IRS Cautions on Abusive Trusts
© by Greta P. Hicks, CPA
The IRS has issued an alert to practitioners (Notice 97-24) about
trust arrangements that purport to reduce or eliminate federal taxes in
ways that are not permitted by law (abusive trust arrangements).
Under the federal tax laws, trusts generally are separate entities
subject to income tax (except for certain charitable or pension trusts
that are expressly exempted by the tax laws and certain grantor trusts
described in sections 671 - 679 of the Internal Revenue Code). Under these
laws and certain court developed doctrines, either the trust, the beneficiary,
or the transferor, as applicable, must pay the tax on the income realized
by the trust including the income generated by property held in trust.
Abusive Trust Arrangements
- In General
Abusive trust arrangements typically are 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 the
abusive trust arrangements, as described below.
Abusive trust arrangements often use trusts to hide the true ownership
of assets and income or to disguise the substance of transactions. These
arrangements frequently involve more than one trust, 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 Of Abusive Trust
Described below are five examples of abusive trust arrangements that
have come to the attention of the Internal Revenue Service. An abusive
trust arrangement may involve some or all of the trusts described below.
The type of trust arrangement selected is dependent on the particular tax
benefit the arrangement purports to achieve. In each of the trusts described
below, 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 Business Trust.
The owner of a business transfers the business to a trust (sometimes
described as an unincorporated business trust) in exchange for units or
certificates of beneficial interest, sometimes described as units of beneficial
interest or UBI's (trust units). The business trust makes payments to the
trust unit holders or to other trusts created by the owner (characterized
either as deductible business expenses or as deductible distributions)
that purport to reduce the taxable income of the business trust to the
point where little or no tax is due from the business trust. In addition,
the owner claims the arrangement reduces or eliminates the owner's self-employment
taxes on the theory that the owner is receiving reduced or no income from
the operation of the business. In some cases, the trust units are supposed
to be canceled at death or "sold" at a nominal price to the owner's
children, leading to the contention by promoters that there is no estate
The Equipment Or Service
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, the business trust may purport
to reduce its income by making allegedly deductible payments to the equipment
or service trust. Further, as to the equipment trust, the equipment owner
may claim that the transfer of equipment to the equipment trust in exchange
for the trust units is a taxable exchange. The trust takes the position
that the trust has "purchased" the equipment with a known value
(its fair market value) and that the value is the tax basis of the equipment
for purposes of claiming depreciation deductions. The owner, on the other
hand, 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.
The Family Residence
The owner of the family residence transfers the residence, including
its furnishings, to a trust. The parties claim inconsistent tax treatment
for the trust and the owner (similar to the equipment trust). The trust
claims the exchange results in a stepped-up basis for the property, while
the owner reports no gain. The trust claims to be in the rental business
and purports to rent the residence back to the owner; however, in most
cases, little or no rent is actually paid. Rather, the owner contends that
the owner and family members are caretakers or provide services to the
trust and, therefore, live in the residence for the benefit of the trust.
Under some arrangements, the family residence trust receives funds from
other trusts (such as a business trust) which are treated as the income
of the trust. In order to reduce the tax which might be due with respect
to such income (and any income from rent actually paid by the owner), the
trust may attempt to deduct depreciation and the expenses of maintaining
and operating the residence.
The Charitable Trust.
The owner transfers assets to a purported charitable trust and claims
either that the payments to the trust are deductible or that payments made
by the trust are deductible charitable contributions. Payments are made
to charitable organizations; however, in fact, the payments are principally
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.
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. In some arrangements, more than one foreign
trust is used, with the cash flowing from one trust to another until the
cash is ultimately distributed or made available to the U.S. owner, purportedly
Legal Principles Applicable
As noted above, when trusts are used for legitimate business, family
or estate 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. When used in accordance
with the tax laws, trusts will not transform a taxpayer's personal, 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 transactions. 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,
several well-established tax principles control the proper tax treatment
of these abusive trust arrangements.
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. Sections 671 - 677. 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. Section 679.
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. Furthermore,
there would be no taxable "exchange" of property with the trust,
and the tax basis of property transferred to the trust would not be stepped-
up for depreciation purposes. See Rev. Rul. 85-13, 1985-1 C.B. 184.
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. See section 262. The courts have consistently held that non-deductible
personal expenses cannot be transformed into deductible expenses by the
use of trusts. Furthermore, the costs of creating these trusts are not
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, supposed 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. See, for example, Fausner v. Commissioner, 55 T.C. 620 (1971).
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. See,
for example, United States v. Buttorff, 761 F.2d 1056 (5th Cir. 1985);
United States v. Krall, 835 F.2d 711 (8th Cir. 1987); Zmuda and Neely.
IRS Enforcement Strategy For Abusive Trusts
The Internal Revenue Service has undertaken a nationally coordinated
enforcement initiative to address abusive trust schemes - the National
Compliance Strategy, Fiduciary and Special Projects.
As part of this strategy, the Service seeks to encourage voluntary
compliance with the tax law. Accordingly, taxpayers who have participated
in abusive trust arrangements are encouraged to file correct tax returns
for 1996, as well as amended tax returns for prior years, consistent with
the explanation of the law set forth in this notice.
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