Over the past decade, numerous individuals claiming to be knowledgeable tax advisors have promoted trust tax schemes. The promoters of these trust schemes often charge unsuspecting taxpayers $5,000 to $100,000 to establish intricate trust plans. Most of these promoters fully understand that they are marketing an illegal enterprise. However, in some situations, abusive trust schemes are being established by accountants and even attorneys who do not understand they are providing fraudulent tax advice. Unwary taxpayers believe they are purchasing a tax plan designed to save them tens of thousands of dollars in taxes. Unfortunately, of these taxpayers are purchasing a tax plan that can result in significant civil or even criminal penalties.
It is the author's hope that this article will alert our readers to the signs of an abusive trust tax scheme which could result in immense civil and criminal penalties levied by the government. To fully understand the trust schemes being offered, this article will review the basic trust taxation rules of the Internal Revenue Code.
A trust is a form of ownership, which is controlled and managed by a designated independent trustee. This trustee should be completely responsible for control of assets of the trust. The Internal Revenue Code recognizes several types of trust arrangements. The trust arrangements most comely recognized by the Internal Revenue Code is for estate planning purposes, charitable purposes, and the holding of assets for beneficiaries. For taxation purposes, all income received by a trust is taxable to the trust at issue, the beneficiaries, or an individual taxpayer designated by the Internal Revenue Code.
Most trusts are permitted to deduct distributions to beneficiaries from its taxable income. Consequently, trusts can eliminate income subject to taxation by making distributions to beneficiaries. These beneficiaries may be other trusts or entities. Unfortunately, promoters of abusive trust schemes often advise taxpayers that they can establish numerous trust entities and claim distribution deductions against income by making repeated distributions. The Internal Revenue Service considers such transactions as a fraudulent method to reduce tax liability.
Currently, there are two widespread trust methods being marketed to fraudulently reduce taxes: the "domestic scheme" and the "foreign scheme." The domestic scheme involves a series of trusts that are formed in the United States, while the foreign trust scheme is formed outside the jurisdiction of the United States. The trusts involved in either plan are usually structured so that numerous trusts are vertically layered. Each trust distributes income to the next layer. This scheme results deductions simply being past on to the next level of trusts and reduction of income tax liability to nominal amounts. Most of these schemes give the appearance of trusts with separate trustees that are being independently operated from the taxpayer. However, in reality, these trusts are being controlled by the taxpayer who established them.
A domestic trust must file a Form 1041, U.S. Income Tax Return for Estates and Trusts, for each taxable year. If the trust is classified as a Domestic Grantor Trust, it is not generally required to file a form 1041, provided all income is reported properly. Foreign trusts are subject to special filing requirements. If a trust has income that is effectively connected with a trade or business in the United States, the trust must file a form 1040NR, U.S. Nonresident Alien Income Tax Return. Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Foreign Gifts, must be filed with the creation of or transfer of property to certain foreign trusts. Form 3520-A, Annual Information Return of Foreign Trusts with U.S. Owner, must be filed annually with a foreign trust. Foreign trusts may also be required to file U.S. Treasury Form TD F 90-22.1, Foreign Bank and Financial Accounts Report if the trust has over $10,000 in foreign bank accounts, securities, or other financial accounts.
Foreign trust may also have to file other reporting forms as well. Foreign trusts to which a U.S. taxpayer has transferred property is treated as grantor trusts as long as the trust has at least one U.S. beneficiary. This means that the Internal Revenue Service does not classify such foreign trusts as a separate taxable entity from the individual transferring property to the trust. Thus, the trust income is taxed to the individual who either established the offshore trust or the individual who transferred property to the foreign trust.
As indicated above, a domestic trust scheme is usually offered in a series of trusts that are layered upon one another. These trusts tend to be classified as a business trust, family trust, or charitable trust. With a business trust, a taxpayer elects to change there trust into a corporation type of entity. However, false administrative expenses are deducted. In addition, in many cases, these schemes gives the appearance that the taxpayer how established the trust has given up control of the running a business placed in the trust. In reality, however, the taxpayer who established the trust runs the day-to-day activities of the business placed in the trust. With a family trust, taxpayers are advised to place their family home in a trust and deduct non-allowable depreciation of the home. Taxpayers are also encouraged to deduct expenses for maintaining and operating the residence such as gardening and utilities. Finally, with charitable trusts, "charitable organizations" pay for personal educational or recreational expenses on behalf of the taxpayer or family members. These payments are falsely claimed as "charitable" deductions on trust tax returns.
Like the above mentioned trust arrangements, foreign trust arrangements start of with a business or family trust. However, in these arrangements, taxpayers are encouraged to transfer funds outside United States jurisdiction. These schemes usually involve foreign bank accounts, trusts, and offshore corporations created in "tax haven" countries. Foreign trust schemes often start with a business trust. However, a foreign trust is formed in a tax haven country, and the income from the business trust is distributed to this trust. In many cases, these foreign trusts are assigned trustees that have no true power over the foreign trust. In reality, the taxpayer who established the foreign trust is in control over the foreign trust. Once the taxpayer's funds are transferred to offshore trusts, there are several methods used to repatriate his or her funds to the United States. These methods usually involve the opening of a foreign bank account.
In most cases, a taxpayer opens a foreign bank account in a tax haven country which issues the taxpayer a debit or credit card from the account. These debit or credit cards are used by the taxpayer in the United States to withdraw cash and pay expenses. Another method is for the taxpayer to establish an International Business Corporation. Fraudulent loans are then established from the foreign corporation to the taxpayer. The taxpayer claims that he or she is receiving loans from a foreign corporation that are not taxable proceeds. As such, the taxpayer does not report the loan proceeds as income on his or her individual tax returns.
Investors of abusive trusts are liable for the taxes evaded through the use of these entities. They are also liable for all applicable interest and penalties which can be as high as 75 percent of an underpayment attributed to fraud. Finally, individuals who invest in trust schemes may receive criminal fines up to $250,000 and up to five years in prison. Given the severity of the penalties associated with abusive trusts. It is advisable for taxpayers to stay clear of any domestic or foreign trust scheme. If a taxpayer believes that he or she may have invested in a domestic or foreign trust scheme, he or she is urged to consult with a competent tax lawyer.
Like any attorneys, we need to add a disclaimer: Unfortunately, it is impossible to give comprehensive tax advice over the internet, no matter how well researched or written. Before relying on any information given on this site, contact us and/or a tax professional to discuss your particular situation.