Some trusts — illegally — try to avoid paying taxes

On the Money
From the April 4, 2008 print edition

Tax avoidance is the legal utilization of the tax law to one’s own advantage. A person is entitled to reduce their amount of tax by legal means.

In Gregory v. Helvering (1935), the U.S. Supreme Court stated that, “The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted.”

Tax evasion is when illegal means are used to not pay taxes. Evasion usually involves deliberate misrepresentation, concealing the true state of fiscal condition, and in particular, dishonest tax reporting.

To prove that if a scheme is creative or complex enough it must be legal, some have developed elaborate structures called “tax shelters.”

When a tax shelter legitimately limits taxation, it’s called avoidance. If the shelter dishonestly pays no tax, it’s called evasion. More specifically, the structure becomes an “abusive tax shelter” or “abusive tax scheme.”

These schemes are characterized by the use of trusts. The word “trust,” when used as a noun, is a “fiduciary relationship in which one party, known as a trustor, gives another party, the trustee, the right to hold title to property or assets for the benefit of a third party, the beneficiary.”

This relationship presumes that the beneficiary “trusts the trust” to look out for their interests.

However, there are times when trusting the trust is misguided and could lead to unhappy consequences — namely, going to jail. That can happen when the trust is part of an abusive tax scheme.

The IRS has developed a nationally coordinated program to combat these abusive tax schemes, primarily focusing on identifying and investigating their promoters, as well as those who support the process, such as accountants and lawyers.

Here are some claims that are warning signs of an untrustworthy trust.

• Establishing a trust will reduce or eliminate income taxes or self-employment taxes.
• The taxpayer will retain complete control over their income and assets with the establishment of a trust.
• Taxpayers may deduct personal expenses paid by the trust on their tax return.
• Taxpayers can depreciate their personal residence and furnishings, and take them as deductions on their tax return.

The IRS has identified five commonly used trust schemes that are regarded as abusive tax schemes:

1. Foreign trust — These often are located in countries that impose little or no tax on trusts and 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. The trust promoter claims that this distribution is tax-free. In fact, the income from these arrangements is fully taxable.
2. Family residence trust — Taxpayers transfer family residences, including furnishings, to a trust, which sometimes rents the residence back to the taxpayer. The trust deducts depreciation and the expenses of maintaining and operating the residence, including pool service and utilities. These expenses aren’t deductible, and the IRS will disallow them.
3. Charitable trust — Taxpayers transfer assets or income to a trust claiming to be a charitable organization. The trust or organization pays for personal, educational and recreational expenses on behalf of the taxpayer or family member. The trust then claims the payments as charitable deductions on its tax returns. These alleged charitable organizations often aren’t qualified and have no IRS exemption letter. Therefore, contributions aren’t deductible.
4. Business trust — This involves the transfer of an ongoing business to a trust. Also called an “unincorporated business organization,” a “pure trust” or a “constitutional trust,” it makes it appear the taxpayer has given up control of their business. In reality, however, through trustees or other entities controlled by the taxpayer, he or she still runs day-to-day activities and controls the business’ stream of income. Such arrangements provide no tax relief.
5. Equipment or service trust — This trust is formed to hold equipment that’s 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. This type of arrangement has the same pitfalls as the business trust. It provides no tax relief.

The IRS continues its nationally coordinated strategy to address fraudulent trust schemes. For more details about the IRS policy regarding fraudulent trusts, read IRS Public           Announcement Notice 97-24, which warns taxpayers to avoid fraudulent trust schemes that advertise bogus tax benefits. Announcement 97-24 may be found at www.irs.gov/pub/irs-tege/n97-24.pdf. It references an IRS brochure, “Too Good to be True Trusts,” found atwww.irs.gov/pub/irs-pdf/p2193.pdf.

Report suspected tax fraud to your local IRS office, 1-800-829-0433.

Once again, heed the adage of, “If it sounds too good to be true, it probably is — or at least illegal.”

© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.