For U.S. business owners living abroad, one of the key U.S. basic concepts to understand is that your foreign entity may be classified differently under the U.S tax law than its legal classification in your country of residence.
As a classic example, trusts are often formed in Australia and New Zealand to run local businesses, with trust formation offering liability protection and tax efficiency under local rules. However, from a U.S. tax perspective, as we explain below, a trust created to run a business, rather than to preserve assets for beneficiaries, may be classified as a partnership or corporation under U.S. rules. This dissonance can lead to deleterious implications for a U.S. business owner who must consider both U.S. and local tax rules.
Ultimately, the entity classification election, or so-called “check-the-box” election, provides U.S. taxpayers with the ability to choose the classification of their entity, by filing the Form 8832 with the IRS. Careful consideration should be giving to choosing a classification that ensures a structure that harmonizes the tax rules in each relevant country.
In this blog, we review the authorities that address the issue of entity classification when it comes to foreign trusts. We include a thorough discussion of the IRS Form 8832 entity classification election and how it can help if properly utilized.
Classification of Trusts
A comprehensive analysis of tax classification under U.S. tax law begins with the issue of whether a financial arrangement should constitute an “entity” for U.S. federal income tax purposes. Neither the Code nor the entity classification regulations specifically define the term “entity” for U.S. federal income tax purposes. However, the Treasury Regulations do provide under § 301.7701-1(a)(1) that “whether an organization is an entity separate from its owners for U.S. federal income tax purposes is a matter of U.S. federal tax law and does not depend on whether the organization is recognized as an entity under local law.” Further, under Treasury Regulation § 301.7701-1(a)(2), “a joint venture or other contractual arrangement may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits there from.”
In the case that a trust satisfies the above definition and therefore constitutes an entity for tax purposes, the next step is to determine whether such entity should properly be classified as a “business entity” or, alternatively, as an entity taxable as a trust, under Treasury Regulation § 301.7701-4. Treasury Regulation § 301.7701-2(a) defines a “business entity” as “any entity recognized for federal income tax purposes… that is not properly classified as a trust under Treasury Regulation § 301.7701-4 or otherwise subject to special treatment under the Internal Revenue Code.”
Under Treasury Regulation § 301.7701-4, in relevant part, trusts classified as “ordinary trusts” are treated as trusts for U.S. federal income tax purposes without the ability to elect otherwise. Once classified as a trust for tax purposes, the further classification of such trust is determined by certain grantor versus non-grantor rules under the Internal Revenue Code.
On the other hand, under Treasury Regulation § 301.7701-4, in relevant part, trusts that are properly classified as “business trusts” are classified as business entities as defined in Treasury Regulation § 301.7701-2. Once classified as a business entity, the further classification of the trust is determined by certain default rules and election options under the so-called “check-the-box” regulations, which render the trust as either a corporation, partnership, or disregarded entity for tax purposes. We discuss the check-the-box regulations in detail further below.
Ordinary Trusts versus Business Trusts
Treasury Regulation § 301.7701-4(a) describes an “ordinary trust” as follows:
“In general, the term ‘trust’ as used in the Internal Revenue Code refers to an arrangement created either by will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts. Usually the beneficiaries of such a trust do no more than accept the benefits thereof and are not the voluntary planners or creators of the trust arrangement… Generally speaking, 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 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 a profit.”
Treasury Regulation § 301.7701-4(b) describes a “business trust” as follows:
“There are other arrangements which are known as trusts because the legal title to property is conveyed to trustees for the benefit of beneficiaries, but which are not classified as trusts for purposes of the Internal Revenue Code because they are not simply arrangements to protect or conserve the property for the beneficiaries. These trusts, which are often known as business or commercial trusts, generally are created by the 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 under the Internal Revenue Code. However, the fact that 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 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.”
Case Law and IRS Authorities
In determining whether a trust should be treated as an ordinary trust or business entity, courts have looked mainly at two factors - the presence of associates and a business purpose. Two cases provide guidance as to whether the absence of one factor can prevent a trust from being recast as a business entity, Bedell Trust. v. Comm’r, 86 T.C. 1207 (1986) and Elm Street Realty Trust v. Comm’r, 76 T.C. 803 (1981). In these cases, the Tax Court held that although the trust had a business objective, it lacked associates and therefore was a trust and not a corporation for federal tax purposes. These two cases established that failure alone of the associates test is decisive wholly apart from whether the trust may have also satisfied the conduct of a business purpose test.
In the Bedell case, the Court held that the family beneficiaries of an elderly man’s testamentary trust, which conducted a manufacturing and retailing business were, not “associates” because (1) they neither created nor contributed to the trust, (2) their interests in the trust were not transferable, and (3) only three out of ten of them participated as trustees in the trust’s affairs. Thus, the trust was held to be a true trust and not taxed as a business entity.
The Elm Street Realty case involved an inter vivos estate planning trust which received rent in the form of passive income from net lease of real estate. The trust’s organizing instrument provided the trustee with broad powers over the trust property and provided the beneficiaries with limited power with respect to amendments to the trust, termination of the trust, and appointment of a successor trustee. The Court found the powers granted to the trustee were broad enough to allow the trustee to go beyond the mere collection of passive income from real estate and actually “acquire, hold, improve, manage, and deal in real estate,” and determined that the trust did in fact have a business objective. However, the Court held that beneficiaries were not associates due to the following reasons: 1) they played no active role in the creation of the trust and received their interest gratuitously; 2) the trust’s interests of the beneficiaries are transferable only under certain restrictive provisions; and 3) the ability of the beneficiaries to influence or otherwise participate in the trust’s activities was limited because the trust agreement required concurrence by all of the beneficiaries or the concurrence of the trustee in addition. Due to the absence of associates, the Court thus held that the trust could not properly be classified as an association within the meanings of the Treasury Regulations.
In Water Resource Control v. Commissioner, 61 TCM 2102 (1991), the Tax Court, following the guidance in Bedell and Elm Street Realty, held that where a husband created a trust to hold a business interest for his wife, the trust was not a business entity because the entity did not have associates. The wife was not an associate where she did not actively participate in the trust’s creation or conduct.
In contrast to the above case law, the IRS has classified trusts as business entities, even without the presence of associates, as long as a business purpose could be established. For instance, in Revenue Ruling 57-534, 1957-2 CB 924, the IRS ruled that a trust utilized by the beneficiaries as a medium to carry on a joint enterprise for their joint profit constituted a business entity and not a trust, even though the beneficiaries had no part in establishing the trust and were without power to modify the trust agreement or to terminate the trust.
In determining whether a business purpose exists, the IRS has focused its analysis on the intent of the trust parties as well as the extent of the trustee’s powers. For instance, in Revenue Ruling 78-371, 1978-2 CB 344, the heirs to a number of contiguous parcels of real property subject to a net lease created a trust to collect the net income and distribute the same quarterly. The trust instrument provided that the trustee could acquire or sell additional or existing contiguous property to “protect or conserve” existing trust property and values. Any sales proceeds not invested in contiguous property could be invested in only liquid non-volatile assets (e.g., certificates of deposit). The Service determined that this trust should be treated as a business entity and not as a trust, because of the presence of broad trustee powers to (1) acquire additional property; (2) sell existing property; (3) erect a building; and (4) otherwise manage the trust property for the beneficiaries.
Classification of Business Trusts
In the case that the proper classification of a particular trust arrangement is that of a business trust and therefore a business entity, the next step in classifying the trust is to determine whether such business entity should be treaty as corporation, partnership, or as disregarded for tax purposes.
Much of the case law and IRS guidance on this issue pre-dates the check-the-box regulations that were promulgated in 1996. This is because prior to the promulgation of the check-the-box regulations, the classification of entities was subject to certain factors described in older case law and former regulations (referred to as the “Kintner regulations”), which were weighed against one another and therefore open to wider interpretation. The check-the-box regulations, as further described below, fundamentally changed the tax classification landscape by allowing eligible entities to choose their classification.
Case Law and IRS Authorities
Based on the factors enumerated in the former Kintner regulations, the IRS has found in several instances that trusts should be recast as partnerships for U.S. federal income tax purposes.
For instance, in Rev. Rul. 64-220, 1964-2 CB 335, the IRS ruled that where beneficiaries of a trust had the sole right to operate the trust’s rental property held by a trust company as trustee for their joint profit, such operation resulted in the creation of a partnership for federal income tax purposes with the beneficiaries as members thereof. The IRS stated, that “where beneficiaries of a trust have the power to manage the trust property and direct the trustee, they have been held liable as partners to third parties (Conover’s Estate, 295 Ill. App. 443, 14 N.E. 2d 980 (1938)). Since management and control of the trust property is in the beneficiaries, the arrangement does not have the corporate characteristic of limited liability.” The IRS viewed the trust as “an arrangement whereby the bare legal title to the business property has been transferred to a trustee to facilitate holding of title and the beneficiaries operate the business either as an association or a partnership.”
In Private Letter Ruling 8510001 (1984), the IRS ruled that a trust was classified as partnership rather than a corporation for federal income tax purposes, because the trust didn’t have the corporate characteristics of centralization of management and limited liability, so the arrangement didn’t have more corporate than non-corporate characteristics. On the issue of limited liability, the IRS stated, “If all or a majority of beneficiaries of a trust have the power to instruct the trustees on questions of management of the business of the trust, the beneficiaries are liable as partners for the debts of the organization. In order for the beneficiaries to be exempt from personal liability, the trust must be one in which the beneficiaries have not reserved any extensive powers of control over the business.”
IRS Form 8832 and Checking the Box
With the promulgation of the check-the-box regulations in 1996, the rules of entity classification were drastically altered. Instead of weighing a number of factors, the check-the-box regulations offer simple default rules as well as the ability to elect a business entity’s tax classification, unless the entity is designated as a per se corporation, in which case it is automatically treated as a corporation for tax purposes without the ability to elect otherwise. Per se corporations generally include entities incorporated in the United States under federal or state statute, as well as certain similar non-U.S. entities listed in the regulations. See Treas. Reg. § 301.7701-2(b).
Under the check-the-box regulations, business entities that are not per se corporations (referred to in the regulations as “eligible entities”) are first subject to certain default rules, which apply separately to U.S. and non-U.S. entities. A U.S. eligible entity is treated by default as a partnership if it has two or more members, or as a disregarded entity if it has a single owner. A non-U.S. eligible entity is treated by default as a partnership if it has two or more members and at least one member does not have limited liability, as an association taxed as a corporation if all members have limited liability, or as a disregarded entity if it has a single owner that does not have limited liability. See Treas. Reg. § 301.7701-3(b).
Thus, in the case of a non-U.S. entity, tax classification is tied heavily to the issue of limited liability. In this regard, the regulations state that for purposes of the default rules:
“a member of a foreign eligible entity has limited liability if the member has no personal liability for the debts of or claims against the entity by reason of being a member. This determination is based solely on the statute or law pursuant to which the entity is organized, except that if the underlying statute or law allows the entity to specify in its organizational documents whether the members will have limited liability, the organizational documents may also be relevant. For purposes of this section, a member has personal liability if the creditors of the entity may seek satisfaction of all or any portion of the debts or claims against the entity from the member as such. A member has personal liability for purposes of this paragraph even if the member makes an agreement under which another person (whether or not a member of the entity) assumes such liability or agrees to indemnify that member for any such liability.” See Treas. Reg. § 301.7701-3(b)(2)(ii).
The Preamble to the check-the-box regulations notes that, “In order to provide most eligible entities with the classification they would choose without requiring them to file an election, the regulations provide default classification rules that aim to match taxpayers’ expectations (and thus reduce the number of elections that will be needed).” See Treasury Decision 8697 (12/17/96).
IRS Form 8832 - The Check-the-Box Election
While the above default rules are certainly relevant in arriving at a business entity’s tax classification, the main novelty of the check-the-box regulations is that they allow an eligible entity to choose its tax classification, subject to the number of owners (for instance, a business entity with one owner can choose corporation or disregarded status but not partnership status, while a business entity with more than one owner can choose corporation or partnership status but not disregarded status). The choice is made by filing the “check-the-box” election, named after the election form, IRS Form 8832, on which the taxpayer checks the box next to its desired classification.
The regulations do have certain logistical limitations designed to prevent potential abuse. For instance, once an eligible entity makes an election to change its classification, the entity generally cannot change its classification by election again during the 60 months after the effective date of the election. The 60-month limitation does not apply if the previous election was made by a newly formed eligible entity and was effective on the date of formation. The regulations also contain certain restrictions regarding the election’s effective date, and they restrict late elections unless a number of conditions are met. See Treas. Reg. § 301.7701-3(c)(1)(iii).
However, given the intended practicality of the default rules and the overall flexibility of the election rules, most taxpayers can easily achieve their desired classification. When choosing such classification for your foreign trust, a number of items should be considered, including timing of income inclusion, foreign tax credit eligibility, the U.S. CFC rules, among others. Given the many important nuances that come with choosing an entity’s classification, it’s highly recommended to consult with an expat tax professional to ensure the tax efficiency of your business structure.