April 1996 Hot Topics

Using Trusts to Avoid Paying Taxes - Will This Work?

by Robert L. Sommers

It's Tax Scam Season

Tax season is over, you've paid too much in taxes and are now angry and frustrated at the system. Watch out! You might be a prime target for the scam artists that prey on people's anger at the IRS and ignorance of the tax system. Typically, these promoters will charge between $5,000 to $10,000 for the promise of eliminating 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.

If you're tempted to participate or wonder what you're missing out on, keep in mind that the masterminds of these shallow schemes usually have no formal education in tax law or accounting. Typically, they never provide a legal analysis or case law authority for their assertions and never discuss the counter-arguments to their positions. It is hard sell - all the way. Remember, mere technical compliance with trust law can still be illegal under the tax law. When challenging trust arrangements, the IRS and the courts scrutinize the substance, not merely the form, of the transactions.

What makes this particular scam popular is that well-drafted trusts have a variety of estate planning purposes and can eliminate probate fees and costs, and minimize estate taxes. These con men deliberately confuse the use of legitimate trusts with the phony ones they are selling. Trust promoters claim that prominent families, such as the Rockerfellers, Kennedys or Fords, have established family trusts to minimize inheritance taxes, protect their assets, and maximize privacy. My website has several articles about this type of legitimate estate planning through the use of revocable living trusts (a "grantor trust") in which the taxpayer remains liable for income taxes on the trust's earnings until death. . These phony trust arrangements all try, but ultimately fail, to circumvent the grantor trust rules. For further information on estate planning, see Estate Planning ; and Use of Revocable and Irrevocable Trusts.

My February Hot Topics made it clear that "tax protestor" arguments are worthless rantings of those ignorant about the tax law. The same is true with these phony trusts: There is nothing in the Internal Revenue Code or its regulations, and neither the IRS nor any court of law has ever upheld the use of these trust arrangements as an honest tax planning device. In fact, every taxpayer who has been caught using one of these trusts has been hit with all the taxes, interest and penalties owed under the Code. In fact, as discussed below, some have been sanctioned with fraud penalties which amount to an additional 75% of the taxes owed!


The Selling of Phony Trusts

Trust promoters use effective marketing techniques and advertising to sell their trust packages. They often offer commissions to participants to get family or friends involved in the trust seminars. Although their efforts to outsmart the IRS are becoming more complex and circuitous, the IRS does frequently catch up with unscrupulous trust promoters. In fact, the Sacramento, California office of the IRS is launching a major investigation into the use of these phony trusts.

The IRS will send a "Pre-filing Notice" to people identified with known abusive trust schemes in an attempt to reduce the proliferation of these schemes and decrease the taxes, interest and penalties of individuals who have gotten involved. Promoters often assure investors that the advice of attorneys is not to contact the IRS or give them any information; however, the IRS letter instructs taxpayers to carefully review the program and to seek tax counsel from a professional not associated with the trust promoter before any further filing of tax returns. The letter states that failure to heed the recommendations may later be used as evidence in support of penalties against the individual.

The best way to protect yourself against these scams is to check out the credentials of the people directing the seminar. Make sure they have education and training in accounting or law. Beware: some abusive trust seminars are actually endorsed by accountants or attorneys who receive payment for their endorsements. Get a second opinion from an unbiased professional, one who has no financial stake in the seminar. Also, download this article and use it as a guide.


Why These Trusts Don't Work

The IRS and the Court are not stupid: They look to the substance of the transaction, not its form. When all is said and done, if you are enjoying 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 lots of paperwork in an attempt to hide your true ownership.

The courts and the 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 stuck with the tax consequences, as though nothing happened.

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


How to Spot a Defective Trust Arrangement.

Abusive trust packages go by a variety of names, such as "Unincorporated Business Organization" (UBO), "Common Law Trust," or "Pure Equity Trust." They attract participants by fear tactics. They may suggest that you are probably paying more than your fair share of taxes; that without their seminar instruction, you may loose all of 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.

Abusive 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 tax advantages, they often promise that you can protect your assets from liabilities, deduct your children's school tuition as "scholarships," and eliminate your estate taxes when you die, while continuing to maintain control of the assets that you assign to the trust.

One promoter even promised to pay the legal bills and family expenses if one of his seminar participants were incarcerated for tax violations! Unfortunately, his seminar participants couldn't take him up on the offer, because the agreement was held unenforceable as against public policy. McBrearty v. United States Taxpayers Union, 668 F.2d 450 (8th Cir. 1982).

Promoters of abusive tax shelter programs operate under the philosophy that you should get something for nothing -- except for fleecing you for their outrageous seminar fees. As explained below, the fundamental requirement for avoiding taxation on trust income is giving up control and management powers of the trust assets, or limiting your powers by requiring the approval and consent of an adverse party. Sham trust documents declare that the taxpayer has relinquished such control in the manner required by the Code; in reality, the taxpayer still retains complete control and management powers, as well as beneficial interest, in the trust assets. The courts typically reject these abusive trust arrangements because they lack economic substance, or because the petitioner retains powers over the trust that cause the trust income to be attributable to the petitioner via the grantor trust provisions of Code 671-679.


What the Courts Have Said About These Trusts

If you receive literature about a trust seminar that claims to eliminate your federal income taxes, ask the promoter to respond in writing why the following cases do not apply to what he is selling:

In Harrold v. Cm., 61 TCM 2925 (1991), the taxpayer failed to avoid taxation on income from trust assets by forming two purportedly irrevocable trusts. A resident of Decatur Arkansas, the petitioner attended a meeting of the National Tax Freedom Forum in Oklahoma City, Oklahoma. The forum presented lectures on Federal income tax topics, such as "Federal reserve notes are not dollars" and "wages are not taxable income." One of the Masters of Ceremonies of the forum was the same promoter that had previously guaranteed payment of legal defense and family expenses, described above.. He had also previously been convicted of violating Federal racketeering laws and other offenses including armed robbery of banks, transporting stolen property across state lines, and harboring fugitives.

The petitioner executed a document forming the "Zident Education Trust," naming three individuals apparently involved with promoting the seminar as trustees. The corpus of the trust initially consisted of petitioner's personal property and household effects and gold mining stock. Petitioner subsequently formed The Zibiz Trust, with the Zident Trust as the sole beneficiary of the Zibiz Trust.

The court concluded that the Zident Trust was a sham trust having no economic substance or utility other than tax considerations:

First, petitioner's relationship to the property transferred to the trust did not change in any significant respect before or after creation of the trust. He continued to use the furnishings, appliances, and other property as he had done before the trust was created.

Second, petitioner had control of the trust's assets and operations...He decided what expenditures the trust would incur and then issued the checks to make the purchases. He controlled the investments made by the trust. It is clear that petitioner had the power to deal with the trust property as his own, and did, in fact deal with it as his own.

Third, there was, no purpose other than tax avoidance for creating the Zident Trust.

The court rejected the petitioner's contention that the trustees were independent; stating that they were "straw men" who "passively acquiesced in petitioner's wishes and did nothing to act independently of his wishes." The court also rejected the petitioner's contention that the Zident Trust was not a family estate trust because the petitioner did not transfer any real property or his wages to it. The court further noted that the Zibiz Trust income paid for all of the petitioner's personal living expenses, and that "(e)conomically, there was no separation of legal title from beneficial enjoyment." The court pointed out that:

Although a taxpayer has a legal right to avoid or minimize taxes, that right does not bestow the right to structure a paper entity to avoid tax when the entity does not stand on the solid foundation of economic reality. When the form of a transaction does not alter economic relationships, the Courts will disregard the form and apply the tax law according to the substance of the transaction.

In Brittain v. Commissioner, 63 TCM 3004 (1992), also refused to recognize a purported irrevocable trust. The petitioner created the Kirksey Irrevocable Trust, appointing himself as trustee, but did not indicate who he designated as beneficiaries. He funded the trust with personal bank accounts, two automobiles, notes receivable, real property, and an investment account. He no longer individually held any income-producing assets. Although he did not use funds contained in trust bank accounts to pay for personal expenses, the petitioner personally used one of the trust's automobiles and lived in a residence purchased by the trust without compensating the trust for his use.

Holding that the trust lacked economic substance, the court noted that that the petitioner failed to prove "that property was held in trust for the benefit of others," or "that anyone or anything existed that could prevent petitioner from acting in derogation of the interests of any purported beneficiaries... Further, petitioner's relationship to the trust's property did not differ in any material aspect before and after the creation of the trust."

The Keefover v. Cm., 65 TCM 2999 (1993) case, illustrates a classic abusive family trust. The petitioner appointed his wife as trustee. She appointed their three adult children and son-in-law as additional trustees, and she later withdrew as trustee. The assets that petitioners transferred to the trust included stocks and bonds, the tools and equipment of petitioner's surveying business, their personal residence and personal household items. The petitioners transferred these assets to the trust in exchange for "Units of Beneficial Interest," (UBI's) a concept common among trust schemes, and rarely associated with conventional trusts. The UBI's were represented by certificates entitling the holder to income distributions as well as a vested pro rata share of the trust corpus upon termination of the trust, but not to any legal title in the trust property. Initially, all 100 UBI's were issued to the petitioner, who subsequently transferred some of the units to his wife, children and grandchildren. The son in law, while a trustee, did not own any UBI's.

The trustees would sign blank checks for the petitioners, who often used them for the payment of expenses. All decisions regarding the trust management required the unanimous agreement of the trustees. Petitioner would attend meetings of the trustees and offer advice. The trustees hired petitioners as caretakers for the trust property. The agreement between the petitioners and the trust provided that as caretakers, petitioners were to be paid $15.00 per hour to perform such duties as mowing the lawn of their residence, cleaning the house, and assuring that the utility bills were paid.

The petitioners also formed a Surveying Trust, naming themselves as trustees. The Main Trust was the beneficiary and held all 100 units of beneficial interest of the Surveying Trust. The Surveying Trust leased equipment and tools from the Main Trust.

In refusing to recognize the Main trust for Federal Income Tax purposes, the court pointed out that the petitioners maintained control over trust assets, and their "relationship with trust assets, especially personal items, did not essentially change during the years at issue." The court noted that Petitioner attended trust meetings and was involved in the decision-making process with regard to the management of trust assets; the petitioners served as "caretakers" of trust property without receiving payment and without paying rent for use of the house and other property; and that petitioners had access to a "steady income" from trust funds through automobile rental payments received each year from the trust and a $9,000 distribution to petitioner's wife. The court further stated that:

It has been held in similar cases that "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."...In such situations, this Court will look through the form of the trust arrangement and determine the tax consequences based upon the substance of the transaction...Although the trust document may have been written in a manner that technically complies with the formalities of the grantor trust rules, such an arrangement cannot be considered a valid trust for Federal income tax purposes if there is no underlying economic substance or reality.

The Petitioners had previously argued that they had relinquished control over the trust assets and income to adverse party trustees, thus complying with the grantor trust rules. However, the court held that in the previous case, as well as in the instant case, petitioners did not prove that their children as trustees exercised control over the trust assets and income. The petitioner's sons lived on the other side of the state and seemed to have had little to do with the trust. The son-in-law was active but did not qualify as an adverse party trustee pursuant to Code Sec. 672(a).

The court also rejected the petitioner's argument that the Surveying Trust was a valid business trust. The petitioner attempted to divert income to the Surveying Trust that he himself earned doing private surveying work. The court stated that:

individuals cannot escape taxation by diverting income to some other entity through some contractual arrangement," noting that a "fundamental principle of tax law is that income is taxed to the person who earns it. An assignment of income to a trust is ineffective to shift the tax burden to the trust when the taxpayer controls the earning of the income.


Foreign Trust Schemes Don't Work Either

Keen to the increased scrutiny of the IRS, some trust promoters advocate even more convoluted schemes, sometimes involving the use of foreign trusts and foreign individuals, with the intent to keep the IRS off their trail of impropriety.

In Sandvall v. Cm., 90-1 USTC (1990), the petitioners attempted to use foreign based trusts to avoid their tax liabilities, while maintaining total control over the trust and using the trust assets for their own personal benefit. The court concluded that the petitioners "did not relinquish ownership and control of their earnings, they merely created a fictitious paper trail by which they hoped to disguise or hide their taxable income."

The court disregarded the petitioners' contention that the Commissioner and the Tax Court lacked authority to determine the trust's legal status because it was an entity created in the Turks and Caicos Isles under the United Kingdom Tax Treaty, and only Article III courts may determine rights arising under a treaty. The court also denied the petitioners' complaints that they were targeted for prosecution because of their association with the American Law Association, an organization that promotes tax shelters, stating that this argument was "not only meritless but also ludicrous," and that:

The Sandvalls have not been singled out; time for them has simply run out. Legal smoke and mirrors, reams of paper, and strings of words will suffice no longer to evade or delay the payment of their fair share of federal income taxes. The time has come for them to join the rest of their fellow citizens at the annual income roundup.

The promoter in Dahlstrom v. Cm. 61 TCM 2863 (1991), attempting to practice what he preached, used a foreign trust scheme to hide his own income. The promoter set up four trust organizations in the Turks and Caicos Islands, paying a tour guide and taxi owner in the Islands $20.00 to sign his name as "creator" for each of the four trusts. He formed another trust organization in Belize, again having a tour guide and taxi owner sign the documents as creator. The taxi owner's participation appeared "to be without any real significance, except perhaps to comply with technical requirements of the laws of Belize. Accordingly, actions ostensibly taken by the taxi driver as "creator" of the trusts" were treated by the court as actions of the promoter.

Finding that the promoter committed fraud in the implementation of his own trust scheme, the court found that the promoter used the trusts to:

transfer assets in non-arm's-length transactions back and forth, creating layers of documentation to impede any examination or investigation.... Petitioners owned and enjoyed the income, funneled through the layers of trusts and paperwork they generated to disguise or hide their income, and they are taxable on that income.

In U.S. v. Smith, 87-2 USTC (1986), a trust promoter marketed a publication entitled "A Manual on How to Establish a Trust and Reduce Taxation," published by Liberty Lobby, a Washington, D.C. based organization. The court found that in the manual, the promoter knowingly made false or fraudulent statements about matters which would be material to a reasonably prudent investor or taxpayer. The promoter made erroneous and misleading representations concerning the manual's conformance with the grantor trust provisions, and assured tax deductions of otherwise personal expenses. The promoter refused to recognize the validity of court decisions adverse to his position.

The court imposed money damages on the promoter and granted an injunction to restrain the promoter from continuing to promote and sell the manual, explaining the Code sections prohibiting the promotion of abusive tax shelters:

In substance, these provisions penalize any person who assists in the organization of any plan...that makes...a material statement regarding tax advantages from that arrangement which he knows or has reason to know is false or fraudulent...The purpose of these provisions is to focus IRS efforts on the promoter of abusive tax shelters, rather than the user or purchaser of abusive tax plans...Considering that widespread marketing and use of tax shelters undermines public confidence in the fairness of the tax system, and that abusive tax schemes impose a disproportionate burden on IRS resources, Sec. 6700 was enacted to permit an attack on the source of such plans... and to protect potentially innocent investors against widespread marketing of such tax schemes.


Major Tax Penalties

Trust promoters often cite cases where citizens have won tax evasion disputes. However, they may give a misleading analysis of the actual facts and circumstances of the case. When they are pressed for specifics regarding their examples, the information may not be forthcoming, or may be difficult to verify.

Establishing a sham trust can subject you to significant penalties. For returns due after December 31, 1989, Code Sec. 6662 imposes a 20 percent accuracy-related penalty on any portion of an underpayment attributable to one or more of the following:

(1) negligence or disregard of the rules and regulations;

(2) any substantial understatement of income tax;

(3) any substantial valuation misstatement;

(4) any substantial overstatement of pension liabilities; and

(5) any substantial estate or gift tax valuation understatement.

The IRS can compel you to pay a 75 percent penalty for any portion of an underpayment that is attributable to fraud. The court will impose additional damages and costs upon the taxpayer for frivolous appeals involving sham trusts.

In Brittain, 63 TCM at 3009 - 3010, discussed above, the manner in which the petitioner created and operated the trust and petitioner's failure to show that the trust had any purpose other than tax avoidance were factors indicative of the petitioner's fraudulent intent.

In Keefover, 65 TCM at 3007, also discussed above, the petitioners were held liable for addition to tax for negligence, substantial understatement of income tax, and additional interest on underpayments attributable to tax-motivated transactions. The petitioners negligently formed the trusts upon the advice of an individual who was neither an accountant nor an attorney, whom they paid $2,000 for instructions and forms for drafting the trusts to use as devices to transfer wealth and avoid probate proceedings. The court reiterated that:

In our view, a prudent individual would have endeavored to obtain independent legal and tax advice before attempting to make such an all-encompassing (though ineffective) disposition of all of his or her assets, including as here, the very means of livelihood.

In Sandvall, 90-1 USTC at 83,849, the court required the petitioners to pay damages of $3,000 and double costs to the Commissioner for the frivolous appeal of their case, explaining that:

The Sandvalls persisted in advancing unreasonable claims with no arguable basis in law or fact. Significant time and energy have been expended by judges, staff, and support personnel on these meritless appeals. In the meantime, the claims of worthy litigants have been delayed because this court's limited resources have been devoted to the processing and disposition of the Sandvalls' frivolous and meaningless arguments.


Conclusion

When considering one of these tax seminars, keep in mind the old proverb: "A Fool and His Money are Soon Parted." The courts blow through these superficial arrangements quite easily, as the above-quoted cases clearly demonstrate. These trust arrangements have no substance, rely on unsupportable conclusions of tax law and have never been accepted by the IRS or any court of law.

The Internet (and my website) abounds in solid, reputable and honest tax information and advice. Don't waste your time and money on the crooks and kooks who claim there is an easy way to evade or avoid your tax obligations. They are just ripping you off and when you get caught, they will be long gone.

For further information on estate planning, see Estate Planning ; and Use of Revocable and Irrevocable Trusts.




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