Scope of Abusive Trust Tax Shelter SchemesDoug H. Moy
November 16, 2007 — 1,899 views
Abusive tax avoidance schemes could threaten our tax system’s integrity and fairness, if honest taxpayers believe that significant numbers of individuals are not paying their fair share of taxes.
The GAO reports that abusive tax schemes encompass such distortions of the tax system as falsely describing the law (saying, for example, that the income tax is unconstitutional), misrepresenting facts (for instance, promoting the deduction for personal expenses as business expenses) or using trusts or offshore bank accounts to hide income. Moreover, the IRS estimates that, as of February 2002, about 740,000 taxpayers had used certain types of abusive schemes in tax year 2000 alone and that $20 billion to $40 billion in improper tax avoidance or tax credit and refund claims had occurred which IRS had not yet been able to identify and address.
Just between October 1, 2001, and mid-August 2003, IRS officials linked 131,000 participants to abusive schemes and estimate that several hundred thousand additional taxpayers likely are engaged in abusive schemes. Of the 740,000 taxpayers using abusive schemes just in the year 2000, the IRS estimated that 65,000 taxpayers used abusive domestic trusts with tax losses approximating $2.9 billion. Michael Brostek, Director, Tax Issues, in giving testimony before the U.S. Senate Committee on Finance on April 11, 2002, testified that, “The sheer number of possible abusive tax schemes that likely will require face-to-face audits could outstrip the IRS’s available resources.”
According to the Service’s fiscal year 2003-2004 Small Business and Self-Employed (SB/SE) Division Strategic Assessment Report, abusive tax schemes represent a rapidly growing risk to the tax base. The Service estimates the potential revenue loss from these schemes to be in the tens of billions of dollars annually. According to an IRS official, to make accurate estimates in this area of noncompliance is difficult. For one reason, the nuances and types of schemes are constantly changing and evolving, particularly, in the areas of abusive trusts and offshore compliance. The taxpayer will often use multiple entities such as partnerships, limited liability companies, or secondary level trusts that can be tiered or layered to mask the taxpayer’s continued ownership or control of the trust’s income or assets. In addition, domestic trusts may file tax returns; however, those returns alone seldom provide enough information for the IRS to determine whether an abusive scheme was used. Therefore, the Service’s estimates of the numbers of taxpayers and the taxes at risk for the domestic trust scheme generally rely on limited numbers of cases that have been examined or investigated on intelligence obtained in the course of normal tax administration and Criminal Investigation activities and on the Service’s professional judgments.
It is not the purpose of this article to discuss all abusive tax schemes. Instead, the focus of this article is on abusive domestic trust tax shelters, the most common abusive trust arrangements currently being promoted, and strategies employed by the IRS to combat abusive tax avoidance schemes, which include abusive domestic trusts.
The IRS defines an abusive trust as any trust that purports to reduce or eliminate federal taxes in ways that are not permitted by federal tax law. Abusive trust arrangements typically are promoted by the promise of tax benefits with no meaningful change in the taxpayer’s control over or benefit from the taxpayer’s income or assets. The promised benefits may include:
• Reduction or elimination of income subject to tax;
• Deductions for personal expenses paid by the trust and depreciation deductions of an owner’s personal residence and furnishings;
• A step-up in basis for property transferred to the trust;
• The reduction or elimination of self-employment taxes;
• The reduction or elimination of gift and estate taxes.
These promised benefits are inconsistent with the tax rules applicable to legitimate trust arrangements. Abusive trust arrangements often use trusts to hide the true ownership of assets and income or to disguise the substance of transactions. These arrangements frequently involve more than one trust, each holding different assets of the taxpayer (e.g., the taxpayer’s business, business equipment, home, automobile, and so forth). Some trusts may hold interests in other trusts, purport to involve charities, or are foreign trusts. Funds may flow from one trust to another trust by way of rental agreements, fees for services, purchase agreements, and distributions.
The IRS has identified eight abusive trust arrangements:
1. Business Trust
2. Equipment or Service Trust
3. Family Residence Trust
4. Charitable Trust
5. The Final Trust
6. Welfare Benefit Funds Trust
7. Contested Liability Trust
8. Family Estate Trust
With the exception of the welfare benefit funds trust and the contested liability trust, in each of the other six trusts, the original owner of the assets that are nominally subject to the trust effectively retains the authority to cause financial benefits of the trust to be directly or indirectly returned or made available to the owner (trustor; settlor). For example, the trustee may be the promoter or a relative or friend of the owner who simply carries out the directions of the owner, whether or not permitted by the terms of the trust. Moreover, in most cases, the CPAs and attorneys writing the opinion letters relative to such trust arrangements are not independent of the promoter; rather, they are captive members of the promoter’s team.
When trusts are used for legitimate business, family, or estate planning purposes, the trust, the beneficiary, or the transferor of property to the trust will pay the tax on income generated by the trust property. Legitimate trusts are not used to transform a taxpayer’s personal, living, or educational expenses into deductible items and do not seek to avoid tax liability by ignoring either the true ownership of income and assets or the true substance of transactions. The tax results promised by the promoters of abusive trust arrangements are not allowable under federal law. Contrary to promises made in promotional materials, several well-established tax principles control the proper tax treatment of these abusive trust arrangements; and, the participants in and promoters of abusive trusts may be subject to civil and/or criminal penalties in appropriate cases.
If you have any questions regarding the information above, please contact:
Doug H. Moy
Consulting Specialist, Estate/Gift Taxation and Planning; Educator
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Doug H. Moy
Doug H. Moy is a nationally recognized author, consulting specialist, seminar instructor and educator. He has an undergraduate degree from Willamette University and a Masters degree from Washington State University. Since 1979, Mr. Moy has consulted to attorneys, tax practitioners and their clients, as well as assisted practitioners representing clients before the IRS Conference of Right and Appeals Division and Settlement Conference Negotiations. He is noted for his ability to communicate his unparalleled knowledge and experience to practitioners at all levels in his field of expertise; namely, estate/gift taxation and planning, with special expertise in living trusts; community property; lottery prize winnings; structured settlement trusts; extricating clients from abusive trust tax shelters; designing effective estate plans; and preparation of Form 706 Estate Tax Returns and 709 Gift Tax Returns. He offers particular assistance and exceptional skill designing creative, practical solutions to challenging and difficult estate planning situations.