The Family Estate Trust in PerspectiveDoug H. Moy
December 18, 2007 — 2,884 views
The family estate trust is one of eight abusive trust arrangements identified by the Internal Revenue Service (IRS; the Service). 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 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. Because 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.
The family estate trust, in particular, is not a recent abusive trust arrangement; it has been around since the mid-1950s and was conceived as part of the tax protest movement in the United States. Though promoters of the family estate trust and the business trust were quite active during the 1970s, their activity, for the most part, went underground during the 1980s; and the use of abusive tax shelters, antitaxation arguments, abusive tax schemes and frivolous returns last peaked during those years. During this time, the IRS was focusing its financial and employee resources toward illegal drug dealers and traffickers and was not too interested in tracking down abusive domestic trust tax shelter promoters or taxpayers who bought into such arrangements. The Service’s position changed dramatically during the mid- to late-1990s when abusive tax schemes, including abusive domestic trust tax shelters, reemerged across the country with the hot bed of activity in Arizona, northern California, Colorado, Idaho, Massachusetts, Montana, Nevada, Oregon, Utah, Washington, and Wyoming. Of the seven standard tax protest schemes, the family estate trust ranks second in popularity. Twenty-six percent of all tax protest returns identified by the IRS in 1980 involved family estate trusts. Many of the family estate trusts effected in 1980 and before are still in existence today.
Extent of the Family Estate Trust. It is difficult to estimate the number of family estate trusts that have been effected since the mid-1950s, because the IRS did not begin keeping data on such schemes until 1978. As previously stated, it is estimated that 65,000 taxpayers used abusive domestic trusts just in tax year 2000 alone. Nevertheless, the IRS has identified about 200,000 or more abusive trusts, which represent about seven percent of the total trust returns filed annually and account for about $1 billion in assets. Included in the number of abusive trusts is the family estate trust.
Illegal Tax Protester. Promoters of and taxpayers who utilize the family estate trust are classified by the IRS as illegal tax protesters. The IRS defines an illegal tax protester as “a person who advocates and/or participates in a scheme with a broad exposure that results in the illegal underpayment of taxes.” Time and time again, the claimed income, estate, and gift tax benefits of the family estate trust have proven ineffective. Several IRS Revenue Rulings have been published adverse to the family estate trust scheme, and the Service’s challenges to these trusts have been upheld in hundreds of court cases. Nevertheless, uninformed taxpayers continue to purchase the family estate trust scheme or variations of it.
Grantor Trust. The family estate trust is an irrevocable grantor trust. Any trust can be made irrevocable. Declaring a trust to be irrevocable does not, by itself, make the assets that a settlor (grantor; trustor) conveys to the trust not includable in the value of the settlor’s gross estate for purposes of the federal estate tax. Nor does such conveyance guarantee that the settlor will not be taxed on the income generated by the assets transferred to the trust. Usually, when a family estate trust is created, the settlor does not divest himself or herself of all ownership of the property placed in the trust.
In most cases, it is true that the settlor creates an irrevocable trust by declaration. However, in order for the settlor to obtain the legal and tax benefits from conveying property to an irrevocable trust, more is required than just a declaration or statement that the trust is irrevocable. Again, the settlor’s divestiture of ownership of the property conveyed to the trust must be so complete that he or she can no longer be considered the owner of the property.
Pure Trust. As previously mentioned, the family estate trust is a pure trust. The pure trust is sometimes referred to as a constitutional trust, a common law trust, or a contract trust. A pure trust is an arrangement that purports to create a separate entity without actually altering the taxpayer’s control over the property or business transferred to the pure trust. In other words, while legal title to property is conveyed to the trustee, who is the grantor, the grantor continues to possess, in effect, the same control over the property as the grantor held before legal title to the property was conveyed by the grantor to the trustee. Generally, the trust issues Certificates of Beneficial Interest (CBIs) that represent ownership of the trust property. In most cases, the pure trust is a sham. Whether and to what extent it is a sham depends on the trust terms and its actual operation. The taxpayer who transfers property or a business to the trust must report all the income earned by the trust and is liable for the taxes. Typically, the grantor-taxpayer’s income tax is reduced by the trustee taking deductions for trust expenses not allowed by the tax rules applicable to trust administration. Bottom line: the grantor-taxpayer may not circumvent the tax system by structuring transactions with the purpose of evading taxes, whether those taxes be income, gift, or estate taxes.
There is no organization classified as a pure trust or pure trust organization under the Code or the accompanying regulations. In addition, neither the Code nor the accompanying regulations provides for special treatment for a pure trust. Therefore, the pure trust, if it is determined to be an entity separate from its owner under Regulation §301.7701-1(a), must be classified under Regulation §§301.7701-2 through 301.7701-4. If the pure trust is not an entity separate from its owner, it is disregarded for tax purposes; and the true owner of the property held by the pure trust must directly report all tax items on the owner’s tax return and pay all taxes due. 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).
Certain promoters sell these arrangements as tax shelters, arguing that they are merely contracts between the grantor and the trustee and, thus, are not taxable under the United States Constitution, Article 1, Section 10, which provides that no state shall pass any law impairing the obligations of contracts. The notion that a pure trust is not subject to federal tax law is false. The sixteenth amendment to the United States Constitution empowers Congress to lay and collect taxes on incomes, from whatever source derived.
How to Identify a Family Estate Trust. Typically, five indicators identify whether the trust being used by the taxpayer is a family estate trust:
1. CBIs will be referred to in the trust instrument;
2. The trust term will either be 20 or 25 years, and provision is not made for what is to occur at the end of the trust term;
3. No dispositive provisions are included in the trust instrument; that is, the matter of distributing trust property upon the grantor’s death is not addressed;
4. In trusts involving married couples, the grantor is generally the husband; and rarely is his wife mentioned, except as a trustee; and
5. No estate tax planning provisions are included in the trust instrument (this is because the promoters represent no need for such provisions, since creating and funding the trust permits the grantor to die with no estate subject to federal estate or generation-skipping transfer tax).
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.