A quick Google search on Asset Protection will return thousands of trust companies promising to solve your tax issues with a “little known” type of trust that the IRS can’t touch and that Judge’s can’t pierce, making you invulnerable to the law. A deeper dive into these schemes shows that not only has the IRS won litigation to pierce such trusts and seized the assets, the unknowing suckers who bought into the schemes have often gone to jail for tax evasion.
When determining what structure to use to protect your assets, keep this one general rule in mind: Tax Evasion is illegal. Tax Avoidance is not. Proper structures do exist. It’s how the wealthy families protect their nest eggs and grow it for generations. But to do so requires adherence to a strict set of compliance rules, rules that everyday people often ignore, which is why it does not work for them. Here are some of the more infamous Abusive Tax Schemes and why they don’t work.
Common Law Trust
Contrary to the claims of promoters, “common law trusts” no longer exist since all states now have statutes relating to the creation and operation of trusts.
Through 1996, a trust was foreign if the trustee, corpus, and administration were foreign. Since 1996, a trust is foreign unless a U.S. court supervises the trust and a U.S. fiduciary controls all substantial decisions. U.S. taxpayers are subject to filing Form 3520, Creation of or Transfer to Certain Foreign Trusts, Form 3520-A, Annual Return of Foreign Trust With U.S. Beneficiaries, and Form 926, Return by a Transferor of Property to a Foreign Estate or Trust, when contributing property to a foreign trust. These trusts are usually U.S. tax neutral and are treated as grantor trusts with income taxed to the grantor.
Foreign trusts that have income attributable to U.S. sources and are not grantor trusts are required to file Form 1040NR, U.S. Nonresident Alien Income Tax Return. Foreign trusts that have income attributable to U.S. sources and are grantor trusts would have that income directly attributable to the grantor (if U.S. grantor income, it must be included on Form 1040 or 1040-SR; if nonresident alien grantor income, it must be included on Form 1040NR).
Personal Residence Trust
A personal residence trust involves the transfer of a personal residence to a trust with the grantor retaining the right to live in the residence for a fixed term of years. Upon the shorter of the grantor’s death or the expiration of the term of years, title to the residence passes to beneficiaries of the trust. This is an irrevocable trust with gift tax implications.
Qualified Personal Residence Trust
A qualified personal residence trust (QPRT) involves the transfer of a personal residence to a trust with the grantor retaining a qualified term interest. If the grantor dies before the end of the qualified term interest, the value of the residence is included in the grantor’s estate. If the grantor survives to the end of the qualified term interest, the residence passes to beneficiaries of the trust. A QPRT is a grantor trust, with special valuation rules for estate and gift tax purposes, governed under IRC 2702.
Grantor Retained Income Trust
In a grantor retained income trust, the grantor creates an irrevocable trust and retains the right to all trust income for: (a) the earlier of a specified term or the death of the grantor; or (b) a specified term. If the grantor survives the specified term, the trust principal passes to others according to the terms and provisions of the trust instrument. For federal tax purposes, this trust is treated as a grantor trust.
Grantor Retained Annuity Trust
In a grantor retained annuity trust, the grantor creates an irrevocable trust and retains the right to receive, for a specified term, an annuity based on specified sum or fixed percentage of the value of the assets transferred to the trust. A grantor retained annuity trust is specifically authorized by Internal Revenue Code Section 2702(a)(2)(B) and 2702(b). For federal tax purposes, this trust is treated as a grantor trust.
Grantor Retained Unitrust
A grantor retained unitrust is similar to a grantor retained annuity trust. However, in a grantor retained unitrust, the grantor creates an irrevocable trust and retains, for a specified term, an annual right to receive a fixed percentage of the annually determined net fair market value of the trust assets (Treasury Regulation Section 25.2702-(c)(1)). For federal tax purposes, this trust is treated as a grantor trust.
Charitable Lead Trust
A charitable lead trust pays an annuity or unitrust interest to a designated charity for a specified term of years (the “charitable term”) with the remainder ultimately distributed to non-charitable beneficiaries. There is no specified limit for the charitable term. The donor receives a charitable deduction for the value of the interest received by the charity. The value of the non-charitable beneficiary’s remainder interest is a taxable gift by the grantor.
Charitable Lead Annuity Trust
A charitable lead annuity trust is a charitable lead trust paying a fixed percentage of the initial value of the trust assets to the charity for the charitable term.
Charitable Lead Unitrust
A charitable lead unitrust is a charitable lead trust paying a percentage of the value of its assets, determined annually, to a charity for the charitable term.
Charitable Remainder Trust
In a charitable remainder trust, the donor transfers assets to an annuity trust or unitrust. The trust pays the donor or another beneficiary a certain amount each year for a specified period. In an annuity trust, the payment is a specified dollar amount. In a unitrust, the payment is a percentage of the value of the trust, as valued each year. The term of the trust is limited to 20 years or the life of the designated recipients. At the end of the term of the trust, the remaining trust assets must be distributed to a charitable organization. Contributions to the charitable remainder trust can qualify for a charitable deduction. This charitable contribution deduction is limited to the present value of the charitable organization’s remainder interest. Revenue Procedures 2003-53, 2003-54, 2003-55, 2003-56, 2003-57, 2003-58, 2003-59, and 2003-60 provide sample trust forms that the Service will recognize as meeting charitable remainder trust requirements.
Pooled Income Fund Trust
A pooled income fund is an unincorporated fund set up by a public charity to which a person transfers property, reserving an income interest in, and giving the charity the remainder interest in that property. The Code and Regulations under Section 642 establish trust requirements. These funds file Form 1041.
Life Insurance Trust
An insurance trust is generally an irrevocable trust that owns insurance on the life of the grantor or grantor and spouse. The trust is designed to avoid federal estate taxation of the insurance proceeds on the deaths of the grantor or spouse. When premium payments or other gifts to the trust are made, the trust instrument grants specified beneficiaries Crummey withdrawal rights over the gifts so that they will qualify for the federal gift tax annual exclusion. These trusts would generally file a Form 1041 as a complex trust, if the $600 income requirement were met.
Qualified Subchapter S Trust (QSST)
A QSST is a statutory creature established by IRC Section 1361(d)(3). By meeting the requirements of a QSST, a trust may own S Corporation shares. An election must be made to be treated as a QSST and once made is irrevocable.
Electing Small Business Trust (ESBT)
An ESBT is a statutory creature established by IRC Section 641(c). By meeting the requirements of an ESBT, a trust may own S Corporation shares. ESBT’s must file Form 1041 and the S Corporation income is taxed at the trust’s highest marginal rate. No income distribution deduction is allowed to beneficiaries. To be treated as an ESBT, an election must be made.
This is an arrangement between the grantor and funeral home/cemetery to allow for the prepayment of funeral expenses. The funeral trust is a “pooled income fund” set up by a funeral home/cemetery to which a person transfers property to cover future funeral and burial costs. These are grantor trusts with the grantor responsible for reporting income. The trustee may make an election on qualified pre-need funeral trusts to not be treated as a grantor trust, with the tax being paid by the trustee.
An irrevocable trust that functions as a type of retirement plan or deferred compensation arrangement that offers a limited amount of security to the deferring employee.
The term “business trust” is not used in the Internal Revenue Code. The regulations require that trusts operating a trade or business be treated as a corporation, partnership, or sole proprietorship, if the grantor, beneficiary or fiduciary materially participates in the operations or daily management of the business. If the grantor maintains control of the trust, then grantor trust rules will apply. Otherwise, the trust would be treated as a simple or complex trust, depending on the trust instrument.
The term “pure trust” is not used in the Internal Revenue Code. Whatever the name of the arrangement, however, the taxation of the entity must comply with the requirements of the Internal Revenue Code. The requirements are based on the economic reality of the arrangement, not its nomenclature. If the pure trust meets the definition of a trust, then it would be taxed under simple, complex, or grantor trust rules, depending on the trust instrument.
Illinois Land Trust
In Illinois, and in five other states, legislation has been enacted that creates a special type of trust, commonly referred to as an “Illinois Land Trust”. These trusts are designed to house real estate within a grantor trust and provide limited access to grantor or beneficiary information contained in the trust instrument or known to the trustee. Once a land trust is established, the ability to trace property transactions becomes limited as state law establishes the right of the trustee not to disclose the true owner of the property or those with a beneficial interest. The “land trust” has no special distinction in the Internal Revenue Code and would be a simple, complex, or grantor trust depending on the terms of the trust instrument. Filing requirements would depend on the type of trust.
Delaware Business Trust or Alaska Business Trust
A trust established to hold and invest assets with greater flexibility than allowed by most trusts. Permits limited liability, creditor protection, and valuation discounts. These trusts are a creation of the Delaware and Alaska legislatures and have no impact on taxation of trusts for federal purposes. These “business trusts” have no special distinction in the Internal Revenue Code and would be a simple, complex, or grantor trust depending on the terms of trust instrument. The regulations require that trusts operating a trade or business be treated as a corporation, partnership, or sole proprietorship, if the grantor, beneficiary or fiduciary materially participates in the operations or daily management of the business. Filing requirements would depend on this classification.
Unincorporated Business Organization (UBO)
A term used by trust promoters to identify trusts they sell and to disguise the fact that it is a trust. This term and the term “Massachusetts Business Trust” are often used interchangeably. These are not terms used by the Internal Revenue Code.