This article is reprinted, with permission, from the IRS' April 2000 "Tax News"
A trust is a form of ownership, which completely separates responsibility and control of assets from all the benefits of ownership. Trusts are used in such matters as estate planning; to facilitate the genuine charitable transfer of assets; and to hold assets for minors and those unable to handle their financial affairs.
Under a trust arrangement, you must give up control over income and assets. An independent trustee is designated to hold legal title to the trust assets, to exercise independent control over the trust, and to manage the trust. Taxes must be paid on the income received by the 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.
A trustee is designated to hold legal title to the trust property, to exercise independent control over it, and is responsible for its management.
All trusts must comply with the tax laws as set forth by the Congress in the Internal Revenue Code, Section 641-683. Trusts established to hide the true ownership of assets and income or to disguise the substance of financial transactions are considered Fraudulent/Abusive Trusts.
Too Good to be True...
Promoters of fraudulent trust arrangements use a variety of methods to advertise their schemes. They may include seminars, flyers, and even the Internet. The main selling point of fraudulent trust arrangements is that the paperwork will look like you are giving up control of your assets and money; when in reality you still control how your money and assets are used.
A fraudulent trust only has the appearance of a trust. It is typically promoted by the promise of tax benefits or avoidance with no meaningful change in the taxpayer's control over or benefit from the taxpayer's income or assets.
Using the name "trust" in association with financial arrangements does not make it a legitimate trust. No matter how carefully written the trust documents are, if the intent is to evade taxes, the trust will be treated as fraudulent.
Fraudulent trusts are illegal and are a specific area of concern for IRS Criminal Investigation.
The Jungle of Fraudulent Trust Schemes
Currently, there are two prevalent fraudulent arrangements that are being promoted: The "domestic package" and the "foreign package." The domestic package involves a series of trusts that are formed in the US, while the foreign trust packages are formed offshore and outside the jurisdiction of the US. Further, trusts involved in the schemes are vertically layered with each trust distributing income to the next layer. The goal of this layered distribution of income is to fraudulently reduce taxable income to nominal amounts.
The Business Trust
Some trust promoters are advising taxpayers to transfer their on-going business to Business Trusts. This scheme gives the appearance that the taxpayer has given up control of his/her business to a trust; however, in reality the taxpayer is still running the day-to-day activities of business and is controlling its income stream. This is accomplished through trustees or other entities controlled by the taxpayer.
The Equipment or Service Trust
The Equipment or Service trust is formed to hold equipment that is rented or leased to the business trust, often at inflated rates. The business trust reduces its income by claiming deductions for payments to the equipment trust.
The Family Residence Trust
Taxpayers are being advised to transfer family residences, including furnishings, to trusts. These trusts sometimes rent the residence back to the taxpayer. They also deduct depreciation and the expenses of maintaining and operating the residence, such as gardening, pool service, and utilities.
The Charitable Trust
Taxpayers are receiving advice to transfer assets or income to trusts claiming to be charitable organizations. These trusts or "charitable organizations" pay for personal, educational, or recreational expenses on behalf of the taxpayer or family members. The payments are then claimed as "charitable" deductions on the trust tax return. (For more information on charitable trusts, see What is a charitable lead trust?.)
These trusts are often domiciled in a foreign country that imposes little or no tax on trusts and also provide financial secrecy. Typically, abusive foreign trust arrangements enable taxable funds to flow through several trusts or entities until the funds are ultimately distributed or made available to the original owner, purportedly tax-free. These trusts are usually used in combination with a foreign corporation and foreign bank account.
Buyer Beware! Recognizing a Fraudulent Trust
Common Warning Signs:
- A promise to reduce or eliminate income and self-employment tax;
- Deductions for personal expenses paid by the trust;
- Depreciation deductions on an owner's personal residence and furnishings;
- High fees for trust packages, to be offset by promised tax benefits;
- Use of back-dated documents and post office boxes for trust addresses;
- Unjustified replacement of trustee;
- Lack of an independent trustee;
- Use of terms such as pure trust, constitutional trust, sovereign trust, or unincorporated business organization.
Just the Facts
It is estimated that $4.8 trillion in wealth will be inherited or transferred from one generation to the next by 2015, with much of it transferred through a variety of trusts. Filings of trust returns (Form 1041's) are now the third most frequently filed income tax return behind individual and corporate returns. Although the vast majority of these transfers are legal, there is widespread potential for fraud.
In Fiscal Year 1999, Criminal Investigation elevated abusive foreign and domestic trusts from an emerging issue to a program area. This elevation was due to the proliferation of abusive promotions in the US. These promotions are targeted towards wealthy individuals, small business owners, and professionals such as doctors, lawyers, and dentists. The promotions, which are in some instances distributed by a national network of promoters, promise taxpayers substantial tax reduction and asset protection. In reality, these promotions are nothing more than complex tax evasion schemes.
The IRS takes fraudulent trust arrangements seriously. It is a matter of maintaining public confidence in the fairness of the tax laws. recommending prosecution of those who violate the tax laws demonstrate the IRS' communityitment to ensuring all taxpayers pay their fair share of taxes.
Civil and Criminal Outcomes
If a taxpayer chooses to participate in a trust that improperly avoids or evades income tax, that person will not be shielded from payment of taxes, interest, and penalties due. Evasion of income taxes may result in a civil fraud penalty or criminal prosecution:
- Civil fraud can include a penalty up to 75 percent of the underpayment of tax attributable to the fraud in addition to the taxes owed.
- Criminal conviction may result in fines up to $250,000 and/or up to five years in prison for such offenses.
Since the 1990's there has been a substantial increase in both civil examinations and criminal investigations. The tax court has consistently found against abusive schemes, deeming them shams or simply grantor trusts that do not deliver the promised tax benefits.
Following false, misleading, or unorthodox tax advice is seldom free. Upfront you pay fees or commissions to subscribe to fraudulent trust schemes and in the end; unfortunately, you pay even more in penalties, interest and fines for following bad advice.
Knowingly participating in fraudulent trust arrangements has led to the incarceration and/or financial ruin of many taxpayers.
The bottom line is Don't Buy In!
Too Good - Exhibit A
A physician was sentenced to 37 months imprisonment followed by 3 years supervised release, and ordered to pay $414,819 in restitution to the IRS for tax evasion for the years 1992 through 1996. The physician created trusts, including one for his family residence, that he controlled and used to conceal his taxable income. In addition, he transferred funds between trusts, offshore corporations, and their corresponding bank accounts located in the US, Bahamas, and the Channel Islands in order to conceal taxable income.
Too Good - Exhibit B
A father and his sons were sentenced to 60, 57, and 46 months imprisonment followed by three years of supervised release, respectively, for conspiracy to defraud the IRS and for failing to file tax returns. A Federal jury found them guilty in an attempt to conceal income, assign their income to several nominees and purported irrevocable trusts that that had no economic substance. As part of the conspiracy, they used several bank accounts opened in trust and other names to conceal insurance communityission receipts and proceeds from the sale of certificates of deposits and coins. They also attempted to conceal their assets from the IRS by the conveyance of real property from their names to purported trusts and nominees. In addition to their imprisonment, the judge in the case ordered them to pay fines of $413,500 and restitution in excess of $635,000 to the IRS.
Too Good - Exhibit C
A former CPA was sentenced to 87 months imprisonment for defrauding the IRS by promoting bogus trusts. In addition, an attorney and a former legislative aide were sentenced for their involvement in the scam. The men sold packages of bogus trusts to clients and advised them on how to use trusts to generate fraudulent tax deductions. Clients of these individuals put businesses, homes, and other assets in trusts, but in fact continued to control those assets. Clients claimed various personal expenses related to the bogus trust on their tax returns including depreciation of personal residences, house cleaning, lawn care, and scholarships for their children. The judge in the case found that the trust scheme cost the federal and state government more than $2.5 million in lost tax revenue.
For more information about what the Federal Courts REALLY say about fraudulent trusts...
See Criminal cases United States v. Scott and United States v. Noske at www.findlaw.com.
"Tax News" (April 2000) is an official publication of the IRS-Southern California District.
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