US Tax Classification of Trusts
US Tax Classification of Trusts
5-1-1986
Stewart S. Karlinsky
Recommended Citation
Joseph V. Sliskovich and Stewart S. Karlinsky, Tax Classification of Trusts: The Howard Case and the Other Current Developments, 19 Loy.
L.A. L. Rev. 803 (1986).
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TAX CLASSIFICATION OF TRUSTS:
THE HOWARD CASE AND OTHER CURRENT
DEVELOPMENTS
Joseph V Sliskovich* and Stewart S. Karlinsky**
I. INTRODUCTION
The distinction for tax purposes between a partnership and a corpo-
ration has been the subject of numerous court cases, Treasury regula-
tions, rulings and procedures.' In the 1950's and 1960's, a major
classification issue arose involving the tax status of professional corpora-
tions.2 During that time, the determination of the appropriate tax status
of the entity in question was especially important because of the limited
pension and fringe benefits available to partnerships. In the 1970's and
1980's, the focus shifted to the proper classification of limited partner-
ships.' If the partnership was determined to be an association, taxable as
a corporation, then none of the losses, credits and special allocations
would pass through to the investors. The corporation versus partnership
classification issue remains vitally important.4
The distinction between a trust and a corporation has received much
* Associate Professor of Law, Loyola Law School, Los Angeles, California. B.A. 1975,
University of Southern California; J.D. 1978, Loyola Law School, Los Angeles; LL.M. 1980,
New York University. Professor Sliskovich has previously published in The Journalof Taxa-
tion and Prentice-Hall's Tax Ideas series.
** Assistant Professor of Taxation, School of Accounting, University of Southern Califor-
nia, Los Angeles, California. B.B.A. 1970, Baruch College; M.B.A. 1976, New York Univer-
sity; Ph.D. 1981, New York University. Professor Karlinsky has published numerous articles
in both professional and academic journals.
The authors wish to thank Melanie Dreyfuss and Kimberlee Singleton for their assistance
in the preparation of this article.
1. For an overview of the definitional questions raised in the corporate versus partnership
classification issue, see generally, B. BITTKER & J. EUSTICE, FEDERAL INCOME TAXATION OF
CORPORATIONS AND SHAREHOLDERS 2.01-2.06 (4th ed. 1979 & Supp. 1985); W. McKEE,
W. NELSON & R. WHITMIRE, FEDERAL TAXATION OF PARTNERSHIPS AND PARTNERS Ch. 3
(1977).
2. United States v. Kintner, 216 F.2d 418 (9th Cir. 1954); Forman v. United States, 232
F. Supp. 134 (S.D. Fla. 1964).
3. For example, see Larson v. Commissioner, 66 T.C. 159 (1976); Zuckman v. United
States, 524 F.2d 729 (Ct. Cl. 1975); Sperling & Lokken, The Limited PartnershipTax Shelter:
An Investment Vehicle Under Attack, 29 U. FLA. L. REv. 1 (1976).
4. See Nelson, The Tax Classificationof Partnerships:Distinguishingfrom Arm's-Length
Economic Arrangements, 40 N.Y.U. TAX INST. 15-1 (1982).
LOYOLA OF LOS ANGELES LAW REVIEW [Vol. 19:803
less attention but is, nevertheless, more important than ever. If a trust is
determined to be taxable as a corporation, then the income of the entity
would be subject to double taxation and lose other pass-through charac-
teristics. Several recent developments, including the United States
Claims Court decision in Howard v. United States,5 have heightened the
importance of ascertaining the trust's correct tax status. The increased
use of royalty, liquidating and family trusts, as well as the advent of flexi-
ble investment unit trusts, 6 require that the trust instrument be carefully
drawn to avoid the trust being classified as an association, taxable as a
corporation. In making this determination, the two crucial attributes are
the presence of business purpose and associates. The term "associates"
denotes some voluntary aggregation of participants in a venture. "Busi-
ness purpose" is present if the trust document permits the conduct of
business activities as opposed to the mere preservation of corpus. This is
true even if the trust does not in fact conduct business activity.
Only if both of these characteristics are present will the entity be
treated as a corporation. The court in Howard specifically addressed
these issues, and in so doing reaffirmed the importance of the trust instru-
ment in determining whether a business purpose is present, while
strongly suggesting that the associates attribute is directly linked to the
level of transferability.'
This Article will first present an historical perspective on the trust
classification issue-the so-called business versus ordinary trust distinc-
tion-by examining judicial and administrative rules. A discussion of
Howard and other current developments in the trust area will follow.
These current developments will then be analyzed in the context of com-
monly used trust techniques, as well as some innovative investment
instruments.
5. 5 Cl. Ct. 334 (1984).
6. Historically, the Treasury Department has ruled that a "fixed investment trust" is
taxable as an ordinary trust because the business objective criteria was lacking. Typically, this
type of trust has one class of ownership and allows the investor to acquire undivided beneficial
ownership in a diversified investment portfolio. More recently, investment bankers have devel-
oped variations on the fixed investment trust theme by splitting the portfolio into a current
income interest and a future appreciation interest. This has been done with stocks, securities
and mortgage instruments. This allows one group of investors to protect themselves against a
premature call option possibility or to receive capital gain income rather than ordinary in-
come. The Treasury has proposed that these arrangements are associations taxable as corpora-
tions or partnerships because they allow the investor to fulfill a specific profit-making objective.
Prop. Treas. Reg. § 301.7701-4(c), 49 Fed. Reg. 18,743 (1984).
7. See infra notes 64-120 and accompanying text.
May 1986] TAX CLASSIFICATION OF TRUSTS
the trust instrument rather than the activities actually carried on in the
taxable year.22
Thus, Morrissey established several important principles that are
echoed in other Supreme Court and lower court cases. The associates
and profit motive attributes must both be present, and the trust docu-
ment, rather than the activity of the trust, is controlling. For example, in
several of the trust's tax years, the actual activity of the trust was clearly
fiduciary in nature. Nevertheless, the Court ruled that the trust instru-
ment, in allowing business activity, was sufficient to justify finding the
profit motive attribute present.2 3
Swanson v. Commissioner24 involved a real estate trust created for
the purpose of acquiring land and erecting and operating an apartment
house. Under the terms of the trust, the trustees were given management
and control of the property. They could exchange, sell, improve, re-
model, reconstruct or encumber the property. The beneficiaries received
"transferable receipts" representing their interest in the trust. The
Court, applying the resemblance test of Morrissey, held that the trust was
taxable as a corporation.2" To some, this finding was surprising since
there were a limited number of beneficiaries and the trust held only one
piece of real estate. The Court found, however, that because the trust
instrument allowed business activity and permitted transferability of in-
terest, the entity was a business trust.2 6
In Helvering v. Coleman-GilbertAssociates27 a trust was created for
the purpose of owning and operating twenty apartment houses. The
Supreme Court held that the trust was an association taxable as a corpo-
ration under Morrissey. The Court stated that the trust's purpose is de-
termined by reference to the terms of the trust instrument and not what
the parties claimed the purpose to be.2 8 Here again, the fact that the
A. Revenue Rulings
In Revenue Ruling 78-371, 41 a trust was established by the heirs of
contiguous parcels of real estate with the following trustees' duties and
powers:
(1) To collect the income, pay all expenses of the property,
manage, maintain and repair the property under the terms
of the trust and distribute the net income to the
beneficiaries.
(2) To accept from any source and retain real estate contigu-
ous or adjacent to the trust's real estate.
(3) To sell any real estate of the trust, and purchase any real
estate adjacent to the trust's real estate.
(4) To borrow money, mortgage and lease property, raze or
erect any building and make any improvements they deem
44. Ltr. Rul. 8510001, 1985 PRIVATE LETTER RULINGS (PH) 1027.
45. Id.
46. 11 T.C.M. (CCII) 694 (1952).
47. Id. at 697.
48. 1978-2 C.B. 344.
May 1986] TAX CLASSIFICATION OF TRUSTS
proper. 49
The ruling discussed regulation sections 301.7701-4(b) and 301.7701-
2(a)(2), as well as two cases, Wyman Building Trust v. Commissioner," 0
5
and Sears v. Hassett. ' The ruling held that the foregoing powers "taken
together indicate that the trustees ... are empowered to do more than
merely protect and conserve the trust's property. '5 2 Thus, the arrange-
ment had the characteristic of a joint enterprise for the conduct of a busi-
ness for profit. The associates attribute was also present since the heirs'
volitional act created the trust and other relatives could join the enter-
prise by contributing contiguous real property. Therefore, the ruling 53
held that the entity was a business trust, taxable as a corporation.
In Revenue Ruling 79-77,14 the trust agreement empowered the
trustee "to act on behalf of the beneficiaries as signatory of leasing ar-
rangements and management agreements, to hold title to the land and
building and to the proceeds and income of the property, 55 to distribute all
trust income and to protect and conserve the property."
The Treasury distinguished this ruling from Revenue Ruling 78-371
by stating that "the trustee [in the instant case] is restricted to dealing
with a single piece of property subject to a net lease. Further, the trustee
has none of the powers described in Rev. Rul. 78-371. '' 56 The arrange-
ment was held to be an ordinary trust. The lack of business purpose was
sufficient to prevent classification as an association, even though the
grantor, as a beneficiary, may have been sufficient to cause a finding of
the associates attribute.57
B. JudicialInterpretation
In Elm Street Realty Trust v. Commissioner,58 the issue before the
Tax Court was once again whether the entity was an ordinary trust or a
corporation. The court found the trust was not an association taxable as
a corporation as defined by Internal Revenue Code section 7701(a)(3). 9
The court found that the trustee's powers were not merely limited to the
conservation and protection of Elm Street property for the trust's benefi-
ciaries. Rather, the trust was found to have a business objective, because
the trust agreement gave the trust the power to carry on a business, even
though it was clear that no business was actually conducted, nor was
there ever any intention to carry on a business. 6° Thus, the ability to
conduct business and not the actual conduct of a business was the crucial
element.
However, the court found that the trust lacked associates within the
meaning of section 7701(a)(3). 6 The court focused on three factors:
(1) the absence of free transferability of trust interests; (2) the fact that
the beneficiaries received their interests gratuitously; and (3) the fact that
the beneficiaries did not play a role in the creation of the trust itself. The
beneficiaries' influence over and ability to participate in trust activities
were limited in scope by virtue of the trust indenture.6 2 Thus the court
concluded that although the Elm Street Trust had a business purpose, it
did not possess the associates attribute and was, therefore, not an associa-
tion taxable as a corporation under section 7701(a)(3).6 3
A. Background
Late 1880s: James J. Hill and several other individuals acquired
stock in ten corporations. Nine of the ten corporations owned mineral
property in Minnesota and negotiated leases with mining companies for
the extracting of ore from these properties on a royalty basis.6 5
1899: James Hill arranged the transfer of stock in the ten corpora-
tions to the Lake Superior partnership "for the benefit of stockholders of
the Great Northern Railway Co. ('the Railway'). ' 66 The Lake Superior
partnership was thereafter used as a holding company.
67. Id.
68. Ch. 104, 24 Stat. 379 (1887) (codified as amended at 49 U.S.C. §§ 10701-10786
(1982)). Specifically, the Railway wished to avoid violating 49 U.S.C. § 10746 which prohibits
a railroad company from transporting commodities owned by it. Howard, 5 Cl. Ct. at 337.
69. 5 Cl. Ct. at 337.
70. Id. at 338.
71. Id. (quoting the GNIOP trust agreement) (emphasis provided by the Howard court).
72. Id. at 338-39.
73. See supra notes 68-72.
74. 5 Cl. Ct. at 339.
75. 75 F. Supp. 408 (D. Minn. 1948).
76. Reynolds v. Hill, 184 F.2d 294, 297 (8th Cir. 1950).
LOYOLA OF LOS ANGELES LAW REVIEW [Vol. 19:803
1. Associates
The Claims Court noted that Morrissey v. Commissioner"4 requires
"'some concerted volitional activity on the part of those beneficially in-
terested' "8' before the associates criterion will be present. This includes
not only participation in the creation of the trust but also subsequent
affirmative action through the purchase of beneficial interests.86
The court found sufficient evidence to support the finding that both
the initial beneficiaries and the subsequent purchasers of beneficial inter-
ests were "associates. ' s7 First, the initial beneficiaries (the shareholders
of the Railway) had control over the disposition of their stock that ulti-
mately became the trust corpus.8" Second, as the Supreme Court stated
in Morrissey, "the terms of an association may make the taking or acquir-
ing of shares or interests sufficient to constitute participation, and may
leave the management or even control of the enterprise to designated
persons." 9 The court relied upon this language in finding that the subse-
quent purchasers of the beneficial interests (many through the New York
Stock Exchange) were also "associates." 9 Further, the officers/trustees
who themselves owned beneficial interests were also "associates" of
GNIOP.9 1 Thus, the courts and the regulations,9 2 though minimizing
the significance of the four characteristics common to both trusts and
corporations, nevertheless seem to link the associates and transferability
attributes.
The taxpayers contended that because the income beneficiaries of
2. Business objective
The Claims Court then turned to the question of whether the trust
was an organization devised to carry on a business and divide the gains.
The taxpayers contended that the activities of GNIOP were similar
to those of an ordinary family trust-leasing mineral lands, and collect-
ing and distributing income to the beneficiaries. These activities, the tax-
payers argued, constituted conserving the corpus. 95 In response, the
court pointed out that even if the activities of GNIOP in 1979 were
merely to conserve and protect the corpus, the relevant factor is what
activities are allowed by the trust instrument.9 6 The court then turned to
a discussion of case law in support of its position.
The importance of the trust instrument's terms, rather than actual
activity conducted, was discussed in Fidelity-Bankers Trust v. Helver-
ing,9 7 where the court stated that "recent Supreme Court decisions have
shifted emphasis to simulation of corporate attributes and the purpose
for which the trust is organized as expressed in the creative instru-
ments.",98 The court in Fidelity-Bankers, citing the Morrissey line of
cases, made it clear that the purpose for which the trust was organized
has often been the most important single factor in determining whether
the entity was taxable as as association, and that the purpose of the trust
was to be primarily determined with reference to the trust instrument.
In Helvering v. Coleman-GilbertAssociates,9 9 the taxpayer was not
allowed to claim that the purpose of the trust was narrower than that
which was set forth in the trust instrument. 10° In Title Insurance &
Trust v. Commissioner,10 the fact that the trustee did little more than
collect the rent and distribute the profits was not decisive, where the
02
powers conferred upon it in the trust instrument were much broader."
Finally, the Howard court quoted Elm Street Realty Trust v. Commis-
sioner, 0 3 for the proposition that "'[t]he presence of [business] powers,
regardless of their exercise, require a finding of a business objective for
purposes of Section 7701(a)(3) and the regulations thereunder.' ,
Next, the Howard court discussed the distinction between "ordinary
trusts" and "business trusts" as found in the regulations,105 summarizing
the regulations as follows: "'[O]rdinary trusts' [are] entities designed
simply and exclusively to protect or conserve property for the benefi-
ciaries, while 'business trusts' are entities technically cast in the trust
form but with the paramount purpose of conducting a business for
profit." 10 6 The court recognized that since almost every trust involves
the doing of some business, "[t]he dispositive question, therefore, be-
comes whether the carrying on of business by a trust in the commercial
sense is incidental
7
to the paramount purpose of conserving or protecting
10
the property."'
Thus, the difficulty arises in attempting to determine whether the
paramount purpose of a given entity is conserving and protecting prop-
erty, or conducting a business for profit. The dividing line has not always
been clear since implicit in a fiduciary's responsibility is the duty to con-
serve and protect property, and put that property to its best and most 08
productive use, which may incidentally involve the making of a profit.1
In addressing this question, the Claims Court turned its discussion
to an examination of GNIOP's trust instrument and the facts underlying
the creating of the trust. The court found that "there can be no question
that the 'principal objective' in the creation of GNIOP was the exploita-
tion of minerals for profit on lands owned by the trust, with a substantial
managerial role to be played by the trustees."' 0 9
The court found that Paragraph 1 of the trust instrument gave the
trustees "wide latitude to manage all business operations involving the
trust corpus." 110 The fact that this power had been exercised by leasing
C. Analysis
The link between the associates attribute and the transferability of
interest now seems clear. The notion of volitional conduct discussed in
Howard v. United States has at its heart those elements of voluntary
transfer found in the regulations discussing transferability. Those par-
ticipants who are unable to alter their relationships voluntarily are not
associates within the scope of Morrissey v. Commissioner."9 Members
who can readily enter or leave the relationship will be considered
associates.
111. Id.
112. 184 F.2d 294 (8th Cir. 1950).
113. Id. at 298-99.
114. Howard, 5 C1. Ct. at 339.
115. Id. at 346.
116. Id. at 345.
117. Id.
118. Id. at 349.
119. 296 U.S. 344 (1935); see supra notes 15-23 and accompanying text.
May 1986] TAX CLASSIFICATION OF TRUSTS
Consistent with the reasoning that the stated purpose of the trust
rather than the actual activities are to be viewed as controlling, courts
have held that a change or reduction in the activities of the business trust
will not be sufficient to reclassify the entity as an ordinary trust. 120
Where, however, the trust instrument is formally amended to restrict the
powers of the trustees so that they can no longer carry on a business, or
so that the beneficiaries will no longer be considered associated, the trust,
12 1
after amendment, may be held not taxable as an association.
120. See, eg., Morrissey, 296 U.S. 344; Commissioner v. Vandegrift Realty & Inv. Co., 82
F.2d 387 (9th Cir. 1936); Howard v. United States, 5 Cl. Ct. 334 (1984).
121. See Commissioner v. Nebo Oil Co., Trust, 126 F.2d 148 (10th Cir. 1942), in which the
court looked at the amended trust indenture terms in determining the appropriate entity sta-
tus. In that case, the amendments were found to be insufficient to avoid either the associates or
business purpose attributes. Id. at 150-51. See supra text accompanying note 115.
122. Houston Oil and Minerals Corporation, and Sabine Corporation, among others, have
used this technique successfully. HOUSTON OIL AND MINERALS CORP., PROXY STATEMENT
FOR THE APRIL 24, 1981 ANNUAL MEETING OF SHAREHOLDERS at TRI-TR5 (Mar. 27,
1981); SABINE CORP., PROXY STATEMENT FOR THE NOVEMBER 12, 1982 SPECIAL MEETING
OF SHAREHOLDERS at 24-27 (Oct. 4, 1982).
123. Tax Reform Act of 1984, Pub. L. No. 98-369, § 54(a), 98 Stat. 494, 568-69 (1984)
(codified at I.R.C. § 311(d) (1982 & Supp. 1984)); Tax Equity and Fiscal Responsibility Act of
1982, Pub. L. No. 97-248, § 223(a)(1), (3)(A)-(B), 96 Stat. 324, 483-84 (1982) (codified as
amended at I.R.C. § 311(d) (1982 & Supp. 1984)). Prior to the Tax Equity and Fiscal Respon-
sibility Act of 1982, I.R.C. § 311 generally provided for the nonrecognition of gain at the
corporate level with respect to the distribution of appreciated property. See generally General
Utils. & Operating Co. v. Helvering, 296 U.S. 200 (1935). The revised statute provides that a
corporation which distributes appreciated property to its shareholders in any ordinary, non-
liquidating distribution must recognize gain as if the property had been sold for its fair market
LOYOLA OF LOS ANGELES LAW REVIEW [Vol. 19:803
value at the time of the distribution. I.R.C. § 311(d) (1982 & Supp. 1984). However, this
technique is still viable for a company with net operating loss carryovers or a company distrib-
uting recently acquired property or property with an adjusted basis greater than its fair market
value.
124. It is interesting to note that in several recently filed proxy statements, the trust agree-
ments forbid the trustees from engaging in any business, commercial or management activity,
and even limit investment activity to ensure that the trusts are not construed as engaging in
business activity. Indentures even forbid the amendment of the agreement to permit the trust-
ees to engage in business or investment activities. HouSTON OIL PROXY STATEMENT, supra
note 122, at TR1-TR5; SABINE CORP. PROXY STATEMENT, supra note 122, at 24-27.
125. See supra notes 122 & 124.
126. I.R.C. §§ 331, 333, 337 (1982).
127. Treas. Reg. § 301.7701-4(d) (1960).
128. 13 T.C.M. (CCII) 24 (1954).
129. Id. at 24-28.
130. Id. at 28-29.
May 1986] TAX CLASSIFICATION OF TRUSTS
VII. CONCLUSION
Even after numerous Supreme Court cases on point, the trust classi-
fication area still has several ambiguities and unresolved questions. The
effect of a trust being classified as a corporation can be catastrophic to
the tax planner and the beneficiaries. Therefore, it is imperative that the
form as well as the substance of the trust and its activities be carefully
considered. For business trust status to be found, both the associates and
business attributes must be present. Thus, if the associates attribute is
present, the trust indenture should clearly forbid the trustee from enter-
ing into any profit-making or business transaction. Alternatively, if busi-
ness activity is contemplated, the trust should restrict the transferability
of beneficial interests and any other volitional beneficiary activity. 34
Moreover, although Morrissey v. Commissioner and its progeny1
133
131. Prop. Treas. Reg. § 301.7701-4(c), 49 Fed. Reg. 18, 743 (1984); see supra note 6.
132. Id.
133. 296 U.S. 344 (1935).
134. See supra notes 9-12 and accompanying text.
822 LOYOLA OF LOS ANGELES LAW REVIEW [Vol. 19:803
Finally, it seems clear that even if the trust's activities do not include
the business purpose or associates attributes, the fact that the indenture
permits the tainted activity may be sufficient to cause the attribute to be
present. Alternatively, a subsequent amendment of the trust instrument
may succeed in prospectively cleansing the trust of the business or associ-
ates attributes.