The common law definition of a business is an investment of capital or property by individuals which creates the means to carry on towards the goal of generating a profit. Every state recognizes different legal formats to conduct business. The simplest and most common is the sole proprietorship. Other forms include partnerships, limited liability company and of course corporation status (S-Corporation is a federal tax option of a corporation). However, two states actually recognize another legal format – business trusts.
Both Massachusetts and Florida have codified this arrangement. The easiest explanation is that it is a hybrid of a corporation, a limited liability company and some attributes of a trust.
Under Chapter 609 a business trust is “defined as an unincorporated business organization created by an investment by which property is to be held and managed by trustees for the benefit and profit of such persons as may be or may become holders of transferable certificates evidencing the beneficial interests in the trust estate”, 8 Fla. Jur. 2nd. Business Relationships Section 417.
Massachusetts General Laws Chapter 182 covers requirements to create a common-law trust.
Both states address business trusts as ‘associations’ with both documented and perceived obligations along with corresponding liabilities. In addition, both states require a copy of the trust document to be filed with the Secretary of the State, i.e. Department of State in Florida and the Commissioner in Massachusetts. One more requirement is posted for Massachusetts; a copy of the trust document must be filed with the clerk of the court in every city or town where business is transacted by the trust.
This article will elaborate more on the structure of the trust, its business attributes and its advantages. It is an effective tool with a narrowly defined scope of activity. However, overall the courts provide limited protection for the trust and its beneficiaries. Because of its strict limitations, it is not a well accepted business form and entrepreneurs should only consider this format in certain situations.
Business Trust Attributes
There are six core attributes associated with a business trust. These same attributes are found in other business forms but not all six at the same time. Thus the combination of these six is what identifies a business trust in lieu of the other business entity forms.
As stated at the onset of this article, a business is an investment of capital by owners. Capital is customarily thought of in the form of money, property (including real property), labor and/or specialized talent (often recognized with a license such as found in medicine, law or accounting). One of the initial distinctions of a business trust is that a trust’s owners only capitalize the business with money and/or property. Business trusts are never capitalized with labor or a skill. This distinctive attribute’s elements doesn’t make this a trust, there are more required.
The second attribute of a trust is its purpose. Just like any business it is created and maintained for a business goal similar to other commercial enterprises, i.e. profit. This second attribute is important because several court cases separate those trusts designed to preserve capital, in these cases money and property, customarily referred to as nominee trusts and those created to carry on a business. Review:
1) Metro Palm I Trust, 153 B.R. 922, 923 (Bankruptcy Court Mid-District Florida, 1993)
2) St. Augustine Trust, 109 B.R. 494-496 (Bankruptcy Court Mid-District Florida, 1990)
Both cases cite Morrissey v. Commissioner, 296 U.S. 3440, 80 L. Ed. 263, 56 S. Ct. 289 (1935), a Supreme Court decision whereby the court identified six distinct characteristics of a business trust:
1) Created and maintained for a business purpose
2) Title to property is held by the trustee
3) Centralized management
4) Continuity exists uninterrupted by death of a beneficiary
5) Beneficiaries can transfer interest
6) Limited liability
To establish a business purpose, the courts will look to the two prong test as found in the economic substance doctrine. The first test involves a subjective goal; that is, what is the motivation behind this business? Overall, the primary goal should be for profit. The second test is objective in nature and it involves quantifiable results. Over the long run, profit should exist and this profit should be paid out to the beneficiaries that paid in the capital (money and/or property).
The third attribute of a business trust relates to title of the assets in the business trust.
The property donated to the trust by the beneficiaries must be in the name of the business trust. The title can not have the name(s) of the beneficiaries identified nor can the beneficiaries use joint tenancy or tenancy in common with the trust. The trust must behave similar to a corporation as to title of assets.
Centralized Management – Trustee(s)
In the corporate form of management, the shareholders (beneficiaries in a corporate structure) elect directors. These directors appoint officers to run the company. Therefore the officers are the central point of information and control for the company. This same form of management must exist with a trust (with some slight modifications).
Trustees are designated by the beneficiaries as stipulated in the trust document and are tasked with the conduct of the enterprise. They must act in a similar manner as officers in a corporation. Often the trust document indicates or names the initial trustee(s) and provides for a succession plan for the trustee(s). The succession article in the trust document may declare a self-perpetuating existence or a selection process by the beneficiaries.
Often the linchpin of the trustee issue is agency. In a typical agency relationship, the agent (think of a real estate agent) is beholden to the principle. An agent acts for and on behalf of the principle. In effect, an agent is subject to the whims or direction of the principle. In a trustee capacity, the trustee has a duty to the trust to do his duty but the trust document is the true controlling authority. One of the distinguishing elements of this agent/trustee separation is of course title processing. In a agency relationship title transfer of the asset must be processed via a signature of the principle. In a trustee relationship, the trustee signs for the trust. A sale of property in a trust only requires the signature of the trustee. In an agency relationship, the principle must sign.
Beneficiaries of a trust may direct the trustee to conduct a business transaction like sell an asset which appears similar to an agency relationship; however, in this situation, the trustee is performing an action for the trust as specifically directed by the beneficiaries.
Another misconception about business trusts are their similarity to partnerships. In partnerships, the general partners are not only managers but also enjoy a share of profits, gains and losses. With business trusts, the trustee(s) may also be the beneficiary(ies). The difference between a business trust trustee and a partnership general partner exists with two inherent characteristics:
A) Liability – In a partnership, the general partners are inherently liable for their mistakes or actions. This exists by the very nature of a partnership which is defined by the Uniform Partnership Act as an “Association of two or more persons to carry on as co-owners a business for profit”. The key word is co-owners subjugating the partners to gains and losses. In a business trust, the trustees are not liable nor sustain losses for their actions. The trust as a whole sustains the losses. Some of you may think this is semantics but there is actually a difference. Most partnerships are in the form of limited partnerships whereby the general partner has significantly greater risk than the limited partners (beneficiaries). In a trust, whether the trustee is a beneficiary or not, the trustee has no greater liability exposure than a beneficiary. In actuality, many trustees are outsiders and are granted indemnity for their actions. Furthermore, most trustees are paid wages by the trust whereas a general partner may receive wages; but, these wages are in addition to their respective share of profits and losses.
B) Death – In a partnership arrangement, death of a partner automatically terminates the arrangement. This is because partnerships are a willful participation between the parties. A death creates a new partnership because the existing parties may either 1) not want to conduct business with the deceased partner’s estate or heir or 2) start a new partnership with the remaining partners and adding additional partners. In effect, a death of a partner is an immediate termination of the business arrangement. In a trust, the death of a trustee doesn’t terminate the trust. Trust documents include a succession plan related to the trustee(s).
Another distinction between partnerships and trusts has to do with wrongful acts of the general partner or a trustee. In a partnership, a wrongful act by a general partner is grounds for dissolution of the partnership. Furthermore, most partnership agreements deny the general partner participation in the winding up process. In addition, partnership agreements assess damages to the general partner and take this value from that general partner’s share of the final distribution.
In a trust format, the trustee’s negligence or wrongful act is grounds for termination as a trustee not the trust itself. A trustee may be sued for his negligence but most trust documents indemnify trustee(s) actions.
Another attribute that is quintessentially and indicator of a business trust is the ability to transfer interest without restriction even in death. This is very similar to stock in a corporation form. There, the shareholder is allowed to sell his interests in the company. Publicly traded corporations make this easy, smaller corporations, especially family owned operations place restrictions on the sale of stock. However, the ownership rights are transferable and do not require organizing a new company like that of a partnership.
Most business trusts issue a certificate of beneficial interest in the trust and simply require notification of the trustee when the interest is sold or transferred.
The last attribute of a business trust is really the one most coveted by investors. This is limited liability for the beneficiary(ies) related to the commercial enterprise. Just like a limited partner or a stockholder in a company, the maximum liability for exposure is the amount invested in the venture. No other legal ramifications exist including lawsuits, third party creditor demands or recourse with debt.
Overall the Supreme Court put it succinctly in Morrissey v. Commissioner:
Business Trusts – Uses and Advantages
The business trust was designed to resolve single asset joint ventures making it relatively easy for family members to address management of a family estate. The most common asset is real estate. The property (traditionally inherited) is re-titled in the name of the trust, a management company is assigned the duties of renting it out and reports to the trustee. As net profits are earned the proceeds are distributed to the family members in accordance with their share.
The trust is allowed to report for tax purposes as an association (corporation or limited partnership) or as a trust via Form 1041.
Over time, this business form has expanded to now include family partnership assets, real estate investment trusts and as a general partner in investment partnerships. Due to restrictions and compliance, this business form works well with assets that generate recurring cash inflows such as real estate (from rentals), royalties and long-term dividend driven investments. The more the assets require active monitoring versus passive management the more input is demanded from the beneficiaries thus the likelihood of falling into the general partnership trap. Status as a general partnership exposes the beneficiaries to lawsuits and/or losses beyond their basis in the underlying assets.
One of the advantages of this business form is the ability to hand over the keys of the asset to a trustee and walk away from the headaches of business. Simply gather your check each year along with your K-1 for tax reporting purposes and enjoy the weather.
Summary – Business Trusts
Business trusts are a narrow version of a business entity form (corporation, partnership, LLC & sole proprietorship) codified by Massachusetts (also known as a ‘Massachusetts Trust’) and Florida. It is technically an association of beneficiaries granting management powers to a trustee to handle the affairs and control title to the trust’s assets. The Supreme Court has identified six attributes of a business trust:
1) Created and maintained for a business purpose
2) The trustee holds title to the assets
3) Centralized management
4) Continuity exists uninterrupted by the death of a beneficiary
5) Beneficiaries can freely transfer interests
6) Limited liability
The trust is most often used to manage family real estate or investments. Its major advantage is the hands off control and financial return with owning business assets. It is narrowly construed by the courts and requires a well drafted trust document. ACT ON KNOWLEDGE.
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