Wednesday, May 24, 2017
I.R.C. §1402(a) defines net earnings from self-employment as “the gross income derived by an individual from any trade or business carried on by such individual, less deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss from any trade or business carried on by a partnership of which he is a member.”
That seems fairly clear – the business activity must be carried on by and “individual.” If that’s the case, that provides some planning opportunities for farm and ranch businesses (and other businesses too). That’s what today’s post takes a look at, based on a piece that I wrote for the University of Illinois Tax Workbook in recent years. That’s a workbook that is used at tax seminars in many states each fall and is a great resource for your tax library.
Business of a Trust Not Subject to Self-Employment Tax
The regulations provide that a trade or business must be carried on by an individual, either personally or through agents or employees. The regulations further provide “accordingly, income derived from a trade or business carried on by an estate or trust is not included in determining the net earnings from self-employment of the individual beneficiaries of such estate or trust.” Treas. Reg. §1.1402(a)-2(b).
As a result of this statutory and regulatory language, income derived from a business maintained by a trust (or an estate) is not included in determining net earnings from self-employment of the individual beneficiaries. Thus, in situations where a trade or business is carried on by an estate or trust rather than an individual, the income derived from the entity is not includable in determining the self-employment earnings of an individual beneficiary (or executor) unless there is a basis for disregarding the entity for purposes of the Code.
What type of a situation would serve as a basis for disregarding the entity (estate or a trust)? One example would be where the grantor of the trust is also the trust beneficiary. For example, in Huval v. Comr., T.C. Memo. 1985-568, a surviving spouse operated an oil and gas lease in her capacity as executrix of her husband’s estate, rather than in her individual capacity. That meant that the leasing business was conducted by the estate, and the Tax Court held that the lease income was not net earnings from self-employment for the surviving spouse.
What is a Trust?
A “trust” is subject to trust taxation, which means that self-employment tax savings can be achieved. Treas. Reg. §301.7701-4(a) addresses the definition of trusts for purposes of the Code, noting that trusts generally refer to arrangements created by either will or inter vivos declaration for the purpose of either protecting or conserving property for beneficiaries. Where the beneficiaries of the trust are the persons who created the trust, the trust will be recognized under the Code if it was created for the purpose of protecting or conserving trust property for beneficiaries who stand in the same relation to the trust as they would if the trust had been created by others for them. But, a trust that is treated as a grantor trust under the provisions of I.R.C. §§671-679 is treated as owned directly by the grantor. That’s because the grantor retains the control to direct the trust income or assets. Consequently, trust taxation does not apply, and self-employment tax savings will not be achieved.
A “business trust” is not subject to trust taxation, and won’t result in saving self-employment tax. Treas. Reg. §301.7701-4(b) addresses business trusts, describing them as arrangements where legal title to property is conveyed to trustees for the benefit of beneficiaries, but which are not classified as trusts for purposes of the Code because they are not arrangements to protect or conserve property for beneficiaries. These trusts are described as being created by the beneficiaries simply as a device to carry on a profit-making business that normally would have been carried on through business organizations that are classified as corporations or partnerships under the Code.
Let’s take a look at an example. Assume that Bob was a farmer at the time of his death. When he died, his farm assets were placed in a trust created under the terms of his will. Bob’s surviving widow, Brenda, was named as the sole trustee of the trust and the sole beneficiary of a QTIP trust and a credit-shelter bypass trust. Both of these trusts became irrevocable upon Bob’s death. Brenda participated in the operations and the management of the farming activity. Brenda reported the income and the distributions from the trusts on her Form 1040 Schedule E where it was not subject to self-employment tax.
This is the factual setting that the IRS was faced with in Tech. Adv. Memo. 200305001 (Jul. 24, 2002). The IRS determined that the QTIP trust and the credit shelter bypass trust were trusts with a separate existence. Thus, the pass-through income from the trusts was not deemed to be net earnings from self-employment to Brenda. The trusts were not found to be business trusts whose separate existence would be ignored under the Code. However, the IRS noted that there could be an issue of whether the wife, as trustee, received adequate payments for the services she performed for these two trusts, and suggested that a determination be made by the IRS Examination Division as to whether the payments that the wife received were reasonable and of sufficient amount for the services that she provided to these trusts.
Let’s change the facts slightly. Assume that Jack died, and an irrevocable, testamentary trust went into effect as a result. His surviving widow, Mary and their son, Doug, were the trustees and beneficiaries of the trust. The trust paid a fee to Doug for managing the farming operation, and paid a fee to Mary for maintaining the farming records. Doug and his mother reported the fees as self-employment income, but did not report the income received as beneficiaries of the trust as subject to self-employment tax.
These facts were involved in Tech Adv. Memo. 200305002 (Jul. 24, 2002). There, there IRS treated the trust as a separate entity with the result that the earnings were not subject to self-employment tax. The trust was to be separately respected under the Code. But, again, the IRS noted that there could be an issue of whether the wife received adequate payments for her services, and whether the son received reasonable and sufficient payments for his management activities.
These IRS Memos suggest that a trust can insulate the beneficiaries from SE income on an actively conducted farming operation, but only if two conditions are met:
- The trust is created to preserve the property for another party or in a testamentary manner that suggests it is not merely an attempt to move business operations into a trust entity (i.e., it is not a business trust);
- The trustees or other individuals rendering management or other services to the trust are reasonably compensated for their services in a manner that is subject to either FICA or self-employment With respect to the second issue, a testamentary trust can serve in much the same manner as an S corporation, where the issue at hand is the reasonableness of fees or compensation to those owners of the entity that also receive Schedule K-1 income exempt from self-employment tax.
As an additional thought, an individual receiving a distribution from a trust as a beneficiary who is also paid for trade or business services that the individual provides to the trust should be able to document that their compensation is reasonable based on what would have to be paid to a third party for the services.
An active business conducted through a trust can achieve self-employment tax savings. But, proper structuring is critical. As is the case with other estate or business planning techniques, whether to use a trust to achieve self-employment tax savings is to be considered in light of a host of planning considerations, both tax and non-tax.