Forgotten trust: a check-the-box Achilles' heel.

• Author: Bishop, Carter G.

The classification question "is a practical one, dependent upon experience. The demand for symmetry ignores the specific difference that experience is supposed to have shown to mark the class. It is not enough to invalidate the law that others may do the same thing and go unpunished, if, as a matter of fact, it is found that the danger is characteristic of the class named." (1)

1. INTRODUCTION

   The 1997 "check-the-box" Regulations (2) replaced the 1960 Kintner (3) corporate resemblance tests, (4) substituting simplicity and certainty for complexity and uncertainty regarding the federal tax classification of unincorporated business entities. (5) The check-the-box Regulations have attracted some criticism. One broad modern critique argues that the regulations fail in several important respects to reach their full promise. (6) While this Article is also critical of the check-the-box Regulations, the approach is different and indeed is based on an issue barely mentioned in the broader modern critique: "it does seem appropriate not to subject the latter type of entity [ordinary trust] to a regime designed to tax businesses." (7) Because of this conclusion, the issue was not further explored and the critics failed to seriously consider the reasonable alternatives and consequences of other approaches. While the broad modern critique is well reasoned in other aspects, this Article directly investigates whether an Achilles' heel of check-the-box Regulations was its failure to address the ancient but vitally important distinction between business trusts and ordinary trusts. (8)

   Extensive early litigation focused on the federal tax classification of common-law trusts, such as the Massachusetts business trust, (9) as ordinary or business trusts. (10) The ordinary trust was taxed under Subchapter J whereas a business trust was classified and taxed as a corporation under Subchapter C. As business entity forms shifted from trusts to partnerships, and particularly limited partnerships, extensive litigation once again used early developed case law standards to differentiate partnerships taxed under Subchapter K and those more properly taxed as corporations. As an ultimate factor, a partnership was taxed under Section 7704 as a corporation when the partnership interests were publicly traded. (11) Over time, as business forms further shifted to limited liability companies, the Kintner Regulations became burdensome to apply and the check-the-box Regulations were released and became final in 1997. While the original case law tax classification efforts were directed at trust classification problems, the Kintner Regulations and Section 7704 were primarily used to distinguish first limited partnerships and later limited liability companies from corporations. The check-the-box Regulations were designed to solve the limited partnership and limited liability company classification problem, not the trust classification issue. Thus, trusts were the forgotten element. For all the good done by the check-the-box Regulations in classifying unincorporated business entities, the regulations failed miserably to clarify distinctions between ordinary trusts and business trusts.

   That exclusion is becoming more problematic as business forms continue to evolve. The statutory trust is now being used to conduct businesses previously conducted in partnership or limited liability company forms. (12) Many states (13) have now adopted a statutory business trust form and, indeed, the National Conference of Commissioners on Uniform State Laws (NCCUSL) has promulgated a Uniform Statutory Trust Entity Act (USTEA). (14) A USTEA statutory trust may be formed for any lawful purpose (15) but may not be used for a predominately donative (ordinary trust) purpose. (16)

   There is no specific answer available as to why the check-the-box Regulations fail to provide any guidelines for distinguishing business trusts, (17) subject to the regulations, (18) and ordinary trusts, (19) subject only to Subchapter J restrictions. (20) The effect is to dodge the question and its importance entirely and subject the trustees for business trusts to an uncertain tax classification status determined by reference to the most ancient litigated cases distinguishing ordinary and business trusts.

   Like other business entities under the check-the-box Regulations, (21) unless a business trust elects to be taxed as a corporation, (22) it is taxed as a disregarded entity, if it has only one beneficiary, (23) or a partnership under Subchapter K, if it has more than one beneficiary. (24) Due to the fact that an ordinary trust is not a business entity, because it exists merely to conserve and protect property, it was excluded from the check-the-box regime. (25) An ordinary trust is taxed under Subchapter J either as a grantor trust, with all income taxed to the grantor, or as a simple or complex trust, with income taxed to the beneficiaries or the trust. The unfortunate check-the-box inclusion of business trusts and exclusion of ordinary trusts reinforces and ignores the uncertain difference between the two trusts with very little tax revenue or policy at stake. The exclusion perpetuates the uncertain classification of common-law trusts as an ordinary or business trust in the first instance. Rather, the ordinary-business trust distinction continues to rely on uncertain rules gleaned mostly from case law parameters developed since the early twentieth century. In order to eliminate this lingering uncertainty that plagues lawyers and trustees, this Article proposes a new but simple and expedient paradigm for eliminating this check-the-box Achilles' heel.

   While seemingly simple and thorough, the regulations have attracted modern criticism. One modern critique argues the regulations fail in several important respects to reach their full promise. (26) The direction of this Article is different and indeed is based on an issue barely mentioned in the modern critique. This Article argues that the Achilles' heel of check-the-box Regulations was the failure to address the ancient but vitally important distinction between business trusts and ordinary trusts. The modern critique devotes scant attention to this significant oversight by merely reiterating that "it does seem appropriate not to subject the latter type of entity [ordinary trust] to a regime designed to tax businesses." (27)

   There are two fundamental tax methods regarding the federal income taxation of business organizations. The corporate method generally taxes income to the entity and again to its owners when the remaining income is distributed (Entity Double Tax Model--Subchapter C). (28) The partnership method does not impose a tax at the entity level but rather taxes entity income directly to the owners regardless of whether distributed (Owner Single Tax Model--Subchapter K). (29)

   The federal tax method applicable to trusts (Subchapter J) generally follows a modified Owner Single Tax Model where the trust owners and beneficiaries--rather than the trust--are taxed on trust income only when actually distributed. (30) However, when an ordinary trust assumes commercial-like purposes and characteristics and becomes a commercial trust, it forfeits the right to be taxed according to the ordinary trust system, and like other business organizations, must be taxed like a corporation or partnership. Prior to the adoption of the 1997 check-the-box Regulations, commercial trusts were frequently classified as associations and taxed like corporations under the then applicable 1960 Kintner Regulations. (31) The check-the-box Regulations radically altered this outcome by implementing a default classification for commercial trusts as partnerships.

   While the 1997 classification changes were highly beneficial to commercial trusts, the regulations failed to consider the initial question of whether a particular trust should be classified as ordinary and subject to Subchapter J, or commercial and subject to Subchapter K. This Article argues that the failure to address this initial question violated the simplification policy goal of the check-the-box Regulations. The proposed fix is quite simple and elegant: the check-the-box Regulations should be amended to provide that all trusts, except statutory business trusts, are classified as ordinary unless the trust elects to be considered a business organization, in which case it would be classified as a commercial trust. Given the minor differences that exist in tax outcomes between ordinary and commercial trust classification under the check-the-box Regulations, the overwhelming complexity and uncertainty associated with the difference is no longer justified.

   In order to provide the proper context for the proposal, Part II first considers the contorted and ancient history regarding the tax classification of trusts dating back to the late nineteenth century. Part III considers the second generation history of trust classification under the 1960 Kintner Regulations. Part IV considers the current tax classification of trusts under the check-the-box Regulations. Finally, Part V considers the merits of a specific proposal to revise and amend the check-the-box Regulations in order to further simplify the characterizations of all trusts as ordinary trusts regardless of the presence of commercial purposes.

2. THE HISTORY OF ASSOCIATION STATUS

   The check-the-box Regulations were not intended to change the determination of when a trust is an ordinary trust versus a commercial trust. (32) The principal function of the regulations, as related to trusts, was to change the classification of commercial trusts from associations taxable as corporations (under the 1960 Kintner Regulations) to partnerships (under the check-the-box Regulations). (33) As a result, the entire legislative, regulatory, and judicial history regarding the classification of trusts prior to the 1997 adoption and repeal of the 1960 Kintner Regulations...