Published in the Tax Practitioners Journal, Spring 1998

There’s something about the word "trust" that makes one feel comfortable and secure. That’s usually the case. In the financial world, however, the word "trust" can be deceiving. If in doubt, ask the Internal Revenue Service’s Criminal Investigation Division, the agency responsible for stopping tax crime. If asked whether your financial portfolio should include "too good to be true" trusts, the IRS will tell you "just because it’s a trust, doesn’t mean it’s trustworthy!"

What is a Trust? A trust is a form of ownership which completely separates responsibility and control of assets from all the benefits of ownership. A trust is controlled and managed by a designated independent trustee. Under federal tax laws, a trust is generally a separate entity subject to income tax (except for certain charitable or pension trusts that are expressly exempted by the tax laws and certain grantor trusts).

The IRS recognizes numerous types of legal trust arrangements. These legal trusts are commonly used in such matters as estate planning, charitable giving, and holding assets for minors and those unable to handle their own financial affairs. Under a legal trust arrangement, you must give up control over income and assets. An independent trustee is designated to hold legal title to the trust assets, to exercise independent control over the trust, and to manage the trust. Taxes must be paid on the income or assets held in trust, including the income generated by property held in trust. The responsibility to pay taxes may fall to either the trust, the beneficiary, or the trustee. All trusts must comply with the tax laws as set forth by Congress in the Internal Revenue Code, Sections 641-683.

A fraudulent trust only has the appearance of a trust. It is typically promoted by the promise of tax benefits or avoidance with no meaningful change in the taxpayer’s control over or benefit from the taxpayer’s income or assets. In some fraudulent trust arrangements, the taxpayer indirectly controls the activities of the trust through another individual designated as the trustee. Fraudulent trusts are illegal and are an emerging area of concern for IRS Criminal Investigation. 

Common Uses of Fraudulent Trusts

Fraudulent trusts often hide the true ownership of assets and income or disguise the substance of transactions. The following arrangements have been used to promote fraudulent trust schemes:

• The Fraudulent Business (or Unincorporated Business) Trust

The owner of a business transfers the business to a trust. The business trust then makes payments to "unit holders" which are characterized as deductible business expenses or deductible distributions that purport to reduce the taxable income of the business trust to the point where little or no tax is due. Also, the promoter claims the arrangement reduces or eliminates the owner’s self-employment taxes on the theory that the owner is receiving reduced or no income from the operation of the business.

• The Fraudulent Equipment or Service Trust

The equipment trust is formed to hold equipment that is rented or leased to the business trust, often for inflated rates. The business trust then reduces its income by claiming deductions for payments to the equipment trust.

• The Fraudulent Family Residence Trust

The owner of the family residence transfers the residence, including furnishings, to a trust. The trust claims to be a rental business and rents the residence to the owner, who is the caretaker of the property. The trust may attempt to deduct depreciation and the expenses of maintaining and operating the residence.

• The Fraudulent Charitable Trust

The owner transfers assets or income to a trust claiming to be a charitable organization. The trust or payments made by the owner to the "charitable organization" pay for personal, educational, or recreational expenses. The payments are then claimed as "charitable" deductions.

• The Fraudulent Final Trust

Often established in a foreign country that will impose little or no tax on the trusts, the final trust contains multiple arrangements allowing the money to flow through several trusts until the cash is ultimately distributed or made available to the original owner, purportedly tax free.

Promised Benefits of a Fraudulent Trust may Include:

Civil and Criminal SanctionsThe IRS takes fraudulent trust arrangements seriously. Taxpayers must take responsibility for their own actions. Should a taxpayer choose to participate in a fraudulent trust scheme, the taxpayer will not be shielded from potential civil and criminal sanctions.

Violations of the Internal Revenue Code may result in civil penalties and/or criminal prosecution. Civil sanctions can include a fraud penalty up to 75 percent of the underpayment of tax attributable to the fraud in addition to the taxes owed. Criminal convictions may result in fines up to $250,000 and/or up to five years in prison for such offenses.Why is IRS Criminal Investigation in Pursuit of Fraudulent Trusts?

Internal Revenue Service Criminal Investigation is focusing enforcement activities on investigations that reduce the tax gap and increase voluntary compliance. The tax gap is defined as the total true tax liability less tax paid voluntarily. In other words, there is a growing gap between what Americans owe and what Americans voluntarily pay in income tax. Tax gap investigations involve tax charges in legal industries. In conjunction with enforcement activities on tax gap investigations, IRS Criminal Investigation is in pursuit of those who establish and participate in fraudulent trusts.

Why? Quite simply, to stop tax evasion. The loss of this income to our federal government negatively impacts each of us. Although we may not like it, as Oliver Wendell Holmes put it so eloquently, "Taxes are what we pay for a civilized society." Income must be reported by the individual who earned it. No matter how carefully documents are drafted, if the intent of the trust is to illegally avoid taxes, the trust will be treated as a sham by the IRS.

Imposing civil penalties and/or recommending prosecution of those who violate the tax laws demonstrates the IRS’ commitment to ensure all taxpayers pay their fair share of taxes.Buyer Beware!

Internal Revenue Service Criminal Investigation cautions beware of groups and/or individuals who try to circumvent our tax system through the establishment of fraudulent trusts. They may come up with the idea, but it is the participant who will incur civil penalties, pay the criminal fines, and possibly go to jail.

If in doubt about investing in a trust, seek guidance from a tax professional or the IRS. If you have erred by participating in a fraudulent trust, file an amended return.

By: Ted F. Brown
IRS Assistant Commissioner (Criminal Investigation)

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