Tax Prophet: FAQ May 26, 1996


Frequently Asked Tax Questions -- May 26, 1996

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, Sunday May 26, 1996



It's Tax Scam Season!

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.

This World Wide Web Server is the creation and property of Robert L. Sommers , attorney-at-law. Copyright 1995-7 Robert L. Sommers, all rights reserved.


Questions

  1. Question: Several companies that write trust agreements claim I can transfer my property and business assets to several trusts, thereby eliminating my obligation to pay income and self-employment taxes. Is this legal? [Answer]


  1. Answer to Question #1:

    No. And you aren't the only one who's been asking.


    It's "Tax Scam Season!"

    Tax season is over, you've paid too much in income taxes and are now angry and frustrated at the system. Watch out! You might be a prime target for the scam artists.

    Typically, these promoters charge between $5,000 to $10,000, promising to eliminate your income and employment tax obligations through a labyrinth of phony trusts. Convert your home into income-producing property, live in it tax-fee, and even write-off your personal medical, food and educational expenses? No problem, according to these charlatans.

    Keep in mind that the "masterminds" of these trusts usually have no formal education in tax law or accounting. Typically, they don't provide any legal analysis or case law in support of their assertions nor discuss the counter-arguments to their positions. Rather, it is hard sell all the way. Remember, mere technical compliance with trust law can still be illegal: When challenging trust arrangements, the IRS and courts scrutinize the substance, not merely the form, of the transactions.


    Distinguishing a Phony Trust from Legitimate Estate Planning Trust Arrangement

    What makes this particular scam popular is that legal, well-drafted revocable trusts actually do have a variety of estate planning purposes and can eliminate probate fees and costs, and minimize estate taxes. They do not save the taxpayer income taxes - in any way! These promoters deliberately confuse legitimate trusts with fraudulent ones, claiming that prominent families (Rockerfellers, Kennedys or Fords) have established family trusts to minimize inheritance taxes, protect assets and maximize privacy. These legal trusts, however, are usually funded by gifts or sales of property; or, the person creating the trust remains liable for all income and estate taxes (which occurs when a funded revocable trust is used).

    In contrast, there is nothing in the tax code or its regulations that sanctions these phony trusts. Every taxpayer caught using these trusts has been hit with all taxes, interest and penalties. In fact, many taxpayers have been accessed fraud penalties of an additional 75% of taxes owed!


    The IRS is on the Trust Scam Trail

    Although the efforts to outsmart the IRS are becoming more complex and circuitous, the IRS frequently catches up with those riding the tax fraud circuit. In fact, the IRS is launching a major investigation of these bogus trusts.

    The IRS usually sends a "Pre-filing Notice" to people identified with selling or using abusive trust schemes. The Notice instructs taxpayers to review the program carefully and seek tax counsel from a professional not associated with the trust promoter before filing a tax return and warns that failure to heed these recommendations may later be used as evidence in support of penalties against the individual.


    Why These Trusts Don't Work

    The IRS and courts are not foolish: They look to the substance of the transaction, not its form. When all is said and done, if you enjoy the benefits of your property, you are taxed as the owner. It does not matter that you placed your property into a trust with your great uncle as trustee and created tons of paperwork attempting to hide your ownership.

    The courts and IRS look to the results, not the methods. These tax seminars invariably fail to address the critical issue: After the paper shuffle, who winds up with the beneficial use and enjoyment of the property? If it is the taxpayer, then all the intermediate documentation is ignored and the taxpayer is responsible for the tax consequences.

    In addition, changes in the tax law now cause trusts to be taxed in the highest bracket amount -- 39.6% on taxable income over $7,650 (individuals pay this on taxable incomes over $256,500). There is clear disincentive to accumulate income within trusts. Also, multiple trusts generally cannot reduce this tax rate.


    How to Spot a Fraudulent Trust.

    Abusive trust packages use names such as "Unincorporated Business Organization" (UBO), "Common Law Trust," or "Pure Equity Trust." They employ fear tactics, suggesting that you are probably paying more than your fair share of taxes; that without their seminar instruction, you may loose all your assets as a result of litigation or medical expenses; or that your heirs will have to sell your assets to pay for inheritance taxes.

    Trust scheme promoters frequently claim that their seminars will teach you how to transfer your business, investments and residence into trusts to protect your assets. They may also "guarantee" that their program will eliminate taxation of your self-employment earnings and significantly reduce your income tax liability, usually by deducting inflated expenses between trusts or deducting personal expenses as "business" expenses. Among other claims, they often promise that you can protect your assets from liabilities, deduct your children's school tuition as "scholarships" and eliminate estate taxes when you die, all the while continuing to maintain control of assets you assign to the trust.

    Here's a simple illustration of how a three-trust scam supposedly works: Trust One contains business assets (allegedly transferred to this trust on a tax-free basis). Trust One generates business income that is subject to self-employment (social security) taxes. Trust Two is created to lease or sell equipment, services or inventory to Trust One at inflated prices, thereby siphoning-off the income generated in Trust One that is subject to self-employment taxes.

    All income generated by Trust Two (and any remaining income in Trust One) is then distributed to Trust Three which contains the taxpayer's personal residence (which again was allegedly transferred to this trust on a tax-free basis). Trust Three uses an inflated depreciation deduction for the residence to offset some of the income distributed to it. The taxpayer lives tax-free in the residence as a "caretaker." As part of the caretaker's package, the trust pays for medical and educational expenses as well and deducts those payments as business expenses to further offset income.

    Of course, none of this is actually legal. There are no provisions in the tax code permitting tax-free transfers of property for trust units. Also, a residence may not be depreciated unless it is used in legitimate rental activity that produces rental income. Under no circumstances may a taxpayer claim he is a caretaker of his own residence. Any personal deductions for medical or educational expenses must meet stringent code requirements.

    Courts typically reject these abusive trusts since they are devoid of economic substance and are purely an income tax-avoidance device. Also, if the creator directly or indirectly controls the trust, courts have applied the grantor trust provisions to tax the income directly to him (see April 14, 1996, column).

    When considering these tax seminars, remember the old English proverb: "A fool and his money are soon parted." The courts blow through these superficial arrangements easily. These trusts have no substance, rely on insupportable conclusions of tax law and have never been accepted by the IRS or any court.


    Conclusion

    Be suspicious of those who claim there is an easy way to evade or avoid your income tax obligations. Legal trusts are widely used in estate planning. They insure privacy, permit a smooth transfer of wealth, eliminate the cost and delay of probate, and often contain provisions that minimize estate taxes. Clearly stated, they are not a vehicle by which taxpayers can use their property while avoiding income taxes.

    [Return]





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