Not all Trusts are Trustworthy

by Stephen Kass on July 21, 2012

There’s something about the word trust that makes people feel secure. In the financial world, however, the use of that word can be deceiving. Each year the IRS
investigates fraudulent trust schemes that promise participants they will reduce or eliminate income taxes. In recent years, convictions for such schemes have increased.
The convictions illustrate that many trust schemes do not provide promised federal income tax relief. In addition, buyers could be subject to civil and criminal penalties.
The courts have held many trust arrangements to be shams, with no economic substance. The resulting income and expenses are attributed to the actual earner of the
income. Contrary to the claims of promoters, trusts are not a legal way to pay personal expenses with pre-tax dollars, reduce personal tax liability or avoid income or
employment taxes.
Fraudulent trusts. Fraudulent trusts often hide the true ownership of assets and income or disguise the substance of transactions. Currently, two fraudulent arrangements are being promoted: a domestic package and a foreign package. The former refers to a series of trusts created in the United States. The latter are formed offshore and outside U.S. jurisdiction. The goal is to fraudulently reduce taxable income to nominal amounts.

Although these schemes give the appearance of separating responsibility and control from the benefits of ownership, they are in fact controlled and directed by the taxpayer.
Here are some common fraudulent trust schemes CPAs should watch out for:

  • 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 makes it appear that the taxpayer has given up control of his or her business. In reality, however, through trustees or other entities controlled by the taxpayer, he or she still runs day-to-day activities and controls the business’s income stream. Such arrangements provide no tax relief.
  • Equipment or Service Trust. This trust is formed to hold equipment that is rented or leased to the business trust, often as 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, including 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.
  • 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.
  • Foreign Trust. These trusts often are domiciled in a foreign country that imposes little or no tax on trusts and also provides financial secrecy. 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 fact, the income from these arrangements is fully taxable.

If a taxpayer participates in a trust that improperly evades tax, he or she is still liable for taxes, interest and civil penalties. Violations of the Internal Revenue Code with
the intent to evade income taxes may result in a civil fraud penalty or criminal prosecution. Civil fraud can include a penalty of up to 75% of the underpayment of tax
attributable to the fraud, in addition to the taxes owed. Criminal conviction may result in fines up to $250,000 and up to five years in prison.

During the 1990’s, the IRS witnessed a substantial increase in both civil examinations and criminal investigations of fraudulent trusts. The tax court consistently
found against such schemes, deeming them shams or merely grantor trusts that will not deliver the promised tax benefits.

The IRS cautions taxpayers to beware of sales pitches that sound too good to be true. If they are in doubt about investing in a trust, clients should be advised to seek
guidance from a tax professional or from the IRS. Taxpayers who have erred by participating in a problem trust should file an amended return immediately. To report
suspected tax fraud, call 800-829-0433. For more information about the IRS policy on fraudulent trusts, read IRS Public Announcement Notice 97-24, IRS Warns of Abusive
Trusts, available at www.treas.gov/irs/ci/tax_fraud/notice.htm. Publication 2193, Too Good to Be True Trusts, at www.treas.gove/irs/ci/tax_fraud/alert.htm warns taxpayers to
avoid trusts that advertise bogus tax benefits.

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