Summary of Abusive Domestic Trusts Schemes

Mitchell A. Port of the California Tax Attorney Blog posted a great summary of the most common domestic trusts that the IRS has deemed to be abusive tax shelters. Below is his summary with my own comments (added purely for color!).

Family residence trust
My wife and I transfer family residences and furnishings to a trust, which sometimes rents the residence back to us. The trust deducts depreciation and the expenses of maintaining and operating the residence including gardening, pool service and utilities. The courts have consistently collapsed these types of trusts, taxing income to us and disallowing personal expenses.

There is such an animal as the Personal Residence Trust (PRT) and the Qualified Personal Residence Trust (QPRT). Typically, residence trusts are used to transfer a grantor’s residence out of the grantor’s estate at a low gift tax value. Once the trust is funded with the grantor’s residence, the residence and any future appreciation of the residence is excluded from grantor’s estate – which is the whole point. They’re also typically split interests trust with the grantor(s) retaining the right to live in the house for a number of years, rent free, and then the remainder beneficiaries of the trust become fully vested in their interest. PRTs are similar by nature to other types of retained interest trusts, like GRITs, GRATs and GRUTs. So they can work but they involve careful planning and very careful drafting.

Charitable trust
My wife and I transfer assets or income to a trust claiming to be a charitable organization. The trust or organization pays for personal, education or recreation expenses on behalf of me and my wife or family members. The trust then claims the payments as charitable deductions on its tax returns. These alleged charitable organizations often are not qualified and have no IRS exemption letter; hence, contributions are not deductible. Charitable deductions are not allowed when the donor receives personal benefit from the alleged gift.

Another kind of “charitable trust” is one where you give money, in trust, to a charity for the charity’s benefit, not yours… That’s usually ok.

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 gives the appearance that I have given up control of my business. In reality, through trustees or other entities controlled by me, I still runs the day-to-day activities and control the business’s income stream. Such arrangements provide no tax relief. The courts have held that the business income is taxable to me under a variety of legal concepts, including lack of economic substance (sham theory), assignment of income, or that the arrangement is a grantor trust. In some circumstances, the trust could be taxed as a corporation.

The most common application of a legitimate trust that is similar to the above is in the arena of federal estate tax planning. Using various discounting schemes (usually associated with majority vs. minority controlling shares) one can reduce the value of closely held business assets in their estate at their death. The IRS reallydoesn’t like these things and it takes a pretty specific set of facts for them to work anymore, but they can. Again, it takes a careful and responsible planner who is also a skilled draftsman/draftswoman.

Asset protection trust
These trusts are promoted as a means of avoiding liability for judgments against an individual or business. However, beware of any asset protection trust marketed as part of a package to reduce federal income or employment taxes. The courts can ignore such trusts and order my property sold to satisfy the outstanding liabilities.

Equipment or service trust
This trust is formed to hold equipment that is 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, and it will result in no tax reduction.

A good rule of thumb is: If it sounds like a bunch of hooey, if it sounds too good to be true, it probably is!

Thanks Mitchell!

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