Pure Trust, Constitutional Trusts, Family Estate Trusts, and Other Sham Trusts
Recent years have witnessed a proliferation of vehicles calling themselves trusts that are promoted with the promise that they can enable a grantor to eliminate all obligations for income, estate, and gift taxes. Among the names for these trusts are family estate trust, constitutional trust, pure equity trust, Patrick Henry trust, offshore estate trust, and tax haven double trust. In this discussion they will be referred to as sham trusts. Using various challenges, the IRS has had little difficulty defeating them.
Common Structures:
While many variations exist on the typical sham trust, there are almost always several common features. The grantor creates a titularly irrevocable trust, either retaining broad managerial powers and discretion or giving them to other family members. The grantor then transfers to the trust all of her assets, and assigns to the trust the right to all of the grantor's future services and to receive all compensation paid for those services. In exchange, the grantor receives certificates representing units of beneficial interest, some of which the grantor may give away.
The grantor then continues to do business or render services as always, with checks from customers, clients, or patients being made to the “Grantor Sham Trust.” The trust pays all of the grantor's personal expenses, and supports the grantor and her family, including maintaining the grantor's residence and paying transportation, business, and medical insurance costs. In a few cases, the trusts name as beneficiaries foreign trusts that, in turn, make “grants” to the grantor and her family.
Failure of Sham Trusts:
The IRS has yet to taste serious defeat in challenging claims that sham trusts can reduce income, estate, or gift taxes. The IRS first attacked the sham trust with four rulings issued on the same day. In Revenue Ruling 75-257, the grantor assigned to a trust the right to the grantor's lifetime services. The grantor, his spouse, and a third person were named the trustees and would take all actions by majority vote. The trustees had broad powers to conduct all types of business, and did employ the grantor and pay various of the grantor's personal and business expenses. The IRS said that the trust was a sham attempt at assignment of income in violation of the principles of the Supreme Court's decision in Lucas v. Earl, and that it also violated Sections 674, 676 and of the grantor trust rules.
In Revenue Ruling 75-258 the grantor created a slightly different type of family estate trust, based on the issuance of transferable certificates of beneficial interest that the grantor then transferred to family members. Again, action was to be taken by a majority of the trustees. In this case, however, the IRS said that the unincorporated entity had more corporate characteristics than trust characteristics, and that it was therefore an association taxable as a corporation.
In Revenue Ruling 75-259 the IRS said that the grantor's retained beneficial enjoyment in the trust, whether through direct or indirect control over the activities of the trust or certificates of beneficial enjoyment, brought the trust funds back into the grantor's gross estate for estate tax purposes, under Sections 2033, 2036, and 2038. In Revenue Ruling 75-260 the IRS also concluded that the transfers to the trust were incomplete for gift tax purposes, until distributions were made from the trust to persons other than the grantor.
The IRS further clarified these rulings during the next five years. It ruled that the fees to create a sham trust were not deductible under either Section 162 (business expenses) or 212 (investment and money management expenses), and that amounts paid to the grantor under one of these trust arrangements were substitutes for compensation and were subject to federal employment taxes. They also struck down a version of the sham trust that involved the use of both domestic and foreign trusts.
The Courts have consistently sustained the IRS' arguments. The IRS has not yet really tried to pursue treating these trusts as associations, but it has been successful at ignoring them entirely as sham entities or treating them as grantor trusts. In a few estate tax cases, the IRS has also been very successful in having the trust funds included in the deceased grantor's gross estate.
In Service Center Advice 1998-006 (Mar. 6, 1998), the Austin Internal Revenue Service Center requested from the National Office advice about the tax reporting requirements for so-called pure trusts or Pure Trust organizations. The Chief Counsel of the IRS advised the Service Center that such a trust is still classified as a trust or another entity, and it must file an application for a taxpayer identification number (Form SS-4), from which the Service Center could determine the proper tax classification of the entity. If it is determined to be a trust under Regulation Section 301.7701-1(a), the trustee must file a fiduciary income tax return (Form 1041). If the particular entity is deemed not to be an entity separate from its owner, then the items of income, deduction, and credit must be reported on the owner's individual income tax return, and Form 1041 is not required.
References:
See discussions in Goldstein, “‘Family Estate’ Trusts, ‘Pure’ Trusts and ‘Constitutional’ Trusts: Apocalypse Now,” 16 U. Miami Est. Plan. Inst. ch. 7 (1982); Perkins, “The Failure of the Family Trust,” 3 Tax Mgmt. Est. Gifts & Tr. J. 20 (1981).
Revenue Ruling 75-257. 1975-2 CB 251
Revenue Ruling 75-258. 1975-2 CB 503
Revenue Ruling 75-259. 1975-2 CB 361
Revenue Ruling 75-260
Revenue Ruling 79-324. 1979-2 CB 119
Revenue Ruling 80-321. 1980-2 CB 33
Revenue Ruling 80-72. 1980-1 CB 137
While there are too many cases in point even to enumerate (most involving taxpayers who represented themselves), the leading decisions are trust taxable under the grantor trust rules); trust was a sham and economic nullity);, appeal dismissed without opinion (10th Cir. 1980) (trust taxable under the grantor trust rules); (osteopath transferred right to future services to beneficial interests, court holds that transaction is an anticipatory assignment of income, a sham, and in any event the grantor trust rules would apply); (dentist created a “family trust” and assigned to it certain properties and the full right to his lifetime professional services, remaining sole beneficiary and co-trustee with his wife; held that the assignment of “lifetime services” was invalid as an attempt to assign anticipatory future income, the trust was a sham); (income from farm was taxable to farmer, not to family trust he had established, because trust lacked substance, as evidenced by vague terms and lack of clearly ascertainable beneficiaries; penalties imposed for failure to file, negligence, and delay of suit). See also ,, (taxpayers created sham trust to receive checks from their customers; trust treated as sham, and one half of receipts taxed to each of the two taxpayers who owned business as community property).
