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Sham Trusts / Independent Trustees / 13 Am Jur 2d / U.S. Constitution
SHAM TRUST ANALYSIS
© 2000, Robert L. Sommers, all rights reserved.
Under the tax law, U.S. citizens and residents must declare their income by filing tax returns and must pay tax on their income. Efforts to claim that someone else earned the money will not work.
Although a taxpayer has a legal right to avoid or minimize taxes, that right does not bestow the right to transfer assets to an entity to avoid tax when the entity does not have economic reality. In other words, apart from tax savings, does the entity serve an economic purpose?
The IRS and the Court are not stupid: They look to the substance of the transaction, not its form. When all is said and done, if one enjoys the benefits of their property, they are taxed as the owner. It does not matter that one places your property into a trust with their friend or relative as trustee and creates lots of paperwork in an attempt to hide true ownership.
The courts and the IRS look to the results, not the methods. The critical issue that must be address is: After the paper shuffle, who winds up with the beneficial use and enjoyment of the property? If it is the taxpayer, then all the intermediate documentation is ignored and the taxpayer is stuck with the tax consequences, as though nothing happened.
What is a "Trust"?: When an individual claims that trust is the actual taxpayer, the first inquiry is whether a trust actually exists. A trust is an arrangement in which a person (called a settlor or grantor) transfers assets to another person (called a trustee) for the benefit of a third person called the beneficiary. A trust is created when a settlor manifests the intention to create a trust, the trust has property, there is a lawful trust purpose and there is an identifiable beneficiary.
The trustee must act for the benefit of the beneficiary, in accordance with the trust agreement, which is almost always written. The trustee takes legal title to all assets, has a fiduciary duty to operate the trust for the exclusive benefit of the beneficiaries, must account for trust assets, must file proper tax returns on behalf of the trust, and cannot personally use or benefit from the trust assets or income. A trustee may be paid reasonable compensation for services rendered.
In U.S. v. Buttorff, 761 F2d 1056 (1985), the Fifth Circuit Court of Appeals upheld an injunction against the seller of fraudulent "Constitutional Pure Equity Trusts," finding the trusts to be shams for tax purposes. One of the benefits claimed by the promoters was that future income earned by the taxpayers could be assigned to the trust. The court reaffirmed the long-standing tax principle that "income is taxed to the person who earns it." The court further noted:
"Where the taxpayer simply assigns his lifetime services and income earned from the performance of those services, and the taxpayer rather than the trust has "ultimate direction and control over the earning of the compensation," the conveyance is ineffective to shift the tax burden from the taxpayer to the trust." Vnuk. 621 F.2d at 1320 (citing Wesenberg v. Commissioner, 69 T.C. 1105, 1010-11(1978)).
To the same effect are Hanson, 696 F.2d at 1234; Holman, 728 F.2d at 464; O'Donnell, 726 F.2d at 681.
As in those cases, appellant's clients were not bona fide servants of the trust because the trust had no right to supervise the taxpayer's employment or determine the resulting income or benefit, and the taxpayer had no legal duty to earn money or perform services for the trust. The grantor's purported conveyance of lifetime services to the trust does not create such a legal obligation because the grantor is on both sides of the transaction, as employee and as trustee, leaving no one to enforce the obligation. Schultz, 686 F.2d at 494. (emphasis added)
In Brittain v. Commissioner, 63 TCM 3004 (1992), the court refused to recognize a purported irrevocable trust that lacked economic substance, the court noted that the petitioner failed to prove "that property was held in trust for the benefit of others," or "that anyone or anything existed that could prevent petitioner from acting in derogation of the interests of any purported beneficiaries... Further, petitioner's relationship to the trust's property did not differ in any material aspect before and after the creation of the trust."
In Keefover v. Cm., 65 TCM 2999 (1993), the court stated that individuals cannot escape taxation by diverting income to some other entity through some contractual arrangement, noting that a fundamental principle of tax law is that income is taxed to the person who earns it. An assignment of income to a trust is ineffective to shift the tax burden to the trust when the taxpayer controls the earning of the income.
In Sandvall v. Cm., 90-1 USTC (1990), the petitioners attempted to use foreign based trusts to avoid their tax liabilities, while maintaining total control over the trust and using the trust assets for their own personal benefit. The court concluded that the petitioners "did not relinquish ownership and control of their earnings, they merely created a fictitious paper trail by which they hoped to disguise or hide their taxable income." The Court concluded that "the Sandvalls have not been singled out; time for them has simply run out. Legal smoke and mirrors, reams of paper, and strings of words will suffice no longer to evade or delay the payment of their fair share of federal income taxes. The time has come for them to join the rest of their fellow citizens at the annual income roundup."
In Dahlstrom v. Cm. 61 TCM 2863 (1991), the court found that the taxpayer used various trusts to, "transfer assets in non-arm's-length transactions back and forth, creating layers of documentation to impede any examination or investigation.... Petitioners owned and enjoyed the income, funneled through the layers of trusts and paperwork they generated to disguise or hide their income, and they are taxable on that income."
Once the four elements of a trust have been established, the trust must be scrutinized to determine whether it will be recognized under the law or rejected is merely a sham. In Buckmaster v CM TC Memo 1997-236, the court considered four factors to ascertain whether a purported trust is a sham, i.e. lacks economic substance for Federal income tax purposes.
(1) Whether the taxpayer's relationship, as grantor, to the property differed materially before and after the trust's formation.
In other words, did the taxpayer transfer the assets to the trust, continue to use the assets and receive income from the assets or his efforts?
(2) Whether the trust had an independent trustee.
In other words, was there any meaningful restriction on the taxpayerís use of the trust property for his own purposes or access to the trustís accounts?
(3) Whether an economic interest passed to other beneficiaries of the trust.
In other words, did the taxpayer transfer an economic interest to a third party when he transferred his assets to the Trust? Did the taxpayer actually transfer away all of his legal and beneficial interests in his assets, including the tools of his trade, for practically nothing in return?
(4) Whether the taxpayer felt bound by any restrictions imposed by the trust itself or the law of trusts.
In other words, were the actions of the taxpayer limited by any restrictions imposed by the trust agreement or the law of trusts as to the use of the transferred property? Did the taxpayer have unrestricted use and control over the property without fiduciary limitations imposed on trustees?
IV. A PRELIMINATARY ISSUE: WAS AN ACTUAL "TRUST" IN EXISTENCE?
Before undertaking the sham trust analysis, one must determine that there is a legal trust in existence.
A trust must have each of the following elements:
1. A manifestation of intention of the settlor to create a trust;
2. Trust property
3. A lawful trust purpose; and
4. At least one identifiable beneficiary
If a trust lacks any one of these elements, it is not a legal trust. Typically, a sham trust will not have specific people named as individual beneficiaries; instead, it will use Certificates of Beneficiary Interests (also called Units of Beneficial Interests or "UBIs"). Such units or certificates do not specify a named individual and, therefore, a trust with UBIs does not have at least one identifiable beneficiary and is not a legal trust.
If it is established that there is not a legal trust, then there is no argument that a trust exists in the first place, and therefore, the settlor (or "creator" in sham trust lingo) is taxed on the income. In other words, unless there is a legal trust to begin with, there is no need to engage in the sham trust analysis, because the analysis presupposes that a legitimate trust is in existence. In essence, the sham trust analysis asks the following question "If there is a legal trust in existence, is that trust a sham for tax purposes?"
The sham trust analysis has a two-part inquiry: (1) Was there a legal trust in existence in the first place? and (2) If the answer to question (1) is yes, was the trust a sham for income tax purposes? If the answer to question one is no, then the inquiry stops because there is no trust in the first place and the settlor is taxed directly on the income because he or she is the only taxpayer who can be taxed. If the answer to question one is yes, then there is a four-part inquiry as to whether the trust is a sham. To be a legitimate trust for tax purposes, each of the four elements necessary to create a trust must be present; otherwise, the trust is a sham and the settlor is taxed directly on the income as though the trust did not exist. In every case in which one of these so-called "pure" or "pure equity" trusts has been the subject of a lawsuit, the court has ruled the trust is a sham.
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[Commentary: This sentence has to be the most irresponsible statement ever written about business trusts and UBIs.]