Trust Troubles in the U.S.

In spite of the fact that trusts are legitimate, legal and beneficial, the IRS claims that in recent years tax abuse of trusts by U.S. citizens has been rampant. IRS officials claim to have identified about 200,000 "abusive trusts" (approximately 7% of the total number of trust returns filed in 1996) that they say control over $1 billion in assets and property.

With much publicity, on April 3, 1997, the IRS issued Notice 97-24 warning citizens to avoid what the agency described as "abusive trust arrangements" that "purport to reduce or eliminate federal taxes in ways that are not permitted under federal tax laws."

While the 1997 IRS notice was aimed primarily at abuse of domestic trusts, enactment of Public Law 104-188 by Congress in 1996 already had clamped down on foreign or "offshore" trusts created by American grantors. As just noted, that law requires extensive annual reporting of offshore trust creation, income and distributions to beneficiaries. It also requires the appointment of a U.S. "limited agent" for a foreign trust to accept service by the IRS should that occur.

The IRS stressed that it was not questioning the 90% or more of all U.S. trusts that are "legitimate." But the IRS-defined target does include "fringe financial advisors", who they claim take advantage of unsophisticated investors.

The Chief Compliance Officer for the IRS, warned, "We'll assess taxes and penalties against the participants and promoters of the trusts we find abusive, and seek criminal charges where warranted." The Commissioner of Internal Revenue added: "Taxpayers need not be concerned about legitimate trusts which are used in such matters as estate planning, charitable giving or to hold property for minors and those unable to manage their financial affairs."

The IRS charged that promoters of abusive trust arrangements falsely promise reduction or elimination of taxes. These trust salesmen also seek to hide true ownership of assets or disguise the substance of transactions so that owners may retain control over personal or business assets after transfer to what courts and the IRS dismiss as "sham trusts."

The IRS has repeatedly renewed its prior warnings. The chief of IRS criminal prosecutions said that ". . . primary IRS targets [are] people selling fraudulent trusts they claim will eliminate or reduce income or estate taxes. These invalid trusts, often part of elaborate money making schemes, may subject both sellers and buyers of fraudulent trusts to fines and a jail sentence." The IRS added: "If we develop sufficient intent and knowledge on the part of the person who purchased a sham trust, they can be prosecuted for criminal tax evasion. Taxpayers who were unaware they bought an illegal trust will be subject to pay taxes owed, interest and fines."

Even before the IRS "abusive trust" warnings, the American Bar Association, various retired persons groups and several state attorneys general made similar warnings. In these tough talk warnings, the IRS only restated established tax and legal rules every good estate planner already knows and follows.

One of the key principles is that during the grantor's lifetime, either the trust, the trust beneficiary, or the grantor who creates a trust must pay tax on income generated by the trust assets and investments. Who pays depends on how the trust is structured under tax law. No honest trust advisor ever claims that a trust can transform a taxpayer's personal, living or educational expenses into deductible items, nor will they try to avoid tax liability by masking either the true ownership of income and assets or the true substance of transactions. Unfortunately, such wild claims are all too common among slick trust promoters who sell illegal trust deals to gullible people who are taken in.