Sham Trusts: How to Avoid Tax Penalties

The IRS warns us about tax evasion schemes, called “sham trusts,” involving foreign and domestic trusts. An important of estate planning is find the best methods to organize your assets to minimize tax.

Yet, there are some promoters of trust schemes that are shams and will ultimately cost you penalties and more tax.

What is a Trust?

A trust is a legal entity formed under state law, used in such matters as estate planning. A trustee is designated to hold legal title to the trust property, to exercise independent control over it, and to be responsible for its management.

Legitimate Trusts vs. Sham Trusts

Legitimate trusts are available for tax and estate planning, to facilitate the genuine charitable transfer of assets; and, to hold assets for minors and those unable to handle their financial affairs.

When you’re considering your trust options, be aware that the IRS has identified several sham trusts.

These sham trusts don’t produce claimed tax benefits and can trigger interest and penalties. This type of trust is disregarded for tax purposes, and all income and expenses are assigned to the true owner of the activity.

It’s important to be aware of these sham trusts because they can be costly and defeat your estate planning objectives.

Examples of Legitimate Trusts

These types of trusts that can be used to accomplish specific tax and estate planning objectives include:

• Marital Deduction Trusts—Can be used to transfer amounts to your spouse without paying gift or estate tax while ensuring that the trust assets will be available for children on the spouse’s death.
• Grantor Retained Annuity Trusts (GRATs), Grantor Retained Unitrusts (GRUTs) and Qualified Personal Residence Trusts (QPRTs)—Any of which can be set up during life to reduce gift and estate tax costs of transferring property to your children.
• Charitable Remainder Annuity Trusts (CRATs), Charitable Remainder Unitrusts (CRUTs) and Pooled Income Funds—Will yield income, gift and estate tax charitable deductions and that can benefit you and your family members.
• Life insurance trusts—Can be used to keep life insurance proceeds that are subject to federal estate tax from being taxed in the insured’s estate.
• Revocable trusts—Provide a benefit in having property pass to beneficiaries on the death of the owner without having to go through the probate process.

In addition, there are special types of trusts that can be used to make gifts to your children of amounts that would qualify for the gift tax annual exclusion and yet minimize the risk that your children will squander the funds.

Likewise, trusts exist to make gifts of S Corporation stock to your minor children to save income and estate taxes while maintaining trustee control and management of the S stock.

Examples of Sham Trusts

The IRS has identified several sham trusts that you should be on the lookout for when making your estate plan. Bottom line, if it sounds too good to be true, it probably is.

“Business Trusts”

These sham trust arrangements make it appear that an individual has given up control of his or her business to secure a reduction in income and self-employment taxes and an elimination of estate tax on the business owner’s death.

These types of arrangements do not provide the claimed tax relief.

Equipment Or Service Trusts

These sham trusts are formed to hold equipment that is rented or leased to the business trust, often at inflated rates, and the service trust is formed to provide services to the business trust, often for inflated fees.

These trusts seek to reduce income taxes in different ways, but the IRS warns that they do not work.

Family Residence Trusts

In this scheme, an individual transfers the family residence, including furnishings, to a trust, which rents it back to the individual. The trust deducts depreciation and the expense of maintaining and operating the residence including, pool service and utilities.

These expenses are not deductible, and the IRS will not allow them.

Sham Charitable Trusts

In this sham trust scenario, 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 transferor or one of his or her family members. The trust then claims the payments as charitable deductions on its tax return.

The IRS says that many of these organizations are not exempt from tax and contributions to these trusts are not deductible.

Certain Trusts Located in Foreign Countries

Some individuals say that tax can be avoided by using trusts located in foreign countries that impose little or no tax on trusts and provide financial secrecy. Abusive 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 sham trust promoter claims that this distribution is tax-free. But the IRS says that the income from these arrangements is fully taxable.

Avoid doing business with promoters of these sham trusts. The IRS is aware of these schemes, and it will benefit you to be wary when planning your estate.

Make sure you work with a trusted and experienced estate planner when you’re working to accomplish your tax or estate planning objectives, and you’ll find legitimate ways to approach your situation.