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The IRS has issued a notice concerning certain "abusive" trusts that purport to reduce or eliminate participating taxpayers' federal taxes but which violate several key principals of federal tax law. Such trusts will not be respected for federal income or transfer tax purposes. Furthermore, the IRS warned that participating taxpayers, as well as the promoters of these "scams, face potential civil and/or criminal penalties for their involvement.
"Have We Got A Deal For You..."
Promoters of abusive trust arrangements typically claim to have found "loopholes" in the U.S. tax code that can be easily exploited by the average taxpayer. They often promote their ideas at seminars in exotic locations under the guise of "estate planning" or "unique investment opportunities." Essentially, these trusts mask the true ownership of assets or the substance of transactions in an attempt to render income received tax-free or to convert nondeductible personal expenses to tax-deductible expenses. It is not uncommon to find multiple-trust arrangements - some that involve one or more foreign trusts - that make it more difficult to "trace the flow of money."
Examples Of Abusive Trusts
The trusts considered to be abusive by the IRS include the following:
So-called "business trusts" that attempt to reduce or eliminate self-employment taxes. These arrangements are often used in conjunction with equipment or service trusts that are formed to hold equipment that is rented to the business trust at inflated rates. The business trust, in turn, claims rental deductions that significantly reduce or eliminate its federal taxable income.
Family residence trusts that attempt to provide depreciation deductions for a personal residence and furnishings. Here, a homeowner transfers his or her residence in trust, continuing to occupy the property. The trust then rents the home back to its original owner, although little or no rent is actually paid. The trust claims depreciation deductions, while the owner and his family claim to be caretakers of the home in an attempt to legitimize the scheme.
Charitable trusts that attempt to secure deductions for contributions to the trust or for amounts paid by the trusts where trust payments are for the grantor's or family member's personal expenses (e.g., a child's college tuition).
If It Sounds Too Good To Be True...
The scams highlighted in the IRS' notice cannot fulfill their promise of tax reduction or avoidance, since they violate several well-established legal doctrines (e.g., "substance-over-form" controls the tax result of a transaction). The IRS has undertaken a nationally coordinated initiative to identify and shut down abusive trust arrangements - imposing penalties and seeking criminal sanctions where indicated. Despite these warnings, however, the IRS continues to recognize the legitimate use of trusts in family wealth planning. If you have any questions about the viability of an estate planning strategy using trusts, consult your financial advisor.
Because the materials covered in this article are complicated, this article should not be regarded as offering a complete explanation and should not be used for making decisions. Any suggestion should be reviewed with your personal financial and tax advisor.