u
EDITED BY PETER J. CONNORS, LL.M.,
ROBERT R. CASEY, LL.M., AND LORENCE L. BRAVENC, CPA, LL.M.
SPECIAL INDUSTRIES
Investment Trusts, the
Power to Vary, and
Holding Partnership
Interests
THOMAS GRAY
A “trust” holding a partnership interest should carefully consider whether
investing in such an asset could result in a power to vary the investment
of its certificate holders.
When most people think about a legal
entity that is managed by a trustee,
holds property for one or more beneficiaries, and is commonly referred
to as a trust, they simply assume that
the entity is a trust for all purposes.
In the tax world, however, the classification of that entity is much more
complicated. It may be classified as a
trust, a corporation, a partnership or
even a disregarded entity. Classification as a trust is dependent on a variety of factors and can lead to some
surprising results.
CLASSIFICATION AS A TRUST
What is the benefit of being classified
as a trust? A trust and its beneficial
owners can be subject to just one level
of taxation and generally enjoy simpler reporting requirements than a
partnership. The classification for federal income tax purposes can depend
on the scope of a trustee’s powers, the
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J o u r n a l o f Ta x aT I o n l m ay 2 0 1 6
permitted activities of the trust, and
even the property held by the trust.
While the Service and the courts have
expanded on these concepts, one area
where clear guidance is still lacking is
the consequences of a trust holding a
partnership interest. As more fully described below, the Service did issue
AM 2007-005, which concluded with
limited explanation that as a result
of its ownership interest in a partnership, a trust was not an investment
trust classified as a trust under Reg.
301.7701-4(c), but rather a business
entity.1 If a trust holds interests in a
partnership and that partnership engages in a trade or business, should
those activities be attributed to the
trust in determining its classification
for federal income tax purposes?
Generally, the classification of an
entity for federal income tax purposes
is determined under the Treasury Regulations.2 An entity may be classified
as an association taxable as a corpo-
ration, a partnership disregarded as
an entity separate from its owner, or
a trust. If an entity is treated as a business entity, it will not be classified as
a trust for federal income tax purposes.3 So while an entity may be generally referred to as a “trust,” it may
not be treated as such for federal income tax purposes. Specifically, an organization referred to as a “trust” can
be classified under the Regulations in
one of three ways, each resulting in
different federal income tax treatment:
(1) an ordinary trust, (2) a business
trust, or (3) an investment trust.4
Ordinary Trust
An ordinary trust is one in which the
purpose of the arrangement is to vest
in trustees responsibility for the protection and conservation of property
for beneficiaries who cannot share in
the responsibility and, therefore are
not associates in a joint venture for
the conduct of business or profit.5
Business Trust
A business trust is called a trust, but
is not considered a trust for federal
income tax purposes. This type of
trust is generally created by the beneficiaries in order to carry on a profit
making business th at normally
would have been carried on through
a corporation or partnership.6 The
contributor of the corpus of the trust
is not determinative of whether the
trust will be treated as a business
trust, but rather the underlying substance of the entity will guide the
classification. In other words, the
arrangement is not intended to just
protect and conserve prop erty.
Whether an organization has a busi-
ness purpose is determined by the
instrument creating it.7
Investment Trust
Another type of trust, and the focus
of this article, is the investment trust.
An investment trust with a single class
of ownership will be treated as a trust
for federal income tax purposes if
there is no power under the trust
agreement to vary the investment of
the certificate holders.8 In addition, an
investment trust with multiple classes
of ownership interests will be classified as a trust only if there is no power
under the trust agreement to vary the
investment of the certificate holders
and the trust is formed to facilitate direct investment in the assets of the
trust and the existence of multiple
classes of ownership interests is incidental to that purpose. 9 However,
what does it mean to vary the investment of the certificate holders?10
DETERMINING WHAT
IS A “POWER TO VARY
THE INVESTMENT”
For years, both the courts and the
Service have been ruling on what
constitutes a “power to vary the investment” of a certificate holder. In its
seminal case, North American Bond Trust,
122 F.2d 545, 27 AFTR 892 (CA-2,
1941), the Second Circuit ruled that
the “‘Depositor’ had it in his power
in effect to change the investment of
certificate holders at his discretion.” In
this case, the Depositor originally selected a variety of bonds to be held
by the trust, and a beneficiary’s interest in the trust was represented by
a unit. The Depositor generally could
not change the composition of bonds
underlying such original units. When
new money came into the trust, however, the Depositor, when acquiring
bonds for the new units, was not restricted to the original composition
of bonds as he selected for the first
units. Since the bonds of all the units
constituted a single group of securities
that each certificate holder shared in
according to his or her proportion of
all certificates issued, Judge Learned
Hand determined that the ability to
acquire different bonds resulted in a
power to vary the investment and
take advantage of changes in the
market to enhance the positions of
the first investors. The investment
trust, therefore, was not fixed.11
Investment Trusts Taxable
as a “Trust” Per Service Rulings
The Service has also examined the
power to vary the investment in a variety of public and private rulings. In
Rev. Rul. 73-460, 1973-2 CB 424, the
depositor deposited with the trustee
interest bearing municipal obligations,
contracts for purchase of such obligations, and the cash to make such purchases. In order to preserve the sound
investment character of the trust, the
depositor could direct the trustee to sell
certain obligations if, for example, there
was a default of payment or a substantial decline in value. The trustee was to
distribute any interest income or principal collected, less a reserve, semiannually. If the obligor of an obligation
was to issue new obligations in exchange for the old ones, the trustee
could accept such replacement under
certain conditions, such as when the
issuer was in default or likely to default
NOTES
1
See “am 2007-005 (Trusts Holding Interests in a Partnership)”, 6 J. Tax’n fin. Products 63 2006-2007.
2
reg. 301.7701-1(b). Prior to the effective date of these
regulations, the determination of whether a business organization was treated as a corporation or
partnership was based on the differences under local law between partnerships and corporations.
Prop regs., 5/13/96. 61 fed. reg. 21989 (1996). The
preamble to the proposed regulations notes further
that the distinction between trusts and business
entities is restated, but the determination of
whether an organization is classified as a trust for
federal tax purposes is intended to remain the
same as under prior law. Id. Generally a corporation
needs associates that enter into a business venture.
Morrissey, 296 u.S. 344, 16 afTr 1274 (1935) (ruling
SPECIal InduSTrIES
on whether an entity should be classified as a trust
or a corporation), see also Bedell Trust, 86 TC 1207
(1986) (trust lacked associates and therefore could
not be classified as an association taxable as a corporation).
8
3
reg. 301.7701-4(c)(1).
reg. 301.7701-2(a).
9
4
Id.
reg. 301.7701-4. The regulations also provide for
trusts designated as liquidating trusts and environmental remediation trusts. These organizations are
classified as trusts under the Code.
5
reg. 301.7701-4(a).
6
reg. 301.7701-4(b).
7
rev. rul. 75-258, 1975-2 CB 503; see also Morrissey at
361 (the character of an organization is “determined
by the terms of the trust instrument”); ltr. rul.
200517020 (entity that held a variety of private investments with the possibility of making additional
investments was a business trust and classified as a
partnership for tax purposes).
10
for a more detailed discussion on ordinary and business trusts, see Sanborn, “u.S. Tax Classification of
Trusts: When is a Trust not a Trust?,” 31 Est. Planning
J. 9 (September 2004).
11
See also Helvering v. Coleman-Gilbert Associates, 296
u.S. 369, 16 afTr 1270, 374 (1935) (“[t]he parties are
not at liberty to say that their purpose was other or
narrower than that which they formally set forth in
the instrument”).
m ay 2 0 1 6 l J o u r n a l o f Ta x aT I o n
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233
on its payment obligations. The Service
ruled that since there was no possibility of reinvestment, there was no
power to vary the investment of the
certificate holders and the fixed investment trust qualified as a trust.
The Service has also concluded
that certain short-term investments
do not create a power to vary the investments of the certificate holders. In
Rev. Rul. 75-192, 1975-1 C.B. 384, an
investment bank gathered funds from
investors and turned over the investment funds to a trustee.12 The trustee,
along with a company specializing in
the administration of mortgages, invested the funds in various mortgages.
The trustee was to make quarterly distributions of all principal and interest
payments. Between distributions, the
trustee was to invest cash on hand in
short-term obligations, such as U.S.
Treasury obligations or in certificates
of deposit. Such investments were required to terminate prior to the next
distribution date and all proceeds
were required to be distributed. The
trustee did not have the ability to
make any other investments. The
ruling noted that the investments in
temporary, short-term obligations
generated a return similar to a bank
account and eliminated the possibility
u
bution date, the sponsor would create
a new fixed investment trust in which
the certificate holders of the existing
trusts could invest their distributions.
A bank would receive the distributions on behalf of those certificate
holders who wish to participate and
would combine such amounts and
purchase certificates in the new trust.
The participant was then credited
with its share of certificates. There was
no reinvestment in the original trust
and the investments in the original
trust remain fixed. Therefore, the Service concluded, the reinvestment plan
did not create a power to vary the investment of the certificate holders.
In Rev. Rul. 86-92, 1986-2 C.B. 214,
the Service addressed the consequences of the failure by the trust to
acquire certain bonds pursuant to
contracts deposited in the trust. In
the ruling, the sponsor deposited in
the trust certain contracts to acquire
bonds. The contracts allowed for the
purchase of the bonds when and if
issued. Such bonds had to be transferred to the trust within 90 days of
the creation of the trust. If the bonds
were not transferred to the trust within the 90-day period due to reasons
beyond the sponsor’s or trustee’s control, the sponsor then had 20 days to
Prior to the issuance of AM 2007-005, most practitioners
probably would have determined that a trust holding a
partnership interest should not result in a power to vary the
investment of the certificate holder.
to profit from market fluctuations. Because there was no ability to invest in
new mortgage obligations or take advantage of market fluctuations, the
Service concluded that the organization was a trust for federal income tax
purposes.
The attributes of an automatic reinvestment plan were discussed in
Rev. Rul. 81-238, 1981-2 CB 248.
There, before each semiannual distri-
transfer different bonds of substantially the same character and quality
as those attributable to the failed contracts. Otherwise, the trustee was required to refund to the certificate
holders certain amounts related to the
failed contracts. The Service noted that
these powers are incidental to the formation of the trust, they exist only
during the first 110 days of the trust,
there was no additional investment,
THomaS Gray is a partner with drinker Biddle & reath llP in new york City. He thanks Kaitlin a.
mcKenzie-fiumara for her thoughtful comments. The views expressed in this article are those of the
author and do not necessarily reflect the views or professional advice of drinker Biddle & reath llP.
234
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and there was no change to the corpus of the trust. Therefore, the Service
concluded that neither the trustee nor
the sponsor had a power to vary the
investment of the certificate holders.13
Similarly, in Rev. Rul. 89-124, 19892 CB 262, the Service found no power
to vary the investments of a certificate
holder when, during the 90-day period immediately following the creation of trust, the depositor could deposit additional securities in the trust
in exchange for additional certificates.
The original securities were debt securities and the additional securities
had to be substantially similar to the
original securities. The ruling noted
that the depositor maintained the
power to deposit additional securities
in order to adjust the size of the trust
based on market conditions. The
Service concluded that such power,
like in Rev. Rul. 86-92, was intended
only to facilitate the organization of
the trust and was limited in time. Because of the limited time involved, the
power restricts the ability of the depositor to take advantage of market
fluctuations, a key conclusion under
North American Bond Trust.
In Rev. Rul. 90-63, 1990-2 C.B. 270,
a trust was created to hold certain
bonds issued by a municipal corpo-
J o u r n a l o f Ta x aT I o n l m ay 2 0 1 6
ration. The municipal corporation
then loaned the proceeds from the
bond issuance to another corporation
that would develop a waste disposal
facility. The developer was to provide
credit support for the loan. Pursuant
to the trust agreement, the trustee, at
the municipal corporation’s request,
was permitted to consent to a change
in the credit support if the trustee believed that the change was advisable
to maintain the value and credit ratings of the bonds. The Service noted
that the trustee could not alter any of
the terms of the bond issue held by
SPECIal InduSTrIES
the trust and any increase in the value
of the bonds as a result in the credit
support would be incidental to maintaining the value of the trust property.
Therefore, agreeing to change the
credit support was not a power to
vary the investment of the certificate
holders.
Unlike the rulings above dealing
with securities, Rev. Rul. 2004-86,
2004-2 CB 191, dealt with real property contributed to a trust. Here, the
depositor had acquired real property
and leased it to a lessee pursuant to a
ten-year net lease, which generally
provided that the lessee would maintain the property and pay the costs
associated with the property. The depositor then contributed the property
to the trust and the trust assumed the
rights and obligations under the lease
and the original acquisition loan. The
trust issued a single class of certificates
that were freely tradable, and the trust
was to terminate at the earlier of ten
years or at the disposition of the
property. Any cash received, less certain reserves, was to be distributed
quarterly to the beneficial owners,
while between distribution dates the
trustee could invest such cash in certain short-term obligations that
would terminate prior to the next distribution date. The trustee’s powers
were otherwise generally limited, but
it could make minor non-structural
modifications to the property.
The Service noted that because of
the distribution requirement, no reinvestment of monies was possible. In
addition, the trustee could not exchange the property for other property, acquire new assets, or accept additional assets. The trustee also could
not renegotiate the lease or the debt
that encumbered the property. The
Service, therefore, concluded that because of these limitations, the trustee
had no power to vary the investment
of the certificate holders to benefit
from variations in the market.
In private rulings, the Service has
also examined whether certain powers constituted a power to vary the
investment of certificate holders. The
Service has held that there was no
such power when trustees established
SPECIal InduSTrIES
a voting trust.14 In Ltr. Rul. 7752045,
the trust held most of the common
stock of a corporation, the trustees
could vote the shares and take part in
and consent to any shareholder’s action, but needed approval by vote of
80% of the registered owners of the
trust certificates with respect to certain
major corporate actions. The trustees
would distribute any cash dividends
received, less certain expenses. Without much explanation, the Service
concluded that there was no power
under the trust agreement to vary the
investment of the certificate holders
and the voting trust would be treated
as a trust for federal income tax purposes.
In another private ruling, 15 the
Service reviewed (1) whether the
trustee’s power to vote shares in the
same manner and in the same proportion as the shares were voted by
owners other than the certificate
holders concerning a proposed reorganization, and (2) whether the retention of any stock or securities received
in the reorganization, would prevent
the trust from being classified as a
trust for federal income tax purposes.
Relying on Rev. Rul. 86-92 and Rev.
Rul. 90-63, the Service determined
that the trustee’s limited power to vote
was incidental to the maintenance
and preservation of the trust property
and was not intended to take advantage of market fluctuations. Furthermore, the receipt of stock or securities
was not a managerial power that allowed the trustee to take advantage
of market variations, and therefore
there was no power to vary the investment of the certificate holders.
In Ltr. Rul. 9807005, the Service determined that a trust agreement that
provided for a roll over by investors
of their investment into a subsequent
new trust following the termination of
the original trust did not cause the
original trust to be treated as a part-
nership or corporation for federal income tax purposes.16 Here the certificate holder would elect to invest in the
units of the subsequent trust by making an in-kind contribution to the
subsequent trust. The subsequent trust
would be similar to the original trust
and have its own indenture, registration statement and prospectus. In ruling that the initial trust would not be
treated as a partnership or corporation, the Service relied on Rev. Rul. 81238. The Service noted that the subsequent trust had independent
economic substance and there was no
legal commitment to create the subsequent trust or invest in the subsequent
trust. For these reasons and also because there was generally no incentive
to choose the subsequent trust over
other investment strategies, the option
to invest in the subsequent trust did
not cause the trust to be a mere continuation of the original trust.
Investment Trusts Taxable as a
“Corporation” Per Service Ruling
The Service has not always ruled that
a trust qualifies as a fixed investment
trust. In Rev. Rul. 78-149, 1978-1 CB
448, the Service concluded that the
trust should be treated as an association taxable as a corporation. The
trust held a portfolio of municipal obligations and was to terminate on the
maturity, redemption, sale, or other
disposition of the last obligation held
by the trust, but no earlier than a
specified date. In order to avoid termination prior to that specified date,
the trust agreement provided that
during the first 20 years of the trust’s
existence it could reinvest funds received from early redemptions of
bonds held in the corpus. The newly
acquired bonds had to be similarly
rated and mature no later than the
specified date of the trust termination.
If the funds were not reinvested
within 20 days of receipt, the trustee
NOTES
12
See also ltr. rul. 8311007 (if the trustee can only reinvest income in short-term obligations that mature
prior to the next distribution date and no additional
contributions allowed, there is no power to vary the
investments of the certificate holders), ltr. rul.
8412003 (if trustees can invest cash held as a reserve
for liabilities or for distribution at the next distribution
date in government securities, certificates of deposit
and repurchase agreements secured by government
securities the trusts will be treated as trusts for federal
income tax purposes).
13
See also ltr. rul. 9329014.
14
ltr. rul. 7752045.
15
ltr. rul. 9435037; see also ltr. rul. 9329014.
16
ltr. rul. 9807005; see also ltr. rul. 200007006.
m ay 2 0 1 6 l J o u r n a l o f Ta x aT I o n
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235
had to distribute the funds to the certificate holders. The Service noted that
it is not the power to sell an asset that
constitutes a power to vary, but rather
the ability to reinvest the proceeds
that creates a power to vary the investment of the certificate holders. If
u
NOTES
236
u
provided such substitution was intended to facilitate the formation of the
trust, (4) consent to the change of the
credit support for bonds held in the
trust corpus, and (5) vote the stock
held by the trust in the same manner
as other stock holders and have the
For years, both the courts and the Service have been ruling
on what constitutes a “power to vary the investment” of a
certificate holder.
this reinvestment takes advantage of
market variations and improves the
position of the certificate holders, the
power to vary is there. Here the Service concluded that the ability to reinvest over such a long period, at the
option of the trustee, allowed the
trustee to take advantage of variations
in the market and therefore constituted a power to vary the investments
of the certificate holders.
In Rev. Rul. 78-371, 1978-2 C.B. 344,
the Service again determined that a
trust was not a fixed investment trust,
but instead classified it as an association taxable as a corporation. In the
ruling, various heirs to continuous
parcels of land contributed the land
to a trust. The land was subject to a
net lease, with the lessee generally responsible for the cost and maintenance of the land. The trustee was to
distribute the income quarterly to the
beneficiaries. The trust instrument
could be amended with consent of all
the beneficiaries and would otherwise
terminate in 30 years. Beneficiaries or
members of their families could contribute to the trust interests in real estate that were adjacent or continuous
to the property held in trust and then
such contributors would become new
beneficiaries of the trust. The trustee
could sell real estate held in the trust
and could purchase additional real estate. Any proceeds from sales not
reinvested in real estate would be
reinvested only in certificates of deposits, or obligations of federal or state
governments. In addition, the trustee
17
could borrow money, mortgage and
lease the property, and generally improve the property. Not surprisingly,
the Service concluded that because of
the broad powers of the trustee and
the ability for new beneficiaries to join
the trust, the trustee was empowered
ltr. rul. 9234017.
J o u r n a l o f Ta x aT I o n l m ay 2 0 1 6
to do more than just protect and conserve the trust’s property. Therefore,
the arrangement was classified as an
association taxable as a corporation
for federal income tax purposes.
Privately the Service has ruled that
a foreign unit investment trust, which
was created so that investors could
earn a return that tracked the performance of a particular index, should
be classified as an association taxable
as a corporation, and not a trust.17 In
Ltr. Rul. 9234017, a stock exchange
created an index that would reflect the
performance of certain companies
listed on the exchange. The trust
would invest all of its assets in the
stock of companies that were included in the index, in the same proportion as reflected in the index. Occasionally, the composition of the
stocks included in the index would
change and the trust would adjust the
stocks it held in the same proportions.
The Service held that the trustee’s
power to acquire new investments
enabled the trust to take advantage of
variations in the market and improve
the position of the investors. Because
of this ability, the trustee had the
power to vary the investment of the
unit holders.
In sum, the Service has provided
guidance that an investment trust will
be classified as a trust for federal income tax purposes even if the trustee
has a power to (1) sell assets, (2) reinvest cash in short-term secure obligations that mature before the next required distribution date and distribute
such amounts on the distribution date,
(3) take substitute assets during a brief
period at the formation of the trust
trust receive stock and securities in a
reorganization. In addition, an investment trust may qualify as a trust when
the certificate holders have the ability
to reinvest in a subsequent trust or
have an automatic reinvestment plan.
The results, however, may not be so
clear when the trust holds interests in
an entity treated as a partnership for
federal income tax purposes.
IMPLICATIONS OF HOLDING
A PARTNERSHIP INTEREST
Should holding a partnership interest
influence the status of a trust for federal income tax classification purposes? Superficially, it would seem
that the holding of any particular asset in and of itself should not determine the federal income tax classification of an entity, but when that
asset is a partnership interest, the required deeper analysis includes
whether the entity or aggregate approach is used with respect to the
partnership and then whether the activities of the partnership are deemed
attributable to the trust. If the partnership activities are attributable to
the holder of the partnership interest
and the partnership performed activities that would be treated as varying
the investment of trust certificate
holders, a trust holding an interest in
such a partnership would be at risk
of being treated as other than a trust
for federal income tax purposes.
Commentators have discussed the
appropriateness of using the aggregate
or entity approach to determine
whether activities and attributes of a
partnership should be attributable to its
SPECIal InduSTrIES
partners.18 Generally, without some
statutory authority such as Section
751(f), 875(1) or 1402, or some other
specific guidance, the assumption
would be that the partnership’s activities and attributes should not be attributable to its partners. The Service,
though, has looked at this issue, and the
resulting guidance demonstrates that
the answer is not so straightforward.
GCM 38201, 12/14/79, considered
whether the Service should issue a
proposed revenue ruling involving a
fixed investment trust holding a 10%
interest in a limited partnership that
was engaged in a business enterprise.
The GCM covered two scenarios. In
the first scenario, an individual created
a trust with a bank, which acted as the
trustee, and the individual contributed
a 10% interest in a partnership to the
trust in exchange for certificates of
ownership, which the individual sold
to the public. The partnership was engaged in commercial fishing operations. The second scenario was identical to the first, except that instead of
commercial fishing, the partnership’s
business was investing in commodity
futures. Relying on various court decisions regarding limited partnerships,
the Service’s proposed ruling concluded that the partners (i.e., the trust)
were engaged in the trade or business
of the partnership. In advising that the
Service not publish its proposed ruling, the GCM emphasized that: (1)
there was no indication in the two
specified scenarios that the limited
partners were active participants in the
partnerships’ businesses, and (2) if
there was a general premise of a matter
of law that a limited partner was to be
treated as engaged in the trade or business of its partnership, Sections 875(1)
and 1402(a) would be superfluous.
If it were published, the ramifications of the proposed revenue ruling
could be profound. For example,
based on the Service’s guidance in this
proposed ruling, a trust holding a
very small limited partnership interest
in a very large syndicated partnership
would be an association taxable as a
corporation for federal income tax
purposes. The GCM advised that the
proposed revenue ruling not be isSPECIal InduSTrIES
sued and recommended that the
Service take the position outlined in
the proposed revenue ruling only in
scenarios where there is a clear legal
basis for such a conclusion.
The Service also analyzed a trust
holding an interest in a limited partnership in Ltr. Rul. 8008084. In this
instance, a trust company created a
trust for the sole purpose of investing
in a limited partnership. The trust
company would be the trustee and
the sole initial limited partner. The ruling explains that the trust would be
funded by various participating accounts at the time of formation or at
other times as required by the limited
partnership agreement. All units acquired by the trust and all allocations
and distributions with respect to such
units would be allocated on the books
u
The Service
has not
always ruled
that a trust
qualifies as a
fixed
investment
trust.
of the trust to the participating account that contributed the related
funds. The trustee was described as
having limited powers. The ruling did
not examine Reg. 301.7701-4(c), but
rather Reg. 301.7701-4(b), and concluded that the participating accounts
would not be associated together to
carry on a joint activity and therefore
the trust will be treated as a trust for
federal income tax purposes.
In Ltr. Rul. 8210049, a trust company
created a trust to invest in a limited
partnership, which in turn would invest in oil and gas properties. The two
general partners were an individual
and a corporation. The trust would be
the sole initial limited partner and the
trust company would be the trustee of
the trust. The corporate general partner
and the trustee were both subsidiaries
of the same entity. The trustee received
funds in various fiduciary capacities
and contributed those funds to the
trust. The accounts for which the
trustee made the contributions on behalf of were referred to as participating
accounts. The amounts contributed to
the trust were then invested in the limited partnership in two installments six
months apart. All amounts allocated to,
or received by, the trust from the limited
partnership would be allocated to the
participating accounts. The trustee’s
powers were limited and met the standards set in Rev. Rul. 75-192. This ruling
did cite Reg. 301.7701-4(c) and held that
the trust would be classified as a trust
for federal income tax purposes.
In both Ltr. Ruls. 8008084 and
8210049, the Service refrained from
discussing the possibility of attributing
the activities of the limited partnership
to its members and did not examine
the reasons behind why the trust became a limited partner, as opposed to
certificate holders investing directly in
the limited partnership. Rather, by not
addressing the issue, the Service implied that it viewed each limited partnership as an entity that should be
treated by the trust as any other investment. On the other hand, the
undisclosed facts related to the limited
partnership could support the conclusion that even if the activities of the
partnership were attributed to the
trust, those activities would be so limited as to not result in a power to vary
the investment of the beneficiaries of
the trust.
In Ltr. Rul. 8632025, the Service took
a deeper look at the activities of a partnership and whether those activities, if
attributed to its partners, could cause
a trust that was a partner to have an
objective of carrying on a business or
the power to vary the trust’s investment. In this instance, a publicly traded
company was engaged in the exploration for and production of oil and
gas and other minerals. The company
owned various properties and wanted
NOTES
18
See mcKee, nelson, and Whitmire, Federal Taxation
of Partnerships & Partners 4th ed. (WG&l, 2007), §
1.02; Willis and Postlewaite, Partnership Taxation, 7th
ed., (WG&l, 2011), § 1.04; Banoff, “When Will an llC’s
Trade or Business Be Imputed to its members” 87
JTax 3 (September 1997); Gray, “Hedge fund Capital
accounts and revaluations: are They Section 704(b)
Compliant?,” 123 JTax 3 (September 2015).
m ay 2 0 1 6 l J o u r n a l o f Ta x aT I o n
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237
to distribute to its shareholders as a
dividend certain royalty interests associated with the properties. Since it
was impractical to distribute undivided
interests in such royalties to its shareholders, the company decided to form
a trust to indirectly hold the royalties
and distribute out the trust interests to
its shareholders, with a bank acting as
trustee. To avoid certain probate issues
and solve certain accounting issues, the
company determined that the trust
should hold the royalties through a
general partnership, with the trust
holding 99% of the partnership interests and the company holding 1%. The
company was required to operate the
properties in accordance with reasonable and prudent business judgment
and good oil and gas field practices.
In analyzing the arrangement, the
Service noted that the trustee had limited powers, only the trust could hold
the partnership interest, and the trust
agreement prohibited the trustee from
engaging in any business activities. The
partnership also had limited powers,
which generally were to hold the royalty interests and to collect and distribute royalty proceeds. The Service further noted that even if the activities and
powers of the partnership were attributed to its partners, the limited nature
of the partnership activities were such
that the trust would not possess an objective to carry on business or the
power to vary the trust’s investment.
Because of this, the Service concluded
that the trust would be classified as a
trust for federal income tax purposes.
AM 2007-005
A different conclusion was reached in
AM 2007-005. There, an LLC, which
was treated as a partnership for federal
income tax purposes, was organized
with the intent to acquire, hold, and
manage a portfolio of investments.
The LLC was to issue two classes of
units. The common units would be
held by a trust, and management units
NOTES
238
19
See reg. 1.671-5.
20
Query whether the Service could have challenged
the validity of the llC as a partnership under the partnership anti-abuse rules. See reg. 1.701-2.
u
J o u r n a l o f Ta x aT I o n l m ay 2 0 1 6
would be held by a small group of investors who would also manage the
LLC. The trust’s sole purpose was to
hold the common units. The AM did
not supply any factual information
from the trust documents that would
indicate that the trustee, who was not
identified, had a power to vary the investment of the certificate holders.
The AM noted that the trust was
holding the LLC interests to provide
investors with the benefits of the managed investments of the LLC. If those
investment activities were conducted
directly by the trust, the trust would
not qualify as a trust for federal income
tax purposes. AM 2007-005 also notes
that the purpose of the arrangement
was to enable information reporting
to be provided to investors under rules
for widely held fixed investment trusts
(WHFIT)19 as opposed to the LLC issuing Schedule K-1s to the investors. The
Service concluded that because the nature and purpose of the trust was to
vary the investment, the trust was not
an investment trust classified as a trust
under Reg. 301.7701-4(c), but rather a
business entity.
There is very little analysis provided for in AM 2007-005, and its
conclusion is based on the premise
that “it is appropriate to consider the
nature and purpose of the Trust.” The
Service, however, does not cite any
specific authority for this position or
provide any “clear legal basis” for its
conclusion, as recommended in GCM
38201.20 It is clear, however, that the
Service determined that the purpose
of the trust was to take advantage of
the more favorable WHFIT reporting
rules, and therefore the activities of
the LLC were attributed to the trust. If
this rationale can prevail in this situation, it would seem that the Service
could attribute the activities of a partnership to a partner, or perhaps disregard the partnership, in other situations when the partner is an entity
created for tax purposes. Neither the
Code nor the Regulations would seem
to provide for this.
Should tax advisors consider AM
2007-005 as demonstrating a stricter
view by the Service with respect to
trusts holding partnership interests, or
does it represent just an isolated scenario so fact specific that it represents
no precedential value? If it is the former,
what are the facts and circumstances
under which a trust holding a partnership interest can produce a power to
vary the investments of the interest
holders? Apparently, if (1) the partnership activities would clearly be treated
as a power to vary if the trust performed such activities itself and (2) the
purpose of the trust is to take advantage of more convenient reporting
rules, then a trust will not qualify as an
investment trust. However, does the fact
that the trust owned all the common
units matter? What if the trust had
other assets? What if there was a principal purpose for forming the trust
other than to avoid more complicated
reporting rules?
There are a wide range of facts and
circumstances where it would seem
appropriate for a fixed investment
trust to hold an interest in a partnership without jeopardizing its classification for federal income tax purposes.
The Service’s guidance currently available, however, does not clearly indicate
what situations may be treated as acceptable with respect to a trust holding
a partnership interest.
CONCLUSION
Prior to the issuance of AM 2007-005,
most practitioners probably would
have determined that a trust holding
a partnership interest should not result
in a power to vary the investment of
the certificate holder. Now, however,
the facts and circumstances surrounding the creation of the trust and the
activities of the partnership that it
holds an interest in need to be carefully examined. Previous guidance
suggested that a trust would not be
treated as having a power to vary the
investment of its certificate holders by
virtue of holding a partnership interest
unless a “clear legal basis” provided for
such a conclusion. Because the analysis in AM 2007-005 is very limited,
however, practitioners are now left to
ponder whether holding a partnership
interest could jeopardize a trust’s federal income tax classification. l
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