Federal Estate Tax Issues of Abusive Trust Tax Shelters

Doug H. Moy
January 28, 2008 — 1,564 views  
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The following discussion is based on a Declaration of Trust effected in 1977 by Mary and her late husband, Roy, which they purchased from the Institute. In 1994, the author’s services were retained to assist Mary’s attorney in extricating her from the Declaration of Trust and to design and implement an effective estate plan for her.

Interests in Property: IRC §2033. The gross estate of a decedent who is a citizen or resident of the United States at the time of his or her death includes the value of all property beneficially owned by the decedent, to the extent of the decedent’s interest in the property, wherever situated, of which the decedent can transfer by a Last Will, trust, right of survivorship, contract, or the law of intestate distribution. It is the decedent’s possession of the economic benefits of property that determines whether the value of the property is included in the decedent’s gross estate. Because the trustor retains the power to terminate the family estate trust and, in effect, reconvey title to the property in the trust to himself or herself, as an individual, the value of the decedent trustor’s interest in such property is includable in the gross estate under IRC §2033.

Units of beneficial interest (UBI) or certificates of beneficial interest (CBI) may be property separate from the assets of the family estate trust includable in the decedent trustor’s gross estate as an interest in property under IRC §2033 and may be subject to probate under the laws of the trustor’s state of domicile or residence. The term units of beneficial interest is not used in the Code but is used by trust promoters in an attempt to gain tax advantages (such as a tax-free exchange). The use of the term does not require the IRS to grant favorable tax treatment to any transaction. The value of the rights in the UBIs may be included in the decedent-trustor’s gross estate under other sections of the Code.  In such a case, no duplicate inclusion is required. The extent to which UBIs have any substantive value subject to federal estate tax depends in large part on the efficacy of the UBI. In some cases, if the identity of the beneficiary of the UBI is impossible to ascertain, the UBI may be worthless for purposes of the federal estate tax simply based on the fact that no transfer of the UBI to a beneficiary can occur.

Retained Life Estate: IRC §2036. IRC §2036 requires the value of assets in a family estate trust to be included in the trustor’s gross estate. In this regard, the value of the gross estate includes the value of all property that the decedent has at any time transferred (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth) by trust or otherwise under which the decedent retained for life: (1) possession or enjoyment of or the right to the income from the property; or (2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income there from. With respect to the latter, it is immaterial: (1) whether the power was exercisable alone or only in conjunction with another person or persons, whether or not having an adverse interest; and (2) in what capacity the power was exercisable by the decedent or by another person or persons in conjunction with the decedent.

IRC §2036(a) reflects a legislative policy that taxes all property that has been the subject of an incomplete inter vivos (lifetime) transfer. The legislative policy is to include in a decedent’s gross estate transfers that are in substance testamentary, i.e., “transfers which leave the transferor a significant interest in or control over the property transferred during his lifetime.” As stated in Commissioner v. Estate of Church: “[A]n estate tax cannot be avoided by any trust transfer except by a bona fide transfer in which the settlor, absolutely, unequivocally, irrevocably, and without possible reservations, parts with all of his title and all of his possession and all of his enjoyment of the transferred property.” Legal title to property conveyed to the trustee of the family estate trust fails this requirement to remove the value of such property from the trustor’s (grantor’s) gross estate for purposes of the federal estate tax.

Even if the estate owner does not expressly reserve a right to the income, the transferred property may be included in the decedent estate owner’s gross estate under IRC §2036(a)(1), if the decedent retained possession or enjoyment of the property. In regards to the family estate trust, the operative word is enjoyment. The trustor of a family estate trust retains the enjoyment of the property by continuing to live in his or her personal residence used as the headquarters for the trust and by receiving enjoyment from all of the other property transferred to the trust. In other words, the trustor’s position with respect to the issue of possession or enjoyment, after transferring property to the trust, is no different than the trustor’s position with respect to the issue of possession or enjoyment before the trustor transferred property to the trust. No material change in enjoyment of the property transferred or economic circumstances occur.

Moreover, if pursuant to an understanding, expressed or implied, the estate owner retains for life the possession or enjoyment of, or the right to the income from, the property transferred to the trust, the trust property is includable in the estate owner’s gross estate under IRC §2036(a)(1). The same result obtains if, pursuant to an understanding, the interest or right would later be conferred.

A retained life interest need not be created by the express terms of the trust, nor need it be legally enforceable, for IRC §2036(a)(1) to apply. Indeed, the existence of an agreement or understanding by which the possession or enjoyment of the property is retained may be inferred from the circumstances of the transfer and the manner in which the transferred property is used. There was no question that, in creating the family estate trust, Roy, the trustor, had an express understanding that he retained the right to the possession and enjoyment of the property transferred to the trust, as well as the income from the property. In this regard, the trust provided: “The declared purpose of the Trustees of this Trust shall be to accept rights, title, and interest in and to real and/or personal properties, whether tangible or intangible, conveyed by The Trustor to be the corpus of THIS TRUST, so that [Roy] can maximize his (her) lifetime efforts through the utilization of his (her) desire to promote the general welfare, all of which [Roy] feels he will achieve because his (her) RELIGIOUS BELIEFS are sustained by this Trust.” Moreover, “[b]y creating this Legal Entity, the Trustor-Creator of THIS TRUST is exercising his constitutional rights and has done that which is right for himself, thereby demonstrating and implementing his individual Religious Beliefs.” The italicized language infers that Roy retained the enjoyment of the property transferred to the trust.

Further in this regard, Roy’s trust provided: “The expressed intent of this instrument is to convey property to Trustees, to constitute a Trust (Estate) for the benefit of the beneficiaries, held by Trustees, in Trust and in joint tenancy for the duration hereof, and to provide for a prudent and economical administration by natural persons acting in a fiduciary capacity, to BEGIN AT ONCE and not to be deferred until after the death of any creator, settlor or maker, as occurs when such Trust Estates are created by Last Will and Testament.” It may reasonably be assumed that the trustor, Roy, was the primary beneficiary of the family estate trust, in view of the fact, that “... [Roy] can maximize his (her) lifetime efforts through the utilization of his (her) desire to promote the general welfare, all of which [Roy] feels he will achieve because his (her) RELIGIOUS BELIEFS are sustained by this Trust.” It may be said that, in effect, the family estate trust is a self-settled trust, the purpose of which may be to shelter assets from the trustor’s creditors.

Moreover, the powers held by Roy, the trustor, and by Roy and Mary, as co-trustees, to: (1) “...[E]xercise their best judgment and discretion, in accordance with the Trust Minutes, making distributions of portions of the proceeds and income as in their discretion, and according to the minutes, should be made...and upon final liquidation distributing the assets to the beneficiaries [i.e., to the trustor] as their interests may appear” (exercise of the trustee’s discretion is not limited by an ascertainable standard, which, if it were, would cause the value of the property in the trust estate not to be included in Roy’s gross estate for purposes of the federal estate tax. Moreover, nowhere in family estate trusts does one find the beneficiary identified or defined); (2) “...[P]erform and function for any purpose on behalf of any individual, group, or combination of individuals, severally or collectively” (the phrase, “...on behalf of any individual ...” permits Roy and Mary, as co-trustees, to act on behalf of Roy, as trustor of the trust, thereby, causing the value of the trust estate property to be included in Roy’s gross estate for purposes of the federal estate tax); and (3) “...[F]ix and pay compensation of all offices, employees, or agents in their discretion, and may pay themselves such reasonable compensation for their services as may be determined by a MAJORITY of the Board of Trustees ...” amounts to a power to designate who shall enjoy the property and income of the family estate trust within the meaning of IRC §2036(a)(2). Further, in this regard, the initial organization and implementation of the family estate trust is conducted by a board of trustees, suggesting that the family estate trust is, in substance, an association taxable as a corporation.

Finally, because Roy, as trustee, was empowered to “borrow money for any business project, pledging [sic] The Trust property for the payment thereof; hypothecate assets, property or both” and relegate the trustor’s (e.g., Roy’s) creditors to the trust agreement for payment, the trustor is deemed to have retained the economic benefit and enjoyment of the entire trust income and principal. In this regard, the trust agreement provided: “Notice is hereby given to all persons, companies, or corporations extending credit to, contracting with, or having claims against THIS TRUST, that they must look only to the funds and property of The Trust for payment or for settlement of any debt, tort, damage, judgment, or decree, or for any indebtedness which may become payable hereunder.” Retention by the trustor (e.g., Roy) of the aforementioned powers causes the value of the assets composing the family estate trust to be included in the trustor’s gross estate under IRC §2036(a)(1).

Revocable Transfers: IRC §2038. Code §2038 requires the value of assets in a family estate trust to be included in the trustor’s gross estate. In effect, if the decedent transferred property in trust (except by bona fide sale for an adequate consideration in money or money’s worth) during his or her lifetime, continued enjoyment of the transferred property, and reserved the power exercisable by the decedent alone or by the decedent with any other person to alter, amend, revoke, or terminate the trust, then, the value of the property subject to such power is includable in the decedent’s gross estate. It cannot be represented that the UBIs are “. . . something which the [trustor] felt was of equal value,” for the property transferred to the trust. In other words, the UBIs do not represent adequate consideration in money or money’s worth which, if they did, would cause the value of the assets transferred to the family estate trust to not be included in the trustor’s gross estate for purposes of the federal estate tax. In effect, the “. . . something which the [trustor] felt was of equal value,” is nothing more than an understanding, expressed or implied, with the trustee that the trustor-trustee would receive distributions of income and/or principal if, as, and when the trustor requested them.

As with IRC §2036, under IRC §2038, it is immaterial in what capacity the power to alter, amend, revoke, or terminate the trust is exercisable or whether the power is exercisable alone or in conjunction with another person or persons, regardless of whether they hold an adverse interest in the transferred property.

The following language in Roy’s family estate trust caused the value of the trust assets to be includable in his gross estate under IRC §2038 because Roy was a trustee, and the fiduciary power Roy held, as a trustee, caused him, as trustor, to be able to benefit himself as a beneficiary: (1) “This Trust is irrevocable and may not be altered or amended in any respect unless specifically authorized by this instrument, and it may not be terminated except through distributions permitted by this instrument.” This language is called the exception clause; (2) “This Trust shall continue for a period of twenty-five years from date, unless the Trustees shall unanimously determine upon an earlier date when they may at their discretion, because of threatened depreciation in values, or other good and sufficient reason necessary to protect or conserve trust assets, liquidate the assets, distribute and close the Trust at any earlier date determined by them. The Trust shall be proportionately and in pro rata manner distributed to the beneficiaries.” Accordingly, for federal estate tax purposes, Roy’s role as trustee placed him in no different standing than if Roy were acting as an individual. Hence, the value of the assets conveyed by Roy to the trust was includable in his gross estate for federal estate tax purposes under IRC §§2036(a)(1) and 2038(a)(1). Again, it must be emphasized that beneficiaries are not defined or identified in the family estate trust. Presumably, the trustor is the primary beneficiary. Neither vested remainder nor contingent remainder beneficiaries are named to receive the trustor’s remainder trust estate upon the trustor’s death.

Unfortunately, Roy’s reliance on the Declaration of Trust caused the loss of his federal estate tax exemption amount ($600,000 at the time of Roy’s death). This is because, under the Declaration of Trust, Mary, as the only supposed beneficiary, received what amounted to 100 percent of that which had been Roy’s estate. Such amount qualified for the federal unlimited estate tax marital deduction in Roy’s gross estate. When Roy died, the Declaration of Trust did not shelter $600,000 of the assets composing Roy’s gross estate in a credit shelter trust so that those assets would be exempt from federal estate tax upon Mary’s subsequent death. Though Mary was not identified in the Declaration of Trust as a beneficiary upon Roy’s death, and because Mary was the surviving trustee of the trust and the only other individual identified in the Trust, it must be presumed that Mary was the sole beneficiary of the trust estate. The statement written in Roy’s own hand in the Trust that, “A good man leaveth an inheritance to his children’s children,” is just that—merely a statement and not necessarily a direction on his part, as trustor, that his or her remainder beneficiaries were, in fact, his grandchildren. It is interesting to note that, even though Mary and Roy’s adult children had transferred their respective shares in the family corporation, they too were not identified as beneficiaries of the trust estate. Furthermore, it is arguable whether Roy and Mary’s children and/or grandchildren would have inherited the assets of the trust estate had Mary not survived Roy because, technically, the assets composing the trust estate would not have been subject to probate, unless the conveyance of legal title to the assets to the trustee was declared null and void ab initio by a proper court of jurisdiction. Clearly, such a trust arrangement creates unnecessary confusion.

All of this occurred for at least the following reasons: (1) because both Roy and Mary were wrongly advised by the Institute that, by conveying their assets to the Declaration of Trust, such assets would not be included in their respective gross estates for federal estate tax purposes upon their respective deaths (in other words, Roy and Mary would not have an estate for purposes of the federal estate tax); and (2) because Roy and Mary were told by the Institute and its “captive” attorney, Peter R. Stromer, that, “Creation of an irrevocable trust has been established.” Believing that they had effected an irrevocable trust and that they had effectively removed from their respective gross estates the assets transferred to the Declaration of Trust, Roy and Mary believed that they could not terminate the trust, which Mary now knows was not true.

This mistaken belief probably contributed to the third reason why Roy’s $600,000 federal estate tax exemption was needlessly wasted. Roy and Mary did not believe, nor did they understand, that, as trustees of the trust, they could have amended Roy’s estate plan by terminating the trust agreement “...because of threatened depreciation in values or other good and sufficient reason necessary to protect or conserve trust assets....” The revolutionary changes brought about by the Economic Recovery Tax Act of 1981 (ERTA ’81), affecting the federal estate/gift tax laws, would certainly have constituted “...other good and sufficient reason...” to terminate the trust agreement. But, because the entire premise of the Declaration of Trust was false, Roy denied himself the opportunity to effectively shelter at least $600,000 of his estate assets from future federal estate taxation.

If you have any questions regarding the information above, please contact:

Doug H. Moy
Consulting Specialist, Estate/Gift Taxation and Planning; Educator
(503) 636-5855
[email protected]

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.