Arguments and Claims Used by Promoters of Abusive Tax SheltersDoug H. Moy
January 15, 2008 — 1,705 views
Promoters of abusive trust tax shelters use myriad arguments to hook their targets. All of these arguments are frivolous. Frivolous arguments are false arguments that are not supported by law. Most often the promoters rely on the socalled common law or constitutional law upon which they frame their frivolous arguments. The tax laws of the United States are not part of the nonstatutory common law; rather, the tax laws are based on federal statutes—that is, statutory law. When a scheme promoter says, “I don’t pay taxes—why should you?” or urges one to “untax yourself for $49.95,” beware. Newspaper advertisements, flyers, information provided in seminars, via the Internet, or through mail order, and “do-it-yourself kits” may claim that the promoter knows the “secret” for never paying taxes again; but that is just plain false. Typically, though, promoters arrive in a city or town, solicit the help of well-known local individuals who know relatively little about trusts, hold seminars, or get their message out by word-of-mouth, and then begin campaigning local individuals owning substantial assets.
Underlying all the arguments and claims are promoters’ assertions that it is a person’s constitutional right to use such trusts or, as the promoters say, “common law trusts.” In some circumstances, a strong element of patriotism is mixed-in with the assertion. One company—namely, the Institute of Individual Religious Studies—incorporated religion into its educational material interspersed with the goals and objectives of the Pilgrims in the American colonies, coupled with the Magna Carta, Declaration of Independence, and references to the U.S. Constitution!
It is interesting to note that many of the companies promoting the so-called common law trust, pure equity trust, and so forth have either patriotic or religious-oriented names. Further, though the promoter’s trust programs may ostensibly be designed for “Christian stewardship,” the trusts, in fact, are designed and used to hide income and assets from the IRS and to take improper tax deductions.
The claims made by the Mitchells in United States v. Marlene Mitchell and the trust packages promoted by them are a typical abusive trust promotion in which the customers are taught to assign their personal income and assets to a sham trust, have the trust cover all personal expenditures, and then claim all of those personal expenses as income tax deductions. In fact, however, “[i]t is fundamental to our income tax regime that personal consumption expenditures— food, clothing, travel, education, entertainment—do not generate income tax deductions unless they are somehow inextricably linked to the production of income.” The Mitchell’s trust devices are transparent shams in an attempt to turn nondeductible personal expenses into deductible expenses. If the trust devices work, their customers would, “unlike the rest of us, make all their consumptive expenditures with pre-tax dollars.”
Payment of Federal Income Tax Voluntary. “The federal income tax system is a ‘voluntary system’ which persons are not required to participate in.” Promoters, such as Marlene Mitchell, assert that their targets are not required to file federal tax returns because the filing of a tax return is voluntary. Such proponents point to the fact that the IRS itself tells taxpayers in the Form 1040 instruction book that the tax system is voluntary. Additionally, the Supreme Court’s opinion in Flora v. United States is often quoted by the promoters for the proposition that “[o]ur system of taxation is based upon voluntary assessment and payment, not upon distraint.”
The word voluntary, as used in Flora and in IRS publications, refers to our system of allowing taxpayers to determine the correct amount of tax and complete the appropriate returns, rather than have the government determine the tax for them. The requirement to file an income tax return is not voluntary and is clearly set forth in IRC §§6011(a), 6012(a) and 6072(a). Similarly, payment of federal taxes is not voluntary. Proponents of this position argue that our system of taxation is based upon voluntary assessment and payment. The requirement to pay taxes is not voluntary and is clearly set forth in IRC §§1 and 11. Furthermore, the obligation to pay tax is described in IRC §6151, which requires taxpayers to submit payment with their tax returns. Failure to pay taxes may subject the noncomplying individual to criminal penalties, including fines and imprisonment, as well as civil penalties.
Government Employees. “The only persons who need file federal income tax returns are government employees and persons who have contracts with the government.” Apparently, this argument is based on a misinterpretation of IRC §§3401 and 3402, which impose responsibilities to withhold tax from “wages.” Code §3401(a) establishes the general rule that “wages” include all remuneration for services performed by an employee for his or her employer. The term employee includes “an officer, employee, or elected official of the United States, a State, or any political subdivision thereof.” The term employee also includes an officer of a corporation; however, a pure trust is not represented to be a “corporation.” No misinterpretation should be taken—the operative word is includes.
System of Complex Trusts. According to the Mitchells, persons can set up a system of complex trusts, including a “business trust,” a “family trust,” a “charitable trust” and “unit trusts,” which can be legally used to hide income and assets from the IRS. Specifically, customers are taught how to transfer personal income to the business trust and distribute all income not eliminated by the business trust’s purported Schedule C expenses to the family trust, which then uses the money to pay for nondeductible personal expenses, such as utilities and home improvements on the personal residence. These personal expenses are then wrongfully deducted as business expenses of the family trust. Customers are told that they can avoid tax on any remaining income by transferring it to a purported charitable trust or distributing
it to children in lower tax brackets. Moreover, the Mitchells asserted that, “Funneling money through the business trust and the family trust and into the charitable
trust would allow customers to deduct 100 percent of every penny
A legitimate charity must benefit in order to claim a valid charitable deduction. Charitable trusts that are exempt from tax are carefully defined in the tax laws. Arrangements are not exempt charitable trusts if they do not satisfy the requirements of the Code, including the requirement that their true purpose be to benefit charity. Furthermore, supposed charitable payments made by a trust are not deductible charitable contributions where the payments are really for the benefit of the owner or the owner’s family members.
Deduction for Personal Expenses. Promoters claim that all expenses associated with maintaining and operating a family residence become deductible business expenses if the home is transferred to the family estate trust because the family home becomes the “headquarters” for the family estate trust. Personal expenses, such as those for home maintenance, education, and personal travel, are not deductible, unless expressly authorized in the Code and accompanying regulations. The courts have consistently held that nondeductible personal expenses cannot be transformed into deductible expenses by the use of trusts. Furthermore, the costs of creating these trusts are not deductible.
Avoidance of Capital Gain Tax. Customers of the abusive trust tax shelter packages are misled to believe that they can avoid paying capital gain tax on property by transferring the property to the charitable trust and having the trust sell the property tax-free. This notion is founded on the erroneous premise that the trust receives a step-up in basis for the property transferred from the trustor to the trustee. The cash received upon the sale of the property is then transferred out of the charitable trust to an “investment trust” where the individuals (i.e., the beneficiaries) now have full control of it—the beneficiaries being the trustor and the trustor’s spouse.
As discussed in Part II, there is no organization in the Code or the accompanying Treasury Regulations classified as a pure trust or pure trust organization. In addition, neither the Code nor the accompanying treasury regulations provide for special tax treatment for a pure trust. Therefore, if the pure trust is determined to be an entity separate from its owner under Regulation §301.7701-1(a), then, it must be classified under Regulation §§301.7701-2 through 301.7701-4. In this regard, the pure trust would be a taxpayer separate from its owner (i.e., the grantor, trustor, settlor, or the person deemed the owner who is not the grantor). If the pure trust is not an entity separate from its owner (i.e., a grantor trust governed by IRC §§671-678), it
is disregarded for tax purposes, and the true owner of the property held by the pure trust must directly report all tax items, including capital gain, on the owner’s tax return and pay all taxes due, including capital gain tax.
However, if the pure trust is determined to be an entity separate from its owner and is not a business entity, it will be classified as a trust under Regulation §301.7701- 4(a). A trust is a taxable entity that must report on a U.S. Income Tax Return for Estates and Trusts (Form 1041) and is required to have an Employer Identification Number (EIN). The notion that a pure trust is not subject to federal tax is false. In all cases, practitioners should make clear to their clients and prospective clients who have effected such arrangements or are contemplating doing so that the only options available to the taxpayer in selecting an entity for which an EIN is required are those provided on the Form SS-4 and that either the taxpayer or the entity must report and pay the tax. Practitioners may be well-advised, in this regard, to provide their clients and prospective clients with a copy of Notice 97-24 as a way of educating taxpayers.
Clearly and unequivocally, the arguments asserted by promoters of abusive trust tax shelters are frivolous and not supported by the Code and accompanying Treasury Regulations or case law. Moreover, with regard to the filing of income tax returns and the payment of taxes, either the trust is a separate entity required to obtain an EIN, file a Form 1041, and pay the requisite taxes, or the income is reported by the owner of the trust on a Form 1040 and the taxes are paid by the owner of the trust. Practitioners play a vital role in assisting the IRS in its campaign to shut down promoters who sell abusive trust tax shelter arrangements.
The practitioner’s role in this regard is further amplified by the fact that abusive tax shelter architects are always a “few steps” ahead of the IRS. In this regard, Mark Matthews, IRS Deputy Commissioner for Services and Enforcement, believes the IRS is currently two or three years behind in its examinations of abusive tax shelter promoters— that’s more than a few steps. Eileen J. O’Connor, Assistant Attorney General for the Justice Department’s Tax Division, asserts that, “People ought to use their common sense: the fact that a scheme is advertised on the radio or Internet . . . doesn’t make it legitimate. The Justice Department is striving to bring people who sell fraudulent tax schemes the response they deserve: injunctions, penalties, and, where warranted, criminal prosecutions.” Once again, Commissioner Mark W. Everson admonishes that, “. . . people shouldn’t fall prey to schemes and scams. No matter how slick the sales pitch, taxpayers should be wary of anyone promising to eliminate their taxes. There is no secret way to escape paying taxes . . . through . . . any scam.”
In Part V, the author will address other federal income tax issues, together with federal estate and gift tax consequences, of creating a family estate trust. With respect to the estate and gift tax issue, the author will examine an actual trust arrangement sold by the Institute of Individual Religious Studies to an unwitting taxpayer whom the author successfully extricated from the trust without adverse tax consequences.
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.