Grim, Biehn & Thatcher
It has often been said that the only two sure things are death and taxes. I would add tax evasion to the list. Avoiding or illegally reducing one’s tax liability seems, for some, to come just after securing food and shelter in the hierarchy of needs. It is a testament to human ingenuity, if not integrity, that a number of professionals and promoters are constantly inventing new products and schemes to satisfy the seemingly primal urge to thwart the tax collector. The latest tactic appears to be the use of bogus trusts.
The Internal Revenue Service (IRS) Criminal Investigation Division has made the investigation and prosecution of abusive trusts a priority. More than 100 people, including attorneys, accountants, promoters and taxpayers, have been convicted since 1996; approximately 86% of those convicted have been incarcerated, with jail sentences averaging 30 months.
Abusive trust schemes come in two flavors. The domestic version involves a series of trusts formed in the US; the foreign version involves offshore trusts set up outside US jurisdiction. Basically, a series of vertically-layered trusts is formed, with each trust paying and deducting phony expenses and distributing its remaining income to the next layer. The trusts are structured so that it appears that the taxpayer-the ultimate recipient of a minimum amount of income from the last trust-has no direction or control over the assets that are held by trusts at the top of the ladder.
These trust schemes are marketed to high-income individuals. For anywhere from $5000 to $70,000, a taxpayer can have a “package” prepared. The package includes the drafting of several trust documents, the use of foreign or domestic trustees offered by the promoters, the use of foreign bank accounts or corporations, and sometimes the preparation of fiduciary (trust) income tax returns.
Trust Taxation 101s
A basic understanding of trust taxation is necessary to see why IRS is getting so upset. A trust is a form of ownership that separates control of an asset from the beneficial interest in the asset (for example, the right to income earned by the asset). Assets or a business held in a trust are controlled and managed by an independent trustee for the economic benefit of one or more beneficiaries. Various types of trusts are recognized and respected by IRS and are commonly used in estate planning for various purposes-for charitable purposes, to hold insurance policies and keep the proceeds out of the insured’s estate, and to manage assets for beneficiaries, among others. Generally, the independent trustee manages the trust, holds legal title to the trust assets, and exercises independent control for the benefit of the beneficiary within the guidelines set forth in the trust document. All non-exempt income received by a trust is taxable either to the grantor, the trust, or the beneficiary. A trust is entitled to deduct from its taxable income legitimate business expenses and distributions to named beneficiaries. Domestic trusts file fiduciary income tax returns on Form 1041 for each taxable year. Grantor trusts (not recognized as separate taxable entities because of one or more powers retained by the Grantor) are not required to file Form 1041 provided that all items of taxable income are reported on the Grantor’s income tax return on Form 1040. Foreign trusts are subject to other filing requirements that are beyond the scope of this article.
How the Schemes Work
Domestic trust packages are usually offered in a series of layered entities that might work as follows: A taxpayer creates an Asset Management Company (AMC), of which the taxpayer is the director, as a domestic trust. An unrelated individual, perhaps on the promoter’s staff, is the initial trustee but is often replaced by the taxpayer. A Business Trust, also a domestic trust, is then formed to run the taxpayer’s pre-existing business (originally either a corporation or a proprietorship). The AMC is the trustee of the Business Trust. False business or administrative expenses may be deducted from the trust’s income as a means to reduce taxable income. Even though it appears that the taxpayer has given up control of the business to a trust, the taxpayer actually continues to run the business and control its income stream. An Equipment 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. In some instances, taxpayers are advised to distribute remaining income from the Business Trust to a Family Residence Trust. Family residences and furnishings are transferred to this trust, which rents the residence back to the owner. These trusts may attempt to deduct depreciation and the expenses of maintaining and operating the residence such as gardening, cleaning, pool service and utilities; these expenses are obviously not legally deductible. In many schemes, the last layer is a so-called Charitable Trust, which pays for personal, educational or recreational expenses on behalf of the taxpayer or family members. These payments are then claimed as charitable deductions on trust income tax returns. After the personal and non-allowable expenses are deducted from the Charitable Trust, the balance of the income remaining, usually a small amount, is distributed and taxed to the taxpayer.
The foreign trust scheme usually also starts off with an AMC, a Business Trust, and several foreign trusts, one (foreign trust #1) to receive income from the business trust, and another (foreign trust #2) to receive income from foreign trust #1, which sometimes serves as trustee for foreign trust #2. Foreign trust #1 is subject to US tax reporting requirements because its income is US-source based and the AMC is often the trustee. Promoters claim that foreign trust #2 is not subject to US filing requirements since the trustee and source of income are foreign. Foreign trust packages take funds offshore, outside US jurisdiction, and use offshore bank accounts, trusts and International Business Corporations (IBCs) created in “tax haven” countries. Taxpayers involved in the foreign schemes usually repatriate their funds in several ways. The taxpayer might be issued a debit card from a foreign bank account, and use the card to withdraw cash and pay for everyday expenses such as groceries, gasoline, medical bills, etc. It is difficult for IRS to trace these transactions (involving foreign bank-issued debit cards) back to the taxpayer. Foreign bank accounts may be used to transfer funds from a foreign trust to an IBC. The IBC would then issue a “loan” and wire the funds to the taxpayer in the US. Since true loans are not taxable as income, the repatriation of funds is not reportable on a US income tax return; and since IBCs usually issue bearer shares as evidence of ownership and the IBCs are located in tax haven countries, it is difficult for IRS to prove that the loans are actually the taxpayer’s income.
What Happens When You Get Caught
The IRS Criminal Investigation Division (CID) is focusing on promoters and taxpayers who have sold or used these schemes to evade tax. It is coordinating its efforts with the IRS Examination and Collection Divisions, the Chief Counsel’s Office and the US Department of Justice. IRS has successfully prosecuted many cases in which packagers of bogus trust schemes sell the packages to clients, advise the clients how to use them and generate fraudulent deductions and conceal income. Some attorneys, accountants and promoters have been sentenced to jail terms of up to 60 months. Clients who purchase and use the packages have also been sent to prison for failing to report income. In addition to being incarcerated, investors in these schemes are liable for taxes,interest and civil penalties. Violations of the Internal Revenue Code with the intent to evade income taxes can result not only in criminal prosecution but also in civil fraud penalties of up to 75% of the underpayment of tax-in addition to the tax owed and interest on the tax and the penalty. It is common for the interest and penalties to exceed the tax due. In addition, criminal convictions of promoters and investors may result in fines of up to $250,000 and up to 5 years in prison, for violation of statutes such as Conspiracy to Defraud the IRS, Tax Evasion, Subscription to a False Tax Return, Aiding or Assisting in a False Tax Return, and Corrupt or Forcible Interference with the Administration of Internal Revenue Laws. I have represented taxpayers who filed false returns prepared by preparers who have been sent to prison, and it has been my experience that in cases where IRS locates a taxpayer from a targeted preparer’s records, there is very little room for negotiation with the Examination or Collection Divisions. The examiner will cite national IRS policy, will claim that he or she has been given no discretion to settle or abate penalties, and will come down hard on the taxpayer. If you don’t pay what you owe, IRS will litigate, and it is unlikely that it will lose.
A Word to the Wise
These are no-win propositions. They are clearly illegal; IRS has been very successful in its prosecutions in these cases; and it is spotlighting its successes in order to deter others from getting involved in these schemes.