How the Family Estate Trust is PromotedDoug H. Moy
January 4, 2008 — 2,358 views
The late Dr. Martin A. Larson may well be considered the dean of the family estate trust scheme. Dr. Larson was a consultant and regular columnist in Liberty Lobby’s weekly newspaper, The Spotlight. Liberty Lobby, a populist organization, based in Washington, D.C., lauded Larson as “one of America’s foremost Jeffersonian scholars, a Miltonian scholar and a scholar of comparative religion.” His widely sold publication entitled A Manual on How to Establish a Trust and Reduce Taxation changed many people’s lives. These changes have not all been for the better.
Over the years, the Family Estate Trust (“The Family Preservation Trust,” designed by Dr. Martin A. Larson, included in A Manual on How to Establish a Trust and Reduce Taxation) has been marketed under numerous names. However, all family estate trusts – pure, equity, or constitutional trusts – contain about the same general provisions; and all operate basically the same.
Today family estate trusts own highly appreciated farm/ranch land, other closely-held business assets, and countless other assets of the estate owners who created them. Family estate trusts seem to be promoted in mainly rural and agricultural areas. The primary targets of the promoters are wealthy individuals, small business owners, farmers, ranchers, doctors, veterinarians, lawyers, and other substantial property owners. The main selling point of abusive trust tax shelter arrangements is the notion that the taxpayer (grantor) gives up control of his or her property and money, when in fact, the grantor still controls how the property and money are used.
Promoter’s Written Information. The written information provided by promoters generally includes suggestions relating to trust operations and reviews certain factual situations illustrating tax benefits to the trustor (grantor) and to the grantor’s family. In these regards, and despite the fact that the family estate trust purportedly is irrevocable, the trustor is advised that a great advantage of creating a trust is that, “It can, unlike an individual, deduct from taxable income all administrative expenditures.” Moreover, these expenditures are deductible, even though “actual control will remain within the family structure [with proper appointment of Trustees].” Additionally, the trust can pay the trustor various fees for consultations and managing trust properties; can pay trustees reasonable fees and all expenses associated with meetings of benefit to the trust; can pay the trustor for the use of his or her own car that was previously leased to the trust; and can pay for the use “of headquarters, which may at least in part, also be the domicile of the Trustor and Spouse.” The trustor is also advised that the family home, upon placement in the trust, becomes income-producing property with all costs of operation being deductible. “All repairs become business expenses; and, most of all, the home can be depreciated like any other business property.”
Trust Package. Most abusive tax schemes, including abusive domestic trust tax shelters, are offered to taxpayers using various means, including conferences or seminars, publications, advertisements, the Internet, out-of-the-trunk of the promoter’s car, or by word-of-mouth. Under the family estate trust scheme, a person purchases a trust package from promoter. These schemes are often promoted by a network of promoters and subpromoters. It is not uncommon for a promoter to solicit CPAs, accountants, tax practitioners, and tax return preparers to act as the promoter’s agents (subpromoters) to sell such packages. In turn, the agents receive a commission of $850 or more on each sale of a package. The IRS would classify the agents as illegal tax protesters subject to the same penalties as the promoters themselves. These packages may sell from $2,000 to $70,000 or more. One practitioner informed this author that his client had paid in excess of $14,000 for such a trust package! The purchaser (grantor; settlor; trustor) of the trust package transfers all of his or her personal tangible and intangible property and real property to the trust. In addition, the trustor usually transfers, by assignment, his or her lifetime services to the trust. The promoters misrepresent that a settlor can assign his or her income (i.e., wages; salary; commissions) to either another person or a trust to escape taxation, and substantially all of the grantor’s living expenses may be deducted on the trust’s fiduciary income tax return as business expenses.
Under the family estate trust scheme, the trust pays many personal expenses of the grantor, such as housing, medical, automobile, and interest expenses. Any remaining trust income is paid to the grantor, who is a trust beneficiary; or the trust income can be divided among several beneficiaries, such as the grantor’s minor children who have little or no income. The taxpayer files a Form 1041, United States Fiduciary Income Tax Return, showing these transactions, and a Form 1040, United States Individual Income Tax Return, showing any distributions from the trust as income.
Notwithstanding unfavorable court decisions and IRS rulings regarding the family estate trust, uninformed taxpayers continue to purchase the family estate trust scheme. In March 1992, clients of this author were approached by an insurance salesman promoting the Estate Preservation Trust. In June 1993, the U.S. Tax Court was involved with a family estate trust established by a taxpayer on September 6, 1980, involving tax years 1986 and 1987.17 This same taxpayer had been before the Tax Court in 1989, involving tax years 1982 and 1983 under the same trust agreement.
Reliance on Case Law. All promoters of family estate trusts rely on case law to prove that the family estate trust is legitimate. In discussing “Points & Authorities,” promoters emphasize what they perceive to be relevant issues in case law. In this regard, the focus seems to be on the recognition of trusts under the common law and the contractual trust. They also cite cases pertaining to the “role of trustees,” as well as “resolving tax and financial issues.” The legal points, or issues on point, cited by the promoters from verifiable case law, seem to unquestionably support the efficacy of the family estate trust scheme. However, in this author’s opinion, these so-called issues on point are taken and used out of context in order to lend credence to the selling points being offered by the promoters of the family estate trust scheme.
Captive Attorney. Invariably, a legal opinion written by a captive attorney is used to dispel any concerns the settlor may harbor about the efficacy of the trust document and whether the taxing authorities will accept the trust instrument. The opinions of such captive advisors certainly do not adhere to the “best practices” contemplated by the proposed amendments to Circular 230. By themselves, the statements made in these letters are probably true. However, when read in conjunction with the actual construction of the family estate trust instrument and supplemental documents, the statements made in the legal opinion letters are misrepresentations.
Targets for the family estate trust scheme who consult their tax advisors and attorneys and are advised that the benefits of the trust are illusory are informed by the promoters that most tax practitioners, attorneys, and other professionals have little experience with pure equity trusts and have not studied the advantages and disadvantages of such a system. Unfortunately, this contention by the promoters is true, in that abusive domestic trust tax shelters are a mystery to most attorneys and tax practitioners. Promoters contend that persons contemplating the use of the family estate trust are fortunate to already have access to research that has taken decades to compile.
Benefits Claimed. In their efforts to educate targets of the benefits and advantages of the family estate trust, the promoters cite generally the following benefits of such a trust: “A [Trust] will eliminate or limit personal liability! By separating you, your business, and your assets into independent units [i.e., Units of Beneficial Interest
(UBIs) or CBIs], a liability or a claim against one does not effect the others. Each unit is isolated from the others. A claim against you, personally, can’t touch your business or your assets. And, if you have no assets, a lawsuit against you is far less likely. A claim against your business also does not touch your assets. In addition to isolating your assets from you and your business, this separation could reduce your need for expensive liability insurance.”
According to another promoter: “Since the creator does not own the trust assets, such assets generally may not be attached by creditors. However, the independent trustees and adverse trustee, if applicable, may in their sole discretion continue to provide benefits to the Creator of the Trust, if he or she is also a beneficiary. Thus, nearly any individual or business could benefit from the use of a pure equity trust.” (Notice the word, Creator. It is not uncommon to find the family estate trust being promoted by “religious” institutes such as the Institute of Individual Religious Studies, operational in the 1970s and now believed to be defunct, but whose trusts are still active.) “An Equity Trust will reduce your self-employment tax! The average business owner pays more self-employment tax than income tax.... With an Equity Trust, you take a very small wage for management, say $10,000. The rest of the net business income passes directly to the holding trust as a dividend. No self-employment tax is ever paid on a dividend!”
“An Equity Trust will reduce your income tax! With an Equity Trust, you have moved your assets and the bulk of your business income to a holding trust. Your small personal income is offset by your Minimum Standard Deduction and by your personal exemptions. You pay little or no personal income tax. Since your holding trust ‘holds’ your assets as capital assets, it can write-off many expenses that you could not. For example, it can depreciate your home and furnishings. It even may get a ‘stepped-up’ basis to start with. Your holding trust can also deduct the cost of maintaining your home – utilities, insurance, maintenance, and improvements. Since the trust has as its purpose the health, welfare, and well-being of the beneficiaries, expenses like health insurance, education, tuition and books, and life insurance become deductible. When through deducting, the trust pays the balance of its annual income to you and other beneficiaries as a dividend. You include this in your personal income tax return.”
“An Equity Trust will eliminate probate and estate taxes upon death! This ‘little known’ benefit becomes very clear if you just think about it. When you die, you have little or no assets so you do not trigger the ‘probate barrier’ set by the state. All of your assets were in your holding or ‘family’ trust. The holding trust did not die. It’s a separate, legal, tax-paying entity that continues after your death. Your wishes can still be carried out.
“Your wishes can include who should be manager next, to who next gets the benefit from certain assets held in trust. Also, the trust agreement contains a ‘pour over’ will to cover any assets or possessions not transferred into the holding trust. With an Equity Trust, you still have control!”
“An Equity Trust will provide complete privacy! Unlike a Corporation, where the ‘Articles of Incorporation’ must be registered and open for public view, the trust document is totally private. Although you must file an annual tax return, no accounting as to business activity details or assets held must be revealed. You do not have to reveal the trustees or the manager. Unlike other forms of business, the Equity Trust lets you carry on business in almost total secrecy.”
More recently, according to court records, the federal government alleges that one promoter asserts that, “Persons can set up a system of complex trusts including a business trust, a family trust, a charitable trust, and unit trusts that can be legally used to hide income and assets from the IRS.” Specifically, the government asserts that the promoter’s “customers are taught how to transfer personal income to the business trust, 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;....”
Fraudulent Statements. The IRS considers the following statements or claims, among others, made by the promoters of family estate trusts to be false and/or fraudulent within the meaning of IRC §6700:
1. Establishing a trust will reduce or eliminate income taxes or self-employment taxes. The transfer of property to a trust does not give the taxpayer additional tax benefits. Taxes must be paid on the income or property held in trust, including the income generated by property held in trust. The responsibility to pay taxes may fall to the trust, the beneficiary or the grantor;
2. The taxpayer’s income (e.g., wages, salary, bonuses, and so forth) transferred to a trust eliminates income taxation on that income. Income remains taxable to the individual who earns it.
3. The taxpayer retains complete control over income and property with the establishment of a trust. Under nongrantor trust arrangements, the grantor must give-up significant control over income and property. A trustee is designated to hold legal title to the trust property, to exercise independent control over the trust and to manage the trust;
4. The trustee-spouse becomes an adverse party, thereby, avoiding the grantor-trust provisions of IRC §§671-679. Any person having a substantial beneficial interest in the trust, who would be adversely affected by the exercise or nonexercise of his or her power with respect to the trust, is an adverse party. A person having a power of appointment over trust property is deemed to have a beneficial interest in the trust. Any person who is not an adverse party is a nonadverse party. A related party to the grantor, such as the grantor’s spouse, is generally considered to be subservient to the grantor in most instances with regard to the exercise of power, unless a preponderance of the evidence indicates otherwise. Thus, the trustee-spouse of the grantor is a nonadverse party. As a nonadverse party, the grantor trust provisions of IRC §§671-679 would apply to the trust;
5. The grantor and trustee-spouse can rent their personal residence after transferring it to the family estate trust, thereby, making it income producing with consequent deductions for depreciation of the home and furnishings therein, maintenance, and repairs. Depreciation of a taxpayer’s personal residence and furnishings is not deductible by conveying legal ownership of the residence to a trust;
6. Expenses of day-to-day trust operations, to include that portion of the home labeled as business headquarters for the trust, are deductible. Nondeductible personal living expenses cannot be transformed into deductible expenses by conveying legal ownership of property and income to a trust;
7. The trust can deduct the cost of operating cars for the benefit of the trust and deduct the depreciation and expenses of that portion of the personal residence, which the grantor (trustor) and spouse designate as trust headquarters; and
8. The grantor (trustor) can lease a personally owned car to the trust, permitting deductions for depreciation and expense of operation and receive cash payments from the trust.
Notwithstanding the fact that no taxpayer has prevailed against the IRS with respect to the use of a family estate trust (or variations thereof ), such abusive domestic trust tax shelters continue to be promoted and sold to unwitting taxpayers. Most practitioners, when confronted by an unwitting taxpayer contemplating such an abusive trust tax shelter trust arrangement or who has already effected such a trust arrangement, simply do not know how to analyze the documentation thrust upon them, let alone know how to counsel taxpayers on the pitfalls of such arrangements.
Furthermore, the unwitting taxpayer may inquire of the practitioner, “How will the IRS know that I am using such an arrangement?” There are three ways the IRS finds out about such questionable transactions:
1. Taxpayers and promoters are required to disclose or register questionable transactions and maintain investor lists under IRC §§6011, 6111, and 6112.
2. The IRS identifies questionable transactions through its examination process.
3. The IRS and the Treasury Department learn about transactions through tips, some of which are anonymous tips through the Office of Tax Shelter Analysis (OTSA) Hotline. Moreover, “The Justice Department is committed to eradicating these schemes with civil injunctions and, in appropriate cases, criminal prosecutions,” as stated by Eileen J. O’Conner, Assistant Attorney General for the Justice Department’s Tax Division. “Promoters of tax fraud schemes will face injunctions, penalties, and, where appropriate, criminal charges.”
Sales Tactics and Pitches
According to the IRS, some comments made by a promoter to his salespeople include, “Let me give you some basic rules regarding marketing.” “You’ve got to hit their [the targets] hot buttons; if you can’t get them upset, it will be tougher to sell the program.” “Everybody is greedy. Unless you can satisfy their greed, you won’t sell anything.” “Almost everyone doesn’t like the tax system, you will have to sell them on the tax advantages.” The IRS admonishes persons taken in by such comments not to be fooled—these promoters are intent on selling a product; namely, abusive trust tax shelters—they are not trust experts. It cannot be overstated that, regardless of the sales tactics or pitches used, the arguments posited by the promoters are frivolous and not founded in the tax law.
Seminars. A discussion of the typical seminars given by promoters is found in United States v. Marlene Mitchell. According to the court record, Marlene Mitchell entered the abusive trust business in 1996, selling abusive trusts for National Trust Services (NTS), an abusive trust marketing organization. In 1997 Marlene severed ties with NTS, and she and her husband Timothy Mitchell began marketing their own abusive trust scheme, similar to that of NTS, through an entity called Premier Trust Solutions. One of the founders of NTS, Roderick A. Prescott, has been permanently enjoined from organizing, promoting, marketing, or selling abusive trusts like those promoted by Marlene Mitchell while working for NTS and through her own Premier Trust Solutions.
The Mitchells promoted their scheme by giving free seminars in which Marlene Mitchell introduced attendees to the trust program. At these initial seminars, Marlene Mitchell gave a presentation showing attendees how, through her trust program, persons could arrange all of their personal affairs in trusts and, thereby, supposedly obtain tax benefits not available to individuals. After Marlene Mitchell presented the free seminar, she and her husband sold, for $12,000, a package on how to use the trust program to obtain its purported benefits. The package includes the seminar notebook, along with twenty hours of private consulting with the Mitchells and a year of “update classes.”
Annual fees of $1,000 are charged for additional consulting and classes after the first year. The classes attended by scheme participants after they have attended the initial seminar and paid the $12,000 fee include instruction on how to set up their own trusts and how to create a paper trail that creates the appearance of economic substance for transactions that are, in fact, economically meaningless. One of the classes offered by the Mitchells was a presentation in which Marlene Mitchell gave a misleading interpretation of Notice 97-24, a Notice that describes several types of trusts that the IRS has determined are abusive. In sum, the Mitchells advised their unwitting customers to conceal income and assets from the IRS, improperly reduce or eliminate federal income taxes by taking improper deductions, and stop paying federal employment taxes.
Untaxing Packages. U.S. courts have continuously and consistently rejected as frivolous the arguments posited by the promoters of abusive trust tax shelters. Unfortunately, people across the country have paid for the so-called “secret” of not paying taxes or have bought “untaxing packages.” In particular, farmers, ranchers, medical doctors, veterinarians and others with significant property holdings succumb to the “secret” out of frustration and disenchantment with the federal government and its tax policies and/or with the IRS. Then they find out that following the advice contained in the “untaxing packages” can result in civil and/or criminal penalties. Numerous sellers of the bogus schemes have been convicted on criminal charges. As of May 2, 2003, the IRS had 464 criminal investigations of abusive tax scheme promoters and investors, as compared with 125 in 2001, and 27 promoter injunctions granted, compared with 1 about a year earlier. More than a dozen injunctions have been issued.
Trusts Marketed for Asset Protection. Promoters of abusive trust tax shelters are well aware that, if the IRS determines that the trusts were set up for tax avoidance purposes, the trusts will be disregarded for tax purposes. If that happens, the income will be taxed to the person who controls the trust and the alleged tax benefits will not be forthcoming. Accordingly, promoters stress and market such trusts as “asset protection” trusts. In the sales pitch, promoters provide examples of how trusts have protected someone from losing all their assets as a result of a lawsuit; however, when pressed for specifics regarding the example, such as the name or disposition of the case, the information is not forthcoming or is difficult or impossible to verify. Even if they advocate that the primary purpose of the trust was to protect assets, the structuring of the whole scheme is clearly for tax avoidance purposes.
Fear and Scare Tactics. Promoters employ fear and scare tactics to sell their abusive trust tax shelter schemes. They create fear by saying that “. . . you are paying too much in taxes . . .,” “. . . you will lose all your assets as a result of litigation or medical expenses . . .,” or “. . . your heirs are going to have to sell the family farm/family business to pay estate and inheritance taxes . . . .” Promoters are so bold as to make their targets believe that only they, the promoters, are familiar by years of research, expertise, and experience with pure equity trusts and that, “Most attorneys and other professionals have little experience with pure equity trusts and have not studied the advantages and disadvantages of such a system.” This statement is not entirely untrue. While it is no shame, it is true that most attorneys and tax professionals do not understand the operation of such trusts; nor do they have the knowledge, expertise, and experience to identify such trusts. This author, in teaching continuing professional education classes for tax practitioners at a local college, never ceases to be amazed by how difficult it is for practitioners to grasp the reality that such trusts do exist and are actively being promoted and marketed to unwitting taxpayers. Moreover, the so-called educational information provided by one promoter—namely, Estate Protection Service—is prefaced by the following:
Famous Wealthy Families. Often, examples of famous wealthy families are used to lend credibility to abusive trust tax shelter schemes. For instance, promoters represent that prominent families, such as the Rockefellers, Mellons, Carnegies, Fords, Kennedys, and others, have established family trusts. All promoters of abusive trust tax shelters state that these families have successfully used trusts to minimize estate taxes, protect their assets, and maximize privacy. The sales pitch always gives examples of how these families have used trusts to reduce taxes; however, it is most unlikely that the promoters have personal knowledge of how these trusts were created, how they operate, and what is reflected on their personal and fiduciary income tax returns. Yes, it is true that these families used trusts for the purposes represented by the promoters; however, they were not so-called pure or family estate trusts. The promoters point out that ordinary individuals can take advantage of the same trust arrangements.
Politicians Use of Trusts. Another effective sales tactic, or pitch, used by promoters is to relate stories of how politicians have used trusts to minimize taxes, protect their assets, and maximize confidentiality and privacy of their affairs; with regard to the latter, no pun intended. The sales pitch in this regard argues that Congress legislates the tax laws; therefore, these trust arrangements must be legitimate. An example of a blind trust is often given where the politician has an investment that creates a conflict of interest for the politician. The investment is transferred into the blind trust with the politician named as the beneficiary. This is done to give management of the investment or asset to an independent person, such as an attorney, portfolio manager, or other disinterested entity or person not subordinate to the politician, so that the politician-beneficiary has no direct control of the trust. This is an example of a legitimate grantor trust subject to the grantor trust rules under IRC §§671–679, the income, deductions, and credits of which pass through the trust to the grantor (trustor; settlor) and are reported on his or her U.S. Individual Income Tax Return (Form 1040). Some promoters have used this example to illustrate the operation of a nongrantor trust, which the family estate trust is not and which may or may not cause taxation of the trust income to the grantor.
Financial Incentives. Promoters often employ marketing incentives for people to get family or friends involved in the abusive trust tax shelter schemes by paying a commission or finder’s fee. Given that the trust packages may sell from $2,000 to $70,000 or more, being able to make some extra money is a good enticement. As mentioned in Part I, Robert Welti, CPA probably increased his income by taking advantage of such an enticement in promoting and selling trust packages of Heritage America, “a private membership association with nationwide services” and The Aegis Company. Additionally, promoters recognize the network potential of following-up with referrals from somebody who has already bought into the trust program. So, too, did William Lee Sefton probably increase his income by more than he acknowledged in United States v. Estate Preservation Services, A Trust.
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.