Ruling 2007-2 - Corporation Business Tax / Qualified Settlement Funds

FACTS:

The United States Securities and Exchange Commission brought an enforcement action in the U.S. District Court against several individuals, claiming violations of federal securities law.   As a result of the enforcement action, the District Court entered final judgments, which required those individuals named as defendants in the enforcement action to pay money in disgorgement, prejudgment interest and civil penalties.  The money that each defendant was ordered to pay was deposited into and remains in Q, an interest-bearing account with the Court Registry Investment System of the District Court.  Q meets the definition of a “qualified settlement fund” as defined under 26 C.F.R. §1.468B-1.  The District Court entered an order appointing an individual to provide tax administrator services to the fund.  Such services include, but are not limited to, filing applicable state tax returns and paying any taxes that may be owed by Q. 

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ISSUE:

Whether a “qualified settlement fund,” as defined in 26 C.F.R. §1.468B-1, is subject to the Connecticut corporation business tax under Chapter 208 of the Connecticut General Statutes, Conn. Gen. Stat. §12-213 et seq.

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RULING:

A “qualified settlement fund,” as defined in 26 C.F.R. §1.468B-1, is not subject to the Connecticut corporation business tax under Chapter 208 of the Connecticut General Statutes, Conn. Gen. Stat. §12-213 et seq.

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DISCUSSION:

Q is a “qualified settlement fund” as defined in the regulations adopted under 26 U.S.C. §468B.  Pursuant to those regulations, a fund, account or trust meets the requirements of a “qualified settlement fund” if:

• It is established pursuant to an order of, or is approved by, the United States, any state (including the District of Columbia), territory, possession, or political subdivision thereof, or any agency or instrumentality (including a court of law) of any of the foregoing and is subject to the continuing jurisdiction of that governmental authority;
• It is established to resolve or satisfy one or more contested or uncontested claims that have resulted or may result from an event (or related series of events) that has occurred and that has given rise to at least one claim asserting liability—

(i) Under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (hereinafter referred to as CERCLA), as amended 42 U.S.C. 9601 et seq.; or

(ii) Arising out of a tort, breach of contract, or violation of law;

(iii) Designated by the Commissioner in a revenue ruling or revenue procedure; and

• The fund, account, or trust is a trust under applicable state law, or its assets  are otherwise segregated from other assets of the transferor (and related persons).

26 C.F.R. §1.468B-1(c). 

Additionally, 26 C.F.R. §1.468B-2(a) provides that:

• A qualified settlement fund is a United States person and is subject to tax on its modified gross income for any taxable year at a rate equal to the maximum rate in effect for that taxable year under [26 U.S.C. §1(e)].  
• The rate in effect under 26 U.S.C. §1(e) is the rate for trusts and estates.  In contrast to this provision, 26 C.F.R. §1.468B-2(k) provides:

[F]or purposes of subtitle F of the Internal Revenue Code, a qualified settlement fund is treated as a corporation and any tax imposed under paragraph (a) of this section is treated as a tax imposed by [26 U.S.C. §11].         

Under the regulations applicable to qualified settlement funds, Q is taxed at the rate imposed on trusts and estates, and treated as a corporation for purposes of subtitle F of the Internal Revenue Code (26 U.S.C. §§6001 et seq.). (Subtitle F deals with issues such as information and returns, the time and place for paying tax, assessments, collection, credits and refunds, limitations on assessment and collection, interest, and additions to tax and assessable penalties.) Thus, the question arises whether Q is subject to the Connecticut corporation business tax, which is imposed under Chapter 208 of the Connecticut General Statutes.

Chapter 208 of the Connecticut General Statutes imposes the corporation business tax on certain “companies” (including any “unincorporated association taxable as a corporation for federal income tax purposes”) doing business in this state.  See Conn. Gen. Stat. §12-214(a)(1).  Q is subject to the Connecticut corporation business tax if it falls within the definition of “company”.  The term “company” and “taxpayer”, which are used interchangeably throughout Chapter 208, are defined in Conn. Gen. Stat. §12-213(a)(1) as

any corporation, foreign municipal electric utility, as defined in section 12-59, electric distribution company, as defined in section 16-1, electric supplier, as defined in section 16-1, generation entity or affiliate, as defined in section 16-1, joint stock company or association or any fiduciary thereof and any dissolved corporation which continues to conduct business but does not include a passive investment company or municipal utility, as defined in section 12-265.

(Emphasis added.)  Clearly Q is not a corporation under Connecticut law nor is it a “foreign municipal electric utility, as defined in section 12-59, electric distribution company, as defined in section 16-1, electric supplier, as defined in section 16-1, generation entity or affiliate, as defined in section 16-1, [or] joint stock company …” Thus, Q will be subject to the corporation business tax, if it is determined that Q is an “association.”

The term “association” and the term “association taxable as a corporation for federal income tax purposes” are defined in Conn. Agencies Regs. §12-213-1(e) as

an unincorporated organization that has, as described in section 301.7701-2(a)(1) of title 26 of the Code of Federal Regulations, associates, an objective to carry on business and divide the gains therefrom, continuity of life, centralization of management, liability for corporate debts limited to corporate property, and free transferability of interest; and, as described in section 301.7701-2(a) of title 26 of the Code of Federal Regulations, more corporate characteristics than non corporate characteristics.

The definition of “association” and “association taxable as a corporation for federal income tax purposes” contained in Conn. Agencies Regs. §12-213-1(e) sets forth the same six characteristics of an association that were contained in the federal regulations, which are commonly referred to as the Kintner regulations (based on the analysis in U.S. v. Kintner, 216 F.2d 418 (9th Cir. 1954), aff’g 107 F. Supp. 976 (D. Mont. 1952)).[1]  The Kintner regulations were adopted in 1960 and were in effect prior to the adoption in 1996 of the current federal regulations regarding entity classification.  The current entity classification regulations which are set forth in section 301.7701-2(a) of title 26 of the Code of Federal Regulations, are commonly referred to as the check-the-box regulations.  Under the Kintner regulations, an entity was classified as a corporation or association, and thus taxable as a corporation, if it had more characteristics of a corporation than characteristics of a trust or partnership. 

In determining whether an entity should be taxed as a corporation or a trust under the Kintner regulations, the Tax Court explained that a trust and an association share four of the six characteristics that the regulations relied upon to determine whether an entity is taxable as an association.  The two characteristics that were not shared by both a trust and a corporation were:  1) whether there are associates and 2) whether there was an object to carry on business.  Bedell Trust v. Commissioner, 86 T.C. 1207 (1986).  In Bedell, the Tax Court explained that, if an entity does not have both associates and an object to carry on business, the entity is not an association taxable as a corporation.  Similarly, if Q does not have both associates and an object to carry on business, it is not an association taxable as a corporation.

Under the facts presented, the defendants were required to place money into a fund, and the proceeds of the fund will be distributed to those individuals who have been injured by the defendants’ actions.  As in Bedell,

The beneficiaries here have not “plan[ned] a common effort or enter[ed] into a combination for the conduct of business enterprise”  Morrissey v. Commissioner, 296 <st1:country-region>U.S.</st1:country-region> 344, 357 (1935).  Additionally, they did not affirmatively enter into the enterprise by way of a purchase of their beneficial interests.  Elm Street Realty Trust v. Commissioner, 76 T.C. at 814.

Bedell, 86 T.C. at 1220-1221.  The conclusion reached by the Tax Court in Bedell was that “the beneficiaries, who neither created nor contributed to the trust, whose interests in the trust are not transferable … are not associates and their trust is not an association.”  Id. at 1222.

In Bedell, the Tax Court relied upon its earlier decision in Elm Street Realty Trust v. Commissioner, 76 T.C. 803 (1981).  In Elm Street Realty Trust, the Tax Court explained that “[w]here non-grantor beneficiaries receive their beneficial interests gratuitously, without solicitation, it is doubtful that they can be considered associated together in a common enterprise in the absence of some further joint activity (or at least the potential therefor) vis-à-vis the trust”.  Id. at 814.  The Tax Court noted that one commentator made the following observation regarding the issue of whether beneficiaries constitute associates.

The characteristic of associates does not exist where the beneficiaries by taking no part in the creation of the trust are not voluntarily associated at the outset; the nature of their interest is such that no other persons can become voluntarily associated by acquiring their interests; and they have no participation in the conduct of the trust’s affairs.  But the characteristics of associates can exist even where the trust has not been created by the beneficiaries, if their interests are freely transferable and they have some voice in decisions as to amendments to the trust or its termination, though they have no voice in management. M. Lyons, “Comments on the New Regulations on Association,” 16 Tax L. Rev. 441, 454-455 (1961). 

Id. at 815.

The beneficiaries of Q are not associates as they did not create or contribute to Q, nor did they voluntarily associate or participate in the conduct of the fund’s affairs.  Rather the beneficiaries were all harmed by the actions of the defendants, and they received their interests in Q pursuant to a court order.  Since the beneficiaries are not associates, it is concluded that Q is neither an “association” nor “association taxable as a corporation for federal income tax purposes” as defined in Conn. Agencies Regs. §12-213-1(e). 

The applicability of Conn. Agencies Regs. §12-213-1(e) may be questioned because the Kintner regulations, which the Department relied upon to define the terms “association” or “association taxable as a corporation for federal income tax purposes”, have been replaced with the check-the-box regulations.[2]  In commenting on the issuance of the check-the-box regulations by the Treasury Department, the Department explained that “Connecticut treats unincorporated business entities based on their classification for federal income tax purposes.”  Special Notice 99(3), Effect of Federal Tax Law Changes on the Taxation of Limited Liability Companies and S Corporations and Their Shareholders.  This statement is consistent with both Conn. Gen. Stat. §34-519, which provides that the Connecticut tax treatment of statutory trusts follows their federal tax treatment, and with Conn. Gen. Stat. §34-113, which provides that the Connecticut tax treatment of limited liability companies follows their federal tax treatment.[3] It is clear that, at least with respect to limited liability companies and statutory trusts, Conn. Agencies Regs. §12-213-1(e) is irreconcilable with subsequent public acts. “An administrative regulation can have no authority beyond the statute that it imports to implement.” Harper v. Tax Commissioner, 199 Conn. 133, 142, 506 A.2d 93 (1986).

The check-the-box regulations provide that “[t]he classification of organizations that are recognized as separate entities is determined under §§301.7701-2, 301.7701-3, and 301.7701-4 unless a provision of the Internal Revenue Code (such as section 860A addressing Real Estate Mortgage Investment Conduits (REMICS) provides for special treatment of that organization.”  (Emphasis added.) 26 C.F.R. §301.7701-1(b). 26 C.F.R. §1.468B-1(b), which deals with the tax classification of qualified settlement funds, provides:

(b) Coordination with other entity classifications. If a fund, account, or trust that is a qualified settlement fund could be classified as a trust within the meaning of §301.7701-4 of this chapter, it is classified as a qualified settlement fund for all purposes of the Internal Revenue Code (Code).  If a fund, account, or trust, organized as a trust under applicable state law, is a qualified settlement fund, and could be classified as either an association (within the meaning of §301.7701-2 of this chapter) or a partnership (within the meaning of §301.7701-3 of this chapter), it is classified as a qualified settlement fund for all purposes of the Code.  If a fund, account or trust, established for contested liabilities pursuant to §1.461-2(c)(1) is a qualified settlement fund, it is classified as a qualified settlement fund for all purposes of the Code.

Although a qualified settlement fund is treated as a corporation for purposes of administration and procedure, 26 C.F.R. §1.468B-1(b) provides that, for federal tax purposes, a qualified settlement fund that could be classified as a trust, an association or a partnership under the check-the-box regulations will be classified as a qualified settlement fund for purposes of the Internal Revenue Code.  This regulation provides that, even if Q met the necessary criteria to be classified as an association within the meaning of 26 C.F.R. §301.7701-2, Q is classified as a qualified settlement fund for purposes of the Code.

Therefore, because Q is neither an association taxable as a corporation for federal income tax purposes under Conn. Agencies Regs. §12-213-1(e) nor classified as an association under the check-the-box regulations, Q is not subject to the Connecticut corporation business tax. 

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LEGAL DIVISION

July 3, 2007