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Post: IRS Warns About Complex Trust Tax Scam Used To Defer Income Taxes



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I have previously written about the resurgence of scam trusts in my article The Complex Trust Is Simply The Criminal Tax Evasion Device Known As The Pure Trust Repackaged (Aug. 18, 2021). Today we look at a different type of trust which similarly — and just as falsely — claims to avoid income and capital gains taxes. Although sometimes pitched under different names, the trust is usually referred to as a “non-grantor irrevocable complex discretionary spendthrift trust”, as if the length of the name alone should justifies the fees that somebody pays to set one of these things up. Attention to this form of trust comes by way of an IRS Office of Chief Counsel Memorandum, AM 2023-006 and will give a more in-depth and technical description than shall be done here.

The basic idea is an old one when it comes to tax scams, being the idea that no income tax has to be paid on the trust’s income so long as no distributions are made to beneficiaries. Eventually, according to the promoters, when distributions are finally made then some tax might or might not have to be paid at that future time, but not now. Thus, also according to the promoters, if a taxpayer can get a heavily-appreciated asset into the trust, the taxpayer can use the trust to churn the asset without paying capital gains taxes on the sale now, which also of course means that they will have a much larger amount to invest in the meantime. The promoters also say that such trusts can effectively sponge up large income streams, such as from royalties, and not pay taxes on those moneys until they are distributed to beneficiaries. It sounds good; it is also totally false.

This is actually part of the scam. If you told somebody that you could set up a trust for them which will never pay taxes, most people will see that as a scam and not believe it. But, if you tell the same folks that the taxes are not totally avoided but instead are deferred, they are more likely to believe that because it sounds sort of reasonable. Of course, it doesn’t help that the Internal Revenue Code is indecipherable to all but real tax professionals. So scam artists do here what they do in all sorts of scams, which is to skim close to the truth in a way that seems plausible. The promoters here do this by misinterpreting some old Private Letter Rulings and sometimes producing an “Opinion Letter” that purports to buttress their position. But it is still all just a lie.

The reality is that if there is taxable activity in a trust, it must be taxed in that year to somebody and in the case of a non-grantor trust that means to the trust itself. There is no such thing as deferral of income or capital gains taxes until the beneficiary receives a distribution, just doesn’t work like that. It might work if the trust were some form of charitable trust, like a charitable remainder trust or a charitable lead trust, etc., under the right circumstances, but these are not charitable trusts. Therefore, no deferral.

To an extent, the promoters are also trying to make their trusts seem like so-called incomplete non-grantor trusts that I wrote about in my article California Finally Closes State Tax Loophole For Incomplete Gift Non-Grantor Trusts (INGs) (July 12, 2023), which can sometimes offer savings as state income taxes under the right conditions, but do not purport to save federal income taxes. Yet, promoters use the similarities between the legitimate ING trusts to try to make it seem like their own trusts can likewise defer federal income taxes, which again is simply false.

Another hurdle to selling trusts like these is that most folks don’t want to actually give up control of the trust assets for fear of embezzlement. Thus, these trusts are also structured to have all sorts of hidden strings so that control of the trust is never lost. Of course, this destroys any asset protection benefits of these trusts as to the person holding such control, although this is usually quite falsely touted as yet another benefit of these trusts.

The bottom line is that the IRS is using this Memorandum to warn about these forms of trusts by advising its agents:

“Contrary to the claims of the promoters, the trust will recognize income on its capital gains and dividends, except to the extent those amounts are distributed or deemed to be distributed to its beneficiaries.

* * *

“In each case using this structure, as a threshold matter, the trust’s income tax returns should be examined to ensure that (a) the trust is reporting all of its taxable income, including capital gains and any income that is described as an extraordinary dividend, and (b) ensure that the trust is disallowed any deduction claimed with respect to such income solely because the trustee, acting in good faith, has allocated such income to the corpus of the trust.”

Note that the IRS General Counsel’s office uses the term promoter which is a term they use when they consider somebody to be marketing an abusive tax shelter. A promoter is not somebody who has made an innocent mistake as to the tax law, but rather is somebody who knows (or should reasonably know) that what they are doing is edgy, but the bucks they are making justify the risk to them. One of the purposes of this advisory is to put these folks on notice that what they are doing is incorrect and they should stop immediately. Also, the promoter label probably also indicates that these folks are about to receive a subpoena for the names of all their clients who have done this deal and that a promoter examination will be in the offing to determine whether they should pay the awful promoter penalties ― 50% of the gross income received by the promoter from selling the deal with no deductions for anything. Their clients will likely also receive notices for their own tax examinations about as quickly as the promoters provide their names pursuant to the subpoena. Not a fun party for anybody involved.

For ordinary folks, the way to avoid this particular scam and all like it is the same way that I have long preached for all tax schemes: Get a truly independent second opinion from a qualified tax professional. If something works to save taxes, then everybody will agree that it works. But if there is not unanimity between tax professionals that it works, that is a bright red flag to look deeper. Similarly, folks who find themselves having created such a trust and having improperly deferred capital gains or income using the trust should immediately contact a qualified tax professional to start correcting returns and unwinding the scheme.

And once again: If it seems too good to be true, it probably is. Redux.

Lora Helmin

Lora Helmin

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