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).
