Not all trusts are trustworthy.

There's something about the word trust that makes people feel secure. In the financial world, however, the use of that word can be deceiving. Each year the IRS investigates fraudulent trust schemes that promise participants they will reduce or eliminate income taxes. In recent years, convictions for such schemes have increased. The convictions illustrate that many trust schemes do not provide promised federal income tax relief. In addition, buyers could be subject to civil and criminal penalties. The IRS has warned taxpayers, "Just because it's a trust doesn't mean it's trustworthy!"

What is a trust?

A trust is a form of ownership --controlled and managed by a designated independent trustee--that completely separates responsibility and control of assets from the benefits of ownership. The IRS recognizes numerous types of legal trust arrangements. These trusts are commonly used for estate planning, charitable giving and holding assets for beneficiaries. Under a valid trust, the grantor must give up control of income and assets. The independent trustee manages the trust, holds legal title to trust assets and exercises independent control.

Trust taxation

Under federal tax law, a trust is generally a separate entity subject to tax on the income it receives, including income generated by property held in the trust. A domestic trust must file Form 1041, U.S. Income Tax Return for Estates and Trusts. If the trust is classified as a domestic grantor trust, it generally is not required to file form 1041, provided the individual taxpayer reports all items of income on his or her own tax return. All income a trust receives, whether from domestic or foreign sources, is taxable to the trust, to the beneficiary or to the taxpayer unless specifically exempted by the Internal Revenue Code.

Foreign trusts are subject to special requirements. If a trust has income that is effectively connected with a U.S. source, it must file Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts; Form 3520-A, Annual Information Return of Foreign Trust With U.S. Owner and form 1040NR. Foreign trusts may be required to file other forms as well. Foreign trusts to which a U.S. taxpayer has transferred property are treated as grantor trusts as long as the U.S. taxpayer is alive and the trust has at least one U.S. beneficiary. The income the trust receives is taxable to the transferor under the grantor trust rules.

Abusive trust schemes

The courts have held many trust arrangements to be shams, with no economic substance. The resulting income and expenses are attributed to the actual earner of the income. Contrary to the claims of promoters, trusts are not a legal way to pay personal expenses with pretax dollars, reduce personal tax liability or avoid income or employment taxes.

Fraudulent trusts. Fraudulent trusts often hide the true ownership of assets and income or disguise the substance of transactions. Currently, two fraudulent arrangements are being promoted: a domestic package and a foreign package. The former refers to a series of trusts created in the United States. The latter are formed offshore and outside U.S. jurisdiction. The trusts involved are vertically layered, with each trust distributing income to the next layer. The goal is to fraudulently reduce taxable income to nominal amounts. Although these schemes give the appearance of separating responsibility and control from the benefits of ownership, they are in fact controlled and directed by the taxpayer.

Here are some common fraudulent trust schemes CPAs should watch out for:

* Business trust. This involves the transfer of an ongoing business to a trust. Also called an unincorporated business organization, a pure trust or a constitutional trust, it makes it appear that the taxpayer has given up control of his or her business. In reality, however, through trustees or other entities controlled by the taxpayer, he or she still runs 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 corporation.

* Equipment or service trust. This trust is formed to hold equipment that is rented or leased to the business trust, often at inflated rates. The business trust reduces its income by claiming deductions for payments to the equipment trust. This type of arrangement has the same pitfalls as the business trust, and it will result in no tax reduction.

* Family residence trust. Taxpayers transfer family residences, including furnishings, to a trust, which sometimes rents the residence back to the taxpayer. The trust deducts depreciation and the expenses of maintaining and operating the residence including gardening, pool service and utilities. The courts have consistently collapsed these types of trusts, taxing income to the taxpayer and disallowing personal and nondeductible expenses.

* Charitable trust. Taxpayers transfer assets or income to a trust claiming to be a charitable organization. The trust or organization pays for personal, education or recreation expenses on behalf of the taxpayer or family members. The trust then claims the payments as charitable deductions on its tax returns. These alleged charitable organizations often are not qualified and have no IRS exemption letter; hence contributions are not deductible. Charitable deductions are not allowed when the donor receives personal benefit from the alleged gift.

* Foreign trust. These trusts often are domiciled in a foreign country that imposes little or no tax on trusts and also provides financial secrecy. Typically, abusive foreign trust arrangements enable taxable funds to flow through several trusts or entities until the funds ultimately are distributed or made available to the original owner, purportedly tax-free. In fact, the income from these arrangements is fully taxable.

Recognizing a problem trust

CPAs should look for these common warning signs that an unscrupulous operator has offered a fraudulent trust scheme to a client.

* A promise to reduce or eliminate income and self-employment tax.

* Deductions for personal expenses paid by the trust.

* Depreciation deductions on an owner's personal residence and furnishings.

* High fees for trust packages, to be offset by promised tax benefits.

* Use of back-dated documents.

* Unjustified replacement of trustee.

* Lack of an independent trustee.

* Use of post office boxes for trust addresses.

* Use of terms such as pure trust, constitutional trust, sovereign trust or unincorporated business organization.

Civil and criminal penalties

If a taxpayer participates in a trust that improperly evades tax, he or she is still liable for taxes, interest and civil penalties. Violations of the Internal Revenue Code with the intent to evade income taxes may result in a civil fraud penalty or criminal prosecution. Civil fraud can include a penalty of up to 75% 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 up to five years in prison.

During the 1990s, the IRS witnessed a substantial increase in both civil examinations and criminal investigations of fraudulent trusts. The Tax Court consistently found against such schemes, deeming them shams or merely grantor trusts that will not deliver the promised tax benefits.

Here are two examples of recent criminal cases.

* California bogus trust tax scam. In April 1999, a former CPA was sentenced to 87 months in prison for defrauding the IRS by promoting bogus trusts. Three others, including an attorney and a former legislative aide, were sentenced to prison terms of up to 63 months for their involvement. The men sold packages of bogus trusts to clients and advised them on how to use the trusts to generate fraudulent tax deductions. Clients put businesses, homes and other assets in trust but, in fact, continued to control those assets. They claimed various personal expenses, including depreciation of personal residences, lawn care, house cleaning and scholarships for their children as deductible trust expenses. In another scheme directed to high-income taxpayers, the conspirators instructed clients to conceal income from the IRS through a series of bank accounts in the United States and the Caribbean. The judge in the case found the trust scheme cost the federal and state governments more than $2.5 million in lost tax revenue.

* Tax evasion in Texas. In January 1999, a Texas physician was sentenced to 37 months in jail for tax evasion and ordered to pay $414,819 in restitution to the IRS. According to the indictment, the physician failed to report substantial taxable income between 1991 and 1996. The physician created trusts, including one for his family residence, that he controlled and used to conceal his taxable income. In addition, he transferred funds between trusts, offshore corporations and their corresponding bank accounts located in the United States, Bahamas and the Channel Islands in order to conceal taxable income.

Buyer beware!

The IRS cautions taxpayers to beware of sales pitches that sound too good to be true. If they are in doubt about investing in a trust, clients should be advised to seek guidance from a tax professional or from the IRS. Taxpayers who have erred by participating in a problem trust should file an amended return immediately. To report suspected tax fraud, call 800-829-0433. For more information about the IRS policy on fraudulent trusts, read IRS Public Announcement Notice 97-24, IRS Warns of Abusive Trusts, available at www.treas.gov/irs/ ci/tax_fraud/notice.htm. Publication 2193, Too Good to Be True Trusts, at www.treas.gov/irs/ci/tax_fraud/ alert.htm, warns taxpayers to avoid trusts that advertise bogus tax benefits.

--Dale Hart, IRS regional commissioner, midstates region, and field executive in charge of abusive trusts.