By David Stoyanoff
On September 13, 2010, the IRS issued proposed regulations (Proposed Regs.) that may have an impact on Virginia Business Trusts. The Proposed Regs seek to change the classification for Federal income tax purposes of a series of a domestic series limited liability company (“series LLC”), a cell of a domestic cell company, or a foreign series or cell that conducts an insurance business. Although the Proposed Regs. do not specifically mention the Virginia Business Trust (VBT), its similarity to a series LLC leads us to believe they may have an impact on how a VBT is taxed.
What is a Virginia Business Trust?
A VBT is a relatively new form of business entity that is different from the traditional trusts with which most people are familiar. A VBT should not be confused with land trusts or with living or testamentary trusts that may be used in an estate plan. These more traditional types of trusts are not separate legal entities – they are just ways to own property. On the other hand, a VBT is a separate legal entity (like a corporation or limited liability company) formed to conduct business. Under the Virginia Business Trust Act, virtually anything that can be done using the corporate form can be accomplished with a VBT. The beneficial owners of the VBT (similar to corporate shareholders or members of an LLC) may elect Trustees (like a Board of Directors) to operate the business of the VBT.
The big difference between series entities like the VBT and the conventional LLC or corporation is the ability for VBT owners to build firewalls between assets and liabilities within a single entity. A VBT has the advantage of having multiple liability baskets (also known as a “series” or “cell”) under one organizational umbrella. This principle is designed to prevent a creditor of one series of the VBT from collecting against other unrelated series within the same trust. Thus, the key advantage of a “series” Business Trust is that liability is “quarantined” from the other series and the trust as a whole. Forming “series” within the entity is something that cannot be done with any other Virginia entity.
The VBT owners may add additional series within the trust by simply signing an addendum to the governing instrument (called the “Declaration of Trust”). In addition, separate series can have different owners with different ownership ratios than other series, and can even have different trustees.
A practical example of using the VBT is found with many real estate investors who used to form multiple LLC’s and/or corporations so that they could hold individual properties in a different entity, thus separating liability. This arrangement could get quite complicated as each property was governed by a different operating agreement or corporate bylaws and each had separate bank accounts and had to file annual renewals with the State Corporation Commission. The VBT allows much of this to be simplified as each property could be held in a separate series. There is a single set of guidelines found in the Declaration of Trust, a single renewal and simplified banking (keep in mind it is still as important to keep separate records for each property).
Current Tax Treatment
An LLC and a VBT is an “eligible entity”, allowing the taxpayer to file a single federal income tax return, either as a sole-proprietorship for a single owner[1] or as a partnership if it has multiple owners (unless it elects to file a separate tax return as a corporation). Similarly, we believed a VBT could file a single federal income tax return for the trust and including all of the series as long as all of the series had the same owners with identical ownership ratios. In either case, the series are treated as disregarded entities for Federal income tax purposes. When different owners or ownership percentages are added to a newly created series, which changes those ratios, it is less clear whether the VBT would file a single Federal income tax return or if that new series should file a separate tax return for that series.
Proposed Tax Treatment
The Proposed Regs. would treat each series as a separate entity formed under local law. This means a series’ classification for Federal income tax purposes would be handled under the same rules as any other entity. For example, such a series may make any Federal income tax elections it would otherwise be able to make independently of the other series or the “series organization” (the VBT) itself. Under this rule, the tax treatment of a series owned by a single beneficial owner should not change – the series could continue to be treated as a disregarded entity for Federal income tax purposes under the Proposed Regs.
What is not clear is whether a series of a VBT with 2 or more owners could make an election to be treated as a disregarded entity if multiple owners have an economic interest in the series. This is partly because the Proposed Regs. state that the determination of who “owns” the interest in the series depends on who bears the economic benefits and burdens of ownership. We believe these provisions mean that each series of a VBT with two or more owners would be forced to file a separate Federal income tax return under the Proposed Regs. We believe this would be the result because the IRS would look into each series and conclude that it has multiple owners (the beneficial owners of the VBT). If made final, these regulations would add a significant burden and eliminate a great deal of flexibility that the owners of a VBT currently enjoy.
Example 1: AB is a series VBT organized under Virginia law. A and B each own 50% of the membership interests in AB. AB forms 5 series and acquires 5 parcels of residential real estate, holding each parcel, along with its associated assets and liabilities in a separate series (Series AB1, AB2, AB3, AB4, and AB5). AB intends to rehabilitate each property and resell them to homeowners as their personal residences or rental properties. Under the AB declaration of trust, A and B are each entitled to 50% of the profits, losses and liquidation proceeds in each series.
Under the Proposed Regs., Because A and B each have an economic interest in each of the series, each series is treated as a separate entity with two owners, A and B. Therefore, none of the series can be treated as a disregarded entity, and AB, along with all 5 series would file separate Federal income tax returns as partnerships, with A and B as the partners.
The Proposed Regs. would not affect the tax treatment of series entities for tax periods prior to the date the IRS makes the Regs. effective, so there is less concern that VBTs will be required to file multiple tax returns for prior years.
Torus Law, PLC has filed comments with the IRS asking that the Proposed Regs. be modified and clarified to allow a multiple-owner VBT (or other series entities) which creates series with the same percentage of ownership as the owners have in the VBT be allowed to treat the series as disregarded entities. This would allow the VBT to file a single tax return for the VBT, as illustrated in the following example.
Example 2: The facts are the same under Example 1. If the Proposed Regs. are modified as suggested, since A and B’s economic interest in each of the series is identical to their respective interest in AB, each series may be treated as a disregarded entity, and AB, along with all 5 series would file its Federal income tax return as a partnership, with A and B as its partners.
We will keep a close eye on this issue and provide you with further information as it develops.
1] Here is why: if an “eligible entity” such as an LLC or a VBT has a single owner, it can be treated as a disregarded entity and have its activity included in its owner’s federal income tax return .
