least one U.S. owner. Section 6048 of the Internal Revenue Code states that each U.S. person treated as an owner of any portion of a foreign trust under the grantor trust rules is responsible for ensuring that the trust files Form 3520-A. The grantor trust rules are codified in Sections 671 through 679 of the Internal Revenue Code. Under Internal Revenue Code Section 6677, the penalty for failing to file Form 3520-A is the greater of $10,000 or 5% of the gross value of the portion of the trust’s assets treated as owned by the U.S. person at the close of the tax year if the foreign trust fails to timely file Form 3520-A, or does not furnish all required information or provides incorrect information to the IRS.

A U.S. person must file a Form 3520 if: (1) a reportable event occurred during the tax year; (2) a U.S. person transferred property to a related foreign trust is deemed an owner of the trust in exchange for an obligation; (3) the person is deemed an owner of the trust based on the grantor trust rules; (4) the person received a distribution from a foreign trust during the current year; (5) the person is a U.S. owner or beneficiary of a foreign trust and in the current tax year the person or a U.S. person related to the person received a loan of cash or securities directly or indirectly from the trust, or the uncompensated use of trust property; (6) the person is a U.S. person who is a U.S. owner or beneficiary of a foreign trust and in the current tax year such foreign trust holds an outstanding qualified obligation of the U.S. person; or (7) the person received a foreign gift or bequest in excess of $100,000 from a nonresident alien or foreign estate.

The penalty for failing to timely file Form 3520 with regard to a foreign trust is the greater of: $10,000; (2) 35% of the gross value of any property transferred to a foreign trust for failure by a U.S. transferor to report the creation of, or transfer to, a trust; (3) 35% of the gross value of the distribution received from a foreign trust; or (4) 5% of the gross value of the portion of the foreign trust’s assets treated as owned by a U.S. person under the grantor trust rules if the foreign trust fails to timely firm of Form 3520-A or does not furnish all information required by the IRS.

A usufructuary (and U.S. beneficiary) may also need to disclose a usufruct on a Form 8938 to the IRS. A Form 8938 is used to report interests in specified foreign financial assets. The reporting threshold for a Form 8938 depends on whether a U.S. person is married or unmarried, and whether the U.S. person is married or unmarried, and whether the individual resides inside or outside the United States. A specified foreign financial asset definition includes the following: (1) financial accounts maintained by a foreign financial institution; (2) stock or securities issued by someone that is not a U.S. person; (3) any interest in a foreign entity; and (4) any financial instrument or contract that has an issuer or counterparty that is not a U.S. person.

Under Section 6038D of the Internal Revenue Code, the penalty for failing to timely file a Form 8938 is $10,000 per year. If the IRS sends an individual a letter requesting a Form 8938 and the individual fails to file a Form 8938, the IRS may assess an additional $10,000 penalty for each 30-day period (or fraction thereof) for a maximum penalty of $60,000 per year.

If a usufruct is established in a foreign country and characterized as trust, the trust could be classified as a foreign entity that needs to be disclosed on a Form 8938 as a specified foreign financial asset.

In some cases, a usufruct could be characterized as a foreign partnership or foreign corporation for U.S. tax purposes. If a usufruct can be classified as a foreign partnership or foreign corporation for U.S. tax purposes, a U.S. usufructuary may also need to disclose the usufruct to the IRS on Form 8865 “Return of U.S. Persons With Certain Foreign Partner” or Form 5471 “Return of U.S. Persons With Respect to Certain Foreign Corporations.” The IRS may assess significant additional annual penalties against an individual that failed to timely file required Form 8865s and Form 6571s.

Conclusion

As indicated in this article, usufructs are a valuable succession-planning tool in France and other foreign countries, but they pose a number of U.S. tax planning and reporting considerations.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.