You may be familiar with the multiple forms of incorporation including sole proprietorship, the limited liability corporation (LLC) and C corporations. However, a less common structure referred to as a business trust has begun to garner some attention. Learn what is a business trust and why, despite its purported tax and asset protection benefits, it can be an inappropriate and possibly illegal way to do business.
What is a Business Trust?
Legally speaking, a trust is an arrangement whereby a settlor (the person creating the trust) designates a trustee or trustees to manage the settlor's assets on behalf of a beneficiary. In personal finance, trusts have a number of advantages. Upon the settlor's death, for example, trust-fund assets pass directly to the beneficiaries, without the intervention of probate, and such trust funds also are exempt from estate taxes. However, the beneficiary must pay ordinary taxes on assets received through a trust.
In a business trust, the settlor also is the beneficiary, and there are often multiple trusts layered over each other in order to evade taxes. For example, imagine that John Doe runs a landscaping business. One day he sets up two trusts: an American trust and an offshore trust. The offshore trust owns Doe's lawnmowers, and leases them to the American trust (typically, at inflated prices). All the money that goes into the offshore trust is now foreign income for John Doe, and therefore non-taxable. Meanwhile, the American trust has racked up a lot of business expenses, and also has an artificially low income (minimal taxes). Neither of these trusts is treated as a corporation, so they avoid certain kinds of scrutiny.
Why Form a Business Trust?
Why would anyone engage in such a convoluted way of doing business? For John Doe, the reason is obvious: tax avoidance on multiple fronts.
As one might expect, the IRS considers this behavior illegal. In John Doe's case, the landscaping company has not only violated tax laws but also abused the very idea of a trust. In a legitimate trust, assets are genuinely placed in the custody of a third person. The settlor does not manage the assets after turning them over to the trustee. However, everything is under John Doe's control. He just makes it look as if there are different companies and trustees involved, but he's pulling the strings.
The vast majority of businesses,have no legitimate reason to enter into a trust. The business trust is perhaps most appropriate for mutual funds. The trustees (fund managers) of these organizations manage capital on behalf of hundreds or thousands of investors, who have a claim on the subsequent profits. This kind of business trust pays taxes as usual and is recognized by the IRS. John Doe's business trust scheme, on the other hand, is a particularly brazen form of tax evasion.
The Seductive Appeal of the Business Trust
Small-business owners already face a significant tax burden and are eager to try to retain more of what they earn. This makes business trust broker's pitch all the more seductive. After all, they are right in claiming that the business trust is recognized in constitutional and tax law. Where they go wrong is in assuming that the business trust is a legitimate way to avoid taxes. The Web abounds with flimsy authorities claiming to know secret tricks, usually involving offshore accounts, to make the tax-reductive business trust work for you.
While some business trusts have so far avoided audits, be aware that the IRS does target phony business trusts. Why take the risk of being audited, fined and even jailed? Put more effort into growing your business rather than agonizing over the best way to avoid taxes. Successful businesses grow not by avoiding taxes but by generating sales.
Why not consider an alternate - and indisputably legal - model such as the limited liability corporation? This form of incorporation will offer you many of the advantages of a corporation without some of the attendant difficulties. An LLC insulates you from personal liability, and taxes you only once, whereas corporate income is taxed twice. Or, if you consider an LLC too advanced for your needs, you can form a sole proprietorship or a partnership. Whatever you decide, you'll retain some tax advantages while remaining clear of the IRS.