- 1 Abusive Trust IRS Tax Evasion Schemes (Foreign & US)
- 2 First, Trusts Can be Good
- 3 General Trust Tax Rules
- 4 Reporting and Filing Requirements
- 5 Abusive Trust Tax Evasion Schemes Are the Culprit
- 6 Key Considerations Involving Whether a Trust Is Legitimate
- 7 IRS Increases Scrutiny of Trusts
- 8 Golding & Golding: About Our International Tax Law Firm
Abusive Trust IRS Tax Evasion Schemes (Foreign & US)
When a US person has income that they want to shield from the Internal Revenue Service, the knee-jerk reaction tends to be that they would simply put the money into a “trust” and that will avoid US tax. Of course, that is incorrect — and further perpetuating this false myth of tax-exempt status are the number of tax promoters selling different tax schemes to US persons about how they can hide their money in US or overseas trusts without issue. One common method is that a person moves money overseas so that it becomes foreign money — and then brings it back to the United States by way of a foreign entity that transfers funds into a Wyoming or Nevada trust, etc. As you would expect, the Internal Revenue Service does not think highly of these types of trusts — and especially overseas trusts. The general phrase used by the IRS to categorize these types of bad trusts is called abusive tax schemes – and these types of trust are key culprits that the IRS has been chasing after for many years. Let’s go through the basics of an abusive trust arrangement tax scheme analysis.
First, Trusts Can be Good
In general, trusts can be used for many legitimate purposes. For example, trusts can help facilitate transferring wealth from one generation to the next and avoid certain probate fees, special needs trust can help support individuals lacking mental capacity, and charitable trusts can help promote good causes. These are not the types of trusts that the Internal Revenue Service refers to when they refer to abusive trust tax evasion schemes.
General Trust Tax Rules
The purpose of a trust is to protect assets. While there are many different types of trusts that may serve various different purposes, the idea of forming a trust does not mean that all income from the trust is exempt from tax or that otherwise nondeductible personal expenses are now suddenly tax-deductible. In general, the trust is comprised of the Settlor (Grantor/Trustor), Trustee, and at least one Beneficiary. And, depending on how the trust is structured (along with whether income is being generated and/or distributed) can impact the tax rules. Compounding the issue is whether the trust is deemed domestic or foreign – which can then invoke other more complex tax rules such as the throwback tax rule.
Reporting and Filing Requirements
If the trust is considered a domestic trust, then it may have to file Form 1041 (aka US Income Tax Return for Estates and Trusts) depending on whether it is a grantor trust or non-grantor trust, to report the trust income and deductions. This is similar to filing the annual Form 1040 personal income tax return. If there is income associated with the trust, it is generally taxable. In addition, certain trust expenses and distributions are deductible as well. But, if the trust is foreign, then the reporting and tax can be much more complex, depending on the source of income, residency of the beneficiaries, and whether or not the Trustee properly reported the information to the IRS on Forms 3520 and 3520-A.
Abusive Trust Tax Evasion Schemes Are the Culprit
The idea behind the abusive trust tax evasion scheme is that a tax promoter or other individual sells taxpayers on the idea that they can use certain types of trust vehicles in order to artificially reduce their income tax. From the US government’s perspective, these types of trusts are fraudulent if not illegal –– and the reduction in tax liability is artificial because the trust itself is abusive. If the trust is used to improperly reduce income tax, hide income, or otherwise reduce the overall tax liability using improper means, that type of trust would be considered an abusive trust and something the IRS would want to go after. These types of trusts are common both in the domestic and foreign offshore world and are on the IRS’s radar.
Key Considerations Involving Whether a Trust Is Legitimate
When determining whether a trust is considered legitimate or fraudulent, there are various factors the Internal Revenue Service will look to. These are some main ingredients to the analysis:
Substance vs. Form
The idea behind substance versus form is the idea that just looking at the words of the trust is not sufficient to determine whether or not the trust is legitimate. Rather, it is the substance of the trust and the purpose behind the formation of the trust, which will determine whether or not the trust is considered a legitimate trust or a sham arrangement. For example, it may appear on its face to exclude certain income from tax and appear to meet the basic form requirements of a trust, but was the substance of the trust really just to improperly avoid tax? If so, then the trust may be considered fraudulent, despite the fact that it meets the basic form requirements.
As provided in Zmuda v Commissioner, 731 F2d 1417:
“The terminology of one rule may appear in the context of the other because they share the same rationale. Both rules elevate the substance of an action over its form. Although the taxpayer may structure a transaction so that it satisfies the formal requirements of the Internal Revenue Code, the Commissioner may deny legal effect to a transaction if its sole purpose is to evade taxation. Stewart,714 F.2d at 987.”
Just because an expense is being claimed by the trust does not mean that the trust expense is legitimate. For example, in general, personal expenses are not deductible on a US tax return. If that person wants to form a trust and then claim the same expenses which were once considered personal, now as trust expenses — the IRS can take the position that the trust is being used for improper purposes (as in, it is being used to claim personal expenses which are not otherwise deductible).
As provided in Neely v. United States, 775 F.2d 1092 (9th Cir. 19850)
“Even where a taxpayer has structured a transaction so that it satisfies the formal requirements of the Internal Revenue Code, legal effect will be denied it if its sole purpose is to evade taxation. A trust arrangement may not be used to turn a family’s personal activities into trust activities, with the family expenses becoming expenses of trust administration. Schulz v. Commissioner, 686 F.2d 490, 493 (7th Cir. 1982).”
Genuine Charity is Required for Charitable Trusts
Using a trust in order to give money or other assets to charity is a great mechanism for both the trustor and the charity. The problem of course is when either the actual charity is not a genuine charity (and therefore the trust would not qualify as a charitable trust sufficient to meet the IRS requirements) or the gift is not a true gift. In order to claim this type of charitable deduction, the IRS is clear that the recipient must be a genuine charity and the benefit must go to the charity and not a cloaked benefit of the payor. As provided in Fausner v. Commissioner, 55 T.C. 620 (1971).
“As used in section 170(c), the term “contribution” is synonymous with the term “gift,” and the term “gift” does not have an esoteric meaning in the context of the section. ChanningUnited States, 4 F. Supp. 33, 34 (D. Mass. 1933), affirming per curiam 67 F.2d 986 (C.A. 1, 1933). Thus, to qualify the payments must have been made as acts of detached or disinterested generosity and not for the anticipated benefit of the payor. Commissioner v. Duberstein, 363 U.S. 278 (1960).”
IRS Increases Scrutiny of Trusts
The Internal Revenue Service is increasing its scrutiny of trusts to make sure they meet the requirements of the Internal Revenue Code. While a typical grantor trust used to hold real estate (personal or rental property) is probably not going to cause an issue, taxpayers need to be cognizant of potential trust pitfalls.
Golding & Golding: About Our International Tax Law Firm
Golding & Golding specializes exclusively in international tax and specifically IRS offshore disclosure.
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