Cracking the Income Tax Code for LLCs and Trusts

Cracking the Income Tax Code for LLCs and Trusts

Presented by James J. Flick

Flick Law Group, P.L.

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Flick Law Group, P.L.3700 South Conway Road, Suite 100

Orlando, Florida 32812

Practice areas limited to:

Estate PlanningBusiness Planning

Asset Protection PlanningProbate and Guardianship

Introduction

In recent years, the use of complex trusts and limited liability company structures for estate tax and asset protection planning has increased dramatically. Tax accountants are responsible for assisting clients with the annual accounting and tax reporting for these structures. This presentation will cover the proper income tax reporting for grantor trusts and LLCs.

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Reporting Options for Grantor Trusts• Introduction to Grantor Trusts.The grantor trust rules were originally enacted to restrict

the ability of wealthy taxpayers to reduce their income tax by creating multiple trusts treated as separate taxpayers.

Modern estate planners generally use an intentional

grantor trust to increase the amount of wealth that can be transferred to future generations than is possible when using non-grantor trusts.

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Reporting Options for Grantor Trusts• History of Grantor Trusts.

– The objective of the development of grantor trust rules was to prevent assignment of income to a taxpayer (a trust) in a lower income tax bracket.

• Historical rates were at one time as high as 91%.• Prior to 1949 joint income tax returns by spouses did

not exist.• All trusts were generally treated as separate taxpayers

subject to progressive income tax rate brackets similar to individuals.

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Reporting Options for Grantor Trusts• Development of income tax status of trusts.

– Beginning in 1924, trust income was reported by the grantor if grantor had a right to receive trust income or a power to revest trust assets even if the grantor did not receive any income or did not exercise the power.

– Taxation of the grantor expanded by case law if trust income could be used to satisfy the grantor's obligations or to benefit the grantor.

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Reporting Options for Grantor Trusts

– Taxation to the grantor expanded if grantor retained such control over trust income or assets that resembled ownership attributes (Supreme Court in Helvering v. Clifford in 1940).

– The IRS adopted the Clifford doctrine in the Clifford Regulations in 1939.

– The 1954 Code codified the Clifford Regulations.– Minor Code amendments in 1969 and 1976.

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– The 1986 Tax reform Act dramatically compressed the graduated income tax rates applicable to trusts.

– Minor Code amendments in 1988 and 1990.– In 1996, all foreign trusts automatically treated as

grantor trusts (enactment of IRC section 679).

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Reporting Options for Grantor Trusts• Expansion of the Use of Grantor Trusts for Estate

Planning.– Rev. Rul. 85-13, the existence of a wholly-owned grantor

trust is ignored for income tax purposes (a sale of trust assets to the grantor disregarded for income tax purposes).

– Under the "check the box" regulations a grantor trust is not a "disregarded entity". It can be a separate taxpayer for gift and estate taxes.

– Rev. Rul. 2004-64. The grantor's payment of the income taxes on the grantor trust's income is not a gift.

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Reporting Options for Grantor Trusts• Explanation of Grantor TrustsFor tax purposes, a grantor trust is a trust in which the grantor

or another person is treated as the owner of any portion of a trust because such person retains or holds certain specified powers with respect to the trust.

Depending upon the power retained or held, the trust can be

classified differently for income, gift and estate tax purposes or it can a grantor trust for all tax purposes.

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Reporting Options for Grantor TrustsThere are two types of grantor trusts: a grantor-controlled trust and a beneficiary-controlled trust.

A grantor-controlled trust exists when the grantor is treated as the owner of the entire trust for tax purposes. A beneficiary-controlled trust exists when a person other than the grantor is treated as the owner of the entire trust for tax purposes.

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– Grantor-Controlled TrustIn general, the grantor is deemed to be the owner of the

trust if the grantor retains (or if a non-adverse party holds):

• a reversionary interest;• control over the enjoyment of the corpus and income of the trust;• certain administrative powers;• a power to revoke the trust; or• a power to use or accumulate funds for the grantor's benefit or

the benefit of a spouse, or to pay premiums on insurance policies on the grantor's life or on the life of his or her spouse.

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– Beneficiary-Controlled TrustA trust beneficiary is treated as the owner of the trust only if the grantor is not taxed as the deemed owner, and:•the beneficiary has a power exercisable solely by himself to vest corpus and income therefrom to himself; or•the beneficiary has previously partially released or otherwise modified such a power and afterwards retains controls over the trust that would cause him to be treated as the owner of the trust under the rules applying to grantors.

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Reporting Options for Grantor Trusts• Federal Income Tax Reporting for Grantor TrustsThe federal income tax reporting requirements for grantor

trusts are set forth in Income Tax Regs. §1.671-4. There are two sets of acceptable reporting methods. One for trusts all of which are treated as owned by one

grantor or by one other person, and another for trusts all of which are treated as owned by two or more grantors or other persons.

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Reporting Options for Grantor Trusts• A trust all of which is treated as owned by one grantor or by one other

person.Federal income tax reporting for the trust must be undertaken using one of

the three options described below. The Form 1041 Filing Method is the default reporting method. It is used by persons

who wish to emphasize the separate existence of the trust and encourage better trust accounting and record keeping.

Optional Filing Method 1 is the simplest, and most commonly used, method for these

types of trusts. This is the traditional method used for revocable living trusts.

Optional Filing Method 2 is rarely used.

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Reporting Options for Grantor Trusts• Form 1041 Filing Method.Complete the entity portion of Form 1041 (U.S. Income Tax Return for Estates

and Trusts). Do not show any dollar amounts on the Form 1041 or use Schedule K-l. Prepare an attachment to Form 1041 showing the grantor's name, SSN, and

address, and items of income, deductions and credits taxable to the grantor (i.e., all income, deductions and credits of the trust).

File the Form 1041 along with the attachment and provide a copy of the Form

1041 and attachment to the grantor.

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Reporting Options for Grantor Trusts• Optional Filing Method 1.The grantor must provide the trustee with his or her SSN on Form W-9,

Request for Taxpayer Identification Number and Certification. The trustee must provide all payers of income with the grantor's name and

SSN, and the address of the trust.

The trustee must provide the grantor with a statement that (i) shows all items of income, deductions and credits of the trust, (ii) identifies the payer of each item of income; (iii) explains how the grantor takes those items into account when figuring his or her taxable income or tax; and (iv) informs the grantor that those items must be included when figuring taxable income and credits on his or her income tax return.

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Reporting Options for Grantor Trusts• Optional Filing Method 2.The trustee must obtain a taxpayer ID number for the trust. The trustee must provide all payers of income with the trust's

taxpayer ID number and address. The trustee must file with the IRS the appropriate Forms 1099 to

report the income or gross proceeds paid to the trust during the tax year that shows the trust as the payer and the grantor as the payee. The trustee must report each type of income in the aggregate and each item of gross proceeds separately.

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Reporting Options for Grantor TrustsThe trustee must provide the grantor with a statement that (i) shows all items of income, deductions and credits of the trust, (ii) identifies the payer of each item of income; (iii) explains how the grantor takes those items into account when figuring his or her taxable income or tax; and (iv) informs the grantor that those items must be included when figuring taxable income and credits on his or her income tax return.

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Reporting Options for Grantor Trusts• A trust all of which is treated as owned by two or

more grantors or other persons. The trustee must furnish the name, TIN, and address of

the trust to all payors for the taxable year, and comply with certain the additional requirements.

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Reporting Options for Grantor TrustsThe additional obligations of the trustee include:

• Obligation to file Forms 1099. The trustee must file with the Internal Revenue Service the appropriate Forms 1099, reporting the items of income received by the trust during the taxable year that are attributable to the portion of the trust treated as owned by each grantor or other person, and showing the trust as the payor and each grantor or other person treated as an owner of the trust as the payee.

The trustee must report each type of income in the aggregate, and each item of gross proceeds separately.

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Reporting Options for Grantor Trusts• Obligation to furnish statement. The trustee must also

furnish to each grantor or other person treated as an owner of the trust a statement that:

• Shows all items of income, deduction, and credit of the trust for the taxable year attributable to the portion of the trust treated as owned by the grantor or other person;

• Provides the grantor or other person with the information necessary to take the items into account in computing the grantor's or other person's taxable income; and

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Reporting Options for Grantor Trusts• Informs the grantor or other person that the items

shown on the statement must be included in computing the taxable income and credits of the grantor or other person on their income tax return.

• Information contained in the Forms 1099 filed by the trustee does not have to be duplicated in the statement furnished to each grantor or other person.

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Entity Classification Rules for LLCs• In GeneralEffective January 1, 1997, the IRS issued rules for

determining whether an entity is classified as a pass-through entity or a corporation.

These rules, referred to as the “check-the-box”

regulations, changed the guidelines for classifying organizations for federal tax purposes in a manner intended to simplify the classification process.

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Entity Classification Rules for LLCsThe regulations eliminated the analysis of corporate characteristics (i.e., limited liability, continuity of life, centralized management, and free transferability of interests) possessed by the entity. The regulations provide default rules for entities that do not elect a particular classification.

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Entity Classification Rules for LLCs• New LLC May Generally Elect ClassificationUnder the regulations, an LLC formed on or after January 1,

1997, and which qualifies as an “eligible entity,” may generally elect its entity classification for federal tax purposes.

An LLC is considered an “eligible entity” if it is a business entity

that is not classified under a specific Code provision, is not considered a trust, and is not automatically classified as a corporation as a matter of law.

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Entity Classification Rules for LLCsAn eligible LLC with two or more members may elect to be classified as either an association (i.e., a corporation) or a partnership. An eligible LLC having a single member may elect to be classified as an association or to be disregarded as an entity separate from its owner.

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Entity Classification Rules for LLCs• Default Classification of LLCs if No Election is MadeIf an eligible entity fails to make a proper election, a set

of default classification rules apply. An entity is defined as a “domestic entity” if it is created

or organized in the United States under the laws of the United States or a particular state. An entity is foreign if it is not domestic.

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Entity Classification Rules for LLCs

– Domestic LLCsUnder the default rules, a domestic eligible entity is:

• taxed as a partnership if it has two or more members; or

• disregarded as an entity separate from its owner if it has a single owner.

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– Foreign LLCsUnder the default rules, a domestic eligible entity is:

• taxed as a partnership if it has two or more members and at least one member does not have limited liability; or

• taxed as a corporation if all members have limited liability; or

• disregarded as an entity separate from its owner if it has a single owner.

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Entity Classification Rules for LLCs• When Is an Election Necessary?An eligible LLC needs to elect classification in only two

circumstances:– It chooses to be initially classified differently from

its default classification.– It desires to change its classification.

Taxpayers may wish to make a “protective” classification election in order to have some record of the LLC's classification.

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Entity Classification Rules for LLCs• How Is the Election Made?An eligible LLC must file Form 8832, Entity Classification

Election, with the IRS Service Center designated on Form 8832.

A copy of Form 8832 must be attached to the federal

tax or information return for the taxable year for which an election is made.

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Entity Classification Rules for LLCs• How Is the Election Made?Relief is available for untimely filed elections. However, the

IRS has the authority to accept or deny the late filing.

An election must be signed by either (i) each member of the electing LLC who is an owner at the time the election is filed, or (ii) any officer, manager, or member of the electing LLC who is authorized under local law or the LLC's organizational documents to make the election.

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Entity Classification Rules for LLCs• Classification of LLCs in Existence before January 1,

1997In general, unless it elects otherwise, an eligible LLC in

existence before January 1, 1997 has the same classification that the entity claimed under prior law in effect before 1997.

However, if an eligible LLC having a single owner

claimed to be a partnership under prior law, the LLC is disregarded as an entity separate from its owner.

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Entity Classification Rules for LLCs• Employment Tax Withholding and Reporting

for a Single-Member LLCFor wages paid on or after January 1, 2009,

disregarded single-owner entities generally are treated as separate from their owners for employment tax purposes. The owner is no longer responsible for FICA and FUTA taxes and obligations.

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Entity Classification Rules for LLCsPrior to this date, the IRS permitted disregarded single-member LLCs to report and withhold employment taxes under the name and taxpayer identification number of the LLC, but the sole member still retained ultimate responsibility for the employment tax liability.

The IRS position is that when employment tax deficiencies are assessed against the single-member LLC, the assessment is also valid against the member. Similarly, the IRS takes the position that it can pursue collection action against the single member owner's property if the LLC fails to pay employment taxes due.

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Entity Classification Rules for LLCs• Annual Income Tax ReturnsReporting of a LLC’s income on the appropriate tax form will depend

on the owner(s) tax status.– Single-Member LLCs That are Disregarded Entities.

The existence of the LLC is ignored for purposes of filing a federal tax return.

The income and expenses of the LLC are reported on whatever tax

form is filed by the member of the LLC. Depending on the member’s tax status, this could be Form 1040, Form

1041, Form 1065, Form 1120 or Form 1120S.

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– Single-Member LLCs That Elect to be Taxed as Corporations.If a single-member LLC desires to file as a corporation, Form 8832, Entity Classification Election, must be submitted. LLCs that wish to be taxed as a S corporation must file Form 2553, Election By a Small Business Corporation. A domestic LLC electing S corporation status is no longer required to file both Form 8832 and Form 2553. It will be treated as a corporation as of the effective date of the S corporation election.

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– Multi-Member LLCs. Multiple-member LLCs will file partnership returns using Form 1065. A multiple-member LLC that desires to file as a corporation, must make the same elections as described above for single-member LLCs.

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Federal Taxation Of Series Limited Liability CompaniesSeries limited liability companies ("LLCs") have been around since Delaware created them by statute in 1996. Other than a Private Letter Ruling issued in 2008, the IRS had never issued any formal guidance on the federal tax treatment of series LLCs. On September 14, 2010 the IRS issued Proposed Regulation Sections 301.6011-6, 301.6071-2, and 301.7701-1(a)(5) (the "Proposed Regulations") addressing the treatment of these entities for federal income tax purposes.

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Federal Taxation Of Series Limited Liability Companies• Background on Series LLCs

– What is a Series LLC?A series LLC is a form of entity that allows a single LLC to establish one or

more series each of which has separate rights, powers, or duties and can have different members.

Each series can have its own separate business purposes. A series can be terminated without affecting the other series of the LLC. A series can make distributions to its own members without regard to the

financial condition of the other series.

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Federal Taxation Of Series Limited Liability CompaniesMost important, most series LLC legislation provides that debts, liabilities and obligations incurred, contracted for or otherwise existing with respect to a particular series are enforceable against that series only, and not against the assets of the LLC generally or any other series of the LLC. Each series must be treated separately. Books and records must be kept for each series and the assets of each series must be held and accounted for separately.

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Federal Taxation Of Series Limited Liability Companies

– States That Authorize Series LLCs.Currently it is possible to form a series LLC in the following nine states:

• Delaware• Illinois• Iowa• Nevada• Oklahoma• Tennessee• Texas• Utah• Wisconsin

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– What are the Reasons for Using a Series LLC?One of the principal benefits offered by series LLCs is administrative convenience and cost savings. One public document is filed with the appropriate state department for the series LLC. The members can then designate new series without any additional public filings by preparing a separate series agreement.

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Federal Taxation Of Series Limited Liability CompaniesFor industries that typically use separate entities for each asset or business line this could provide a significant cost savings.

For example, in Delaware, a real estate investor who owns ten properties and wants to separate each property for liability purposes, can either form ten LLCs with $900 of state filing fees or form a series LLC with only a $90 state filing fee. In each subsequent year, the investor would file a single annual franchise tax return and pay $250 versus ten annual franchise tax returns at a total cost of $2,500.

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Federal Taxation Of Series Limited Liability Companies• What Guidance is Provided in the Proposed

Regulations?– Entities to Which the Proposed Regulations

ApplyThe Proposed Regulations apply to all domestic

series LLCs and foreign (i.e., non-U.S.) series LLCs conducting insurance businesses.

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– Separate Entity Status and Ownership of a SeriesUnder the Proposed Regulations, each series of a series LLC will be treated as an entity formed under local law. Whether a series is recognized as a separate entity for federal tax purposes is determined under §301.7701-1 of the Treasury Regulations and general tax principals.

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Federal Taxation Of Series Limited Liability CompaniesEach series that is recognized as a separate tax entity will be classified under the "check-the-box" regulations and may make any federal tax election it is otherwise eligible to make independently of the series LLC or any other series. Some planners have suggested that if the series LLC is the sole owner of each of the series, each series will be classified as a disregarded entity and a single income tax return can be filed by the series LLC.

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– Segregated Liability for Taxes (Maybe)Because each series is treated as a separate entity formed under local law for federal tax purposes, each series should only be liable for federal income taxes related to that series. However, the IRS reserves the right to impose liability for taxes upon the series LLC or another series within such series LLC under certain circumstances.

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– No Employment Tax GuidanceAt this time, the IRS has not issued guidance on the

federal employment tax treatment of a series LLC.

– Transition RuleA taxpayer that has been treating all series within a

series LLC as one entity for federal income tax purposes may continue to do so under the Proposed Regulations.

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Federal Taxation Of Series Limited Liability CompaniesGenerally, this Transition Rule will apply provided that the following requirements are satisfied:

• the series was established prior to September 14, 2010;• the series conducted business on and prior to

September 14, 2010;• no owner of the series treats the series as an entity

separate from the series LLC or any other series within the series LLC for purposes of filing federal income tax returns, informational returns, or withholding documents in any taxable year;

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• the series and the series LLC had a reasonable basis for the classification; and

neither the series nor any owner of the series or the series LLC was notified on or before the date the final regulations are published in the Federal Register that the classification of the series was under examination.

The Transition Rule will no longer apply if 50 percent or more of the ownership interests of a series LLC or any of its series are owned, in the aggregate, by persons who were not owners of that series or series LLC prior to September 14, 2010.

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– Annual StatementThe Proposed Regulations require an annual statement to be filed by a series LLC and each of its series to provide the IRS with certain identifying information to ensure the proper assessment and collection of federal income tax. The Proposed Regulations require the annual statement be filed on or before March 15 of each year beginning after the date the final regulations are published in the Federal Register.

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Trusts and LLC as Eligible S Corporation Shareholders• Certain Trusts Seven types of trusts qualify as eligible S corporation

shareholders. Although the statute refers to these trusts as

“permitted shareholders,” none of the trusts is actually treated as the shareholder for purposes of the S corporation eligibility or shareholder consent requirements.

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Trusts and LLC as Eligible S Corporation Shareholders

– Grantor-Type TrustsAn eligible shareholder includes a trust all of which is treated as owned by an individual who is a U.S. citizen or resident. If a grantor trust qualifies as an eligible shareholder, the deemed owner of the trust (and not the trust itself) is treated as the shareholder of the corporation for purposes of the S corporation eligibility requirements. The deemed owner (rather than the trust) files any required consent to an S election.

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– Grantor-Type Trusts Following Death of OwnerAn eligible shareholder includes a qualifying grantor-type trust which continues in existence following the deemed owner's death. Such a trust is often designed to continue in existence as an irrevocable trust after the death of the deemed owner.

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Trusts and LLC as Eligible S Corporation ShareholdersSuch a trust generally continues to qualify as an eligible S corporation shareholder until the earlier of: (1) the transfer of the stock by the trust; or (2) the expiration of the two-year period beginning on the day of the deemed owner's death. However, if it qualifies, and a qualified subchapter S trust (QSST) election or an electing small business trust (ESBT) and an ESBT election is made for the trust, the trust can continue to be an eligible shareholder after the transfer or the expiration of the two-year period.

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– Testamentary Trusts An eligible shareholder includes a trust to which stock is transferred pursuant to the terms of a will or qualifying grantor-type trust. The transferee trust qualifies as an eligible shareholder until the earlier of (1) the date on which the trust disposes of the S corporation stock or (2) the end of the two-year period beginning on the date on which the S corporation stock is transferred to the trust, unless the trust qualifies as another type of eligible trust.

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– Voting TrustsAn eligible shareholder includes a trust created primarily to exercise the voting power of stock transferred to it and which meets certain specific requirements Each beneficiary of a voting trust is treated as a shareholder for all subchapter S purposes. Because each beneficiary is treated as a shareholder, a voting trust cannot be used to circumvent the 100-shareholder limit.

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– Qualified Subchapter S Trusts (QSSTs)An eligible trust also includes a “qualified subchapter S trust,” or “QSST.” If the QSST income beneficiary so elects, the QSST is treated as a grantor-type trust with respect to the S corporation stock it holds

and, thus, qualifies as an eligible shareholder.

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• Trust RequirementsA trust qualifies as a QSST only if all of the income of the trust is distributed (or is required to be distributed) currently to one individual who is a U.S. citizen or resident and the terms of the trust require that:

– during the current income beneficiary's life, there can be only one income beneficiary;

– any corpus distributed during the current income beneficiary's life may be distributed only to that income beneficiary;

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–the current income beneficiary's income interest in the trust will terminate on the earlier of that income beneficiary's death or the termination of the trust; and

–upon termination of the trust during the current income beneficiary's life, the trust will distribute all its assets to that income beneficiary.

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Trusts and LLC as Eligible S Corporation Shareholders• QSST Election A QSST is treated as an eligible shareholder only if the

current income beneficiary elects to have the QSST treated as an eligible shareholder with respect to the stock of the corporation.

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Trusts and LLC as Eligible S Corporation Shareholders• ProcedureThe QSST election is made by the current income beneficiary of

the trust or by his or her legal representative.

A separate QSST election must be made with respect to the stock of each corporation held by the trust for which an S election is desired.

A special election procedure is available for an electing small

business trust (ESBT) to convert to a QSST or for a QSST to convert to an ESBT.

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Trusts and LLC as Eligible S Corporation Shareholders• DeadlineIf S corporation stock is transferred to a trust, the QSST election

must be filed within the later of: – the two-month-and-16-day period beginning on the

date on which the stock is initially transferred to the trust; or

– the two-month-and-16-day period beginning on the first day of the first taxable year for which the corporation's S election is effective.

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Trusts and LLC as Eligible S Corporation Shareholders• Electing Small Business Trusts (ESBTs)Any trust, except an electing QSST, a charitable remainder trust,

or a tax-exempt trust can be an ESBT if the following conditions are met:

– the trust has no beneficiaries other than individuals, estates, or certain charitable organizations;

– no interest in the trust was acquired by purchase; and

– an election is made to treat the trust as an ESBT.

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Trusts and LLC as Eligible S Corporation Shareholders• ESBT ElectionAn ESBT is treated as an eligible shareholder only if the trustee elects to have

the ESBT treated as an eligible shareholder with respect to the stock of the corporation.

A trust that ceases to be a grantor-type trust and that satisfies the ESBT

requirements may elect to be an ESBT. Likewise, a testamentary trust that is a permitted shareholder and that

satisfies the requirements of an ESBT may file an ESBT election. If certain requirements are met, a QSST may automatically convert to an ESBT.

An ESBT may automatically convert to a QSST if certain conditions are met.

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Trusts and LLC as Eligible S Corporation Shareholders• ProcedureTo make the ESBT election, the trustee must file an

election statement with the IRS service center with which the S corporation files its income tax return.

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Trusts and LLC as Eligible S Corporation Shareholders• DeadlineThe election must be filed within two months and 16

days after the S corporation stock is transferred to the trust.

If the trust holds stock of a C corporation that makes an

S election, the trust must file the ESBT election within two months and 16 days of the date on which the S election is effective.

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Trusts and LLC as Eligible S Corporation Shareholders• Pension TrustsQualified retirement plans are eligible to own S

corporation stock in taxable years beginning after 1997.

• Foreign Trusts– Foreign trusts do not qualify as eligible S corporation

shareholders. – Note: This rule applies to foreign trusts that are treated as

grantor trusts under IRC section 679.

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Trusts and LLC as Eligible S Corporation Shareholders• Disregarded Entities—Partnerships and Limited Liability

CompaniesIf a single-owner limited liability company (LLC) is disregarded as

an entity separate from its owner and the owner is an eligible S shareholder (e.g., an individual or a QSST), the LLC qualifies as an eligible S corporation shareholder.

Similarly, a state-law limited partnership formed by two limited

liability companies owned by the same person is an eligible S shareholder when both the partnership and the limited liability companies are disregarded entities.

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Cracking the Income Tax Code for LLCs and Trusts

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