Taxpayers have long utilized trust arrangements for the transfer of wealth to beneficiaries or for the protection of assets from creditors. Generally, there is nothing nefarious about these types of arrangements. Rather, the Internal Revenue Code of 1986, as amended (the “Code”) simply provides special rules for the taxation of trusts and/or beneficiaries in addition to certain reporting requirements—particularly if the trust is foreign.
Recently, the IRS cautioned taxpayers that it has become aware of taxpayers who are using trusts in a manner that crosses the bounds into illegality. Given these warnings, taxpayers who have entered into trust arrangements should be diligent in ensuring that their arrangements comply with federal income tax laws. This article discusses general tax concepts applicable to trusts and also discusses the IRS’s renewed push to focus on abusive trust arrangements. It concludes with potential options taxpayers may have to eliminate or mitigate civil penalties and criminal exposure.
The Taxation of Trusts – Subchapter J.
Under federal tax law, trusts are generally treated as separate entities. Accordingly, the fiduciary (i.e., the trustee) must file an IRS Form 1041, U.S. Income Tax Return for Estates and Trusts, with the IRS if, among other things, the trust has any taxable income for the tax year or gross income of $600 or more (regardless of its taxable income). See I.R.C. § 6012(a)(4), (a)(5); see also Treas. Reg. § 1.641(b)-2(a) (“The fiduciary is required to make and file the return and pay the tax on the taxable income of . . . a trust.”).
Because trusts are separate entities, they are generally subject to income tax. Specifically, the Code imposes an income tax on the “taxable income” of property held in trust. I.R.C. § 641(b). For these purposes, the taxable income of the trust is computed in a manner similar to that of individuals, with certain modifications. See I.R.C. § 641(b); see also Treas. Reg. § 1.641(b)-1. Modifications include: (1) no standard deduction; (2) a small personal exemption; (3) an unlimited charitable contribution deduction, if certain requirements are met; and (4) a deduction for trust administration costs. See I.R.C. §§ 63(c)(6)(D); 642(b), (c); 67(e).
In certain instances, the trust may also be permitted a deduction for distributions made to beneficiaries. In these cases, the beneficiaries pay federal income tax on the income of the trust that is distributed to them.
The Deduction for Distributable Net Income (DNI).
For federal income tax purposes, a trust may be either characterized as “simple” or “complex.” See Treas. Reg. § 1.651(a)-1. Simple trusts are trusts that meet all three of the following requirements in a tax year: (1) the trust agreement requires that all fiduciary accounting income (“FAI”) be distributed currently; (2) the terms of the trust do not provide for any amounts to be paid, permanently set aside, or used for the tax year for a charitable purpose as set forth in section 642(c) of the Code; and (3) the trust does not actually distribute any amounts during the year other than its FAI required to be distributed currently. I.R.C. § 651(a). If a trust fails any one of these requirements, it is considered a complex trust for federal income tax purposes. The characterization of a trust as either simple or complex is made on a year-by-year basis.
Trusts that are simple trusts are governed by section 651 and section 652 of the Code. Section 651(a) permits the trust to claim a deduction for income “required to be distributed currently.” And section 652(a) subjects the beneficiary to taxation on amounts “required to be distributed, whether distributed or not.”
Conversely, trusts that are complex trusts are governed by section 661 and section 662 of the Code. Under those provisions, only the part of the trust income which is paid or credited to the beneficiary during the year may be deducted by the trust and taxed to the beneficiary. “Taxable income” that stays within the trust and that is not distributed to the beneficiaries is taxable to the trust itself. I.R.C. § 641.
In all cases, the amount of the trust deduction is limited to DNI, which is a rough measure of the income not previously taxed by the trust. See I.R.C. § 643(a).
Trust Reporting Obligations.
Aside from income tax payment and filing obligations, trusts can also give rise to other tax and reporting obligations. For example, transfers to a trust for the benefit of a third-party beneficiary may subject the transferor to gift tax and/or a gift tax return reporting obligation. In addition, transfers to foreign trusts may give rise to certain information reporting obligations, including Forms 3520 and/or 3520-A.
Gift Tax and Gift Tax Reporting.
The Code imposes a gift tax on certain transfers of property (directly or indirectly) to third parties. I.R.C. § 2501. In addition, the Code imposes certain reporting requirements associated with certain transfers by gift. Accordingly, a transferor’s transfer of property to a trust for the benefit of beneficiaries can give rise to both gift tax and gift tax reporting obligations.
However, there are exceptions to these gift tax and gift tax reporting obligations. First, donors of certain lifetime gifts are provided an annual exclusion of $15,000 per donee in 2021 ($16,000 in 2022) that does not count towards the unified credit. I.R.C. § 2503(b). Second, the unified credit effectively exempts a total of $11.7 million (for 2021) in cumulative taxable transfers from the gift tax. Rev. Proc. 2020-45, I.R.B. 2020-46.
If the gift exceeds the applicable annual exclusion threshold, taxpayers are required to file IRS Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, to report the gift.
Foreign Trust Reporting.
The establishment of a foreign trust can create a multitude of IRS reporting obligations: to the foreign trust, to certain transferors, and even to the beneficiaries. To determine whether a trust is domestic or foreign—i.e., whether there is a reporting obligation—the Code sets forth a “court test” and a “control test.” I.R.C. § 7701(a)(30); Treas. Reg. § 301.7701-7(a)(1). If either test is not met, the trust is deemed a foreign trust.
The court test is satisfied if a court within the United States is able to exercise primary supervision over the administration of the trust. Treas. Reg. § 301.7701-7(a)(1)(i). The control test is satisfied if one or more United States persons have the authority to control all substantial decisions of the trust. Treas. Reg. § 301.7701-7(a)(1)(ii). For these purposes, substantial decisions include: (1) whether and when to distribute income and corpus; (2) the amount of any distributions; (3) the selection of a beneficiary; (4) whether a receipt is allocable to income or principal; (5) whether to terminate the trust; (6) whether to compromise, arbitrate, or abandon claims of the trust; (7) whether to remove, add, or replace a trustee; (8) in certain instances, whether to appoint a successor trustee; and (9) in general, investment decisions. Treas. Reg. § 301.7701-7(d)(1)(ii).
If a trust is determined to be a foreign trust, section 6048 of the Code governs. Under that provision, a “responsible party” must file an IRS Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts, if a “reportable event” occurs during the tax year. For these purposes, a “reportable event” means: (1) the creation of a foreign trust by a United States person; (2) the transfer of money or property to a foreign trust by a United States person (including through a written will); and (3) the death of the United States resident or citizen, if the decedent was either treated as the owner of any portion of the foreign trust under the grantor trust rules or any portion of the foreign trust was included in the gross estate of the decedent. See I.R.C. § 6048(a)(3). A “responsible party” means either: (1) the grantor if the reportable event relates to the creation of the foreign trust; (2) the transferor in the case of a transfer of money or property to the trust (unless accomplished solely by death); or (3) the executor in all other cases. See I.R.C. § 6048(a)(4).
United States beneficiaries who receive distributions from foreign trusts as well as United States persons who are treated as grantors of foreign trusts also have reporting obligations. Specifically, a United States beneficiary who receives a distribution from a foreign trust must file Form 3520 whereas a United States person who is treated as the owner of any portion of a foreign trust under the grantor trust rules must file IRS Form 3520-A, Annual Information Return of Foreign with a U.S. Owner, if the foreign trust does not file the form with the IRS. I.R.C. § 6048(b), (c).
Failure to file a Form 3520 and/or Form 3520-A can result in significant penalties. For example, if a United States person establishes a trust and transfers property to the foreign trust but fails to file Form 3520, the IRS may impose a 35% penalty on the fair market value of the property transferred to the foreign trust.
Abusive Trust Arrangements.
The IRS continues to caution taxpayers that it is aware of “Abusive Trust Tax Evasion Schemes.” Specifically, the IRS has communicated to taxpayers that “[i]n the last few years, the Internal Revenue Service has detected a proliferation of abusive trust tax evasion schemes . . . [which] are targeted towards wealthy individuals, small business owners, and professionals such as doctors and lawyers.” And that:
Taxpayers should be aware that abusive trust arrangements will not produce the tax benefits advertised by their promoters and that the IRS is actively examining these types of trust arrangements. Furthermore, in appropriate circumstances, taxpayers and/or the promoters of these trust arrangements may be subject to civil and/or criminal penalties.
Generally, in these promoter-type trust cases, a promoter charges the taxpayer—from $5,000 to $75,000—for the use of trust documents and other resources. In exchange for the service fee, the promoter generally assures the taxpayer that entering into the trust arrangement will significantly reduce or eliminate federal income taxes. And the promoter may use either a “domestic package” or a “foreign package”—i.e., a purely domestic or purely foreign trust.
Because the IRS has indicated that it is aware of promoters selling abusive trust schemes, taxpayers who have utilized promoter services should tread carefully. Generally, after the IRS identifies a promoter, it will request a list of the promoter’s clients through either an administrative summons or a judicial subpoena. Armed with this information, the IRS can begin civil and criminal examinations of each promoter’s clients’ tax returns. And the IRS has a litany of defenses it can use to defeat abusive trust arrangements, such as the sham trust doctrine.
What Should Taxpayers with Questionable Trust Arrangements Do?
Taxpayers who have entered into questionable trust arrangements have many options. First, the taxpayer should hire a tax professional to review the trust agreement to determine whether it complies with federal income tax laws. Second, if the trust agreement does not, the taxpayer should explore whether the taxpayer meets certain eligibility requirements for IRS amnesty programs that are offered, such as the IRS Voluntary Disclosure Program or the IRS Streamlined Filing Compliance Procedures. Depending on the taxpayer’s facts and circumstances, other options may be available as well. However, taxpayers should be cognizant that many of the IRS’s amnesty programs are not available after the IRS discovers the non-compliance.
Trusts can be wonderful tools if used properly. However, abusive trust arrangements will continue to be a top priority to the IRS for the foreseeable future. Given this renewed scrutiny, taxpayers who have entered into trust agreements should consult with a tax professional to determine whether there are any risks of civil penalties and/or criminal exposure. If the trust arrangement is considered abusive, taxpayers should act quickly to try to remedy the non-compliance through an IRS amnesty program, if that option is available.