Trusts are one the most popular investment and business vehicles used worldwide. It provides various benefits and planning opportunities for families and businesses.
However, the reader should be aware that the legal definition of a trust is not necessarily the same as that of the IRS for federal income tax purposes.
This article will broadly examine the issues local and global tax advisors must address when a client uses a trust structure for US expansion and how it could be classified for federal income tax purposes with specific emphasis on when it constitutes a “business trust”.
Classifying a trust for US Federal Income Tax purposes is of critical importance. An entity which is not classified as an “ordinary” trust for US tax purposes is treated as either a corporation or a partnership. (Reg. Section 301.7701-2(a)).
Reg. Section 301.7701-1(a)(1) provides that:
whether an organization is an entity separate from its owners for federal tax purposes is a matter of federal tax law and does not depend on whether the organization is recognized as an entity under local law.
If the participants of a trust carry on trade, business, financial operations or ventures and divide the profits from that trade, it could create a separate entity for federal tax purposes.
THE CLASSIFICATION OF A TRUST FOR FEDERAL INCOME TAX PURPOSES
The entity classification rules use the term “ordinary” trust to distinguish such an entity from a “business” trust which would be classified as either a corporation or a partnership.
The Internal Revenue Code does not define a trust, however the regulations contain sections that define trusts and differentiate them form taxable entities such as corporations or partnerships.
Section 301.7701-4(a) of the Regulations provide that in general, the term “trust” refers to –
“an arrangement created either by a will or by an inter vivos declaration whereby trustees take title to property for the purposes of protecting or conserving it for the beneficiaries.”
The regulations also distinguish a trust from a taxable association.
An arrangement will be treated as a trust under the Internal Revenue Code if it can be shown that the purpose of the arrangement is to vest in trustees the responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.
WHAT IS CLASSIFIED AS A BUSINESS TRUST FOR FEDERAL TAX PURPOSES
Section 301.7701-4(b) addresses “business trusts” and state that they are Trusts that generally are created by beneficiaries simply as a device to carry on a profit-making business which normally would have been carried on through business organizations that are classified as corporations or partnerships.
The main reason why business trusts are not regarded as trusts for federal tax purposes is because it’s not used to protect or conserve the property for the beneficiaries but rather to carry on a profit-making business.
A business trust with more than one beneficiary may be taxable as a partnership and a business trust that is a domestic eligible entity, with a single owner is disregarded as an entity separate from its owner.
It’s however important to note that if the corpus of the trust is not supplied by the beneficiaries is not sufficient reason in itself for classifying the arrangement as an ordinary trust rather than as an association or partnership.
The fact that any organization is technically cast in the trust form, by conveying title to property to trustees for the benefit of persons designated as beneficiaries, will not change the real character of the organization if the organization is more properly classified as a business entity under § 301.7701-2.
A business entity is any entity recognized for federal tax purposes (including an entity with a single owner that may be disregarded as an entity separate from its owner) that is not properly classified as a trust under Section 301.7701-4 or otherwise subject to special treatment under the Internal Revenue Code.
A business entity with two or more members is classified for federal tax purposes as either a corporation or a partnership. A business entity with only one owner is classified as a corporation or is disregarded; if the entity is disregarded, its activities are treated in the same manner as a sole proprietorship, branch, or division of the owner.
METACOGNITION – “GAIN ABILITY TO THINK ABOUT THE WAY YOU THINK”
When it comes to the US and classification of entities for Federal Tax Purposes, you should utilize metacognition. In simple terms, do not just assume your trust, either US or foreign is a trust for US Federal Tax Purposes.
An entity that purports to be a trust, but that conducts an active trade or business will be reclassified as a business trust in the US and this could have severe tax implications.