When will a court disregard a trust for federal tax purposes? The Tax Court’s recent opinion in Wegbreit v. Commissioner demonstrates the pitfalls when a court finds that a trust should be disregarded for tax purposes.
But first of all: What is a trust? A trust is an entity or relationship created and governed under state (or other) law. A trust involves the creation of a fiduciary relationship between a grantor, a trustee, and a beneficiary for a stated purpose. Trusts can be classified as inter vivos, testamentary, revocable, irrevocable, simple, complex, grantor—among other potential characterizations. A trust is generally required to file a Form 1041 to compute and report its income; however, a trust that is classified as a grantor trust may not be required to file a Form 1041—instead, its activities are reported on the grantor’s Form 1040.
Courts, however, have the ability to disregard a trust on economic substance grounds under what is generally known as the “sham trust” doctrine. If a trust lacks economic substance apart from tax considerations, a court will treat the trust as a “sham” and disregard it for Federal tax purposes. In such cases, the trust may then be treated as a mere alter ego of the taxpayer—and its income and activities will be attributed to the taxpayer for Federal tax purposes.
Generally speaking, courts have held that “a transaction will be characterized as a sham if ‘it is not motivated by any economic purpose outside of tax considerations’ (the business purpose test), and if it ‘is without economic substance because no real potential for profit exists’ (the economic substance test).” The Tax Code, in other words, elevates substance over form, asking not what the surface of a transaction suggests but what the economic realities of the transaction show. See Comm’r v. Court Holding Co., 324 U.S. 331, 334 (1945).
Because even the most “patriotic” citizens do not have a “duty to increase [their] taxes,” Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934), it “is entirely legal and legitimate” to minimize taxes through permissible means, Estate of Kluener v. Comm’r, 154 F.3d 630, 634 (6th Cir. 1998). But if a transaction or entity has no “valid, non-tax business purpose,” id., nominally uses another person or entity “as a conduit through which to pass title,” Court Holding Co., 324 U.S. at 334, or “br[ings] about no real change in the economic relation of the [taxpayers] to the income in question,” Comm’r v. Tower, 327 U.S. 280, 291 (1946), the IRS may find that the transaction or entity lacks economic substance and disregard it for tax purposes, see Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1354 (Fed. Cir. 2006) (characterizing the economic-substance doctrine as “a judicial tool for effectuating the underlying Congressional purpose that, despite literal compliance with the statute, tax benefits not be afforded based on transactions lacking in economic substance”).
In deciding whether to disregard a trust for Federal tax purposes, the Tax Court considers four factors to determine whether the trust lacks economic substance: (1) whether the taxpayer’s relationship to the property transferred to the trust materially changed after the trust’s creation; (2) whether the trust has an independent trustee; (3) whether an economic interest passed to other trust beneficiaries; and (4) whether the taxpayer feels bound by the restrictions imposed by the trust agreement or the law of trusts. Whether a trust lacks economic substance is ultimately a question of fact.
In analyzing these factors, courts have found it significant that the taxpayer/grantor maintained exclusive control over the trusts’ assets; was the trusts’ sole beneficiary; and that a trust lacked independent trustees. Courts have also found it significant where the taxpayer’s use of the trust’s assets was not more constrained after the creation of the trusts than it was before the formation of the trust.
Courts have also found that there was no “valid, non-tax business purpose” for a trust where “all that changed after the formation of the trust was the [taxpayer’s] tax obligation.” If the court finds that the taxpayer used the trust as nothing more than a “conduit through which to pass title,” Court Holding Co., 324 U.S. at 334, and experienced “no real change in the[ir] economic relation . . . to the income in question,” Tower, 327 U.S. at 291, it may invoke the sham trust doctrine.
Moreover, courts have held that the fact that a trust is valid under state law does not, alone, make the trust legitimate for federal income tax purposes, finding that by adhering to state law in forming a trust, an individual does not necessarily give it economic substance as a matter of federal law. As courts have held:
Just as the world can see through a Potemkin village, so the Tax Code sees through sham entities in assessing taxes, even though the trusts are otherwise “valid under state laws.” Tower, 327 U.S. at 291; see also Zmuda v. Comm’r, 79 T.C. 714, 720 (1980) (“[W]e will look through that form . . . regardless of whether the entity has a separate existence recognized under State law. . . .”).
Richardson v. CIR, 509 F.3d 736 (6th Cir. 2007).
In 1997, the IRS issued Notice 97-24, which gave a detailed account of “abusive trusts.” See1997-16 I.R.B. at 6-7 (describing abusive trusts as those that create “deductions for personal expenses paid by the trust,” “reduce[] or eliminate[] the owner’s self-employment taxes” and create deductions for trusts with “purported” charitable purposes that are in reality “principally for the [benefit] of the owner”). That notice gave the following warning:
This notice is intended to alert taxpayers about certain trust arrangements that purport to reduce or eliminate federal taxes in ways that are not permitted by federal tax law. (The notice refers to such arrangements as ‘‘abusive trust arrangements.’’ See Section I. ABUSIVE TRUST ARRANGEMENTS—IN GENERAL, below.) The notice describes some typical abusive trust arrangements, as well as the tax benefits promised by promoters, and then explains the correct tax principles that apply to these trust arrangements. Taxpayers should be aware that abusive trust arrangements will not produce the tax benefits advertised by their promoters and that the Internal Revenue Service is actively examining these types of trust arrangements as part of the National Compliance Strategy, Fiduciary and Special Projects. Furthermore, in appropriate circumstances, taxpayers and/or the promoters of these trust arrangements may be subject to civil and/or criminal penalties.
The IRS has also warned taxpayers about what it believes are abusive trust tax evasion schemes.
Taxpayers should be careful to observe the necessary requirements of a trust arrangement in order to ensure that the structure and any tax benefits are recognized for federal tax purposes. As has often been repeated, even the most “patriotic” citizens do not have a “duty to increase [their] taxes,” Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934), and it “is entirely legal and legitimate” to minimize taxes through permissible means. Trusts are often touted as a means to reduce taxes. The use of trusts may, indeed, present tax-planning opportunities—but taxpayers must always be careful not to run afoul of the “sham trust” doctrine.
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