Frequently Asked Tax Questions --April 20, 1997

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, Sunday April 20, 1997.



IRS Announces Crack Down on Trust Scams

ROBERT L. SOMMERS

Note: This exercise is for educational purposes only and is not intended to be legal or tax advice. Your particular facts and circumstances must be considered when applying the U.S. tax law. You should always consult with a competent tax professional with respect to your particular situation.

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IRS Announces Crack Down on Trust Scams

Trust scam promoters have been conducting expensive seminars across the country, encouraging frustrated and disillusioned citizens to violate tax laws.

Abusive Trusts

Abusive trust packages use names such as "Unincorporated Business Organization" (UBO), "Common Law Trust" or "Pure Equity Trust." Promoters employ fear tactics, suggesting that you are paying more than your share of taxes; that without their seminar, you may loose all your assets as a result of litigation or medical expenses; or that your heirs will have to deplete your assets to pay inheritance taxes. Often, these trusts have patriotic or constitutional themes which have nothing to do with the trust's actual terms and conditions, and can serve as a red flag to tax examiners.

The IRS has announced a nationwide crackdown on the approximately 200,000 phony trusts filed annually. Taxpayers have been warned to come forward and file proper returns, or face civil or potentially criminal penalties, if caught.


IRS Targets Five Trusts

The IRS has targeted five phony trusts: (1) small business trusts where the beneficiary (person receiving the benefits) is the same person as the grantor (creator); (2) equipment or service trusts which rent equipment or perform services for the business trust; (3) family-residence trusts which assume ownership of the home and furnishings in which the grantor (owner) is the renter (beneficiary) or occupant; (4) charitable trusts which treat non-deductible payments (tuition for the grantor's children) as charitable distributions; and (5) final trusts which oversee multiple abusive trusts and are often located in foreign jurisdictions.

If you placed your assets in an abusive trust, remember, mere technical compliance with trust law can still be illegal: When challenging trust arrangements, the tax authorities scrutinize the substance, not merely the form, of transactions. When all is said and done, if you enjoy the benefits of your property, you are taxed as the owner. It matters not that you placed your property into a trust with your uncle, spouse, children or the trust promoter as trustee, and created complex paperwork to hide your ownership.


Tax Scam Promoters

These tax seminars invariably skip the critical issue: After the paper shuffle, who has the beneficial use and enjoyment of the property? If it is the original taxpayer, then all intermediate documentation is ignored and the taxpayer is responsible for all tax consequences.

In addition, changes in tax law now cause trusts to be taxed in the highest bracket -- 39.6% on taxable trust income over $7,900 (individuals pay 39.6% on taxable incomes over $263,750). There is clear disincentive to accumulate income within trusts. Also, multiple trusts generally cannot reduce this tax rate.

The IRS warns that several lawsuits will be filed against high-profile trust promoters in the Bay Area shortly. Stay tuned.


The Mortgage Foreclosure Tax Scheme

Many homeowners, facing the bleak prospect of foreclosure, also own "upside-down" mortgages (loans exceeding the value of their homes). In addition to losing their home, their credit is also damaged. However, another nasty side to these foreclosures is that taxpayers may also have taxable income!

If you are personally liable on a $200,000 mortgage and your home's value drops from $250,000 to $150,000, foreclosure at $150,000 relieves you of $50,000 in mortgage debt (the foreclosure is considered a sale at fair market value). Generally, if you are solvent, the tax code treats this $50,000 cancellation of indebtedness as income.


Mortgage Scam

Into this dire predicament steps a purported savior, usually a "financial institution," stating it can save your credit and prevent the tax on cancellation of your mortgage debt. Often, these companies search public real estate records for homes in foreclosure.

Watch out! Their tax fraud works like this: For a fee (usually 1% of the mortgage), the company takes title to your home and assumes the outstanding mortgage obligation (in this case $200,000). (By the way, the seller receives no money from this transfer.) The company then rents it to you, without charge, until foreclosure or sale.

The company then attempts to negotiate a "short sale" with the lender (the property is sold for $150,000 which is paid to the lender, which forgives the loan balance -- $50,000 in our example). Under federal law, the lender must issue a Form 1099 for $50,000, but the owner of the property is now the company -- not you -- and the Form 1099 is issued to the company, supposedly sparing you from paying taxes on the $50,000 cancellation of indebtedness of your original loan. If foreclosure occurs, generally the same result applies.


IRS and California Response

The IRS and California attorney general consider these transactions a "shell game" because the transfer of title to the company is transitory and without economic substance. The company is acting merely as your agent, selling your home for a fee, and you remain fully liable for the $50,000 debt reduction. The IRS has declared it will not recognize these as bona fide sales, and you are not eligible for the forgiveness-of-debt information reporting or income recognition. Thus, you -- not the company -- will realize forgiveness of indebtedness income when the property is finally sold or foreclosed.


If you underpay income tax as a result of these bogus schemes, the IRS warns that you will be liable for tax deficiency, interest and penalties. Remember: if it seems too good to be true, it probably is. Consult your original lender or an independent tax advisor.




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