Any opinions, findings, conclusions or recommendations expressed in this material are those of the authors and do not necessarily reflect the views of Parallelewelten.
Interpretation of trusts has been a highly discussed topic for many years. Numerous court cases have focused on deciding whether an established trust is legitimate for taxing purposes or a sham. Certain characteristics will distinguish the true trusts from the abusive ones. Once a set of requirements is met, the Internal Revenue Service (IRS) will recognize the trust as a taxable entity and tax the income to the trust, not a taxpayer. Trusts can be considered shams from the beginning or develop into such over a period of time. Advertisers of abusive trusts can be very persuasive. They will promote benefits such as keeping control of assets in a trust, while not having to pay taxes on the assets. The IRS hopes that taxpayers will be skeptical of these abusive trust arrangements and realize that these benefits are not realistic. Participating in abusive trusts will subject the taxpayer and the seller of such trusts to civil and even criminal repercussions (IRS 1997).
Sham trusts have been presented in an array of methodologies over the years. With many warning signs and characteristics of sham trusts available in existing literature, taxpayers can hopefully segregate a legitimate taxable trust from a sham. If taxpayers fail to properly analyze the characteristics of a trust, numerous court cases throughout the years have demonstrated that the courts have no problem drawing a conclusion for them. After examining qualities and types of lawful trusts, the traits and forms of sham trusts will be discussed. This discussion will be followed with ways to avoid shams, suggestions on how to analyze a trust, and further cases and recent news surrounding trusts. Attached at the end will be a flowchart to assist taxpayers in deciphering a sham from a legitimate taxable trust.
Legal Trust Qualities
A trust is formed when a grantor transfers assets to a trustee to preserve for the care of a beneficiary. Trusts can be formed during the grantor’s life, inter vivos, or by a decedent’s will, testamentary. Based on certain requirements, trusts are considered either simple or complex. Trusts are often created to manage assets for young children, incompetent individuals, or taxpayers not interested in handling the assets. For a trust to be considered legal for tax purposes, it must consist of “a manifestation of intention of the settler to create a trust, a lawful trust purpose, trust property, and at least one identifiable beneficiary” (Sommers 2000). Failure to meet all four of these requirements dismisses a trust as a legal taxable entity. Taxpayers with a legal trust must file a trust federal income tax return, Form 1041. Lawful reasons for creating a trust include facilitating estate planning, transferring charitable property, and holding assets for other taxpayers (IRS 1997).
Trusts are usually formed to hold income-generating property. The principal amount remains in the trust, while the produced income is paid out to a beneficiary. Valid trusts are allowed a deduction from taxable income for the amount of distributions paid to the beneficiaries. To be considered a taxable trust under trust law, a trust must have a legitimate business purpose and contain economic substance. Taxpayers should be constructing trusts with a sensible possibility of making a profit. The intentions of the taxpayers creating trusts are crucial. The lone objective of the trust cannot be tax avoidance or else the IRS will ignore the trust and enforce the tax liability on the grantor or beneficiary (Martindale 2010). For example, grantors may try to create multiple trusts to distribute income to more than one trust and in return get multiple exemptions. If the trusts are created by essentially the same grantor for the same beneficiaries, the multiple trusts will be deemed a single trust and taxed accordingly.
After considering the true purpose of the trust, another important issue to evaluate is the role of the trustee. The trustee is granted an array of decision making abilities when managing trust assets. Coinciding with the trust agreement, trustees must perform actions such as operating the trust to solely benefit the beneficiary, keeping up with trust assets, and filing appropriate tax returns for the trust. The trustee should be aware of and accordingly follow the reason for the creations of a trust. Even though the trustee has been assigned the care of the trust assets, trustees should not be hesitant to seek outside assistance when needed. Discussing and documenting decisions made by the trustee is always a good idea so everyone is informed of how the assets are being handled. Because of the responsibilities involved, a trustee is often allowed realistic compensation (Sommers 2000).
Since the trustee is accountable for overseeing the assets of a trust, the beneficiary has an inactive role. The lone responsibility of the beneficiary is to accept the benefits provided by the trustee’s handling of the trust assets. Beneficiaries are classified as either income beneficiaries or remainder beneficiaries. Examples of agreements generally lacking the special relationship include trusts formed to hold real estate property, custodial arrangements, and agencies. The only circumstance where a real estate trust will be treated as a trust for income tax purposes is if the trust is passively undertaking real estate actions. The agency and custodial arrangements are not considered trusts for similar reasons. Even though the agent is acting for the principal in an agency agreement, the principal still maintains extensive control over the agent’s actions. Likewise in a custodial arrangement, the custodian has minuscule responsibilities in overseeing the property (Wolters 2011).
Trusts can be formed to benefit many different individuals such as an alimony trust. One category of trusts that is focused more on the intention of the trust than the beneficiaries is the purpose trust. This type of trust is formed for a particular motive rather than to benefit beneficiaries. Purpose trusts can be constructed for charitable or non-charitable reasons. Examples of purpose trusts include funeral trusts and cemetery trusts. A funeral trust consists of an arrangement initiated by the grantor to prepay for funeral expenses prior to death. Cemetery trusts are further broken down into two types, including the endowment care cemetery trust and the service and merchandise trust. The endowment care cemetery trust is established to use the earnings, not the trust principal, to pay for the maintenance and upkeep of the gravesite. Similar to the funeral trust, the service and merchandise trust is created to compensate for merchandise such as a tombstone (Goffe 2010).
Another kind of trust is the blind trust, which is often utilized by public officials and business executives to diminish concerns surrounding conflict of interests and other regulations. These individuals normally want to hold a particular type of investment but desire to restrict their knowledge of how the investment is managed. Blind trusts can be considered either a qualified blind trust or a qualified diversified trust. A further example is the Coogan trust, a unique type of trust created specifically for child actors and actresses. As to no surprise, the Coogan trust originated in Hollywood, named after child actor Jackie Coogan. This trust is basically a blocked trust account that is enacted to prevent the parents of a child performer from wasting all of the child’s earnings. The Coogan trust is required in Louisiana, along with New York, California, and New Mexico (Goffe 2010).
Additional examples of eligible trusts for income tax purposes are liquidating trusts, mortgage pools, and investment trusts. A liquidating trust, consisting of an agreement to liquidate and allocate assets, is taxed like a trust when the actions follow liquidation. If the investments of mortgage pools and investment trusts are set and not allowed to be altered by the trustee, they are levied taxes like a trust (Wolters 2011). A further illustration of a valid trust is the life insurance trust. The beneficial idea behind this trust is a taxpayer releases asset ownership to enhance the amount of assets excluded from the taxable estate. This type of trust is beneficial because of its ability to turn small transfers of money into hefty tax-free sums. After the trust pays the insurance premiums, the insurance proceeds ultimately will transfer to the beneficiaries free of estate taxes. To avoid having assets brought back into the estate because of excessive control, life insurance trusts should have restrictions such as the right to alter beneficiaries (Burg 1999).
Characteristics of a Sham
Trusts that are established with no true purpose and are absent of substance are considered shams. Because the IRS does not recognize sham trusts for income tax purposes, the income and expenses are instead usually assigned either to the grantor or beneficiary. Abusive trusts are notorious for promising tax benefits. Several sham trusts attempt to take advantage of the deduction allowed to a trust for the distributions to beneficiaries by designating other trusts as beneficiaries. After making distributions from trust to trust and taking the subsequent deduction, the end result is minimal taxable income. As the IRS persistently investigates sham trust allegations, common benefits offered consist of lowering or removing taxable income, allowing deductions for personal expenses paid by the trust, lessening or abolishing self-employment taxes, and reducing or eliminating gift and estate taxes (Martindale 2010).
Certain signs can indicate a shady trust promoter or even an outright sham trust. Creating numerous layers of trusts for no apparent reason other than to puzzle the IRS can be indicative of a sham. An additional selling point trust advocates may try to insist on performing is placing a business in a trust. Even though doing so is not illegal, generally there is not a lawful reason to perform such an action. Also, suggesting that the taxpayer’s adviser is not aware of a particular type of trust arrangement because of the complexity is not a positive sign. Another warning sign is when an advertiser states that a taxpayer can control assets while not actually owning them. In an effort to reduce taxable estate, such a statement would sound extremely appealing to a taxpayer. However, a claim of this sort is normally not true since the controller of the assets is the one who usually will pay the taxes (Novack 2000).
Sandvall v. Commissioner [90-1 USTC (1990)] demonstrates a situation where the taxpayers did not relinquish control of the assets placed in a trust. A chiropractor and his wife tried to evade taxes by establishing a foreign trust, while using the assets for personal benefit. The foreign trust was designed to allow the husband’s income from his business to flow through it before being paid back to the couple. Because the trust was determined to be a sham, the couple was responsible for paying taxes on the gross income of the trust. The court ruled that the taxpayers “did not relinquish ownership and control of their earnings, they merely created a fictitious paper trail by which they hoped to disguise or hide their taxable income” (Sommers 2000).
Additional Warning Signs
A further area of concern is when a taxpayer is told income can be assigned to a trust and not be taxed to the taxpayer who actually earned the income. This statement is proved to be untrue in such cases as U.S. v. Buttorff [761 F2d 1056 (1985)], where the court determined that the “Constitutional Pure Equity Trusts” were shams. The seller of the trusts alleged that individuals could assign future earned income to the trust. The Fifth Circuit Court of Appeals drew support for their decision from the IRS tax code that “income is taxed to the person who earns it” (Sommers 2000). The Keefover v. Commissioner [65 TCM 2999 (1993)] case further supports this tax principle. The court informed the individuals that a taxpayer cannot escape paying taxes by shifting income to another entity. A taxpayer is not allowed to transfer tax obligations to a trust if the taxpayer is in complete control of earning the income (Sommers 2000).
Sham trusts can be titled an array of names such as pure trusts, freedom trusts, contract trusts, or common law trust organizations. As illustrated above often times sham trusts will include descriptions surrounding subjects like religion, patriotism, or constitutional rights (Goffe 2010). When analyzing the issue of potential sham trusts, the following are further characteristics that could lead to a sham trust:
No paper trail exists, which suggests the trust has not been correctly managed.
The grantor or trustee is also a beneficiary.
The trust designer does not fully comprehend the nature of the trust.
The trustee, without asking questions, complies with any instruction given by the grantor.
Using a “letter of wishes” to take precedence over the trust instrument, which shows the granter is still in control of the assets.
The decisions are made “unilaterally without a majority decision” or without following the established guidelines.
A trust has greater potential of being ruled a sham when any of the preceding elements exist (Jooste 2005). However, a trust possessing negative connotations does not automatically qualify that trust as a sham. Certain traits that are not exclusively indicative of a sham trust are careless execution of the trust, disapproval of the courts, and ulterior purposes (Kessler 1999).
Types of Sham Trusts
The IRS believes sham trusts can be categorized into two general categories – foreign trusts and domestic trusts – with various forms of shams existing under each heading. The foreign trust is developed outside of the United States, frequently located in countries with minimal income tax on trusts. New York attorney Gideon Rothschild states, “There are special rules for foreign trusts, and they can be very restrictive” (Burg 1999). Foreign trusts, also referred to as final trusts, involve income flowing through an assortment of trusts, offshore bank accounts, and other foreign entities before ultimately being paid to the grantor. Resources flow from one trust to the next through methods such as “management agreements, rental agreements, fees for services, purchase and sale agreements, and distributions” (Goffe 2010).
The theory behind foreign trusts is income will maneuver through enough foreign accounts that the IRS will lose sight of who is actually in control of the assets in the trust. The promoters of this type of sham insist that the final distribution made to the grantor will not be taxed; however, the supporters are often proven wrong. The IRS is frequently able to show that the grantor is still in control of the trusts and will tax the income to that person. A good rule of thumb to remember is a legal taxable trust will not attempt to escape taxation by hiding assets or offering a tax deduction for “personal, living, or educational expenses” (Martindale 2010).
A common domestic trust is the business trust or unincorporated business trust. This type of sham trust involves a grantor fictitiously handing over the operation of a business to a trust, when in reality the grantor is still controlling the daily business operations through the trustee. The taxpayer receives units of beneficial interest in return for transferring the business. Then, the trust makes disbursements to the unit holders mimicking a deductible distribution. Not only is the taxpayer claiming to reduce taxable income but also the self-employment taxes. Another abusive trust example is the equipment trust. This sham trust is designed to hold equipment that is leased, frequently at an inflated rate, to the business trust. The agreement is set up to allow the business trust the ability to make deductible payments to the equipment trust, essentially reducing taxable income (IRS 1997).
The family residence trust is an additional variation of sham trusts in which a couple places their house in a trust. The trust pretends to rent the home back to the couple, while the taxpayers claim to live in the home to benefit the trust. To reduce taxable income, the trust takes deductions for depreciation and expenses related to the maintenance of the home. Once this form of a sham trust is discovered by the IRS, the couple is taxed on the income and prohibited from taking the expense deductions. A final domestic sham trust example is the charitable trust, where the taxpayer shifts assets into what is claimed to be a charitable organization. Then, the trust pays the taxpayer’s personal expenses and claims deductions for the expense payments. Since the so-called charitable organizations are not qualified as true charitable organizations, the contributions made are not deductible and are included in the taxpayer’s taxable income (Martindale 2010).
Sham Trust Avoidance
Taxpayers should take every precaution to prevent falling into a sham trust trap. Avoiding sham trusts begins in the early stages during drafting. The possibility of drafting oneself into a sham trust is much greater than the unlikelihood of drafting oneself out of such. A trust can become a sham during drafting by generating false documentation for the trust or failing to accurately portray the true intention of the grantor. The possibility of a trust being ruled a sham increases as the difference between the trust documentation and the reality of the trust expands. In order to avoid a sham, another aspect to scrutinize is the administration of a trust. The grantor needs to fully understand and intend to create a trust, along with possessing the willingness to no longer own the assets. Also, the grantor should transfer all managing powers of the trust assets to the trustee. A trustee should not allow a grantor to feel as if the grantor has all the power and the trustee will do as told. A wise decision for trustees is to maintain a paper record of their decision making process (Kessler 1999). Pristine record keeping by the trustee will make claims of sham trusts more difficult to prove.
In an effort to avoid shams, taxpayers are turning more often to independent trustees to be protectors of trust assets. An independent trustee has the power to remove the current trustee and name another one. The increased need for trust overseers creates an opportunity for the accounting profession and Certified Public Accountants (CPA). Because of the perceived independence and quality professional judgment, a CPA is thought to be one of the best choices as a protector of a trust. This new demand for a CPA’s ability fuels the growth of the assurance sector in the accounting profession. Accompanying the already established tax and audit divisions, assurance services are widely needed and continue to grow. One area where CPAs can utilize their tax expertise is when offering tax structure assurance. In this sense, a CPA guarantees the grantor that correct tax planning strategies have been implemented. Also, a CPA can offer assurance as an enforcer in partner and contract compliance situations when dealing with purpose trusts. Because purpose trusts do not have beneficiaries, these trusts need to fill the enforcer role. “Users turn to CPAs for assurance services because of their reputation for integrity, objectivity and due professional care” (Vernazza 2000).
As taxpayers try to evade sham trusts, a recent area of concern is the blind discretionary trust. This style of trust is an irrevocable discretionary trust that initially has charitable organizations as the beneficiaries but maintains the authority to replace beneficiaries when deemed necessary. Blind discretionary trusts have raised apprehension surrounding offshore trusts. Trust regulators hope the use of this type of trust will decline, but some experts believe the use of blind discretionary trusts might actually increase as the push for accounting transparency intensifies (Lambert 2000). Regardless of which side of the argument is correct, the use of blind discretionary trusts is an issue officials should watch closely.
Substance versus Form
A number of reputable tax principles direct the accurate taxing of sham trust situations. Sham trusts present a classic example of substance over form. When evaluating the legitimacy of a trust, the IRS and the courts system will consider the economic substance of the transaction and not just the form. Even though a taxpayer has a right to minimize tax liability, transferring assets to a trust lacking a business purpose does not constitute a viable tax avoidance method. The trust must be established for other reasons than just trying to avoid taxes (IRS 1997). For example, the Brittain v. Commissioner [63 TCM 3004 (1992)] case involved an irrevocable trust that was deemed unrecognizable by the court based on the nonexistence of economic substance. The court said that the individual did not successfully show “that property was held in a trust for the benefit of others. Further, the petitioner’s relationship to the trust’s property did not differ in any material aspect before and after the creation of the trust” (Sommers 2000).
In Markosian v. Commissioner [73 T.C. 1235 (1980)], the trust was ruled a sham because the participants involved failed to follow the conditions of the trust. Furthermore, the relationship between the grantors and the trust property did not change once the assets were transferred. The Zmuda v. Commissioner [731 F.2d 1417 (9th Cir. 1984)] case involved a variety of trusts. Because the taxpayer maintained total control over the trust property, the foreign business trusts were ruled shams. After considering substance over form, the court ruled that the assets of the business trust and foreign trust, the home in the family residence trust, and the equipment in the equipment trust would revert back to the grantor for taxation. Two other applicable cases are Gregory v. Helvering (293 U.S. 465 (1935), XIV-1 C.B. 193) and Helvering v. Clifford (309 U.S. 331 (1940), 1940-1 C.B. 105). Based on the substance over form standard, the trusts in both cases were ruled to be shams and discarded by the IRS for income tax purposes (IRS 1997).
Four Factor Test
When trusts are created under the tax laws, the grantor, the beneficiary, or the trust will be taxed on the income derived from the trust property. Valid trusts will not attempt to take frivolous deductions or avoid taxes (IRS 1997). In determining whether or not a trust will be considered a sham for income tax purposes, a four factor test can be used to test economic substance. This test was presented in the case of F.L. Buckmaster v. Commissioner (TC Memo 1997-236), where the taxpayer established a trust to collect his compensation. The taxpayer was denied the ability to shift the taxation on his earnings to the trust because he controlled the earnings and the trust bank account. The four questions to be answered are as follows:
Does the grantor’s relationship to the property before the trust was created vary significantly compared to the relationship after the creation of the trust?
Did the trust establish an independent trustee and restrict the grantor’s use of trust property?
Did an economic interest transfer to other trust beneficiaries?
Was the grantor restricted by the trust agreement or laws of trusts?
After determining a legal trust exists, answering these four questions will help guide a court when analyzing a trust as either a sham or a properly developed entity (Sommers 2000).
Other Guiding Principles
Another guideline for taxing sham trusts states that grantors are able to be taxed as holders of the trust. In accordance with IRS Code Sections 671 and 677, if the grantor maintains control over the trust, the grantor is considered owner of the assets transferred to the trust. IRS Code Section 679 furthers states that a United States citizen transferring assets to a trust overseas is still the owner of the assets if the beneficiary is a United States citizen. The results would involve the owner reporting all income and expenses of the trust, while disregarding any tax deductions from losses among the owner and trust. A further principle deals with the taxation of a non-grantor trust. A valid trust not considered a grantor trust is taxed on the amount of income minus beneficiary distributions. In order to exist, the trust has to acquire a taxpayer identification number, file the required tax returns, and detail the beneficiary deductions on the K-1 form (IRS 1997).
An additional taxing principle points out that trust transfers could be considered gifts for gift tax purpose, thus being liable for estate and gift taxes under IRS Code Section 2036(a). The federal estate tax would come in to play if the grantor held the control of the property placed in the trust until death. Upon the grantor’s death, the property would then be levied a federal estate tax. A further point to remember for abusive trust tax guidance is personal expenses are normally non-deductible. Contrary to what many sham trust promoters will say, IRS Code Section 262 reminds taxpayers that personal expenses such as travel and education are not allowed as deductions from taxable income. Examples of cases that upheld this law are Schulz v. Commissioner [686 F.2d 490 (7th Cir. 1982)] and the Neely v. United States, [775 F.2d 1092 (9th Cir. 1985)] case (IRS 1997).
Another standard is a valid charity must benefit in some manner in order for a legal charitable deduction to be made. Tax-exempt charitable trusts are well defined in the tax code. As demonstrated in Fausner v. Commissioner [55 T.C. 620 (1971)], to gain exemption status charitable trusts must be established exclusively to benefit a charity. Moreover, trust payments to charities are not deductible if the payments are made to benefit the owner of the trust. Taxpayers must be cautious when handling foreign trusts, as special rules usually apply. Special rules for foreign trusts are applicable in situations such as levying United States withholding taxes to foreign trust payments and applying excise taxes to property being transferred to a foreign trust. Rules surrounding these situations can be found in IRS Code Sections 1441, 1491, 6048, and 6677 (IRS 1997).
Additional Judicial Decisions
Federal Trade Commission v. Affordable Media, LLC [179 F.2d 1228 (CA-9, 1999)] involved a couple, Mr. and Mrs. Anderson, who were co-trustees of a trust in the Cook Islands. After being instructed by a district court to remove assets from their trust, the Andersons claimed that they could not follow the orders because of duress. The couple was sentenced to six months of jail time for contempt of court. The Ninth Circuit upheld the lower court decision. “The Andersons were protectors of the trust, and thus had the power to themselves determine whether an event would be treated as an event of duress or not. The finding itself implies that the trust was a sham” (Vernazza 2000). In the H. Paster (20 TCM 1239, TC Memo 1961-240) case, a business trust organization was deemed null and void for federal income tax purposes. The taxpayer formed the sham trust to transfer the assets and income from his dental practice. The sham lacked economic reality based on the fact that the taxpayer’s relationship to the trust property stayed the same both before and after the transfer.
G.E. Tatum (59 TCM 52, TC Memo 1990-119) demonstrates the attempted use of a trust to avoid self-employment taxes. The income earned by the sham business trusts was ruled to be income earned by partnerships operated by the taxpayer. Because the taxpayer ran the operations of the partnerships, he was responsible for self-employment taxes on the income. The taxpayer thought he could place the partnerships into business trusts to avoid the self-employment tax. The P.F. Spencer (68 TCM 1010, TC Memo 1994-531) case involved a taxpayer structuring a trust so it would appear that the trust income was disbursed to foreign trust beneficiaries. Then, the income would be redistributed to other foreign trust beneficiaries. The trust in which the taxpayer transferred all his income and assets was ruled to be a sham. The IRS determined the trust’s only purpose was to eliminate income tax without relinquishing control of the transferred property (Wolters 2011).
Based on the case of H.L. Richardson [91 TCM 981, Dec. 56,475(M), TC Memo. 2006-69, aff’d, CA-6, Dec.11 2007], Homer Lee Richardson was sentenced to 30 months in prison on January 11, 2011 for marketing sham trusts for a former business, Aegis Company. In addition he was assessed a $60,000 fine along with $61,212 in restitution. The Cincinnati, Ohio taxpayer also filed false individual tax returns for himself which caused an understatement of income. The sham trusts lacked economic substance and business purpose, while pretending that Aegis members released control of the trust assets. Individuals who participated in the sham trusts filed falsified individual tax returns as a result. Mr. Richardson would help these clients escape being audited by sending threatening letters to the IRS and suggesting the clients not produce any documents the IRS requested (Cincinnati 2011).
In December of 2010, Anne Marie Connor of Bethany Beach, Delaware was sentenced to two years in prison for filing false returns and utilizing sham trusts to escape taxes. Ms. Connor was required to pay $117,446 in restitution to the U.S. Treasury as well. Anna Conner funneled income from her two businesses, Bethany Massage and Healing Arts Center along with Wholesome Habits Health Food Store, to the established sham trusts. She also put the deed to her house in one of the trusts. While her money was in the trust, she maintained total control over the income. The promoter of the scheme, who worked for Innovative Financial Consultants, was also sentenced to prison. U.S. Attorney David C. Weiss said, “Today’s sentence makes it clear that those who scheme to evade taxes face substantial criminal penalties” (Whig 2010).
A press release from the U.S. Department of Justice states that a Utah taxpayer, Blayde Crockett, was sentenced to 70 months in federal prison for promoting and selling sham trusts. Bladye Crockett was convicted of preparing untrue tax returns and conspiracy to defraud the IRS. Evidence shows Mr. Crockett operated his scheme through two businesses, Business Research and Development as well as TNT Company. Details of the case explain that he reportedly sold abusive trusts to a family in Wyoming, who owned Nuway, Inc. Next, he told the family to put their wages into the sham trusts and pay for personal expenses through the trust. Mr. Crockett also filed fraudulent individual, trust, and corporate tax returns on the family’s behalf. The tax loss from the fraudulent scheme was estimated to be greater than $950,000. U.S. Attorney Paul Warner declared, “It is only fair to the vast majority of law abiding citizens who pay an honest and fair tax that we aggressively pursue those who do not” (Rydalch 2004).
The old adage “don’t judge a book by its cover” is very relevant when dealing with trusts. The effects of sham trusts are far reaching. Not only are the average investors being fooled by shams but even the sophisticated investors as well.
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