Abusive Domestic Trust Tax Shelter ArrangementsDoug H. Moy
November 27, 2007 — 2,108 views
An abusive trust arrangement may involve some or all of the trusts described below. The type of trust arrangement selected is dependent on the particular tax benefit the arrangement purports to achieve. In each of the trusts described below, the original owner of the assets that are nominally subject to the trust effectively retains authority to cause the financial benefits of the trust to be directly or indirectly returned or made available to the owner. 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. Often, the trustee gives the owner checks that are pre-signed by the trustee, checks that are accompanied by a rubber stamp of the trustee’s signature, a credit card or a debit card with the intention of permitting the owner to obtain cash from the trust or otherwise to use the assets of the trust for the
The owner of a business transfers the business to a trust (sometimes described as an unincorporated business trust) inexchange for units of beneficial interest (UBIs; or trust units) or certificates of beneficial interest (CBIs). The business trust should not be confused with the Massachusetts Business Trust, a legitimate unincorporated association organized under Massachusetts law for the purpose of investing in real estate in much the same manner as a mutual fund invests in corporate securities. The business trust makes payments to the trust unit holders or to other trusts created by the owner (characterized either as deductible business expenses or as deductible distributions) that purport to reduce the taxable income of the business trust to the point where little or no tax is due from the business trust. In addition, the owner claims the arrangement reduces or eliminates the owner’s self employment taxes on the theory that the owner is receiving reduced or no income from the operation of the business. In some cases, the trust units are supposed to be canceled at death or sold at a nominal price to the owner’s children, leading to the contention by promoters that there is no estate tax liability. Promoters of the business trust liken it to the Massachusetts Business Trust in their efforts to legitimatize the business trust. Of course, such comparison is misleading and is fraudulent.
The equipment trust is formed to hold equipment that is rented or leased to the business trust, often at inflated rates. The service trust is formed to provide services to the business trust, often for inflated fees. Under these abusive trust arrangements, the business trust may purport to reduce its income by making allegedly deductible payments to the equipment or service trust. Further, as to the equipment trust, the equipment owner may claim that the transfer of equipment to the equipment trust in exchange for the trust units is a taxable exchange. The trust takes the position that the trust has purchased the equipment with a known value (its fair market value) and that the value is the tax basis of the equipment for purposes of claiming depreciation deductions. The owner, on the other hand, takes the inconsistent position that the value of the trust units received cannot be determined, resulting in no taxable gain to the owner on the exchange. The equipment or service trust also may attempt to reduce or eliminate its income by distributions to other trusts.
Not to be confused with the legitimate Personal Residence Trust and Qualified Personal Residence Trust sanctioned by Treasury Regulation 25.2702-5, the owner of the family residence transfers the residence, including its furnishings, to an abusive family residence trust. The parties claim inconsistent tax treatment for the trust and the owner (similar to the equipment trust). The trust claims the exchange results in a step up in basis for the property, while the owner reports no gain. The trust claims to be in the rental business and purports to rent the residence back to the owner; however, in most cases, little or no rent is actually paid. Rather, the owner contends that the owner and family members are caretakers or provide services to the trust and, therefore, live in the residence for the benefit of the trust. Under some arrangements, the family residence trust receives funds from other trusts (such as a business trust), which are treated as the income of the trust. In order to reduce the tax that might be due with respect to such income (and any income from rent actually paid by the owner), the trust may attempt to deduct depreciation and the expenses of maintaining and operating the residence.
Not to be mistaken for the popular and often used legitimate charitable remainder trust [charitable remainder annuity trust (CRAT) and the charitable remainder unitrust (CRUT)] governed by IRC §664, the taxpayer transfers assets to a purported charitable trust and claims either that the payments to the trust are deductible or that payments made by the trust are deductible charitable contributions. Payments are made to charitable organizations; however, in fact, the payments are principally for the personal educational, living, or recreational expenses of the owner or the owner’s family. For example, the trust may pay for the college tuition of a child of the owner.
In some multi trust arrangements, the United States owner of one or more abusive trusts establishes a final trust that holds trust units of the owner’s other trusts and is the final distributee of their income. A final trust often is formed in a foreign country that will impose little or no tax on the trust. In some arrangements, more than one foreign trust is used with the cash flowing from one trust to another until the cash is ultimately distributed or made available to the U.S. owner, purportedly tax free.
Promoters of the welfare benefit funds trust believe that such trusts qualify as collectively bargained welfare benefit funds excepted from the account limits of IRC §§419 and 419A. The tax benefits purportedly generated by these transactions are not allowable for federal income tax purposes. In general, contributions to a welfare benefit fund are deductible when paid but only if they qualify as ordinary and necessary business expenses of the taxpayer and only to the extent allowable under IRC §§419 and 419A. Those sections impose strict limits on the deduction for contributions in excess of current costs. An exception to some of the limits is provided under IRC §419A(f)(5) for contributions to a separate welfare benefit fund under a collective bargaining agreement. The exception is based in part on the premise that deductions in such a setting will not be excessive because of the arms’ length negotiations between adversary parties inherent in the collective bargaining process.
Such an arrangement purportedly allows a business to take a current tax deduction for all contributions to a welfare benefit fund. Prior to such an arrangement, these businesses typically have had no involvement with labor organizations or other aspects of the collective bargaining process. The promoters of these arrangements rely on IRC §419A(f)(5), claiming that the benefits are provided under a collective bargaining agreement. The individual or company promoting the arrangement typically arranges for an organization (sometimes referred to as a management group) to act on the business’s behalf in bargaining with an employee representative over benefits to be provided to some or all of the employees of the business (including employees who are also owners of the business) and over certain other terms. While its name may include the word union, the employee representative is often established specifically for the purpose of the welfare benefit arrangement that is being promoted. In other cases, the employee representative may be affiliated with an established union.
These arrangements usually require large employer contributions relative to the amount actually needed to provide the current coverage for the welfare benefits under the arrangement. Typically, benefits that are provided or expected to be provided to employees who are also owners are more favorable than the benefits provided to employees who are not owners. For example, if death benefit protection is being provided, owners may be covered by cash value life insurance policies (and entitled to certain benefits resulting from amounts accumulating under those policies) while other employees receive only term insurance coverage or other less valuable coverage than that provided to the owners.
In some of the arrangements, participants can access funds by obtaining a loan from the trust. While the plan documents may indicate that the loans are available only for unanticipated future events, in reality, most owners will be able to obtain a loan without regard to whether those events occur. Often, the arrangement will operate to allow the owner or owners of the business to benefit from any contributions to the trust in excess of amounts actually used to provide coverage to other employees.
In general, these arrangements and other similar arrangements do not satisfy the requirements of IRC §419A(f )(5) and do not provide the tax deductions claimed by their promoters. For example, if an employer (or its agent) bargains for benefits to be provided to employees, including the owner or owners of that employer, and the benefits to be provided to an owner are more favorable than those provided to other employees, the circumstances of that bargaining process strongly indicate a lack of the good faith bargaining required to satisfy the conditions for the IRC §419A(f)(5) exception. Further, even if the stated benefits for an owner are not more favorable than those for other employees (e.g., all benefits are based on a uniform percentage of compensation), the facts and circumstances of the particular arrangement or the bargaining process may indicate that the good faith bargaining requirement, or another requirement to be treated as a collective bargaining agreement for purposes of IRC §419A(f )(5), has not been met.
In addition, an employer’s deduction for contributions to the trust will be subject to the deduction limits of IRC §§419 and 419A, if it is not a separate welfare benefit fund under a collective bargaining agreement. Moreover, the deduction may be subject to or disallowed by other provisions of the Code. For example, depending on the facts and circumstances, the arrangement may actually be providing deferred compensation or a constructive dividend to an owner rather than welfare benefits. If the arrangement is providing deferred compensation, the employer’s deduction for contributions to the trust is governed by IRC §404(a)(5), rather than by IRC §§419 and 419A. If the arrangement is providing a constructive dividend, to the extent of the constructive dividend, the contributions are nondeductible.
Such a trust arrangement is, in fact, designed for no material purpose other than the improper exploitation of provisions that are appropriate only for legitimate collectively bargained plans. Such an arrangement is not viewed as the product of good faith bargaining and an entity is not considered to be an employee representative merely because of its status for tax exemption or a determination by the IRS with respect to that status. The IRS has disallowed deductions for contributions to these types of arrangements in the past and intends to do so in the future. The fact that a trust used to provide benefits under an arrangement may have received a determination letter stating that the trust is exempt under IRC §501(c)(9) has no relevance to such a trust arrangement. A determination letter under IRC §501(c)(9) determines only the tax status of the trust. It does not determine the tax deductibility of contributions to such a trust, nor does it determine the taxation of the benefits provided through the fund to the participants. Also, as provided by regulations, even if a union has been recognized as exempt under IRC §501(c)(5), the Service nevertheless has the authority to determine whether there is a collective bargaining agreement under the Code and under Regulation §301.7701 17T. Finally, such trust arrangements and any arrangement that is substantially similar to such trust arrangements are identified as listed transactions for purposes of Regulation §§1.6011 4(b)(2) [December 30, 2003], 301.6111- 2(b)(2) [March 4, 2003] and § 301.6112 1(b)(2) [December 30, 2003].
Contested liability trusts improperly attempt to accelerate deductions for contested liabilities under IRC §461(f). These trusts are abusive tax avoidance transactions and are listed transactions for purposes of Regulation §§1.6011-4(b)(2), 301.6111-2(b)(2) and 301.6112- 1(b)(2). These transactions involve taxpayers who establish trusts purportedly to qualify under IRC §461(f) but fail to comply with the requirements of IRC §461(f ) or the regulations by reason of:
1. Retention of powers over the trust assets (such as the power to substitute assets, to pay the contested liabilities out of assets other than those in the trust or to limit the trustee’s ability to sell the taxpayer’s assets that the taxpayer transferred to the trust) contrary to the requirement that the taxpayer relinquish control over the property transferred;
2. Transfer to the trust of related party notes under circumstances indicating the liability is not genuine or that there is no intent between the parties to enforce the obligation, which is not a valid transfer to provide for the satisfaction of an asserted liability; or
3. Establishment of trusts for contested tort, workers compensation, or other liabilities designated in Regulation §1.461-4(g) for which economic performance requires payment to the claimant.
Not all family trusts, such as the revocable or irrevocable living trust, the credit shelter trust, or by-pass trust, commonly used in estate planning are alike. With respect to estate planning, the family estate trust is perhaps one of the most egregious and troubling. The IRS and the courts disapprove of the so-called family estate trust, also known as a pure, constitutional, or equity trust. The overall purpose of the family estate trust is to reduce the grantor’s personal income tax, avoid gift tax on the transfer of assets to the trust, and eliminate federal estate tax upon the death of the grantor. The family estate trust is an irrevocable inter vivos grantor trust, is a listed transaction, and is classified by the IRS as an abusive trust.
In this regard, a listed transaction is a transaction that is the same as or substantially similar to one of the types of transactions that the IRS has determined to be a tax avoidance transaction and identified by notice, regulation, or other form of published guidance as a listed transaction. Since Regulation §1.6011-4(b)(2) defines “a listed transaction that is the same as or substantially similar to one of the types of transactions that the IRS has determined to be a tax avoidance transaction and identified by notice [e.g., Notice 97-24], regulation, or other form of published guidance as a listed transaction,” the family estate trust is a listed transaction and an abusive trust arrangement. To the uninformed practitioner, understanding why the typical family estate trust will not work is extremely difficult.
Furthermore, a taxpayer is considered to have participated in a listed transaction if the taxpayer’s tax return reflects tax consequences or a tax strategy described in the published guidance that lists the transaction under Regulation §1.6011-4(b)(2). A taxpayer also has participated in a listed transaction if the taxpayer knows or has reason to know that the taxpayer’s tax benefits are derived directly or indirectly from tax consequences or a tax strategy described in published guidance that lists a transaction under Regulation §1.6011-4(b)(2).
If you have any questions regarding the information above, please contact:
Doug H. Moy
Consulting Specialist, Estate/Gift Taxation and Planning; Educator
Copyright 2004-2005 by Doug H. Moy. All rights reserved. Without limiting the rights under copyright reserved above, no part of this publication may be reproduced, stored in or introduced into a retrieval system or transmitted, in any form or by any means (electronic, mechanical, photocopying, recording or otherwise), without the prior written permission of the author and copyright holder of this material. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is made available with the understanding that neither the author nor Doug H. Moy, Inc. and/or employees is/are engaged in rendering legal or accounting services. If legal advice or accounting assistance is required, the services of a competent professional should be sought. These articles previously published in TAXPRO Journal, the official Journal of the National Association of Tax Professionals (NATP), Part I, Spring 2004; Part II, Summer 2004; Part II, Fall 2004; Part IV, Winter 2005, Part V, Spring 2005; Part VI, Summer 2005. Copyright 2004-2005 by the author and NATP. Reprinted with permission.
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.