SECTION 2. BACKGROUND

Prior to the Small Business Job Protection Act of 1996, Pub. L. 104–188, 110 Stat. 1755 (1996) (SBJP Act), the status of a trust as domestic or foreign turned upon the subjective determination of whether the trust was more comparable to a resident or a nonresident alien individual. See Rev. Rul. 60–181, 1960–1 C.B. 257, citing B.W. Jones Trust v. Commis- sioner, 46 B.T.A. 531 (1942), aff’d, 132 F.2d 914 (4th Cir. 1943) (prior law).

Section 1907(a) of the SBJP Act amended § 7701(a)(30) and (31) of the Code to provide more objective criteria for determining the status of a trust. New § 7701(a)(30)(E) provides that a trust will be treated as a domestic trust if: (1) a court within the United States is able to exercise primary supervision over the administration of the trust, and (2) one or more United States persons ¹ have the au

1As originally enacted by the SBJP Act, new § 7701(a)(30)(E)(ii) required one or more United States fiduciaries to have the authority to control all substantial decisions of the trust. The Taxpayer Relief Act substituted the word “persons” for the word “fiduciaries.”

thority to control all substantial decisions of the trust. New § 7701(a)(31) provides that a foreign trust is any trust that is not a domestic trust.

New § 7701(a)(30) and (31) apply in determining the status of a trust for taxable years beginning after December 31, 1996. A trust may, however, elect pursuant to § 1907(a)(3)(B) of the SBJP Act to have the new criteria apply to the first taxable year of the trust ending after August 20, 1996 (the date of enactment of the SBJP Act).

A trust that qualified as a domestic trust under prior law could fail to qualify as a domestic trust under new § 7701(a)(30)(E). Thus, solely due to the change in law, a domestic trust could become a foreign trust as of the first day of its first taxable year beginning after December 31, 1996. Such a change may have significant adverse tax consequences. A nongrantor trust whose status changed from domestic to foreign prior to August 5, 1997 (the effective date of the repeal of § 1491), was treated for purposes of § 1491 as having transferred, upon becoming a foreign trust, all of its assets to a foreign trust, and therefore may have been subject to the § 1491 excise tax. A nongrantor trust whose status changed from domestic to foreign on or after August 5, 1997 (the effective date of § 684) is treated as having transferred all of its assets to a foreign trust and must recognize as gain the excess of the fair market value of the property transferred over its adjusted basis under § 684.

To avoid the change from domestic to foreign status, a domestic trust needed to amend its provisions to meet the definition set forth in new § 7701(a)(30)(E) by the first day of its first taxable year beginning after December 31, 1996. To assist domestic trusts that may have had difficulty conforming to the new domestic trust criteria, the Service published Notice 96–65, 1996–2 C.B. 232. That notice permits a domestic trust in existence on August 20, 1996, to continue to file tax returns as a domestic trust for taxable years beginning after December 31, 1996, notwithstanding the status of the trust under new § 7701(a)(30)(E), if certain conditions are satisfied. See also § 1601(i)(4) of the Taxpayer Relief Act. To obtain the relief provided in Notice

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96–65, a trust is required to: (1) initiate modification of the trust to conform to new § 7701(a)(30)(E) by the due date (including extensions) for filing the trust’s income tax return for its first taxable year beginning after December 31, 1996; (2) complete the modification within two years of that date; and (3) attach a statement to the trust’s income tax return, as described in Notice 96–65.

Subsequent to the publication of Notice 96–65, Congress enacted § 1161 of the Taxpayer Relief Act. Section 1161 allows a trust that was in existence on August 20, 1996 (other than a trust treated as owned by the grantor), and that was treated as a domestic trust on August 19, 1996, to elect to continue treatment as a domestic trust, regardless of the result of the application of new § 7701(a)(30)(E) to the trust.