Why Abusive Trust Arrangements are Under the IRS Microscope

Abusive Trusts Arrangements are Under the IRS Microscope

Many US Taxpayers across the globe utilize different types of trusts, in order to protect and guide their finances for themselves and future generations — such as a Dynasty Trust. There are several different types of trusts, such as revocable and irrevocable trusts – as well as grantor and non-grantor trusts. For example, many US persons may have a basic revocable grantor trust for their home, so that they can transfer the property relatively easily to their beneficiaries and heirs. In addition to these types of legitimate trusts, many people may try to form trusts in order to shift or hide their domestic or foreign income from the IRS —and oftentimes these trusts are located overseas, which explains the IRS’ distaste of offshore trusts. In a typical example, a grantor may try to shift the tax burden to the beneficiaries, who then turn around and get the money back to the grantor — all in an effort to avoid or artificially reduce their US tax liability. Trusts are directly in the crosshairs of the IRS and they are seeking to further enforce trusts that are used to facilitate tax evasion and other tax crimes.

As provided by the IRS:

Background

• • • Substantial wealth is transferred from one generation to the next, much of which is transferred using variety of trusts. Although the vast majority of these transfers are legitimate, there is widespread potential for fraud.

    • In the last few years, the Internal Revenue Service has detected a proliferation of abusive trust tax evasion schemes. These promotions are targeted towards wealthy individuals, small business owners, and professionals such as doctors and lawyers.

    • Abusive trust arrangements typically are promoted by the promise of such benefits as:

      • Reduction or elimination of income subject to tax.

      • Deductions for personal expenses paid by the trust.

      • Depreciation deductions of an owner’s 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.

      • The reduction or elimination of gift and estate taxes.

    • Abusive trust arrangements often use trusts to hide the true ownership of assets and income or to disguise the substance of transactions. Although these schemes give the appearance of separating responsibility and control from the benefits of ownership, as would be the case with legitimate trusts, the taxpayer in fact controls them.

    • These arrangements frequently involve more than one trust, each holding different assets of the taxpayer (the taxpayer’s business, equipment, home, automobile, etc.), as well as interests in other trusts. The trusts are vertically layered, with each trust distributing income to the next layer. Funds may flow from one trust to another trust by way of rental agreements, fees for services, purchase and sale agreements, and distributions. The goal is to use inflated or nonexistent deductions to reduce taxable income to nominal amounts.

    • Although the individual abusive promotions vary, two basic schemes have been identified:

      • • The domestic package, and

        • The foreign package.

    • These schemes are often promoted by a network of promoters and sub-promoters who have charged $5,000 to $70,000 for their packages. This fee enables taxpayers to have trust documents prepared, to utilize foreign and domestic trustees as offered by promoters, and to use foreign bank accounts and corporations. In some instances, tax return preparer services are also made available.

    • 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.

Abusive Domestic Trust Schemes

Domestic trusts are trusts created in the U.S. Here are some common abusive domestic trust schemes:

Business Trust

• • • This involves the transfer of an ongoing business to a trust. Also called an unincorporated business organization, a pure trust or a constitutional trust, it gives the appearance that the taxpayer has given up control of his or her business. In reality, through trustees or other entities controlled by the taxpayer, he or she still runs the day-to-day activities and controls the business’s income stream. Such arrangements provide no tax relief. The courts have held that the business income is taxable to the taxpayer under a variety of legal concepts, including lack of economic substance (sham theory), assignment of income, or that the arrangement is a grantor trust. In some circumstances, the trust could be taxed as a partnership.

Equipment or service trust

• • • This trust is formed to hold equipment that is rented or leased to the business trust, often at inflated rates. The business trust reduces its income by claiming deductions for payments to the equipment trust. This type of arrangement has the same pitfalls as the business trust, and it will result in no tax reduction.

Family residence trust

• • • Taxpayers transfer family residences and furnishings to a trust, which sometimes rents the residence back to the taxpayer. The trust deducts depreciation and the expenses of maintaining and operating the residence including gardening, pool service and utilities. The courts have consistently collapsed these types of trusts, taxing income to the taxpayer and disallowing personal expenses.

Charitable trust

• • • Taxpayers transfer assets or income to a trust claiming to be a charitable organization. The trust or organization pays for personal, education or recreation expenses on behalf of the taxpayer or family members. The trust then claims the payments as charitable deductions on its tax returns. These alleged charitable organizations often are not qualified and have no IRS exemption letter; hence, contributions are not deductible. Charitable deductions are not allowed when the donor receives personal benefit from the alleged gift.

Asset protection trust

• • • These trusts are promoted as a means of avoiding liability for judgments against an individual or business. However, beware of any asset protection trust marketed as part of a package to reduce federal income or employment taxes. The courts can ignore such trusts and order the taxpayer’s property sold to satisfy the outstanding liabilities.

Abusive Foreign Trust Schemes

• • • Abusive foreign trusts are often formed in foreign countries that impose little or no tax on trusts and also provide financial secrecy. These are usually “tax haven” countries, supposedly outside the jurisdiction of the U.S. Typically, abusive foreign trust arrangements enable taxable funds to flow through several trusts or entities until the funds ultimately are distributed or made available to the original owner, purportedly tax-free. In actuality, the income from these arrangements is fully taxable.

    • Foreign packages often begin with an Asset Management Company, a business trust, and then distribution of income to several trust layers. These schemes also involve offshore bank accounts and International Business Corporations (IBC’s). A typical abusive foreign trust scheme has the following steps:

Asset Management Company

• • • In many promotions, taxpayers are advised to create asset management companies (AMCs). The AMC, which lists the taxpayer as the director, is formed as a domestic trust. An individual on the promoter’s staff is usually the trustee of the AMC, but the taxpayer quickly replaces this individual. The purpose of the AMC is to give the appearance that the taxpayer is not managing his or her business and to start the layering process.

Business Trust

• • • The next step is to form the business trust, again very similar to the domestic scheme.

Foreign Trust One

• • • Next, a foreign trust is formed in a tax haven country and the income from the business trust is distributed to this trust. We will refer to this foreign trust as “foreign trust one”. In many cases, the AMC will be the trustee of foreign trust one. Because the source of income is U.S.-based and there is a U.S. trustee, this foreign trust has filing requirements as discussed earlier in this section.

Foreign Trust Two

• • The next step is to form a second foreign trust or “foreign trust two”. All income of foreign trust one is distributed to foreign trust two. Either foreign trust one or a foreign member of the promoter’s staff becomes the trustee of foreign trust two. If the trustee is foreign trust one, the taxpayer still controls foreign trust two by the fact that he/she is in control of foreign trust one’s trustee, by the directorship of the AMC. If a foreigner is the trustee of foreign trust two, the taxpayer is empowered by the promoter to overrule any decisions by this trustee. In either case, the taxpayer is in control of foreign trust two.

  • Promoters will claim that since the trustee and the sources of income are now foreign, there are no U.S. filing requirements. Promoters also advise taxpayers that since the trusts are formed in tax haven countries it is impossible for the IRS to determine who is in control of the trusts. In actuality, the taxpayer has never relinquished control of their business, but has set up, with the assistance of a promoter, an elaborate scheme to subvert and evade U.S. tax laws.

Asset Protection Trust

• • • Either as part of the second foreign trust or as a separate trust, an asset protection trust is formed. The taxpayer supposedly transfers all of his assets to it including his home and other assets actually located within the United States. According to the promoter, this will make the taxpayer judgment-proof. In actuality, the courts look at the economic substance of the transaction and, if the taxpayer continues to reside in his home and control his assets, those assets may be seized and sold in satisfaction of his liabilities. This definition of an asset protection trust is not meant to imply that all are formed as part of an abusive tax scheme. However, beware of any asset protection trust marketed as part of a package to reduce federal income or employment taxes. The courts can ignore such trusts and order the taxpayer’s property sold to satisfy the outstanding liabilities.

Late Filing Penalties May be Reduced or Avoided

For Taxpayers who did not timely file their FBAR and other international information-related reporting forms, the IRS has developed many different offshore amnesty programs to assist taxpayers with safely getting into compliance. These programs may reduce or even eliminate international reporting penalties.

Current Year vs Prior Year Non-Compliance

Once a taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist who specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties. 

Need Help Finding an Experienced Offshore Tax Attorney?

When it comes to hiring an experienced international tax attorney to represent you for unreported foreign and offshore account reporting, it can become overwhelming for taxpayers trying to trek through all the false information and nonsense they will find in their online research. There are only a handful of attorneys worldwide who are Board-Certified Tax Specialists and who specialize exclusively in offshore disclosure and international tax amnesty reporting. 

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure. 

Contact our firm today for assistance.