Federal Income Tax Issues Of Abusive Trust Tax Shelters

Promoters of abusive trust tax shelters represent that 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. Furthermore, promoters represent that persons can avoid federal income tax and selfemployment tax by transferring their personal income to the “business trust” (i.e., pure, constitutional, equity, or business trust organization, collectively known as common law trusts) because the trust is now supposedly earning money, rather than the individual. It should be noted that the structure of the “business trust” or “business trust organization” (BTO) is not unlike that of the family estate trust; i.e., all such trusts, regardless of their nomenclature, are common law trusts, which are listed transactions.

Earned Income. In Revenue Ruling 75-257, the IRS disputed the income tax benefits claimed by promoters of the family estate trust. The trustor, whom we’ll call Harry, created a family estate trust (Trust) and transferred a personal residence, an apartment building, and income-producing securities to the trustees who were Harry, his wife, and a third party. In addition, by affidavit, Harry assigned his “lifetime services,” including his weekly salary, and all remuneration earned by him, regardless of its source, to the Trust. In exchange, Harry received certificates representing units of beneficial interest (UBIs) in the Trust.

The IRS held that, regardless of whether an assignment of income is irrevocable, and, regardless of whether the income is assigned for a substantial period of time, the true earner of the income realizes economic gain from the disposition of such income and is taxable on it. In resolving the question of who earns the income, the court will look to who has actual control over the earning of the income, rather than who has apparent control over the income. Similarly, in Revenue Ruling 55-2, the IRS held that unpaid accounts receivable, which represent compensation for personal services and which were transferred by a taxpayer to an irrevocable trust for the benefit of his minor child, were, upon collection, taxable to the taxpayer grantor and not to the trust.

The IRS opined that it was evident in Harry’s case that one who transfers future earned income by an anticipatory assignment realizes income quite as much as if such person had collected the income and paid it over to the object of that person’s bounty. It is of no consequence that such income has been assigned to a trust. With respect to the services that Harry performed for his corporate employer, the legal relationship of employer and employee continues to exist between the employer and Harry. It is Harry—not the Trust—who earns the income as an employee of the corporation.

The family estate trust merely has the right to receive Harry’s earnings, reduced by amounts withheld by Harry’s employer. Accordingly, any income from services performed by Harry for the corporation is income to Harry and not income to the family estate trust.

Securities and Rental Property. As to the issue of the securities and real property Harry transferred to the Trust, the IRS held that Harry was taxable on the income derived from those assets under IRC §§671-678 (the grantor trust rules). In effect, IRC §671 provides that income of a trust over which the grantor (trustor) is deemed the owner of any portion of the trust is taxed to that person—not to the trust itself—or to the beneficiary to whom the income may be distributed. An item of income, deduction, or credit included in computing the taxable income of the trustor is treated as if received by the trustor—not the trust. Though not directly related to the discussion at hand, it is interesting to note that, under the grantor trust rules, the grantor may be the owner of a trust for federal income tax purposes but not the owner of the same trust for federal estate tax purposes.

Although Harry’s family estate trust did not specifically provide that the trustees had the power to distribute income to Harry under the authority inherent in the Trust, the trustees exercised the power to distribute income to Harry (the grantor) by discharging certain of his obligations for housing and health care. Accordingly, for federal income tax purposes, because of his dominion and control over the Trust, Harry is deemed the owner of the Trust under IRC §§674, 676, or 677. Therefore, as provided by §671, in computing his taxable income and credits, Harry must include those items of income, deductions, and credits on his U.S. Individual Income Tax Return (Form 1040) to the extent such items would be taken into account in computing taxable income or credits against the tax on an individual.

Association Taxed as a Corporation. In Revenue Ruling 75-258, the taxpayer, whom we’ll call Fred, created a family estate trust to which he transferred substantially all of his real and personal property, including his sole proprietorship retail clothing establishment, in exchange for freely transferable “units of beneficial interest” therein, half of which he assigned to his wife and son. In this case the IRS, unlike its position in Revenue Ruling 75-257, ruled that, because the trust possessed a preponderance of corporate characteristics over noncorporate characteristics, it was not a trust but, rather, an association taxable as a corporation within the meaning of IRC §7701.

Deduction for Personal Expenses. In Revenue Ruling 79-324, the IRS held that no deduction is allowed under IRC §212 for amounts paid for the trust form documents and related materials used to create a family estate trust. The purchase price of the trust package is a personal expense—a deduction for which is prohibited by IRC §262. In this regard, the creation of the trust was not intended to result in management or control of the trust property, which was significantly different from the control exercised by the taxpayer before the trust was created. Furthermore, the taxpayer’s expenditure for the trust instrument and materials was itself not intended to produce income. Therefore, the taxpayer’s payment for the trust instrument and materials was not an expenditure for the management, conservation, or maintenance of property held for the production of income, as described in IRC §212(2). Finally, the taxpayer’s payment for the trust instrument package was not a payment made as consideration for assistance in connection with the determination, collection, or refund of any tax, as described in IRC §212(3).

Assignment of Lifetime Services. The IRS again addressed the issue of “lifetime services” transferred to a family estate trust in Revenue Ruling 80-321. In this case, unlike Harry’s situation in Revenue Ruling 75-257, wherein Harry merely requested his employer to assign his salary to his family estate trust, a corporation’s employee, whom we’ll call Sam, assigned his “lifetime services” to a family estate trust. The trust contracted to provide services to the corporation for a monthly fee equal to what otherwise would be Sam’s gross monthly salary. Sam continued to perform the same tasks for the corporation under the same conditions and with the same amount of control as before the assignment. The IRS held that such an assignment is ineffective as a means of avoiding the employee’s income tax liability with respect to the payments for the services, and the payments are wages for purposes of FICA and income tax withholding.

Family Estate Trusts are Grantor Trusts. In view of the foregoing, and with respect to the income tax issue of family estate trusts, the IRS has determined that the family estate trust is a grantor trust governed by IRC §§671-678, regardless of the fact that it is, supposedly, irrevocable. This position is consistent with the Service’s position in Revenue Ruling 75-25718 and related court cases. In Jerome D. Hanson v. Commissioner, the family estate trust purchased by taxpayers Jerome D. Hanson and Bernetta O. Hanson, of Lincoln City, Oregon, in 1976, was identical as to each and every paragraph, sentence, word, comma, and period, to the trust purchased by the author’s client, Mary, and her late husband, Roy, from the Institute of Individual Religious Studies (Institute). In Hanson, the Tax Court held that such a trust, “is a sham,” and that, “[t]he family estate trust was a nullity for income tax purposes.” Furthermore, petitioners in forty-one other cases that were pending before the Tax Court agreed to be bound by the Tax Court’s decision in Hanson. With respect to Mary and Roy, as the result of an income tax audit initially unrelated to their family estate trust, the IRS examiner determined that a taxpayer’s “...attempt to assign present or future income to the trust merely by filling in the appropriate blanks is a fruitless effort to circumvent personal income taxation.” Furthermore, the IRS determined that, “[a]ll allowable income, deductions, and credits are that of the individual taxpayer(s) and not that of the trust.”

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Doug H.