Trust Classification (I.R.C. 7701)

April 18, 2016

General Discussion:

Section 301.7701-4(c)(1) of the regulations (part of the “Sears Regulations”) provides that an investment trust that has multiple classes of ownership interests is ordinarily classified as a business entity under section 301.7701-2.  An investment trust that has multiple classes of ownership interest, however, is classified as a trust for tax purposes if (1) there is no power under the trust agreement to vary the investment of the certificate holders, and (2) the trust is formed to facilitate direct investment in the assets of the trust and the existence of multiple classes of ownership interest is incidental to that purpose.

See TAM 200512020, describing the use of a trust purportedly to accomplish the stripping of interest from underlying securities. The trust, through a side agreement, provided multiple classes of ownership interest.

Why are trust arrangements that are commonly used in connection with certificated municipal lease financings not classified as business entities under the Sears Regulations?  See Announcement 84-62 (Jan. 1, 1984).  Although a “grantor trust” is used in these financings, the grantor trust rules are not applicable.  The IRS announced in Ann. 84-62 that the multiple-class investment trusts do not apply to certain state and local government financing arrangements.  “The financing arrangements, which are an alternative to the direct issuance of serial and/or term obligations by state and local government obligors, are used to satisfy exceptions to debt limitations imposed under state law. […] The substance of these financing arrangements is the same as if a state or local government obligor directly issued a series of separate debt obligations.  Under such arrangements, the trustee serves in the same capacity as an indenture trustee in a typical secured bond issue by making payments from the state or local government obligor to the COPs owners.”  Darrell R. Larsen, American Bar Association, Secondary Market Tax-Exempt Asset Securitization for Sponsors, Investors, Other Market Participants and their Counsel.