Not All Trusts Are Trustworthy
There's something about the word trust that makes people feel secure. In the financial world, however, the use of that word can be deceiving. Each year the IRS investigates fraudulent trust schemes that promise participants they will reduce or eliminate income taxes. In recent years, convictions for such schemes have increased. The convictions illustrate that many trust schemes do not provide promised federal income tax relief. In addition, buyers could be subject to civil and criminal penalties. The IRS has warned taxpayers, "Just because it's a trust doesn't mean it's trustworthy!" What is a trust? A trust is a form of ownership --controlled and managed by a designated independent trustee--that completely separates responsibility and control of assets from the benefits of ownership. The IRS recognizes numerous types of legal trust arrangements. These trusts are commonly used for estate planning, charitable giving and holding assets for beneficiaries. Under a valid trust, the grantor must give up control of income and assets. The independent trustee manages the trust, holds legal title to trust assets and exercises independent control. Trust taxation Under federal tax law, a trust is generally a separate entity subject to tax on the income it receives, including income generated by property held in the trust. A domestic trust must file Form 1041, U.S. Income Tax Return for Estates and Trusts. If the trust is classified as a domestic grantor trust, it generally is not required to file form 1041, provided the individual taxpayer reports all items of income on his or her own tax return. All income a trust receives, whether from domestic or foreign sources, is taxable to the trust, to the beneficiary or to the taxpayer unless specifically exempted by the Internal Revenue Code. Foreign trusts are subject to special requirements. If a trust has income that is effectively connected with a U.S. source, it must file Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts; Form 3520-A, Annual Information Return of Foreign Trust With U.S. Owner and form 1040NR. Foreign trusts may be required to file other forms as well. Foreign trusts to which a U.S. taxpayer has transferred property are treated as grantor trusts as long as the U.S. taxpayer is alive and the trust has at least one U.S. beneficiary. The income the trust receives is taxable to the transferor under the grantor trust rules. Abusive trust schemes The courts have held many trust arrangements to be shams, with no economic substance. The resulting income and expenses are attributed to the actual earner of the income. Contrary to the claims of promoters, trusts are not a legal way to pay personal expenses with pretax dollars, reduce personal tax liability or avoid income or employment taxes. Fraudulent trusts. Fraudulent trusts often hide the true ownership of assets and income or disguise the substance of transactions. Currently, two fraudulent arrangements are being promoted: a domestic package and a foreign package. The former refers to a series of trusts created in the United States. The latter are formed offshore and outside U.S. jurisdiction. The trusts involved are vertically layered, with each trust distributing income to the next layer. The goal is to fraudulently reduce taxable income to nominal amounts. Although these schemes give the appearance of separating responsibility and control from the benefits of ownership, they are in fact controlled and directed by the taxpayer. Here are some common fraudulent trust schemes CPAs should watch out for: * 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 makes it appear that the taxpayer has given up control of his or her business. In reality, however, through trustees or other entities controlled by the taxpayer, he or she still runs day-to-day activities and controls the business's income stream. …