Is that trust an ordinary trust or a
business trust? Learn the difference.
If a business trust, will it be taxed as a partnership or as a corporation?
by Carter G. Bishop, professor at Suffolk University
Law School in Boston
Is that trust an ordinary. trust or a business
trust? The tax man [I.R.S. in USA] says it makes a difference.
Business lawyers commonly assume that trusts
formed for their clients will be taxed as "ordinary trusts" under [U.S.A.]
federal income tax rules. This generally means trust income is taxed to the
beneficiaries when trust income is actually distributed. When trust income
is accumulated for later distribution, it is "temporarily" taxed to the
trust itself and then later to beneficiaries who receive distributions and a
form of tax credit for the tax paid earlier by the trust.
These trust taxation norms do not apply when a
trust is considered a "business trust" and is therefore taxed like other
similar business entities [corporations and partnerships].
The applicable legal standard distinguishing an ordinary trust from a
business trust has remained relatively static (albeit vague) since the
ancient origins of our federal tax system. However, the consequence of
business trust status was radically altered in 1997. In that year, the
blockbuster "check-the-box" federal tax regulations mercifully mitigated the
stakes of a trust being considered a business trust (the regulations were so
designated because they allowed lawyers to choose tax classification simply
by in effect checking the box relating to the most desired tax
classification [corporation or partnership]. See Treas. Reg. ß 301.7701-1 to
-4.
Prior to the 1997 release of the watershed check-the-box regulations,
the 1960 "Kintner" federal tax regulations generally incorporated ancient
case law to classify trusts. Ordinary trusts were classified and taxed like
trusts. Business trusts were considered a corporation or a partnership
depending on whether the trust's legal characteristics more closely
resembled those of a corporation or a partnership.
Applying standards first articulated in
Morrissey v. Commissioner, 296 U.S. 344 (1935), the Kintner
regulations provided that trusts possessing three of four identified
corporate criteria were taxable as corporations (free transferability of
interests, limited liability, centralized management, and continuity of
life). Trusts possessing less than three of these criteria were taxable as
partnerships.
Notably, the ordinary legal characteristics of a trust dictated that
most business trusts were taxable as corporations. Lawyers with experience
in these matters were occasionally able to draft trust instruments to make a
business trust taxable as a partnership.
The check-the-box regulations carried forward the
Kintner regulations theme that ordinary trusts were classified and taxed
like trusts. However, once a trust is considered a business trust, the
classification results are dramatically different. Business trusts are no
longer classified as other business entities on the basis of their corporate
resemblance.
Rather, under a default rule, all business trusts are considered either
disregarded entities (one beneficiary) or partnerships (two or more
beneficiaries). Those business trusts interested in being classified as a
corporation for federal tax purposes may do so by filing an election to be
taxed as a corporation.
Although disregarded entity status is not typical for a trust, the
reporting status of such a trust is essentially that of a grantor trust
where trust income is taxed directly to the sole beneficiary as if received
directly by the beneficiary (see Treas. Reg. 1.671-2(c)). It's important to
note that the trust is disregarded only for federal income tax purposes and
not other state law purposes. For example, the trust liability shield should
apply to beneficiaries who do not improperly participate in the management
of trust affairs and the trust would continue to be a separate legal entity
for contract law purposes.
Partnership tax rules are different from normative
taxation and some of the differences may create concerns. Notably,
partnership income is taxed directly to its partners in their profit-sharing
ratios in the year earned by the partnership regardless of whether actually
distributed. Trust rules will mirror this result only where trust income is
actually distributed to beneficiaries.
Thus, partnership taxation would eliminate separate taxation of
accumulated income to the trust and place more pressure on trustees to
actually make discretionary distributions in an amount at least necessary to
cover beneficiary tax liability.
The classification consequences above only occur
when a trust is first considered a business trust rather than an ordinary
trust. While the check-the-box regulations dramatically converted the
Kintner regulations' ordinary corporate classification into disregarded
entity (grantor trust) and partnership status, those same regulations did
nothing to affect when an ordinary trust will be considered a business
trust. Indeed, that momentous decision incorporates ancient case law.
Whether a trust is considered an ordinary trust or
a business trust depends on (1) whether the terms of the written trust
instrument grants the trustee broad powers to engage in a business with the
trust property and (2) whether the trust also has associates. This is true
regardless of whether the business purpose powers are necessary for a
particular trust and regardless of whether the trustee actually exercises
those powers.
Ordinary trusts do not have associates or an objective to carry on
business for profit (Treas. Reg. ß 301.7701-1(b)). The term "trust" as used
in the classification regulations therefore refers to an arrangement whereby
trustees accept title to property for the sole or primary purpose of
protecting or conserving it for the trust beneficiaries. Thus, a trust-type
arrangement will be respected as a trust only where a settlor creates the
trust with a purpose to vest the trustees with responsibility for the
protection and conservation of property for beneficiaries who cannot share
in the discharge of this responsibility and therefore are not considered
associates in a joint enterprise for the conduct of business for profit
(Treas. Reg. ß 301.7701-4(a)).
Business trusts, on the other hand, often involve trusts created by
beneficiaries as a device to carry on a profit-making business and thus do
not involve a trust created by a settlor to simply protect or conserve
property for beneficiaries (Treas. Reg. ß 301.7701-4(b)). This means that
whether a trust will be initially considered an ordinary trust or a business
trust will depend on whether it is imbued with both (1) an objective to
carry on a business and divide its gains (business purpose issue) and (2)
associates (associates issue). [Legal
Court Decision: "In business trusts, the object is not to hold
and conserve a particular property, but to provide a medium for the conduct
of business and the sharing of profits. The court held that the nature of a
trust as a business organization is to be determined primarily from the
intent of the parties as manifested in the terms of the trust agreement.
Koenig v. Johnson, 71 Cal. App. 2d 739, 163 P.2d 746 (1945)", as cited
at In the Interest of Green Valley Financial Holdings, Colorado Court
of Appeals No. 00CA2060, August 16, 2001]
The presence of a business purpose gives trusts
their "business trust" moniker and often is the most important of the two
tests because it is not possible for a trust to have "associates" when the
trust does not also have a business purpose.
Elm Street Realty Trust v. Commissioner, 76 T.C. 803
(1981), determined that a trust created with a business purpose was not a
business trust because it lacked associates. Two businessmen created the
trust by transferring property to the trust subject to an 11-year net lease.
The two settlors were also the initial beneficiaries but they soon
gratuitously transferred the beneficial interests to other family members.
The Tax Court noted that the Morrissey standard
requires that the beneficiaries be joined together in a common business
effort. This in turn requires some concerted, purposeful and voluntary
effort on the part of the beneficiaries to either "plan or join" a
pre-existing business activity for the "purpose of sharing the fruits" of
its business
activities. When the beneficiaries do not create the
trust but receive their interests by gift (rather than by purchase, see
Howard v. United States, 5 Cl. Ct. 334 (1984)), some further act on their
part is necessary to satisfy the "associates" requirement.
To apply this analysis, the Tax Court examined the
trust instrument searching for a power of beneficiaries to share or
influence the trustee's duties under the trust. Where the trust instrument
vests exclusive power and authority over trust matters in the trustee and
thus precludes beneficiaries from sharing this responsibility, the test will
not be met (see also Bedell v. Commissioner, 86 T.C. 1207 (1986) and Field
Service Advisory, 1993 Westlaw 1470195)
The important Elm Street Realty Trust case
therefore sets forth various methods that lawyers may use to assure that a
trust lacks associates and to further assure ordinary trust status even in
trusts created with a business purpose. In order to lack associates, a
trust:
• should not be created by the
beneficiaries who instead receive their beneficial interests by way of gift
from the settlor and
• the instrument should
specifically prohibit the beneficiaries from exercising any trustee powers
(but a removal power should be acceptable).
Even a trust with a demonstrated business purpose will not be
classified as a business trust unless it also has associates. Given that
many lawyers considered it prudent for the trust instrument to grant the
trustee the broadest possible powers to deal with trust property on behalf
of the beneficiaries, the presence or absence of associates may be critical
to the classification issue. Unfortunately, as discussed below, once the
business purpose standard is met,
the associates standard is also very easy to satisfy.
Morrissey again played a central role in the early
formulation of this standard by indicating that the term "associates"
implies persons entering into a joint business enterprise for the purpose of
sharing the gains of that business. Under this definition, simply becoming a
beneficiary in a trust created with a business or commercial purpose may be
adequate to label the beneficiaries as associates.
Copyright © 2003 by American Bar Association and by Carter G. Bishop
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