by Christian, civil trial attorney, RL Johnson
Many taxpayers are looking for estate planning vehicles that will ensure that upon their deaths their hard-earned wealth transfers seamlessly to their loved ones with minimal government interference. Often, these same taxpayers have in mind a desire to spare their loved ones the expenses of transfer taxes and the wailing and gnashing of teeth often associated with the probate court.
Indeed, as judge Learned Hand observed: “There is nothing sinister in so arranging one's affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant.”[i]
Thus, while a seamless transfer of wealth and lawful tax avoidance are both laudable and achievable goals, abusive tax schemes should be avoided at all costs. Some—but certainly not all—of the abusive tax schemes arise from the tax protest movement. The tax protest movement is an anti-government movement that opposes federal income taxes on a convoluted theory that no Constitutional, statutory, or regulatory authority empowers the government to impose, assess, or collect taxes.
For instance, in United States v. Sanders[ii] the defendant, Frankie Sanders, a self-employed farmer had not filed a federal income tax return or paid federal income taxes since at least 1991. In fact, it was unclear if Mr. Sanders had filed a federal income tax return or paid federal income taxes. Mr. Sanders, a self-styled "tax defier" believed that he has no obligation to pay income taxes. Nonetheless, the court noted that as many tax protestors before Mr. Sanders learned, adherence to this belief—no matter how sincerely held—is unwise and can be costly. In the Sanders matter the government filed a collection lawsuit seeking to satisfy, or at least partially satisfy, Mr. Sanders's tax debt by selling the two farms on which three generations of his family have earned their livelihood. The government sought a judgment for the tax years 1991 through 1997, which made Mr. Sanders liable for $441,845.75 in unpaid federal income taxes, penalties, and interest through January 31, 2015. Further, the government sought additional interest and statutory additions accruing from February 1, 2015, to October 20, 2016. Finally, the government sought a judgment declaring that Mr. Sanders's tax liabilities constituted a valid lien on all property belonging to him—including a farm in Fayette County, Illinois, and a farm in Montgomery County, Illinois—and permitting the government to enforce those liens by foreclosing on and selling the properties.
As you can no doubt guess, the court held that Mr. Sanders bore the burden of proving that the government’s tax assessment was incorrect, which he quite obviously could not do. Thus, as a result of his failure to timely respond to the government's request to admit the accuracy of the 1991-1997 income tax assessments, the court deemed those matters admitted. Indeed, even if that were not the case, Mr. Sanders had not come forward with an alternative calculation regarding his tax liability or a reasonably complete set of financial records that would support any alternative calculation. In fact, the court held that during the course of discovery in that matter, Mr. Sanders refused to produce any financial records that would have allowed the Government to make an alternative assessment. Therefore, Mr. Sanders failed to rebut the presumption of correctness applied to the assessment of his tax deficiency.
The Verdict Against Mr. Sanders
Based on the presumption of correctness that the court attached to the IRS's assessment, and Mr. Sanders's complete failure to dispute it, let alone to overcome the presumption, the Court was forced to conclude that the government was entitled to judgment as a matter of law on Mr. Sanders's tax liabilities pertaining to tax years 1991 through 1997, which amounted to $441,845.75—plus the additional interest and statutory penalties accruing from February 1, 2015.
Common Abusive Trust Schemes to Avoid[iii]
The so-called “Pure Trust”— also known as the “Constitutional Trust” or the “Common Law Trust” amongst its many other names — is neither a pure nor a legitimate trust. It is a scam that continues to be perpetrated for upwards of fifty years now. It is promoted as asset protection against creditors and income tax freedom from the IRS. Unfortunately, the opposite is true. The courts and the IRS have been combating these trusts for years.[iv] Now let’s uncover the abusive scheme.
In IRS Notice 97-24, the IRS stresses the following concerning The Family Residence Trust:
“The Family Residence Trust. The owner of the family residence transfers the residence, including its furnishings, to a trust. The parties claim inconsistent tax treatment for the trust and the owner (similar to the equipment trust). The trust claims the exchange results in a stepped-up basis for the property, while the owner reports no gain. The trust claims to be in the rental business and purports to rent the residence back to the owner; however, in most cases, little or no rent is actually paid. Rather, the owner contends that the owner and family members are caretakers or provide services to the trust and, therefore, live in the residence for the benefit of the trust. Under some arrangements, the family residence trust receives funds from other trusts (such as a business trust) which are treated as the income of the trust. In order to reduce the tax which might be due with respect to such income (and any income from rent actually paid by the owner), the trust may attempt to deduct depreciation and the expenses of maintaining and operating the residence.” Id. at pp. 6-7.
The IRS also posits the following legal principles applicable to trusts:
either the trust, the trust beneficiary, or the transferor to the trust, as appropriate under the tax laws, will pay the tax on the income generated by the trust property;
trusts will not transform a taxpayer’s personal, living or educational expenses into deductible items, and will not seek to avoid tax liability by ignoring either the true ownership of income and assets or the true substance of transactions [id. at p. 7]; additionally,
the following well-established tax principles control the proper tax treatment of these abusive trust arrangements.
Substance—not form—controls taxation. The Supreme Court of the United States has consistently stated that the substance rather than the form of the transaction is controlling for tax purposes. See, for example, Gregory v. Helvering, 293 U.S. 465 (1935), XIV–1 C.B. 193; Helvering v. Clifford, 309 U.S. 331 (1940), 1940–1 C.B. 105. Under this doctrine, the abusive trust arrangements may be viewed as sham transactions, and the IRS may ignore the trust and its transactions for federal tax purposes. See Markosian v. Commissioner, 73 T.C. 1235 (1980) (holding that the trust was a sham because the parties did not comply with the terms of the trust and the supporting documents and the relationship of the grantors to the property transferred did not differ in any material aspect after the creation of the trust); Zmuda v. Commissioner, 731 F.2d 1417 (9th Cir. 1984). Accordingly, the income and assets of the business trust, the equipment in the equipment trust, the residence in the family residence trust, and the assets in the foreign trust would all be treated as belonging directly to the owner.
Grantors may be treated as owners of trusts. The grantor trust rules provide that if the owner of property transferred to a trust retains an economic interest in, or control over, the trust, the owner is treated for income tax purposes as the owner of the trust property, and all transactions by the trust are treated as transactions of the owner. Sections 671—677. In addition, a U.S. person who directly or indirectly transfers property to a foreign trust is treated as the owner of that property if there is a U.S. beneficiary of the trust. Section 679. This means that all expenses and income of the trust would belong to and must be reported by the owner, and tax deductions and losses arising from transactions between the owner and the trust would be ignored. Furthermore, there would be no taxable ‘‘exchange’’ of property with the trust, and the tax basis of property transferred to the trust would not be stepped-up for depreciation purposes. See Rev. Rul. 85–13, 1985–1 C.B. 184.
Taxation of Non-Grantor Trusts. If the trust is not a sham and is not a grantor trust, the trust is taxable on its income, reduced by amounts distributed to beneficiaries. The trust must obtain a taxpayer identification number and file annual returns reporting its income. The trust must report distributions to beneficiaries on a Form K–1, and the beneficiary must include the distributed income on the beneficiary’s tax return. Sections 641, 651, 652, 661 and 662.
Transfers to trusts may be subject to estate and gift taxes. Transfers to a trust may be recognized as completed gifts for federal gift tax purposes. Further, whether or not the gift tax applies, if the owner retains until the owner’s death the use of, enjoyment of, or income from the property placed in a trust, the property will be subject to federal estate tax when the transferor dies. Section 2036(a).
Personal expenses are generally not deductible. Personal expenses such as those for home maintenance, education, and personal travel are not deductible unless expressly authorized by the tax laws. See section 262. The courts have consistently held that nondeductible personal expenses cannot be transformed into deductible expenses by the use of trusts. Furthermore, the costs of creating these trusts are not deductible. See, for example, Schulz v. Commissioner, 686 F.2d 490 (7th Cir. 1982); Neely v. United States, 775 F.2d 1092 (9th Cir. 1985); and Zmuda.
A genuine charity must benefit in order to claim a valid charitable deduction. Charitable trusts that are exempt from tax are carefully defined in the tax law. Arrangements are not exempt charitable trusts if they do not satisfy the requirements of the tax law, including the requirement that their true purpose is to benefit charity. Furthermore, supposed charitable payments made by a trust are not deductible charitable contributions where the payments are really for the benefit of the owner or the owner’s family members. See, for example, Fausner v. Commissioner, 55 T.C. 620 (1971).
Special rules apply to foreign trusts. If an arrangement involves a foreign trust, taxpayers should be aware that a number of special provisions apply to foreign trusts with U.S. grantors or U.S. beneficiaries, including several provisions added in 1996. For example, a U.S. person that fails to report a transfer of property to a foreign trust or the receipt of a distribution from a foreign trust is subject to a tax penalty equal to 35 percent of the gross value of the transaction. Other examples of these provisions are the application of U.S. withholding taxes to payments to for eign trusts and the application of U.S. excise taxes to transfers of appreciated property to foreign trusts. See sections 6048, 6677, 1441, and 1491.
Civil and/or criminal penalties may apply. The participants in and promoters of abusive trust arrangements may be subject to civil and/or criminal penalties in appropriate cases. See, for example, United States v. Buttorff, 761 F.2d 1056 (5th Cir. 1985); United States v. Krall, 835 F.2d 711 (8th Cir. 1987); Zmuda v. Commissioner, 731 F.2d 1417 (9th Cir. 1984); and, Neely v. United States, 775 F.2d 1092 (9th Cir. 1985).
The IRS’s Enforcement Strategy for Abusive Trusts
“[T]he Service seeks to encourage voluntary compliance with the tax law. Accordingly, taxpayers who have participated in abusive trust arrangements are encouraged to file correct tax returns for 1996, as well as amended tax returns for prior years, consistent with the explanation of the law set forth in this notice.” IRS Notice 97-24 at p. 8.
It should also be noted that state law does not determine whether something is property under the Internal Revenue Code. For example, in many states a liquor license is not property. Under the Internal Revenue Code, however, the question is whether the taxpayer has rights under state law. Thus, if a taxpayer does have rights under state law, a liquor license is property under the Internal Revenue Code.[v]
Further, the IRS is free in some instances to invade marital property even in the case on an innocent spouse. That is to say, while the tenants by the entireties form of ownership has traditionally provided protection against the creditors of either spouse, the U.S. Supreme Court has held that a federal tax lien against a husband can attach to the husband’s interest in property owned by the entireties.[vi] In fact, relying on this holding, the U.S. Court of Appeals for the Sixth Circuit subsequently allowed the IRS to enforce its tax lien and sell a principal residence owned by a husband and a wife as tenants by the entireties when the wife did not owe any taxes.[vii]
Thus, if you are looking for ways to minimize transfer taxes and avoid probate court, please don’t listen to tax protestors. Rather, find a reputable estate and asset planning lawyer.
ENDNOTES
[i] Commissioner of Internal Revenue v. Newman, 159 F.2d 848 (2d Cir. 1947).
See also Gregory v. Helvering, 293 U.S. 465 (1935), where Judge Hand also said that: “Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the Treasury; there is not even a patriotic duty to increase one’s taxes.”
[ii] United States v. Sanders, Case No. 11-CV-912-NJR-DGW, (S.D. Ill. Oct. 20, 2016). See also, e.g., Lamb v. Comm'r of Internal Revenue, 46 T.C. 539, (U.S.T.C. 1966), holding that the educational expenses incurred and paid by petitioner to attend law school are not deductible as ordinary and necessary business expenses under section 162(a), I.R.C. 1954.
[iii] Note well that these schemes have make names: E.g., the “pure trust” aka “contractual trust” aka “common law trust” aka, a “pure” or “constitutional trust” aka “business trust”. Regardless of the name, the IRS considers them abusive tax schemes.
Typically, these abusive schemes involve the transfer of an ongoing business to a trust. Also called an unincorporated business organization, a pure trust or a constitutional trust, it gives the appearance that the taxpayer has given up control of his or her business. In reality, through trustees or other entities controlled by the taxpayer, he or she still runs the day-to-day activities and controls the business's income stream. Such arrangements provide no tax relief. The courts have held that the business income is taxable to the taxpayer under a variety of legal concepts, including lack of economic substance (sham theory), assignment of income, or that the arrangement is a grantor trust. In some circumstances, the trust could be taxed as a partnership.” Source: https://www.irs.gov/businesses/small-businesses-self-employed/abusive-trust-tax-evasion-schemes-facts-section-iii
[iv] See People vs. Lynam, 261 Cal App 2d 490 (1968) & IRS Notice 97-24@ www.irs.gov
[v] Drye v. United States, 528 U.S. 49, 58-59 (1999).
[vi] United States v Craft, 535 US 274 (2002).
[vii] United States v Davis, 815 F3d 253 (6th Cir 2016).
Helpful Links:
• Christian Legal Society
https://www.christianlegalsociety.org
• The Library of Congress’ website:
https://www.loc.gov/law/help/guide/states.php
• Civil Pro Se Forms
https://www.uscourts.gov/forms/civil-pro-se-forms
• Federal Rules of Civil Procedure
https://www.uscourts.gov/rules-policies/current-rules-practice-procedure/federal-rules-civil-procedure
• Public Access to Court Electronic Records (“PACER”) system
Disclaimer: The information contained in this article is offered for educational purposes only and is not intended to substitute for legal advice and is not customized to your particular needs. Before undertaking self-representation, we urge you to consult with an attorney licensed to practice in your state.