As I mentioned in an earlier article, U.S. tax law includes a number of important exceptions to legal definition of a foreign trust – i.e. an entity can be classified as a foreign trust for legal purposes and not as a trust (but as a corporation or a partnership) for U.S. tax purposes. This is also true with respect to domestic trusts, but, in international context, the issues are far more complicated and require detailed exploration of facts and, often, local laws. In this article, I would like to discuss one of the most common exceptions to foreign trusts – business trusts.
Business Trusts Taxed as Corporations or Partnerships
Where an entity is organized as a trust but engages in the active conduct of trade or business, the IRS may re-classify this trust as a “business trust” and tax it as a corporation or partnership. The most relevant primary law on this point can be found in IRS Regs. §301.7701-4(b):
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 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.
Let’s explore these regulations in more depth in order to have a clear idea of the general test for business trusts.
Most Important Features of Business Trusts for Federal Income Tax Purposes
There are two most important factors in determining whether a trust is a business trust. The first and most important distinction between ordinary trusts and business trusts is the conduct of a “profit-making business” which “normally” would have been done by a business entity. It is important to understand that it is not simply the ownership of business assets which re-classifies ordinary trusts in business trusts; rather, while ordinary trusts must be created for the purpose of conservation and preservation of assets for beneficiaries, business trusts should be created for the purpose of the profit-making activities.
How does one determine the purpose for which a trust is created? There are various factors, including the history of the trust. The trust agreement (the document that creates the trust), however, is the key document on which the IRS will focus.
The second important feature of business trusts concerns domestic and foreign trusts which have associates to conduct an active trade or business for their benefit. In such cases, the trusts will be reclassified as business trusts and taxed as corporations or partnerships.
Both of these factors in determining the business nature of a trust rely are highly dependent on facts and require minute analysis of a trust’s history and circumstances. The help of an experienced international tax lawyer is indispensable in this matter.
Contact Sherayzen Law Office for Professional Help With Trust Classification
If you are a beneficiary or grantor of a foreign trust, contact Sherayzen Law Office for professional help in determining the classification of the trust. The founder of our firm, Mr. Eugene Sherayzen, is a highly experienced international tax lawyer who has helped hundreds of taxpayers in and outside of the United States with their U.S. international tax compliance issues.