Trusts come in many variations, rendering them often difficult for non-attorneys to follow and comprehend. Indeed, this variation can often be seen in the nomenclature used for trust arrangements, which includes terms such as grantor and non-grantor, simple and complex, revocable and irrevocable, and discretionary or non-discretionary. In many instances, trusts may also have provisions designed to protect the trust principal from third-party creditors—such as spendthrift clauses—making trusts even more difficult for a layman to understand.
Of course, the many variations of trusts also give rise to income tax reporting complexity. Although the IRS has readily recognized that there is nothing unlawful in establishing a trust, it has also actively communicated that it will police trust arrangements to ensure that trusts and trust beneficiaries are complying with the federal income tax and reporting laws. Accordingly, taxpayers establishing trusts—and particularly those where the drafter intends to charge a large fee—should have the trust agreement carefully scrutinized by a tax professional to make sure that the trust complies with these tax laws.
What is a Trust?
Trusts are nothing more than an agreement between the settlor (or grantor) and the trustee in which the settlor transfers property to the trustee to hold in trust for the benefit of the trust beneficiaries. When a trust is settled, the trustee has fiduciary obligations to the trust beneficiaries, limited only by the terms of the trust agreement and governing state law.
Generally, trusts contain provisions whereby the beneficiaries receive specified distributions from the trust. For example, a trust provision may provide that the income beneficiaries receive income for life with the corpus (or principal of the trust) going to the principal beneficiaries. Because certain items have the hallmarks of both income and return of capital, there may often be disagreements amongst the beneficiaries as to the proper treatment of those items for trust purposes and fiduciary accounting income.
IRS Notice 97-24.
As indicated supra, there is nothing prohibiting taxpayers from conducting their personal or business affairs through trust arrangements. In fact, the IRS has readily conceded that taxpayers may utilize trusts for valid purposes, such as to protect assets or more easily transfer wealth to third parties. There is nothing nefarious about creating a trust. Rather, taxpayers run afoul with the IRS when the settlor, the trust, or the trust beneficiaries fail to properly report trust activities to the IRS when they are otherwise required to do so by law.
After a proliferation of abusive trust arrangements in the 1990s, the IRS issued Notice 97-24 (the “Notice”), attempting to warn taxpayers that certain trust arrangements were unlawful—particularly those that purported to reduce or eliminate federal income taxes in a manner not permitted by federal tax law. In the Notice, the IRS cautioned taxpayers of “too good to be true” arrangements that were being offered and sold by third-party promoters. Since issuance of Notice 97-24, the IRS has successfully challenged abusive trust arrangements under a litany of different legal theories, which are discussed more fully below.
Sham Trusts Theory.
For some time, the IRS has successfully challenged certain trust arrangements as sham trusts. For example, in Linmar Property Management Trust v. Commissioner, T.C. Memo. 2008-219, the taxpayer established a trust and contributed four parcels of real estate to the trust. The taxpayer named his wife as initial trustee with his daughter as a contingent trustee. In various tax years, the trust claimed significant income distribution deductions attributable to purported trust distributions to the taxpayer’s businesses; however, the taxpayer was unable to show that such income was distributed to those entities, nor that those businesses waived their right to such distributions. In addition, checks from the taxpayer’s business were deposited in the trust’s bank accounts, which funds were then used to pay for the taxpayer’s life insurance, vacation timeshare, family members’ educations, antiques, piano, and homeowner’s insurance. The trust filed tax returns effectively zeroing out the income reported for each year through income distribution deductions. On the other hand, the taxpayer did not file individual income tax returns.
At trial, the IRS contended that the trust “should be disregarded as a separate entity for Federal tax purposes because it lack[ed] economic substance and [was] a sham.” The United States Tax Court agreed with the IRS, recognizing that:
If the creation of a trust lacks economic effect and alters no cognizable economic relationship, the Court may ignore the trust as a sham. This rule applies regardless of whether the entity has a separate existence recognized under State law and whether, in form, it is a trust, a common law business trust, or some other form of jural entity. Whether a trust lacks economic substance for tax purposes is a factual question to be decided on the basis of the facts before the Court.
Because the Tax Court found in favor of the IRS under the sham trust theory, the taxpayer was ordered to pay the IRS over $700,000 of back taxes, penalties, and interest.
Grantor Trust Rules.
The IRS has also found success in challenging abusive trust arrangements under the grantor trust rules. See I.R.C. §§ 671-679. Under these rules, if a trust is treated as a grantor trust, the grantor or deemed owner of the trust must report the trust activities on his or her individual income tax return regardless of the trust’s separate state-law existence. See I.R.C. § 671; see also Treas. Reg. § 1.671-4 (generally requiring grantor trust activities to flow through to the grantor on the grantor’s tax return). Whether a trust is a grantor or non-grantor trust is usually a complex determination based on the provisions of the Internal Revenue Code, governing regulations, and federal case law.
Respecting the Trust Arrangement.
Interestingly, the IRS often contends that the trust arrangement is a legitimate non-grantor trust and not a sham, opting instead to argue that the trust itself should be required to pay federal income tax (or alternatively, if the trust has made certain income distributions to trust beneficiaries, the trust beneficiaries).
Federal Gift/Estate Tax.
Finally, the IRS also looks at abusive trust arrangements to determine whether those arrangements have properly complied with other parts of the Internal Revenue Code, such as federal gift tax and federal estate tax provisions. For example, in many instances the transfer of assets to an irrevocable trust may result in a completed gift to the trust beneficiary, which may, in turn, result in federal gift tax or gift tax reporting requirements. See, e.g., Hess v. Comm’r, T.C. Memo. 2003-25 (recognizing federal gift taxes on the trust settlor when closely-held stock was transferred to an irrevocable trust with the settlor’s daughter as the sole beneficiary).
In more serious instances, the IRS may refer a civil case to the Department of Justice for criminal prosecution. Generally, the IRS tends to refer these types of cases where the taxpayer was aware that the trust arrangement was abusive, and the taxpayer is sophisticated (such as a medical professional or finance professional).
For example, in U.S. v. Ellefsen, 655 F.3d 769 (8th Cir. 2011), the taxpayer was an orthopedic surgeon. In 1997, the taxpayer attended a presentation that suggested that he could utilize domestic and foreign trusts to shelter assets from federal income taxes. After attending the presentation, the taxpayer requested that his long-time Certified Public Accountant (CPA) discuss the potential transactions with the promoters. The CPA spoke with the promoters and cautioned the taxpayer to avoid the transaction, urging him to seek a second opinion from an independent tax attorney (i.e., one not affiliated with the promoter). The court noted in its opinion that the taxpayer “failed to do so.” Later, the taxpayer entered into the trust arrangement.
When the CPA learned that the taxpayer was utilizing the trust arrangement, he forwarded a copy of the Notice to the taxpayer and wrote in an email to the taxpayer:
It seems to me that the promoters are relying on an elaborate chain of complex entities to conceal taxable income. They have concocted a series of transactions to cloak earned taxable income from rendering patient services in . . . Missouri into non-reported foreign source income and then arranging to lend or gift the money back to you. I am especially suspicious when I learned that they will provide you with a Visa card to access the money. They have also represented that you will have a power of attorney that will allow you to transfer funds at will. You will be earning the income by performing services and you will be enjoying the benefits of the income. Therefore, it is reasonable that the IRS could potentially look through this masquerade and say that it is taxable income to you regardless of the structure.
I am asking that you consider the worst case scenario in which the IRS takes the position that you are committing tax evasion. They have the power to assess huge penalties and interest, to prosecute you, to ruin your career, and seize property. Is the risk worth it?
Later, federal agents executed search warrants at the promoter’s offices. After the search warrant, the taxpayer was advised by a third party that she had contacted a tax attorney to discuss the trust arrangement and had been informed by the tax attorney that the arrangement was illegal. When the CPA advised the taxpayer that he could no longer prepare the tax returns without certain backup items and an opinion from a tax attorney, the taxpayer informed the CPA that he had hired another tax preparer to prepare the tax returns. Notwithstanding, the CPA continued to warn the taxpayer of the potential risks of the abusive trust arrangement even after his termination—for example, the CPA forwarded an IRS amnesty program that permitted taxpayers an option to regain compliance if they had already entered into improper offshore transactions and arrangements.
In March 2005, the CPA received a grand jury subpoena from an IRS agent for records pertaining to the taxpayer and his businesses. Thereafter, the taxpayer amended certain tax returns and remitted $534,676 to the IRS.
In April 2007, the taxpayer was indicted and pleaded not guilty to, among other tax charges, a conspiracy count alleging that from 1997 through 2003, the taxpayer conspired to divert more than $1.5 million in funds from his business for his own benefit without paying taxes on the diverted funds. After an 11-day trial, the jury found the taxpayer guilty of conspiracy to evade tax. On appeal, the taxpayer challenged the sufficiency of the evidence that he was willful. He contended that he was not a tax professional and could not have been aware of the abusive nature of the trust arrangement. The Court of Appeals concluded otherwise, noting that:
The district court . . . carefully recounted the evidence that showed . . . [the taxpayer] acted willfully. [He] used a series of domestic and offshore entities to move money from the medical practice to several bank accounts, from which [he] received the benefit of the money without paying taxes on it. [He] received multiple warnings from [his CPA] that the [trust arrangement] was illegal . . . Yet [he] did nothing until after files were subpoenaed from [the CPA]. The record is replete with evidence to support the jury’s finding that [the taxpayer] acted willfully.
As discussed supra, the stakes can often be high when a taxpayer elects to establish a trust, particularly if the taxpayer does not necessarily understand the tax ramifications of executing the operative trust agreement. At a minimum, taxpayers should consult with tax professionals to determine whether the trust arrangement will work as advertised by a third-party drafter. An oft-quoted saying goes that an ounce of prevention is worth a pound of cure. That saying certainly applies here where the taxpayer risks significant legal fees, back taxes, penalties, interest, and potential criminal prosecution for failure to properly vet a trust prior to execution.