Abusive Trust Agreements and Tax Avoidance Schemes (Foreign and US)

When a USA person has an income that he wants to protect from Internal Revenue Service, the knee-jerk reaction tends to be that they would just put the money in a “trust” and it will avoid US tax. Of course, that’s inaccurate – and further perpetuating this false myth of tax-exempt status, the number of tax promoters selling different tax schemes to American people about how they can safely hide their money in American or foreign trusts . A common method is for a person to move money overseas to become foreign money – then bring it back to the United States through a foreign entity that transfers funds into a trust from Wyoming or Nevada, etc. As you might expect, the Internal Revenue Service does not have a high opinion of these types of trusts – and especially foreign trusts. The general term used by the IRS to categorize these types of bad trusts is called abusive tax regimes – and these types of trusts are the main culprits that the IRS has been pursuing for many years. Let’s review the basics of an abusive trust arrangement tax regime analysis.

First, trusts can be good

In general, trusts can be used for many legitimate purposes. For example, trusts can help facilitate generational wealth transfer to another and avoid certain probate fees, special needs trusts can help support people who lack mental capacity, and charitable trusts can help promote good causes. These are not the types of trusts the Internal Revenue Service refers to when they refer to abusive trust tax avoidance schemes.

General tax rules for trusts

The purpose of a trust is to protect assets. While there are many different types of trusts that can serve different purposes, the idea of ​​forming a trust does not mean that all trust income is tax-exempt or that otherwise non-deductible personal expenses are now suddenly tax deductible. In general, the trust is made up of the settlor (grantor/trustee), the trustee and at least one beneficiary. And, depending on how the trust is structured (and whether income is generated and/or distributed), this may affect the tax rules. The question of whether the trust is deemed domestic or foreign can complicate the issue, which can then invoke other more complex tax rules such as the return tax rule.

Reporting and filing requirements

If the trust qualifies as a domestic trust, it may need to file Form 1041 (a.k.a United States Income Tax Return for Estates and Trusts) depending on whether it is a grantor trust or a non-grantor trust, to report the trust’s 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 expenses and distributions from the trust are also deductible. But, if the trust is foreign, reporting and tax can be much more complex, depending on the source of income, the residency of the beneficiaries, and whether or not the trustee has properly reported the information to the IRS. the Forms 3520 and 3520-A.

Abusive trust tax avoidance schemes are the culprit

The idea behind the abusive trust tax avoidance scheme is that a tax promoter or other person sells taxpayers the idea that they can use certain types of trust vehicles in order to artificially reduce their income tax. From the perspective of the US government, these types of trusts are fraudulent, even illegal –– and the reduction in tax liability is artificial because the trust itself is abusive. If the trust is used to inappropriately reduce income tax, hide income or otherwise reduce overall tax payable by improper means, this type of trust would be considered an abusive trust and something the IRS would like to sue. These types of trusts are common in both the domestic and foreign offshore world and are on the radar of the IRS.

Key Considerations Regarding the Legitimacy of a Trust

To determine whether a trust is considered legitimate or fraudulent, the Internal Revenue Service will look at various factors. Here are some key ingredients of the analysis:

substance versus form

The idea behind substance versus form is the idea that looking at the words of the trust is not enough to determine whether the trust is legitimate or not. Rather, it is the substance of the trust and the purpose underlying the formation of the trust that will determine whether or not the trust is considered a legitimate trust or a sham arrangement. For example, it may at first appear 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 unduly avoid tax? If so, the trust may be considered fraudulent, despite meeting the basic requirements of the form.

As provided in Zmuda v Commissioner, 731 F2d 1417:

  • “The terminology of one rule can appear in the context of the other because they share the same reasoning. Both rules elevate the substance of an action above its form. Although the taxpayer may structure a transaction so that it meets the formal requirements of the Internal Revenue Code, the Commissioner may deny legal effect to a transaction if its sole purpose is to evade tax. Stewart,714 F.2d to 987.”

Personal expenses

Just because an expense is 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 that 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 for claim personal expenses that are not otherwise deductible).

As expected in Neely v. United States, 775 F.2d 1092 (9th Cir. 19850)

  • “Even where a taxpayer has structured a transaction so that it meets the formal requirements of the Internal Revenue Code, it will be denied legal effect if its sole purpose is to evade tax. cannot be used to transform the personal activities of a family into trust activities, the family expenses becoming expenses for the administration of the trust. Schulz v. Commissioner, 686 F.2d 490, 493 (7th Cir. 1982).

A bona fide charity is required for charitable trusts

Using a trust to donate money or other assets to charity is a great mechanism for both the trustee and the charity. The problem is of course when the actual charity is not a true charity (and therefore the trust would not be considered a sufficient charitable trust to meet IRS requirements) or the donation is not is not a real gift. In order to claim this type of charitable deduction, the IRS makes it clear that the recipient must be a genuine charity and that the benefit must go to the charity and not some hidden benefit from the payer. As expected in Fausner v. Commissioner55 TC 620 (1971).

  • “As used in Section 170(c), the term ‘contribution’ is synonymous with the term ‘gift’, and the term ‘gift’ has no esoteric meaning in the context of the section. channingUnited States, 4 F. Sup. 33, 34 (D. Mass. 1933), confirming per curiam 67 F.2d 986 (CA 1, 1933). Thus, to be eligible, the payments must have been made as detached or disinterested acts of generosity and not for the anticipated benefit of the payer. Commissioner v. Duberstein, 363 United States 278 (1960). »

IRS increases scrutiny of trusts

The Internal Revenue Service is stepping up its review of trusts to make sure they meet the requirements of the Internal Revenue Code. Although a typical settlor trust used to hold real estate (personal or rental property) is unlikely to cause a problem, taxpayers should be aware of the potential pitfalls of the trust.