"Retain me, and
you will talk
only to me."
IRS Announces Crackdown on Abusive Trusts
By Scott Kauffman, A California Tax Lawyer.
The criminal investigation division of the Internal Revenue Service (the “Service”) is heightening its focus of abusive trusts to a national level after observing that an increasing number of taxpayers are entering into trusts that the Service deems abusive. While the primary target of the Service’s focus will be the promoters of abusive trusts who make claims that the use of their trust instruments will reduce or eliminated income and estate taxes, purchases of the trust instruments may also face fines and jail sentences if the Service is able to develop sufficient evidence of intent and knowledge of tax avoidance by taxpayers employing abusive trusts. Even taxpayers who were not aware that they had purchased an abusive trust will be subject to the payment of taxes owed, interest, and penalties. (Address by Dennis Crawford, national director of operation for criminal investigations, to a conference sponsored by the American Bar Association of Taxation, the Center for Continuing Legal Education, and the American Institute of Certified Public Accountants, The Wall Street Journal, November 18, 1998, at 1, col. 5: 2 IRS Practice Advisor 58, December 11, 1998.)
As the purchase of abusive trusts are high wealth and income individuals, Orange County practitioners may in the near future be receiving inquiries from those who have been the marketing victims of the promoters of abusive trusts and who are not the subject of the Service’s focus.
MARKETING OF ABUSIVE TRUSTS
While abusive trusts are an old tax scam that have been around for years, the marketing of these trusts in concentrated at the close of the tax filing season when taxpayers, who believe that they have paid too much in income taxes, are angry and frustrated with the tax system and feel bilked. Promoters of abusive trusts are able to prey upon taxpayer discontent and typically able to charge from $5,000 to $10,000—and prices of $25,000 are not uncommon. These promoters promise their customers that if they will only purchase and sign the promoter’s trust instrument, they will eliminate income taxes, employment taxes, estate taxes, and probate, as well as limit their personal liability from frivolous lawsuits. These benefits are often achieved by converging the settlor’s home into income producing property in which the settlor is permitted by the trust instrument to live tax free and, in addition, the settlor is permitted to deduct personal, medical, meal, and entertainment expenses.
The promoters of abusive trusts almost never posses a formal education in tax law or accounting. Often the promotional materials contain no analysis of the law and they never present any contrary arguments explaining why the alleged trust benefits might not be available to the purchaser. The materials do, however, usually provide a legal opinion declaring the validity of the trust and cite precedents that provide little if any substantiation of the assertions made. The trust promoters deliberately obfuscate the use of legitimate trusts with phony ones and claim that prominent families (such as the Rockefellers or the Kennedys) have established similar trusts. Frequently they offer commissions to their purchasers if their friends or family attend the seminars of the promoters.
The promoters of abusive trusts are often linked to the tax protester movement or patriot organizations. Farmers, doctors, veterinarians, and property owners are their primary targets.
Often the promoters of abusive trusts contend they have access to research that has taken them decades to compile and that estate planning lawyers, not being familiar with the legal precedents at issue, will only express a negative opinion. See Tax Prophet Hot Topics, April 1996. Abusive trusts go by a number of monikers: Unincorporated business organizations, common law trusts, constitutional trusts, and pure equity trusts. These trusts are identifiable primarily by the absence of named beneficiaries. Instead of naming specific beneficiaries, the trust instrument purports to create beneficial interests, similar to bearer stock, that will provide the holder with specified distribution rights.
PURE EQUITY TRUST AS EXAMPLE OF ABUSIVE TRUST
The pure equity trust contains many of the characteristics common to abusive trusts in general. A pure equity trust will usually be created for a stated term of 20-25 years and purports to be irrevocable. The settlor of a pure equity trust will fill four key roles: Settler, trustee, beneficiary, and trust employee.
The settlor will assign to the trustee of a pure equity trust the exclusive use of the settlor’s lifetime services, which services in turn are leased out by the trustee, for which the settlor is compensated by the settlor’s employer. The settlor will also transfer the settlor’s personal residence, income producing real estate, securities, business assets, and perhaps the business itself. The settlor receives, in exchange, all of the units of beneficial interest that entitle the holder to a proportionate share of the distributable income of the trust. The settlor may serve as trust manager and receive a salary and the use of trust property such as the family residence. See 26 The Colorado Lawyer No. 4/49, April 1997.
SERVICE CHARACTERIZATION OF ABUSIVE TRUSTS
In IRS Notice 97-24, 1997-16 IRB 6, the Service characterized abusive trusts as trusts whose promoters promise tax benefits with no meaningful change in the taxpayer’s control over or benefits from the taxpayer’s income or assets. The Service found that the promised benefits often include:
- The reduction or elimination of income subject to tax;
- Deductions for personal expenses paid by the trust;
- Depreciation deductions of the settlor’s personal residence and furnishings;
- Stepped up basis for property transferred to the trust;
- The reduction or elimination of self-employment taxes; and
- The reduction or elimination of estate and gift taxes.
The Service has also found that the settlors of abusive trusts often use the trust to hide the true ownership of assets and income or to disguise the substance of a transaction. The Service has further found that the settlors of abusive trusts frequently use more than one trust with each trust holding different assets. Funds may flow from one trust to another through rental agreements, fees for services, purchase and sale agreements, and distributions. Trusts purportedly created for charitable purposes are often used to pay the educational expenses of the settlor or the settlor’s family.
The Service has also determined that the characteristics common to all abusive trusts are that the settlor retains the authority to cause financial benefits of the trust to be directly or indirectly returned or made available to the owner. The trustee of an abusive trust may be the promoter or a relative or friend of the settlor who carries out the settlor’s directions irrespective of the terms of the trust. The trustee may provide to the settlor with checks that are pre-signed by the trustee or accompanied by a rubber stamp of the trustee’s signature as well as a credit card or debit card that are provided with the intention of permitting the owner to obtain cash or to the use of the assets of the trust.
The Service has characterized abusive trusts into five categories.
Business Trusts . A business owner will transfer a business in trust in exchange for certificates of beneficial interests. The trustee will then make payments to certificate holders which payments are characterized as deductible expenses or as deductible distributions that purport to reduce the taxable income of the business trust so that little or no tax is due from the business trust. In addition, the settlor claims that the trust arrangement reduces or eliminates the settlor’s self-employment taxes on the theory that the settlor’s receiving reduced or no income form the operation of the business. Sometimes the trust instrument provides that the beneficial units are to be canceled at death or sold at a nominal price to the settlor’s children, leading to the contention by the trust promoters that there is no estate tax liability.
Equipment or Service Trusts. The equipment trust and service trust are formed either to hold equipment or to render services that are rented or rendered to the business trust at inflated rates. The business trust purports to reduce its income by making (ostensibly) deductible payments to the equipment or service trust. The equipment owner often claims that the transfer of equipment to the equipment trust in exchange for trust units is a taxable exchange. The trustee takes the position that the trust has purchased the equipment with a known (fair market) value that is the basis of the equipment for purposes of claiming depreciation deductions. The settlor, however, takes the inconsistent position that the value of the trust units received cannot be determined, resulting in no taxable gain to the owner on the exchange. The equipment or service trust also may attempt to reduce or eliminate its income by distributions to other trusts.
Family Residence Trust. The settlor creating a family residence trust will transfer the residence, including its furnishings, to a trustee and the parties to the transfer then claim inconsistent tax positions for the settlor and the trustee similar to the equipment trust. The trustee will claim that the exchange results in a basis step up while the settlor reports no gain. The trustee will also claim to be in the rental business and purport to rent the residence back to the settlor though usually little or no rent is in fact paid. Instead the settlor will contend that the settlor and the family members of the settlor are caretakers or providing services to the trustee. Sometimes the trustee will receive funds from other trusts that are treated as trust income. In order to reduce the tax that might otherwise be due with respect to the trust income, the trustee may attempt to deduct depreciation and maintenance and operating expenses.
Charitable Trust. The settlor creating charitable trust will transfer assets to a purported charitable trust and claim either that the payments to the trustee are deductible charitable contributions. While some payments are principally for the personal, education, living, or recreational expenses of the settlor or the settlor’s children such as paying for their college tuition.
Final Trust. The settlor of one or more abusive trusts may establish a final trust that holds trust units of the settlor’s other trusts and which is the final distributee of the trust income. A final trust is often formed outside of the United States in a jurisdiction that imposes little or no tax. The trustee will distribute or make available the trust cash to the United States settlor, purportedly free of tax.
SERVICE CHALLENGES TO ABUSIVE TRUSTS
When trusts are formed for legitimate business, family or estate planning purposes, the Service’s position is that the trustee, trust beneficiaries or settlor, as appropriate under the tax laws, will pay the tax on the income generated by the trust assets. Additionally, when a trust is used in accordance with the tax laws, it will not convert a taxpayer’s person, living, or educational expenses into deductible items and will not seek to avoid tax liability by ignoring either the true ownership of income and assets or the true substance of the transaction. The primary Service arguments attacking abusive trusts are as follows.
Sham Transaction/Form Over Substance. A trust is a sham where the parties fail to comply with the trust terms and supporting documents and the relationship of the settlor to the property transferred does not materially change subsequent to the creation of the trust. Markosian v. Commissioner, 73 T.C. 1235 (1980). Accordingly, the income and assets of the trust are treated by the Service as belonging directly to the settlor.
Settlor Treated as Owner. The grantor trust rules ( Internal Revenue Code §§671-677) provide that if the settlor of the property transferred to a trust retains an economic interest, in, or control over, the trust, the settlor is treated for income tax purposes as the owner of trust property and all trust transactions are treated as transactions by the owner. All expenses and income of the trust would thereby belong to, and be reported by, the settlor and taxable distributions and losses arising from transactions between the settlor and the trustee would be ignored. There would be no taxable exchange of property with the trustee and the tax basis of any property transferred to the trustee would not be stepped up for purposes of depreciation.
Taxation of Non-Grantor Trusts. If the trust is neither a sham nor a grantor trust, the trust is subject to tax upon its income reduced by beneficiary distributions, which distributions must be reported on a Form K-1 and included in the income of the beneficiaries.
Trust Transfers May Be Subject to Estate and Gift Tax. Transfers to a trustee may be recognized as completed gifts for purposes of the federal gift tax. Additionally, if the settlor retains until the settlor’s death the use or enjoyment of income from the trust property, the property will be subject to federal estate tax at the death of the settlor.
Personal Expenses Not Deductible. Personal expenses such as those for home maintenance, education and personal travel are not deductible and may not be made deductible by the use of a trust, and the cost of creating such a trust is not deductible. Schulz v. Commissioner, 686 F.2d 490 (7 th Cir. 1982).
A Genuine Charity Must Benefit in Order to Claim a Valid Charitable Deduction. The true purpose of a charitable trust, the Service contends, must be to benefit charity and not to benefit the settlor or the family members of the settlor.
Special Rules for Foreign Trusts. A United States person who fails to report a transfer of property to a foreign trust or the receipt of a distribution from a foreign trust is subject to a tax penalty equal to 30% of the gross value of the transaction.
Civil and Criminal Penalties. The participants in and promoters of abusive trust arrangements may be subject to civil or criminal penalties, or both, in appropriate cases.
The use of an abusive trust for tax planning purposes is misguided and dangerous and is not a valid tax shelter. The practitioner whose client endures an audit that results in a loss of the tax benefits the client thought he or she would be receiving may, however, have entered into a valid trust for state law purposes that the client wishes now to have undone. The practitioner should consider a court petition pursuant to Probate Code §17200 et seq., and either argue that the trust was void at the inception or request that the probate court reform the trust to remove or modify its more onerous provisions.
Scott Kauffman is of counsel with the firm of Joseph E. Mudd, PLC, in Irvine, Ca.