Grantor Trust Tax Filing Mistakes Plague Estate Planning
In the complex framework of modern estate and tax planning, practitioners often use a combination of non-compliant entities and grantors to achieve various valuation, liability and succession objectives. A common strategy involves a client owning a limited liability company and then trusting or selling interests in the LLC to one or more “deficient” donors. While this structure is sound from a tax perspective, it often creates administrative misunderstandings, leading to significant compliance errors.
The core of the problem lies in the fundamental misunderstanding of the relationship between ownership of state law, management accounts (especially employer identification numbers) and federal tax classification. By examining the regulatory framework governing trust and disregarded entities, I show that the presence of multiple owners or multiple EINs under state law does not necessarily constitute a partnership for federal income tax purposes.
Grantee Trust Reporting Framework
Under the Internal Revenue Code, an “imperfect” grantor trust is an irrevocable trust that is treated as a separate legal entity for state law purposes but is disregarded for federal income tax purposes because the grantor retains certain powers listed in IRC sections 671 through 679. Individual tax return. (Treasury Rules Section 1.671-3(a)(1)).
Frequent confusion arises when such a trust wants to open a brokerage or bank account. Financial institutions, often guided by internal “know your customer” protocols, often require a trust to provide its own EIN. Even if a trustee feels compelled to comply, the Treasury Regulations clearly state that a wholly grantor trust is not required to obtain a separate EE. According to Treas. Regs. Section 301.6109-1(a)(2)(b), a donor’s deemed proprietary trust may use the donor’s social security number for tax reporting.
Even if a trust elects or is required by a third-party institution to obtain a separate EI, this administrative action does not change the tax status of the trust. The trust remains a grantor trust, and the grantor remains the sole taxpayer for the assets held in it. An EIN is just an identifier. It lacks the legal alchemy required to transform a neglected trust into a separate taxable entity or partnership.
A multi-member LLC as an undisclosed entity
The confusion gets worse when the primary asset is an LLC. Generally, an LLC with one owner is classified as a separate legal entity from the owner (discarded entity), while an LLC with two or more owners is classified as a partnership. (Treas. Regs. Section 301.7701-3(b)(1) In a typical plan situation, a grantor can transfer a 99% interest in a wholly-owned LLC to a grantor trust. On the surface, it appears that the LLC now has two owners: the grantor and the trust.
However, for federal tax purposes, the analysis must look to the grantor trust’s deemed owner. Because the grantor is considered the owner of the trust assets, the grantor is considered the owner of the 99% interest held by the trust in addition to the 1% interest they own personally.
The Internal Revenue Service addressed this exact situation in Revenue Rule 2004-77. The ruling explains that if an entity has two owners under state law, but one of the owners is owned by a disregarded entity (such as a grantor trust or other DRE), the entity is considered to have only one owner for federal tax purposes. Therefore, the LLC remains a disregarded entity. It’s not a partnership, and filing Form 1065 (US Partnership Income Return) is not only unnecessary, it’s a technical error.
EIN as a fake identifier
The professional trap occurs when management’s tail wags the objective dog. When a CPA or tax advisor sees an LLC with an EIN and a cap chart showing two different legal names, the knee-jerk reaction is often to prepare a partnership return. This pressure is intensified if the bank or state tax authority requests that the LLC be issued an EIN.
It is important to distinguish between the “check-the-box” rules that govern the classification of an entity and the “identification number” rules that govern the administration of that entity. The fact that an LLC has its own EIN does not provide any evidence of tax classification. An LLC may have an EIN for payroll tax purposes, to satisfy a creditor, or to comply with state law, but it still remains an exempt entity for federal income tax purposes. (Treas. Regs. Section 301.7701-2(c)(2)(iv) (treating the exempt entity as a separate entity for employment tax and certain excise tax purposes, while remaining for income tax purposes).
The critical question is, “How much EI is there?” It is not. or “How many names are on the operating agreement?” Rather, the question should be: “How many owners are there for federal income tax purposes?” In an entirely donor and donor-trusted structure, the answer is “one.”
Eliminating the trap
The partnership that never existed is a common result of the disconnect between administrative convenience and tax law. Practitioners should be vigilant to ensure that obtaining an EIN through a trust or subsidiary LLC does not result in an erroneous assumption of partnership status. By complying with the principles established by Revenue Law 2004-77 and the rules of trust of supporters, advisers can avoid the trap of unnecessary and incorrect partnership submissions, while maintaining the accuracy of the client’s tax reporting structure.
