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William Byrnes (Texas A&M) tax & compliance articles

Posts Tagged ‘Treasury Regulations’

Employees and Independent Contactors

Posted by William Byrnes on August 9, 2013


Why is this Topic Important to Financial Professionals? Many small business owners are faced with issues surrounding Form 1099 and how the rules apply to their businesses.  

What are some distinctions of the employees versus independent contractors?

An independent contractor, in general, has a majority of control over the details of his job function and only the end result is dictated by the company or individual who hires.  This is what is commonly known as “the degree of behavioral control.”  Another category used by the IRS and the courts to determine the status of an individual as either an employee or independent contractor is “financial control”.  Financial control involves examining the financial relationship between the parties such as reimbursement, and/or if any materials or space has been provided to accomplish the job.  Other relationship factors such as having a contract or agreement between the parties, as well as the terms of any contract, must also be examined in determining the employment status of the individual.

One of the issues that is often overlooked in the area of an employee relationship instead of an independent contractor relationship is that employees have X number of hours to dedicate to employment each week, whether that number is 40, 50, or anything else that an employment agreement might state.  Independent contracts are often not required to expend a set number of hours to accomplish a task, but instead enough hours to accomplish the task.

Another relevant issue to be considered in determining which of the two employment relations exist is that of termination.  An “At-Will” employee can normally be terminated and generally has no cause for a breach of contract and cannot sue for damages.  An independent contractor cannot usually be terminated without a breach of contract.

Tax Distinctions

Taxation of the two dissimilar positions is significantly different.  Independent contractors essentially work for themselves, and the business that pays them is, in effect, a client.  Generally, and independent contractor will file a tax return as a sole proprietor or closely held corporation, such as a Subchapter S Corporation.  An employee is subject to federal income tax withholding and the employer is subject to payroll taxes, included in the general W-2 process.

Independent contractors, like other businesses, recognize revenue and expenses. The independent contractor usually receives a Form 1099 from the source that pays him.  The Code and Regulations state that when a trade or business pays an individual for certain “services” over $600 that a Form 1099 is required to be filed with the Secretary of the Treasury.[1] And just as other businesses realize “legislative graces of Congress,” such as Section 162 deductions, the sole proprietor too may have expenses that generally qualify as trade or business expenses.

For a detailed analysis regarding independent contractors, see Tax Facts Q 814. How are business expenses reported for income tax purposes?


[1] Internal Revenue Code Section (IRC) 6041, Treasury Regulations (TR) 1.6041-1(a)(1)(i), TR 1.6041-1(a)(2).  

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Investment Trusts (or Not) Via Limited Liability Companies

Posted by William Byrnes on March 14, 2011


Is a state law trust that is established as an investment trust to hold interests in an LLC, which has the power to vary its investments, classified as an investment trust?

Example:

LLC is organized under the laws of State as a limited liability company and is treated as a partnership for federal tax purposes.  LLC will acquire, hold and manage a portfolio of investments.  The governing document of LLC permits the managers of LLC to sell assets in the portfolio and acquire new assets.

LLC will issue two classes of interests:  common interests and manager interests.  Holders of common interests and holders of manager interests have different rights to the income, deductions, credits, losses, and distributions of LLC.  Manager interests will be held by a select group of investors who are also responsible for managing LLC.  The common interests of LLC will be held by Trust.

Trust is organized under the laws of State as a trust.  The governing documents for Trust provide that Trust is only permitted to hold common interests in LLC.  Trust will issue trust certificates and each certificate will entitle the holder to all the income, gain, profit, deductions, credits, losses, and distributions associated with one common interest in LLC.  The governing documents for Trust indicate that Trust is a trust for federal tax purposes.

First, the Treasury Regulations provide that a “business entity” is an entity recognized for federal tax purposes that is not properly classified as a trust under or otherwise subject to special treatment under the Code. [1]

In addition, an arrangement will be treated as a trust if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit. [2]

There are arrangements that are known as trusts because legal title to property is conveyed to trustees for the benefit of beneficiaries, but which are not classified as trusts for purposes of the Code because they are not simply arrangements to protect or conserve the property for the beneficiaries.   These trusts, which are often known as business or commercial trusts, generally are created by the beneficiaries simply as a device to carry on a profit making business which normally would have been carried on through business organizations that are classified as corporations or partnerships (business entities) under the Code. [3]

Moreover, an “investment” trust will not be classified as a trust if there is a power under the trust agreement to vary the investments of the certificate holders. [4] An investment trust with a single class of ownership interests, representing undivided beneficial interests in the assets of the trust, will be classified as a trust if there is no power to vary the investments of the certificate holders.

The essential nature of an arrangement, whatever its form, as shown by the objects attained and the manner of their attainment, is what controls the classification of the arrangement as a trust.[5] In determining the character of an arrangement, the managerial powers of all parties to an arrangement will be combined in order to arrive at the full amount of permitted managerial activity and its object. [6]

Going back to our example, to determine whether Trust is an investment trust for tax purposes, it is appropriate to consider the nature and purpose of Trust.  Trust is holding the interests in LLC for the purpose of providing investors with the benefits of the managed investments of LLC.  These investment activities would result in Trust failing to be classified as a trust if Trust were permitted to engage in those activities directly.  Because the nature and purpose of Trust under this arrangement is to vary the investments of the certificate holders, Trust is likely a business entity for federal tax purposes and not an investment trust.

Restated, a state law trust that is established as an investment trust to hold interests in an LLC partnership, that has the power to vary its investments, is generally not classified as a trust for federal tax purposes.

Tomorrow’s blogticle will discuss relevant topics to wealth managers in 2011.

We invite your opinions and comments by posting them below, or by calling the Panel of Experts.


[1] Treasury Regulations § 301.7701-2(a).

 

[2] Treasury Regulations § 301.7701-4(a).

[3] Treasury Regulations § 301.7701-4(b).

[4] Treasury Regulations §  301.7701-4(c); See also Comm’r v. North American Bond Trust, 122 F.2d 545 (2d Cir. 1941), cert. denied, 314 U.S. 701 (1942).

[5] Morrissey v. Comm’r, 296 U.S. 344 (1935).

[6] See Comm’r v. Chase Nat’l Bank, 122 F. 2d 540 (2d Cir. 1941).

 

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