Published by: Journal of Asset Protection; Warren, Gorham Lamont
Author: Howard Rosen, Esq. & Patricia Donlevy-Rosen, Esq.
Date of Publication: July, 1997
Attorneys, accountants, and other professional advisors need to be aware of the significant “abusive trust arrangements” that may be solicited to clients and that may be subject to significant penalties announced in a recent IRS notice.
For years we have been writing that offshore asset protection trusts do not offer any income tax advantages for United States citizens or residents.(1) We have been constantly concerned about unfavorable “fallout” and/or (typical) legislative overreaction when one or more of these tax-driven schemes backfired. In any event, we had been hoping that the Internal Revenue Service (the “Service”) would address this issue, and this occurred on April 21, 1997, when the Service issued Notice 97-24 (the “Notice”).(2)
The Notice alerts taxpayers that the Service is actively examining certain trust arrangements which purport to reduce or eliminate federal income taxes in ways that are not permitted under our tax laws. We have seen schemes offered which attempt to combine corporate and trust tax law provisions in a single entity to provide no less than amazing tax benefits for the taxpayer. The schemes addressed in the Notice are collectively referred to as “abusive trust arrangements”.
The Service’s investigation is part of a national compliance program under the name, “National Compliance Strategy, Fiduciary and Special Projects”. The Notice advises that, in appropriate circumstances, taxpayers and/or the promoters of such schemes may be subject to civil and/or criminal penalties. Of course, the Notice acknowledges the many legitimate uses of trusts.
WHAT IS MEANT BY ABUSIVE TRUSTS?
Abusive trust arrangements are typically promoted by the promise of tax benefits with no meaningful change in the taxpayer’s control over or benefit from the taxpayer’s income or assets. The most commonly promised benefits include:
- reduction or elimination of income subject to tax;
- deductions for personal expenses paid by the trust;
- depreciation deductions for an owner’s personal residence and furnishings;
- a stepped-up basis for property transferred to the trust;
- the reduction or elimination of self-employment taxes; and
- the reduction or elimination of gift and estate taxes.
These promised benefits are inconsistent with the tax rules applicable to trusts and the other entities that may also be involved.
The schemes targeted by the Service often consist of convoluted, multi-tiered structures, typically involving more than one trust (and other entities as well), each holding different assets of the taxpayer (for example, the taxpayer’s business can be owned by one entity, the business equipment by a second entity, the taxpayer’s home by a third, and an automobile by a fourth), as well as interests in other trusts.
Funds may flow from one trust to another trust by way of rental agreements, fees for services, purchase and sale agreements, and distributions. Some trusts purport to involve charitable purposes. In some situations, one or more foreign trusts may also be part of the arrangement.
IRS EXAMPLES of ABUSIVE TRUST ARRANGEMENTS
In the Notice, the Service classified abusive trust arrangements into the following five types, and further indicated that an abusive arrangement might involve some or all of the arrangements described:
1. The Business Trust
This scheme involves the transfer of a business by its owner to a “trust” (sometimes described as an unincorporated business trust) in exchange for ownership or beneficial interest certificates. The trust makes payments to the holders of these certificates, deducting such payments as either a business expense or a trust distribution, which purports to result in the reduction of the taxable income of the business. Of course, the owner’s self-employment income is eliminated because he is receiving distributions from a trust — not income from self-employment. In some cases, the connivance purports to eliminate the owner’s estate tax liability through a “self-canceling at death” feature of the trust units (alternatively, by a sale at a nominal price).
2. The Equipment or Service Trust.
The equipment trust is formed to hold equipment that is rented or leased to the business trust, often at inflated rates. The service trust is formed to provide services to the business trust, often for inflated fees. Under these abusive trust arrangements, income is drained from the business trust through inflated rentals and/or fees, and those amounts are offset by the equipment trust through inflated depreciation deductions resulting from a sham “purchase” of the equipment by the trust. In addition, distorting the principle of Burnet v. Logan,(3) the owner (“seller” of the equipment) takes the inconsistent position that the trust units he received in exchange for the sale of the equipment had an indeterminable value, and that he therefore owes no tax on the sale. Both the equipment and the service trust will often utilize distributions to other trusts to further reduce or eliminate trust income.
3. The Family Residence Trust
The owner of the family residence transfers the residence, including its furnishings, to a trust. The goal of this arrangement is to convert nondeductible personal expenditures into “deductible” items. The machinations created to effect the desired result again include the taking of inconsistent positions by the trust and the owner: the trust takes the position that it has acquired the residence in an exchange which resulted in a stepped-up basis with respect to which the trust is allowed a depreciation deduction because it is in the business of renting the property; little or no rent is paid, of course, and the owner takes the position that no gain is recognized on the sale because the trust units he received have no ascertainable value (again based on a distortion of Burnet v. Logan), and he and his family can live rent-free in the residence as its caretakers (for the benefit of the trust). In the event the trust were to receive income, it would be offset by depreciation deductions on the “rental” property held by the trust.
4. The Charitable Trust
This scheme involves the use of a charitable trust to pay for the personal educational, living, or recreational expenses of the owner or the owner’s family. For example, the trust may provide for payments to the University of Miami (an otherwise deductible educational gift), and such payments will in fact be utilized for the college tuition of a child of the owner.
5. The Final Trust
In some multi-trust arrangements, the U.S. owner of one or more abusive trusts establishes a trust (the “final trust”) that holds trust units of the owner’s other trusts and is the final distributee of their income. A final trust often is formed in a foreign country which imposes little or no tax on the trust.
A common factor in each of these trusts is that the original owner of the assets that are nominally subject to the trust effectively retains authority to cause the financial benefits of the trust to be directly or indirectly returned or made available to the owner.
For example, the trustee may be the promoter, or a relative or friend of the owner who simply carries out the directions of the owner whether or not permitted by the terms of the trust. Often, the trustee gives the owner checks that are pre-signed by the trustee, checks that are accompanied by a rubber stamp of the trustee’s signature, a credit card or a debit card with the intention of permitting the owner to obtain cash from the trust or otherwise to use the assets of the trust for the owner’s benefit.
WHO ENDS UP PAYING THE TAX?
When trusts are used for legitimate planning purposes, either the trust, the trust beneficiary, or the transferor to the trust, as appropriate under the applicable tax law, will pay the tax on the income generated by the trust property – but someone will pay the tax.
Trusts cannot transform a taxpayer’s personal, living or educational expenses into deductible items. Succinctly stated: the tax results that are promised by the promoters of abusive trust arrangements are not allowable under federal tax law. The IRS noted that contrary to the promises made in promotional materials, several well-established tax principles control the proper tax treatment of these abusive trust arrangements. Among those mentioned are the following:
1. Substance — not form — controls taxation
The Supreme Court of the United States has consistently stated that the substance rather than the form of the transaction is controlling for tax purposes.(4) Under this doctrine, the abusive trust arrangements would be viewed as sham transactions, and the Service would ignore the trust and its transactions for federal tax purposes.(5) Therefore, the income and assets of the business trust, the equipment in the equipment trust, the residence in the family residence trust, and the assets in the foreign trust would all be treated as belonging directly to the owner.
2.Grantors may be treated as owners of trusts
The grantor trust rules provide that if the owner of property transferred to a trust retains an economic interest in, or control over, the trust, the owner is treated for income tax purposes as the owner of the trust property, and all transactions by the trust are treated as transactions of the owner.(6) In addition, a U.S. person who directly or indirectly transfers property to a foreign trust is treated as the owner of that property if there is a U.S. beneficiary of the trust.(7) This means that (1) all expenses and income of the trust would belong to and must be reported by the owner, and (2) tax deductions and losses arising from transactions between the owner and the trust would be ignored. Thus, the putative “taxable” exchanges between the owner and the trusts described above and the stepped-up basis derived in each case therefrom would not exist.(8) We have seen cases where the promoter executes the trust as “settlor”, with the owner contributing property to the trust. The apparent thought in such instance being that the trust will not be a grantor trust as to the owner because by executing the trust, the promoter becomes the grantor. In such cases, the “substance over form” issue is totally ignored.
3. Taxation of Non-Grantor Trusts
If the trust is not a sham and is not a grantor trust, the trust is taxable on its income, reduced by amounts distributed to beneficiaries. If the trust is a foreign trust, it will likely be subject to a withholding tax on its U.S. source income other than capital gains.(9)
4.Transfers to trusts may be subject to estate and gift taxes
If a transfer to a trust is a completed gift under Section 2511, federal gift tax implications may arise, and if the transferor retains a beneficial interest in or control over the trust, the entire trust, or the portion with respect to which such interests are retained, will be included in the transferor’s gross estate for federal estate tax purposes.(10)
5. Personal expenses are generally not deductible
Personal expenses such as those for home maintenance, education, and personal travel are not deductible unless expressly authorized by the tax laws. The courts have consistently held that non-deductible personal expenses cannot be transformed into deductible expenses by the use of trusts.(11)
6. A genuine charity must benefit in order to claim a valid charitable deduction
Charitable trusts that are exempt from tax are carefully defined in the tax law. Arrangements are not exempt charitable trusts if they do not satisfy the requirements of the tax law, including the requirement that their true purpose is to benefit charity. Furthermore, putative charitable payments made by a trust are not deductible charitable contributions where the payments are really for the benefit of the owner or the owner’s family members.(12)
7. Special rules apply to foreign trusts
If an arrangement involves a foreign trust, taxpayers should be aware that a number of special provisions apply to foreign trusts with U.S. grantors or U.S. beneficiaries, including several provisions added in 1996. For example, a U.S. person that 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 35 percent of the gross value of the transaction.(13) Other examples of these provisions are the application of U.S. withholding taxes to payments to foreign trusts(14) and the application of U.S. excise taxes to transfers of appreciated property to certain foreign trusts.(15)
8. Civil and/or criminal penalties may apply.
The participants (including the owner and his advisors) in and the promoters of abusive trust arrangements may be subject to civil and/or criminal penalties in appropriate cases.(16)
In our experience, the promoters of these abusive schemes often advise potential clients not to contact their tax attorney or accountant because the formal education undertaken by those professionals will somehow preclude their understanding of the scheme. In our opinion, such schemes evolve either from ignorance (giving the promoter the benefit of the doubt) or as a variety of tax protest. These schemes may be known by a variety of names:
- the Common Law Trust,
- the Pure Trust,
- the Pure Equity Contract Trust, and
- the Contract Trust.
One related scheme uses a general partnership form of organization (referred to by the promoters as an “unincorporated business organization”) promoted as a Constitutional “loophole” to the payment of tax and tax reporting, based upon our right to enter into contracts unimpeded. Apparently the promoters of the latter scheme are unaware of (or choose to ignore) Treas. Reg. Sec. 301.7701-2 and the “catch-all” definition of a partnership found in Treas. Reg. Sec. 301.7701-3.
The manner in which these schemes are presented to the lay public, citing constitutional bases, case law, and the like, often presents a credible picture — particularly because the recipient of the information is hearing what he wants to hear: “no more taxes”. As professionals, we must be aware of what is being offered to our clients in order to be able to provide useful, learned advice.
1. See, e.g., H. Rosen, “The Uses and Abuses of Offshore Trusts“, J. of Asset Protection, Vol. 1, No. 1 (Sept/Oct 1995), p. 9
3. 283 U.S. 404 (1931). In that 1930’s case, the Court permitted the taxpayer to recover basis first where the payments to be received in an installment sale were based upon the future production of a mine.
5. See, e.g., Buckmaster v. Comm’r, TC Memo, 1997-236 (May 21, 1997), a multi-level sham trust case involving the transfer of a sole proprietorship to a trust wherein the court found that the “trust” was “merely a device conjured up for petitioner and other taxpayers seeking to avoid Federal income tax”); Markosian v. Comm’r, 73 T.C. 1235 (1980) – dental practice and personal residence transferred to an “equity pure trust”; Zmuda v. Comm’r, 731 F.2d 1417 (9th Cir. 1984) – a multi-foreign trust machination utilizing nominal foreign grantors, previously unknown to the taxpayer. The Court referred to the scheme as a “phony diversion”).
8. See, Rev. Rul. 85-13, 1985-1 C.B. 184; See also, H. Allan Shore and Howard Rosen, “Beyond Chapter 14 – A Tale of Two (New) Freezes, Taxes Magazine, February 1993, P. 97, for a discussion of grantor trusts).
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