IRS warns taxpayers on abusive trusts.

On Apr. 4, 1997, the IRS issued Notice 97-24, cautioning taxpayers to be wary of abusive trust arrangements that promise benefits not allowed under the current tax law.

The trust arrangements of concern to the Service are those that ignore the true ownership of assets or the substance of the transaction. According to the IRS, promoters of such arrangements claim that the trusts allow the owner to retain full benefit from business or personal assets while reducing or eliminating taxes. The Service also indicated that often, abusive trust arrangements involve multiple trusts in an attempt to cover the different aspects of a taxpayer's life.

In the notice, the IRS presented the following five examples of trust arrangements it views as abusive:

* Business trust: The owner of a business transfers the business to a trust in exchange for units of beneficial interest. The business trust then makes payments to the trust unit holders that purport to reduce the taxable income of the trust to a point at which little or no tax is due. In addition, the owner claims the arrangement reduces or eliminates self-employment tax.

* Equipment or service trust: The equipment or service trust is formed to hold equipment rented or leased to the business trust at inflated rates. In addition, the taxpayer and trust frequently take inconsistent tax positions. The equipment owner may claim that the transfer of equipment to the trust in exchange for units is an exchange, and that because the value of the trust units cannot be determined, no taxable gain results. The trust takes the position that it has purchased the property for a known value, which it can then depreciate.

* Family residence trust: The owner of a family residence transfers the residence, including furnishings, to a trust. The trust then "leases" the residence and furnishings back to the grantor and takes depreciation and other expenses to reduce or eliminate income. Again, inconsistent tax positions are taken. The trust claims the exchange results in a stepped-up basis for the property, while the owner reports no gain. Note: The family residence trust is not the same as a qualified personal residence trust; the latter is permitted under Sec. 2702 and the regulations thereunder.

* Charitable trust: The owner transfers assets to a purported charitable trust and claims either that the payments made to the trust are deductible or that payments made by the trust are charitable contributions. Payments are made to charitable organizations from the trust; however, the payments are principally for the benefit of the owner or the owner's family (e.g., for personal educational, living or recreational expenses).

* Final trust: In certain multi-trust arrangements, a final trust is formed to hold trust units of the owner's other trusts and is a final distributee of their income. The final trust is often formed in a foreign country that will impose little or no tax on the trust.

According to the IRS, abusive trust arrangements typically are promoted by the promise of tax benefits with no meaningful change in the taxpayer's control over or benefit from his income or assets. The promised benefits may include reduction or elimination of income subject to tax; deductions for personal expenses paid by the trust; depreciation deductions for a taxpayer's personal residence and furnishings; a stepped-up basis for property transferred to the trust; the reduction or elimination of self-employment taxes; and the reduction or elimination of gift and estate taxes.

The Service indicates that it is reviewing trust arrangements as part of a "National Compliance Strategy" in order to identify abusive trusts and that in appropriate circumstances, taxpayers and/or promoters may be subject to civil and/or criminal penalties. The IRS is encouraging taxpayers who have entered into abusive trust arrangements to file amended returns to correct previously filed returns.

From Dale R. Baumann, CPA, J.D., Washington, D.C.