How to Use a Business Trust with a Self-Directed IRA


by Bradford N. Dewan, J.D., MBA

Self-directed IRAs provide the IRA owner with greater investment options than a standard IRA account. With a Self-Directed IRA, the IRA owner initiates investigation and analysis of various investment opportunities (usually other than publicly traded stocks and mutual funds). Often, the IRA owner has a strong interest in acquiring for investment purposes various types of real estate such as an apartment complex, commercial property, industrial property, single-family rental home, or deeds of trust. Once a decision has been made to make an investment of the IRA funds in real estate, the next question is often whether to simply hold title to the real property in the IRA account or to create an entity into which the IRA funds will be invested. The entity will then make the investment with funds transferred into it from the IRA account and hold title to the real property investment until a decision is made to sell the real property and, thereby, realize the return on investment.

One example of such an entity is a “business trust.” With a business trust, the IRA account makes an investment in the business trust by acquiring the “beneficial interests” of the business trust. Often the IRA account will acquire 100% of the “beneficial interests” of the business trust. Acquiring the beneficial interests of the business trust is similar to an IRA account acquiring the “membership interests” of a limited liability company or shares of a corporation. Essentially, the term “beneficial interests” is the title for the “equity interests” in the business trust that are acquired when the investment is made in a business trust.1

By acquiring 100% of the “beneficial interests” of the business Trust, the IRA account has now become both (i) the “trustor,” or “settlor,” of the business trust (i.e. the party that has transferred assets into the business trust) and (ii) the “beneficiary” (i.e. the party that holds the “beneficial interests” of the business trust).

Declaration of Trust. The initial step in forming and structuring a business trust is to prepare a “Declaration of Trust” which is often commonly referred to as the “trust agreement.” The Declaration of Trust sets forth the primary purposes and objectives of the business trust. The primary purpose of the business trust is, of course, to make appropriate investments using the funds that were transferred to it from the IRA account. Consequently, all the activities and operations of the business trust that are done in connection with the investments must be for the sole and exclusive benefit of the IRA account.2

The Declaration of Trust will set out the rights and duties of the beneficiary. Typically, the rights and powers of the beneficiary are going to be very broad. For example, the beneficiary will have the right to make investment decisions and amendments to the Declaration of Trust, but these broad powers will not be exclusive. Rather, the trustee will also be given similar broad powers and, very importantly, the trustee will not be required to obtain the consent and approval of the beneficiary for any investment or management decisions the trustee makes regarding the assets and investments owned by the business trust.

The rational for this structure is straightforward. Since the beneficiary is the IRA account, then, if the trustee had no independent authority, all requests for approvals would have to go through the custodian of the IRA account. However, the business trust was created in order to minimize the number of decisions or transactions that would have to go through the custodian’s review and administrative process.

Consequently, while it is advisable to reserve these broad powers with the beneficiary in the event a situation arises where obtaining the direction and approval of the beneficiary would be appropriate, granting the trustee the power and authority to independently make investment and other asset management decisions achieves the “check book” control typically desired by the IRA owner.

The owner of the IRA account will typically appoint himself or herself as the “trustee” of the business trust. Pursuant to the terms of the Declaration of Trust, the trustee will have the authority to make all the decisions regarding (i) the purchase of investments, (ii) expenditures for the maintenance or upgrading of such investments, and ultimately (iii) the sale of each of the investments.

Bank account. Once the Declaration of Trust has been finalized, the trustee will then want to open a bank account in the name of the business trust. The trustee will typically be the “signator” on the bank account. However, prior to contacting a bank regarding the account, the trustee will apply for an EIN or “tax identification number” from the IRS. This is generally a straight forward process that can be done online by filling out the Form SS-4. All banks require an EIN with respect to the entity opening the account. 3

One of the documents that the trustee will be required to fill out in connection with opening the account is a “Certification of Trust.” While each bank will have its own form for the Certification of Trust, the terms and information required are pretty standard. Essentially the trustee will be certifying that (i) he or she is the trustee, (ii) the Declaration of Trust is enforce, (iii) the IRA account is the “trustor” and “beneficiary” and is the party with the right to revoke or amend the Declaration of Trust, and (iv) that the trustee has the authority to open the bank account in the name of the trust.4 Importantly, the Certification of Trust is being provided to the bank in lieu of providing a full copy of the Declaration of Trust. Thus the privacy and confidentiality of the provisions of the Declaration of Trust are maintained.

Providing the Certification of Trust can be compared to providing the bank with a copy of the Articles of Incorporation if an account for a corporation was being opened or with the Articles of Organization if an account for a limited liability company was being opened. Thus, the Certification of Trust provides the bank with the evidence and assurance that the entity, the business trust, does exist and the Trustee has the power and authority to open the bank account on behalf of the business trust.

The IRA owner, upon submitting his or her direction to the custodian to make the investment in the business trust, will provide the custodian with instructions and information necessary to have the funds in the IRA account wired directly into the bank account of the business trust. Wiring the funds into the new bank account is the preferred method for transferring the funds.

Classification of Business Trust for Federal and State Income Tax Purposes. Since the business trust is an entity separate and apart from the IRA account (i.e. the IRA account is simply investing in, and holding, the “beneficial interests” of the business trust), the tax classification of the business trust becomes important to understand. By design and structure, a business trust is quite distinct from and very unlike a trust that is used for gift and estate planning purposes.

A trust that is used in the gift and estate environment will be taxed under the provisions of Subchapter J of the Internal Revenue Code, starting with Section 641.

In contrast, the classification for tax purposes of a business trust is determined under the “check-the-box” Treasury Regulations.

Under Treas. Reg. 301.7701-4(b) a “business trust” is treated as a “business entity” that will be classified for federal tax purposes under Treas. Reg. 301.7701-2. Under this regulation, a “business entity” with two or more members is classified for federal tax purposes as either a “corporation” or a “partnership.” A “corporation” is then defined to mean a business entity organized under a state statute which refers to the entity as “incorporated” or as a “corporation."5 Since a “business trust” is not organized under such a state statute, then it will not be classified as a “corporation.” With it not being a “corporation,” the business trust will likely then be classified as a “partnership.” The term “partnership” means a business entity that is not a “corporation,” as defined above, and has at least two members.6 Thus, if the “business trust” has at least two “beneficial owners,” it will be taxed as a “partnership.”

Often, however, the IRA account will own 100% of the “beneficial interests” of the business trust resulting in the business trust only having a single owner. When a business entity has a single owner, and is not a corporation, then it is “disregarded as an entity separate from its owner."7

It is probably worth briefly noting that a “business trust” is an “eligible entity"8 and has the ability to elect out of the default classification. The default classification is as noted above. An “eligible entity” will be classified as a partnership if it has two or more members or it will be “disregarded” as an entity separate from its owner if it has a single owner.9

If a business trust is classified as a “disregarded entity” because it has only one owner of the “beneficial interests,” then the business trust will not have to prepare and file either federal or state income tax returns.

No Minimum Franchise Tax for a Business TrustEvery corporation doing business in California is subject to the minimum franchise tax of $800.00 which is due annually.10 Similarly, a limited liability company doing business in California must pay annually for the privilege of doing business in this state the same minimum franchise tax of $800.00.11

But other entities, such as partnerships and business trusts, are not required to pay a franchise tax, i.e. a tax for the privilege for doing business in California. The non-applicability of the minimum franchise tax to a business trust is clear from the provisions of the California Revenue and Taxation Code and related regulations.12

Importantly, in two recent Chief Counsel Rulings, the California Franchise Tax Board has now made it clear that an entity classified as a business trust is not a corporation for purposes of the annual Minimum Franchise Tax imposed under CA Revenue and Tax Code (RTC) section 23153.

Chapter 2 of the RTC governs the Corporation Franchise Tax (“Chapter 2 Corporation Franchise Tax”). The Chapter 2 Corporation Franchise Tax requires qualifying corporations to pay at least a minimum franchise tax of $800.00 no matter their level of income. That is, the minimum franchise tax has to be paid even if the corporation realized a loss for the tax year (“Minimum Franchise Tax”). Chapter 3 imposes the Corporation Income Tax on corporations (“Chapter 3 Corporation Income Tax”).

RTC section 23153, subdivision (a), contained in Chapter 2, states: “Every corporation described in subdivision (b) shall be subject to the minimum franchise tax specified in subdivision (d) . . . .” Further, RTC section 23153, subdivision (b) states:

  • Unless expressly exempted by this part or the California Constitution, subdivision (a) shall apply to each of the following:

    1. Every corporation that is incorporated under the laws of this state.

    2. Every corporation that is qualified to transact intrastate business in this state pursuant to Chapter 21 (commencing with Section 2100) of Division 1 of Title 1 of the Corporations Code.

    3. Every corporation that is doing business in this state.

    Thus, the Chief Counsel Rulings state, the primary question regarding the applicability of the Minimum Franchise tax to a business trust is whether a business trust is treated as a “corporation” for purposes of the Chapter 2 Corporation Franchise Tax.

    RTC section 23038, subdivision (a) states, the term “[c]orporation” includes every corporation except corporations expressly exempt from the tax by this part or the Constitution of this state.” Both Chapter 2 Corporation Franchise Tax and Chapter 3 Corporation Income Tax use the definition of “corporation” contained in RTC section 23038, subdivision (a). However, and very importantly, the Chief Counsel Rulings point out that RTC section 23038, subdivision (b)(2)(A), explicitly expands the term “corporation” to include business trusts for the Chapter 3 Corporation Income Tax. However, the definition of “corporation” is not expanded to include business trusts for purposes of Chapter 2 Corporation Franchise Tax. Therefore, the Chief Counsel Rulings conclude, although a business trust may be considered a “corporation” (i.e. it falls within certain other criteria for being classified as a corporation) that is subject to the Chapter 3 Corporation Income Tax, a business trust is not a “corporation” for purposes of the Minimum Franchise Tax.

    Based on the above, the Chief Counsel Ruling concluded that, because business trusts are not included in the definition of a “corporation” in RTC 23038 for purposes of the Chapter 2 Corporation Franchise Tax, a business trust is not a “corporation” under Chapter 2 Corporation Franchise Tax and, therefore, not subject to the Minimum Franchise Tax.

    No "Total Income" Fee. In addition to the minimum franchise tax described above, every limited liability company doing business in California must also pay annually a graduated fee that is based on the “total income from all sources derived from” its activities in California. The term “total income from all sources” means gross income plus the cost of goods sold that are paid or incurred in connection with the trade or business of the limited liability company. 13 The fee ranges from $900, if the “total income” is between $250,000 and $499,999; $2,500, if the “total income” is between $500,000 and $999,999; $6,000, if the “total income” is between $1,000,000 and 4,999,999; and $11,000, if the “total income” is $5,000,000 or more.

    Importantly, a business trust is not subject to the payment of this “fee.” Therefore, another expense of operations is avoided.

    "Disregarded Entities" Do Not File State Income Tax Returns. As noted above, a limited liability company with just one Member will be classified for federal and state income tax purposes as a “disregarded entity.” With this classification, the limited liability company will avoid having to prepare and file a federal income tax return, but this is not so at the state level. Despite being a “disregarded entity” for state income tax purposes, the limited liability company must still comply with the return filing requirements for a limited liability company. 14

    In contrast, if a business trust has only a single holder of its “beneficial interests,” it will then be classified as a “disregarded entity” and, as a result, not have to file either federal or state income tax return.

    Summary. The above discussion provides a brief overview of the factors to consider when selecting an entity that an IRA account will invest in with the goal of achieving “check book” control. By choosing a business trust as the entity to be invested in by the IRA account, certain costs and expenses associated with a limited liability company can be avoided. Avoidance of these expenses results in increased income that will be allocated to the IRA account which is not subject to tax. Avoidance of these expenses also increases the funds available for future investments by the business trust.

    1. See IRC sec. 4975(e)(2)(G); ERISA Regs. 2510.3-101(b)(1)
    2. When an IRA invests in an equity interest of an entity that is neither a publicly traded security nor a security registered under the Investment Company Act of 1940, then the assets of the IRA include both the equity interest and an undivided interest in each of the assets of the entity unless certain exceptions apply. See ERISA Regs. 2510.3-101(a)(2) This is often referred to as the “plan asset” rule.
    3. Importantly, the IRA owner should not use his or her SSN in connection with the bank account. A separate EIN should always be obtained.
    4. Essentially the CA Probate Code establishes the permitted terms of a Certification of Trust. CA Probate Code sec. 18100.5
    5. Treas. Reg. sec. 301.7701-2(b)
    6. Treas. Reg. sec. 301-7701-2(c)(1)
    7. Treas. Reg. sec. 301-7701-2(c)(2)
    8. An eligible entity is a business entity that is not classified as a corporation. Treas. Reg. 301.7701-3(a)
    9. Treas. Reg. sec. 301.7701-3(b)
    10. Rev and Tax Code sec.23153(a),(d)
    11. Rev and Tax Code sec. 17941
    12. See Rev and Tax Code sec. 23038; CA Administrative Code Title 18, sec. 23038(a), 23038(b)-1, 23038(b)-2.
    13. See Rev and Tax Code sec. 17942(a), (b)
    14. See Rev and Tax Code sec. 18633.5; Cal Admin. Code, Title 18 sec.23038(b)-2(c)(2)

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