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Trust Law/Level VII · Property and business/7.2 Business/Lesson 1

Business trusts

What a business trust is, where the form came from, and why US federal tax rules usually classify it as a business entity rather than a trust.

Education, not legal advice. Trust law changes from country to country and state to state, and the right structure depends on your situation. Anything you sign should be drafted or reviewed by a qualified lawyer where you live.

The lean path

The cheapest, lowest-tax, simplest and most private route the law allows, best first. Each step names the rule it rests on and the condition that keeps it lawful.

  1. For most small businesses an LLC is simpler than a business trust: one owner is disregarded and two or more form a partnership by default under Treas. Reg. §301.7701-3, with no federal entity-level income tax.
  2. The trust label buys no tax advantage: a trust that carries on business is classified as a business entity, which may elect corporate treatment on Form 8832 only where that lowers total tax.
  3. A Massachusetts trust with transferable shares must file its declaration of trust with the Secretary of the Commonwealth and an annual report by 1 June under G.L. c.182; failing to file can bring fines.
  4. Any promoter claiming a business trust makes business income tax-free is selling a scheme the IRS warns against; profits remain taxable to the entity or its owners.
  5. Liability protection depends on the statute: Delaware statutory trust owners get stockholder-style limits, while older common-law trusts may leave investors exposed, so check the governing state law first.

MaterialsTreas. Reg. §301.7701-4, the federal regulation that separates ordinary trusts from business trusts (on law.cornell.edu)Treas. Reg. §301.7701-3, the ‘check-the-box’ rules for classifying business entitiesLesson 1.1.7, on how a trust differs from a company, and lesson 5.2.6, on tax-motivated trusts and the anti-abuse rules

Wonder

  1. Why would anyone run a business as a trust instead of a company?
  2. If an arrangement is called a trust, does the tax system have to treat it as one?
  3. Who answers for a business trust’s debts: the trustees, the investors or the trust itself?

Explore

  1. A business trust is an unincorporated business organisation in which trustees hold and manage property for beneficial owners, whose interests are divided into transferable shares or certificates. The investors put in capital expecting a profit, much as shareholders do. That sets it apart from an ordinary family trust (lesson 1.1.7), where a settlor hands property to trustees to look after for beneficiaries who usually contributed nothing. The governing rules are mostly state law and differ from state to state, so the jurisdiction always matters.
  2. The form grew up in 19th-century Massachusetts, where a corporation generally could not be formed to hold and develop real estate without a special act of the legislature. Investors instead transferred property to trustees under a written declaration of trust and received transferable certificates in return. This ‘Massachusetts trust’ gave many of a corporation’s practical advantages without a charter (lesson 7.2.2). Massachusetts later recognised the form in Chapter 182 of its General Laws, which requires the declaration of trust to be filed with the state.
  3. Many states now have statutes under which a business trust is formed by filing a certificate. The best known is the Delaware Statutory Trust Act (12 Del. C. ch. 38), enacted in 1988 as the Delaware Business Trust Act and renamed in 2002. Unless its documents say otherwise, a Delaware statutory trust is a separate legal entity, and its beneficial owners have the same limit on personal liability as stockholders of a Delaware for-profit corporation (lesson 7.2.3). Mutual funds, securitisation vehicles and some real estate investments use this form.
  4. For US federal income tax, the word ‘trust’ does not decide the classification. Treas. Reg. §301.7701-4 treats an arrangement as an ordinary trust when its purpose is to protect or conserve property for beneficiaries who do no more than accept the benefits. A ‘business trust’ created as a device to carry on a profit-making business is generally not classified as a trust, even if it was formed under a trust statute; it is a business entity. An ‘investment trust’ with a single class of ownership and no power to vary the investment can still be classified as a trust (lesson 7.2.3).
  5. Business entities are then classified under Treas. Reg. §301.7701-3, the ‘check-the-box’ rules. An eligible domestic entity with two or more owners is a partnership by default and may elect, on IRS Form 8832, to be taxed as a corporation (an ‘association’); one with a single owner is disregarded by default and may also elect. A partnership generally pays no federal income tax itself; its owners report their shares of its income. Some entities have no choice: a publicly traded partnership is generally taxed as a corporation under IRC §7704, and a mutual fund organised as a business trust is typically taxed as a corporation that qualifies as a regulated investment company (lesson 7.2.2).
  6. A business trust is not a way to make business income tax-free. IRS warnings about abusive trust schemes have included so-called business trusts that claimed to do exactly that (lesson 5.2.6). Liability protection also depends on the state statute, the governing instrument and, for older common-law trusts, case law, and a trust formed in one state may be treated differently in another. This lesson explains the law; it does not suggest using a business trust, and the choice among a trust, an LLC and a corporation turns on facts a qualified adviser should review.

Key facts

  • A business trust is an unincorporated business organisation in which trustees hold property for beneficial owners holding transferable shares or certificates.
  • The form developed in 19th-century Massachusetts as a way to gain corporate-style advantages without a special legislative charter.
  • Treas. Reg. §301.7701-4 treats an ordinary trust as one that protects or conserves property for beneficiaries who do no more than accept the benefits.
  • A business trust created to carry on a profit-making business is generally classified as a business entity, not a trust, for US federal income tax.
  • Under the check-the-box rules, an eligible domestic entity with two or more owners is a partnership by default and may elect to be taxed as a corporation.
  • The Delaware Statutory Trust Act was enacted in 1988 as the Delaware Business Trust Act and renamed in 2002.

Exercise nine, six, three, one

9CollectList up to 9 organisations described in this lesson or in a source you are reading that use a trust form for business or investment (some lists are shorter), such as a mutual fund, a securitisation vehicle, a REIT or a family holding trust.
6ClusterSort them into 6 categories: investment funds, real estate vehicles, finance vehicles, family or private holding arrangements, ordinary trusts that only conserve property, and examples you are unsure about.
3DistillReduce the 6 categories to 3 groups: likely classified as trusts for federal tax, likely classified as business entities, and examples whose classification you would need to check.
1CrystallizeWrite 1 sentence explaining, in your own words, why calling an arrangement a trust does not decide how US federal tax classifies it.

Fact check

Dates, figures and claims checked against the published sources listed below.

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