Volume VI, Number 2 – April 1997
© Donlevy-Rosen & Rosen, P.A.
IRS INVESTIGATES ABUSIVE TRUSTS:
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.