Co-authored with Osvaldo Garcia, Executive Director, J.P. Morgan Private Bank.
In a blog post early last year,1 we reported on the passage of the Corporate Transparency Act (“CTA”) enacted on January 1, 2021, as part of the National Defense Authorization Act for Fiscal Year 2021.2 As previously discussed, the CTA impacts many domestic and international private clients and their trust and U.S. closely-held company structures. This article provides an update on particular aspects of the recently proposed regulations issued by the Financial Crimes Enforcement Network (FinCEN) on December 8, 2021,3 and what private clients should be doing in preparation of the implementation of the CTA.
Generally, the CTA creates a national company (non-public) beneficial ownership registry accessible only by law enforcement, government agencies, and other officials and requires reporting companies to provide certain identifying information on its beneficial owners and company applicants. The CTA tasked FinCEN with implementing the CTA.
On April 5, 2021, FinCEN issued an advanced notice of proposed rulemaking requesting comments with respect to several aspects of how the CTA should be implemented. Over the 60 day period for commentary, FinCEN received 220 public comments. Such comments were considered by FinCEN before issuing a notice of proposed rulemaking on December 8, 2021, setting forth proposed regulations and seeking further commentary on 40 different issues (the “Proposed Regulations”).
FinCEN intends to issue three sets of rulemakings to implement the requirements of the CTA: a rulemaking to implement the beneficial ownership information reporting requirements, a second to implement the statute’s protocols for access to and disclosure of beneficial ownership information, and a third to revise the existing Customer Due Diligence Requirements for financial institutions to ensure consistency with the CTA requirements. The Proposed Regulations issued on December 8, 2021, are FinCEN’s attempt to implement the first set of proposed rules meant to implement the beneficial ownership reporting requirements. The Proposed Regulations address: (1) who must file; (2) the filing deadlines; and (3) the information required to be submitted in such filings.
B. Who Must File? Reporting Companies
The CTA obligates a “reporting company” to report the requisite information on its beneficial owners and company applicants. A “reporting company” is defined in the CTA as “a corporation, limited liability company, or other similar entity that is – (i) created by the filing of a document with a secretary of state or a similar officer under the law of a State or Indian Tribe; or (ii) formed under the law of a foreign country and registered to do business in the United States by the filing of a document with a secretary of state or a similar office under the laws of a State or Indian Tribe….”4
1. Domestic Reporting Companies and Foreign Reporting Companies
The Proposed Regulations do not significantly change the CTA’s definition of what constitutes a reporting company, but do distinguish between a “domestic reporting company” and a “foreign reporting company.” A domestic reporting company is defined by the Proposed Regulations as “(A) a corporation; (B) limited liability company; or (C) other entity that is created by the filing of a document with a secretary of state or similar office under the law of a State or Indian Tribe.”5 According to FinCEN, whether an entity is a corporation or limited liability company will be determined based on the governing law of the jurisdiction in which the entity is formed.
A foreign reporting company is defined by the Proposed Regulations as “(A) [a] corporation, limited liability company, or other entity; (B) [f]ormed under the law of a foreign country; and (C) [r]egistered to do business in any State or tribal jurisdiction by the filing of a document with a secretary of state or any similar office under the law of a State or Indian Tribe.”6 This definition tracks the statutory text of the CTA, but otherwise does not provide much clarification on the meaning of the “registered to do business” requirement. For example, will an entity that is required to be registered to do business but fails to do so and therefore fails to report to FinCEN be in violation of the CTA? Moreover, what constitutes registering to do business and are certain de minimis activities exempted, as may be the case under different state laws? For example, a foreign company that owns non-income producing real estate may not be required to file a registration to do business in the State of Florida, raising the question of whether FinCEN could still wish to capture these companies in its definition. FinCEN acknowledges that the registered to do business requirement is likely broader than the filing requirement for domestic entities, and therefore seeks further comment on how this registered to do business requirement should be implemented.
2. Exempt Companies
The CTA provides for 23 types of companies that would be exempt from CTA reporting. The Proposed Regulations keep the same 23 exemptions for reporting companies provided by the CTA without adding more despite its statutory authority to do so. Notable to private clients is the fact that FinCEN received comments regarding family offices and was otherwise not persuaded to exercise its authority to create a special exemption. As a result, succession planning structures commonly employed by private clients such as family offices, family limited partnerships, private trust companies, limited liability companies owned by spouses to solely own real estate, would be deemed reporting companies. Interestingly, state-chartered independent professional trust companies also would be reporting companies, even though they are regulated by the state.
Many private clients and families own closely-held businesses. FinCEN acknowledged several comments requesting that small businesses be granted an exemption. Under the CTA, only large operating companies are exempted from the reporting requirements. Commentators noted the potential unfairness of having small businesses incur potentially significant compliance costs while large businesses are exempted.7 Surprisingly, FinCEN responded that it believes the compliance cost for any reporting company to be only $45, though FinCEN seeks further comments on whether small businesses will require professional expertise to comply with the beneficial ownership reporting requirements. We have no doubts that professional expertise, particularly legal expertise, will be sought by small businesses attempting to understand and comply with the CTA and that such professional costs will certainly exceed $45.
3. Trusts and Other Types of Entities
Much debate during the commentary period centered on the “other similar entity” language in the CTA’s definition of reporting company. FinCEN stated that it did not want to provide an unduly narrow interpretation of such phrase given the key objective of the CTA, which is to be able to detect criminals who use shell companies to evade taxes, hide their illicit wealth, and defraud employees and customers. FinCEN proposes to focus on the act of filing to create the entity as the determinative factor in defining entities besides corporations and limited liability companies that are also reporting companies.
It was not clear when the CTA was enacted if common law estate planning type trusts could somehow be construed as an “entity” for purposes of a reporting company. While FinCEN does not intend to narrowly interpret the phrase, there is greater comfort that common law estate planning trusts should not be treated as a reporting company as there is generally no act of filing a document in any local jurisdiction for such trust’s establishment. By contrast, FinCEN did note that it believes that business trusts (a/k/a statutory trusts or Massachusetts trusts) would be considered reporting companies because such entities are typically created by a filing with a secretary of state or similar office.
FinCEN also stated that it believes the proposed definition of domestic reporting company would likely include limited liability partnerships, limited liability limited partnerships, and most limited partnerships (in addition to corporations and limited liability companies), because such entities are typically created by a filing with a secretary of state or similar office. FinCEN noted, however, that it understands that state and Tribal laws may differ on whether certain other types of legal or business forms––such as general partnerships and sole proprietorships––are created by a filing, and therefore does not propose to categorically include any particular legal forms other than corporations and limited liability companies within the scope of the definition (at least for now).
C. Who is Reported? Beneficial Owners
The CTA defines “beneficial owner” as “an individual who, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise – (i) exercises substantial control over the entity; or (ii) owns or controls not less than 25 percent of the ownership interests of the entity….”8 The Proposed Regulations offer clarifications around the meaning of “substantial control” under the first prong and the meaning of “ownership interest” as part of the second prong.
1. Substantial Control Prong
In considering substantial control, FinCEN said that reporting companies should be guided by the specific examples provided in the Proposed Regulations, but they should also consider how individuals could exercise substantial control in other ways. The ordinary execution of day-to-day managerial decisions with respect to one part of a reporting company’s assets or employees typically should not, in isolation, cause the decision-maker to be considered in substantial control of a reporting company, unless that person satisfies another element of the “substantial control” criteria. It is expected by FinCEN that a reporting company would not need to spend significant time assessing which of its beneficial owners would be the most appropriate to report as being in substantial control. Rather, according to FinCEN, entities should simply report all persons in substantial control as beneficial owners, with no need to distinguish amongst them.
The Proposed Regulations define what constitutes substantial control through a non-exhaustive list. In particular, substantial control may be exercised, directly or indirectly, through (1) service as a senior officer of a reporting company (i.e., C-level officer, president, etc.), (2) authority over the appointment or removal of any senior officer or dominant majority of the board of directors (or similar body) of a reporting company, (3) direction, determination, decision of, or substantial influence over, important matters of a reporting company (such as the reorganization or dissolution of the company), and (4) any other form of substantial control (a catch-all section).
The Proposed Regulations go on to more expansively say that substantial control can be exercised directly or indirectly through a variety of means such as through board representation; ownership or control of a majority or dominant minority of the voting shares of the reporting company; rights associated with any financing arrangement or interest in a company; control over one or more intermediary entities that separately or collectively exercise substantial control over a reporting company; arrangements or financial or business relationships, whether formal or informal, with other individuals or entities acting as nominees; or through any other contract, arrangement, understanding, relationship, or otherwise.
The broad interpretation taken by FinCEN could seemingly cause many different roles within a trust structure to be considered as having substantial control of any reporting company owned by such trust. The easiest role within a trust that would meet the substantial control prong would be the trustee having legal title to the ownership of the reporting company and who would presumably have, at a minimum, some type of decision-making authority or influence over important matters of the reporting company. It, therefore, leads one to question whether other roles found in trust arrangements, such as that of a Protector, or an Investment Advisor who may be able to direct the trustee as to investments, may be also deemed to exercise substantial control under the Proposed Regulations. Going one step further, would the individuals who can remove and replace these persons potentially also have substantial control over the reporting company and therefore need to be reported? The Proposed Regulations are silent on whether these particular roles would fall under the substantial control umbrella.
2. Ownership Prong
With respect to the ownership prong of beneficial ownership, the Proposed Regulations clarify that a 25% ownership interest in an entity includes both equity in the reporting company and other types of interests, such as a capital or profits interest or convertible instruments, warrants, rights or other options to acquire an interest in a reporting company. FinCEN proposes to adopt this understanding as a way of ensuring that the underlying reality of ownership, not the form it takes, drives the identification of beneficial owners. According to FinCEN, this approach also thwarts the use of complex ownership structures and ownership vehicles other than direct equity ownership to obscure a reporting company’s real owners.
The Proposed Regulations attempt to include an aggregation rule for purposes of meeting the 25% ownership threshold. In determining whether an individual owns or controls 25% of the ownership interests of a reporting company, the ownership interests of the reporting company include all ownership interests of any class or type, and the percentage of such ownership interests that an individual owns or controls are determined by aggregating all of the individual’s ownership interests in comparison to the undiluted ownership interests of the company. Unfortunately, the Proposed Regulations do not specifically address the meaning of indirect ownership through tiered structures, or through trusts, and there is no overlapping rule as to how to count one’s beneficial ownership when more than one person owns the same 25% interest.
Although common law estate planning trusts are not directly mentioned in the CTA, the Proposed Regulations make it clear that ownership of a reporting company by a trust can cause different parties of a trust to be considered beneficial owners of the reporting company. More specifically, the Proposed Regulations provide that the following would be considered a beneficial owner:
1. settlors with the power to revoke or withdraw assets from the trust;
2. trustees or other individuals with the authority to dispose of trust assets; and
3. a beneficiary if such beneficiary is the sole permissible recipient of both income and principal or any beneficiary that has the right to demand a distribution of, or withdraw substantially all of the assets from, the trust.
It is very common for trust agreements to provide for discretionary distributions. It is not clear under the approach taken in the Proposed Regulations if a purely discretionary beneficiary would be captured as a beneficial owner of the reporting company as such beneficiary could be a permissible recipient of income and principal, notwithstanding the fact that only the trustee would have the discretion to make a distribution. A conservative approach would be to disclose the beneficiary in the face of uncertainty until further guidance is issued. Another conservative reading would also imply that protectors and other types of trust advisors could be considered beneficial owners of a trust based on their powers of directions with respect to trust property.
Taking all the above together, consider the example of a Florida manager-managed limited liability company for which the membership interest is wholly owned by a Florida governed law estate planning trust that is currently revocable by the settlor with a professional trust company serving as the trustee. Based on the Proposed Regulations, the beneficial owners of the Florida LLC, as the reporting company, are: (1) the manager of the company, (2) potentially certain officers of the company, if any, (3) the trustee, (4) and the settlor. Under the 25% ownership test, it remains unclear whether each beneficial owner reports as owning 100% or 25% of the interest.
The CTA does provide some exceptions for beneficial owners. For example, those individuals whose only interest is through a right of inheritance are carved out as a beneficial owner. It was not clear at the time the CTA passed what was meant by “right of inheritance.” The Proposed Regulations clarify that the right of inheritance exception applies only to a future right of inheritance. In other words, FinCEN has addressed the exception by applying a temporal test such that when any future ownership interest is received upon conclusion of estate administration proceedings, such individual will have the same relationship to an entity as any other individual who acquires an ownership interest through other means. Unfortunately, the Proposed Regulations still do not provide a definition of what constitutes an inheritance and whether, for example, an interest in a trust would be considered an inheritance.
D. Who is Reported? Company Applicants
A reporting company is not only required to report its beneficial owners, but also any company applicants. The Proposed Regulations clarify that company applicants are any individual who (A) files an application to form the domestic reporting company, or (B) registers or files an application to register a foreign reporting company to do business in the United States.
FinCEN has taken a broad interpretation of such definition, clarifying that an applicant is not only the individual that makes the filing but also the individual that directs the making of such filing. The purpose of such broad definition is to ensure that companies do not simply list an employee performing a ministerial function as the applicant. However, this will be a potentially burdensome task for reporting companies to assume as it requires every person in the “chain” who was involved in the filing of the application with respect to a reporting company to be reported.
Notably, the Proposed Regulations fail to provide a cut-off period for reporting company applicants. Thus, as an illustration, a reporting company formed in 1982 by a paralegal of a law firm would have to find that paralegal, wherever such paralegal may be, as well as any other person that directed that paralegal, and obtain all the requisite information on such individuals. The only relief granted by the Proposed Regulations is if such person has already passed away, in which case, such person does not have to be reported.
E. What is Reported?
1. Beneficial Owners/Company Applicant Information
The CTA requires each reporting company to provide, with respect to beneficial owners and applicants of that company: (1) the full legal name; (2) the date of birth; (3) a current residential or business streets address; and (4) a unique identifying number from an acceptable identification document or FinCEN identifying number.
The Proposed Regulations make a distinction between the address that needs to be provided by beneficial owners and company applicants. With respect to beneficial owners, a reporting company will need to provide the residential street address that the individual uses for tax residency purposes; whereas for company applicants, the reporting company needs to provide the business street address of such applicant. FinCEN explains that this is intended to maximize the usefulness of the information provided to FinCEN so that, for example, individuals do not simply list their business address, which address could be less useful to law enforcement. What remains unclear, however, is what FinCEN means by “tax residency”? Residency for tax purposes can be applied differently amongst different jurisdictions and it is not clear what standard should be applied. FinCEN has asked for comments on this issue.
2. Reporting Company Information
It may come as a surprise to the reader that nowhere in the CTA is it required that the reporting company provide information with respect to itself. Thus, a reporting company could provide information regarding its beneficial owners that would be virtually useless to law enforcement if the register does not contain any more information about the reporting company itself. FinCEN views this as an oversight and therefore seeks to correct it in the Proposed Regulations, arguing that not doing so would frustrate the purposes of the CTA and “amount to an absurd result.”9 The Proposed Regulations would therefore require reporting companies to provide: (1) its name; (2) any alternative names (such as d/b/a names); (3) its business street address; (4) its jurisdiction of formation or registration; and (5) a unique identification number (i.e. Employer Identification Number). The last requirement may present difficulties for some entities, as many foreign entities never register to obtain an Employer Identification Number or may be faced by long delays at the Internal Revenue Service when attempting to obtain one.
F. When is a Filing Required? Reporting Due Dates
The CTA afforded FinCEN the decision-making authority around the due dates for the different reports for new and existing companies. An area of notable concern during the commentary period was whether FinCEN would provide reporting companies with sufficient time to comply with the CTA. FinCEN has proposed the following due dates for initial reports, updated reports, and corrected reports:
1. Initial Reports
Newly formed or registered companies must file a report within 14 calendar days of the date that such company (i) is formed, in the case of a domestic company, or (ii) is registered to do business, in the case of a foreign reporting company. FinCEN’s stance is that the relevant information on all of the beneficial owners and company applicants should be available at the time of creation of the reporting company. However, the authors note that in some instances, the process for requesting an Employer Identification Number with the Internal Revenue Service, which information is required to be reported with the initial filing, can take several days (and that is assuming there is not a government shutdown at the relevant time). Thus, it is possible that all of the required information to complete the initial report may not be available within 14 days.
Entities formed or registered before the effective date of the regulations must file a reporting within one year of the effective date of the final rules. While this time period appears reasonable, it is a shorter time period than the maximum of two years afforded by the CTA.
Formerly exempt entities must file a report within 30 calendar days after they fail to meet the exempt criteria. This requirement is not imposed by the CTA, but FinCEN believes it has the authority to impose such a requirement and that such requirement is implied by the CTA.
2. Updated Reports
Reporting companies are also required to file an updated report within 30 days from the date that there was a change to the information submitted to FinCEN. This includes changes to the beneficial ownership of the reporting company or changes to the identification information previously reported for a beneficial owner. The foregoing deadline is shorter than the maximum 90 day period afforded by the CTA for making such updates. It is noted that in most states the company is renewed annually and is the time when updates are made in the local jurisdiction. Thus, it could be very easy for the reporting company to forget to file an updated report.
3. Corrected Reports
Reporting companies are required to file a corrected report within 14 days after it discovers or has reason to discover an inaccuracy in the filing submitted to FinCEN. This deadline is also shorter than the maximum 90 day period afforded by the CTA. Nevertheless, FinCEN believes 14 days provides adequate time to make such corrections and serves the governmental interest of quickly correcting errors.
G. Effective Date
The CTA provides that the effective date of the law would be when FinCEN prescribes implementing regulations which shall not be longer than 1 year from the enactment of the CTA (i.e., January 1, 2021). As of the date of this article, the Proposed Regulations have a 60 day commentary period. The authors expect that FinCEN will receive another round of voluminous comments to the 40 raised questions, which will take time for FinCEN to review. As a result, the Proposed Regulations are not yet effective and it is not yet certain when will be the effective date. According to FinCEN, the effective date for the final reporting rule will be determined based on several factors, such as: (1) how long reporting companies, and small businesses in particular, will need to comply with the new rules; (2) the time needed for secretaries of state and Tribal authorities to understand the new requirements and to update their websites and other documentation to notify reporting companies of their obligations under the CTA; and (3) the anticipated timeline for revising the Customer Due Diligence Requirements, which are triggered by the effective date of the final reporting rule.
H. Penalties and Individual Liability
Failing to comply with the CTA could result in a civil penalty of $500 for each day that the failure continues or has not been remedied, and a fine of up to $10,000 or imprisonment for up to two years, or both, for a criminal violation. While the CTA requires reporting companies to comply with its reporting requirement, the statute is unclear as to who will be liable if the required information is not properly reported. The Proposed Regulations clarify that any individual, in addition to the reporting company, will be liable and subject to the foregoing civil and criminal penalties.
Specifically, under the Proposed Regulations: “[i]t shall be unlawful for any person to willfully provide, or attempt to provide, false or fraudulent beneficial ownership information, including a false or fraudulent identifying photograph or document, to FinCEN in accordance with this section, or to willfully fail to report complete or updated beneficial ownership information to FinCEN in accordance with this section.”10
The Proposed Regulations further refine that definition as follows:
What is notably missing in these definitions is that FinCEN did not provide any further detail on what is meant by “willful.” We would expect FinCEN to provide more guidance on this standard, and hopefully, to provide some type of relief for inadvertent mistakes, particularly at the start of the reporting period when the regulations become effective and many may not yet be aware of the reporting requirements.
I. Conclusion – What Should Private Clients be Doing?
FinCEN seeks further commentary on the Proposed Regulations through a 60-day notice period, which period expires on February 6, 2022. Nevertheless, domestic and international private clients and their closely-held companies should already start becoming familiar with the compliance requirements imposed by the CTA and clarified or expanded upon by the Proposed Regulations.
While the rules may be adjusted in part before becoming final, we at least know that clients should start identifying all of the reporting companies in their structures and gathering information and necessary documents on all of the beneficial owners and company applicants. In the context of estate planning trusts owning underlying reporting companies, the trusts should be reviewed closely to determine which parties within the trust may need to be reported as beneficial owners. Obtaining information on company applicants could prove difficult, particularly with respect to companies that have been established for a long time. It is therefore worth undertaking this task as soon as possible, particularly as a result of the short time periods that the Proposed Regulations have provided in terms of due dates.
We will continue to monitor any developments with respect to the implementation of the CTA and provide updates. We are available to assist should you have any questions or concerns that you may have with respect to the CTA and its effect on your trust and closely held company structure.