IRS INVESTIGATES ABUSIVE TRUSTS:
Finally!
INTRODUCTION. For years we have been writing that
offshore asset protection trusts do not offer any income tax
advantages for United States citizens or residents. We have
been constantly concerned about unfavorable "fallout" and/or
(typical) legislative overreaction when one or more of these
schemes backfired. In any event, we had been hoping that the
Internal Revenue Service (the "Service") would address this
issue, and our wish was granted on April 21, 1997, when the
Service issued Notice 97-24 (the "Notice").
BACKGROUND. The Notice alerts taxpayers that the
Service is actively examining abusive trust
arrangements as part of a national compliance program, and
that in appropriate circumstances, taxpayers and/or the
promoters of such schemes may be subject to civil and/or
criminal penalties.
ABUSIVE TRUSTS - IN GENERAL. 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
promised benefits may include reduction or elimination of
income subject to tax; deductions for personal expenses paid
by the trust; depreciation deductions of 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.
Abusive trust arrangements often involve more than one
trust (and other entities as well), each holding different
assets of the taxpayer (for example, the taxpayer's
business, business equipment, home, automobile, etc.), 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 also may be part of
the arrangement.
EXAMPLES. In the Notice the Service was able to
classify abusive trust arrangements into five types, and
further indicated that an abusive arrangement might involve
some or all of the arrangements described. Common factors in
each of the trusts described in the Notice were: 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. The five types:
1. The Business Trust. This scheme involves the
transfer of a business to a trust (sometimes described as an
unincorporated business trust) which purports to result in
the reduction of the taxable income of the business,
reduction or elimination of the owner's self-employment
taxes, and, in some cases, an elimination of the owner's
estate tax liability.
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 service trust through inflated depreciation
deductions resulting from a sham "sale" of the equipment to
the trust. Of course, the owner (seller) takes the
inconsistent position that what he received in exchange for
the sale of the equipment had an indeterminable value, and
that he therefore owes no tax on his sale.
3. The Family Residence Trust. The owner of the
family residence transfers the residence, including its
furnishings, to a trust with the goal of converting
nondeductible personal expenditures into "deductible" items.
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 pay 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 that will impose little or no tax on
the trust.
BOTTOM LINE: SOMEONE MUST PAY 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 tax laws, 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. Accordingly, the tax
results that are promised by the promoters of abusive trust
arrangements are not allowable under federal tax law.
Contrary to promises made in promotional materials, the
Service noted that several well-established tax principles
control the proper tax treatment of these abusive trust
arrangements. Among those mentioned:
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. Under this doctrine, the
abusive trust arrangements may be viewed as sham
transactions, and the IRS may ignore the trust and its
transactions for federal tax purposes. Accordingly, 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. 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. This means that all expenses and income of the
trust would belong to and must be reported by the owner, and
tax deductions and losses arising from transactions between
the owner and the trust would be 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.
4. Transfers to trusts may be subject to estate and
gift taxes.
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.
6. 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. Other examples of these provisions
are the application of U.S. withholding taxes to payments to
foreign trusts and the application of U.S. excise taxes to
transfers of appreciated property to certain foreign trusts.
7. Civil and/or criminal penalties may apply. The
participants in and promoters of abusive trust arrangements
may be subject to civil and/or criminal penalties in
appropriate cases.
CONCLUSION. The Service has undertaken a
nationally coordinated enforcement initiative to address
abusive trust schemes - the National Compliance Strategy,
Fiduciary and Special Projects. More information can be
obtained by calling (202) 622-4512 (IRS - not toll-free) and
asking about Notice 97-24.