By Yusef El

When trusts are used for legitimate purposes, tax on the income generated by the trust property is paid by one of three entities depending on applicable tax laws, the type of trust, and the trust document. The three possible entities are the trust itself, the beneficiary, or the entity that transferred the property to the trust.

Legitimate trusts do not transform a taxpayer’s personal, living, or educational expenses into deductible items and do not seek to avoid tax liability by ignoring either the true ownership of income and assets or the true substance of transactions.

Contrary to promises made in promotional materials, several 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 a transaction is controlling for tax purposes.

Gregory v. Helvering, 293 U.S. 465 (1935), XIV-1 C.B. 193; and Helvering v. Clifford, 309 U.S. 331 (1940), 1940-1 C.B. 105 – The court determined abusive trust arrangements may be viewed as sham transactions, and the IRS may ignore the trust and its transactions for federal tax purposes.

Markosian v. Commissioner, 73 T.C. 1235 (1980) – Held 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) – 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 were all determined to belong directly to the owner.

Lucas v. Earl, 281 U.S. 111 (1930) – Stated an assignment of income does not shift the incidence of taxation – the income remains taxable to the one who actually earned it.

The doctrine of substance over form for trusts is a legal principle that dictates the actual economic reality of a trust arrangement, rather than its formal legal appearance, will determine its tax consequences. This doctrine is a key weapon for tax authorities, like the IRS, to prevent taxpayers from using trust structures solely for improper tax avoidance. 

The principle is most commonly invoked in the following circumstances:

• Abusive trust arrangements: Taxpayers sometimes create complex or artificial trust structures that have no legitimate business purpose beyond generating tax benefits. The IRS uses the substance over form doctrine to challenge and disregard these schemes, reclassifying the transactions based on their true economic effect.
• Family-related transactions: Transfers of assets between family members are subject to heightened scrutiny, especially when they involve multiple steps. For instance, the IRS may use the doctrine to disregard a series of transfers that were part of a prearranged plan to avoid gift tax and instead treat the transaction as a direct, taxable gift.
• Grantor vs. non-grantor trusts: In determining whether a trust is a grantor trust (where the grantor still controls the assets and pays the taxes) or a non-grantor trust (a separate taxable entity), the IRS looks at the actual control the grantor has retained, not just the technical terms of the trust document. 

Substance vs. form: A detailed comparison

Feature	Form (Legal Appearance)	Substance (Economic Reality)
What it is	The formal legal documentation that describes a transaction or trust structure. This includes the legal agreements, titles, and other paperwork.	The underlying economic reality and genuine purpose of the transaction, irrespective of the legal packaging.
Example in a trust	A trust document specifies that the grantor has technically given up all rights to the trust assets.	The grantor secretly continues to use, control, and benefit from the trust assets.
Legal result	If only the form were considered, the transaction would produce the tax benefits sought by the taxpayer.	The IRS can ignore the stated legal form to produce a different tax result that reflects the transaction’s true intent.

Related doctrines

The substance over form doctrine gave rise to or is closely associated with other principles used by the IRS to challenge improper transactions: 

• Economic Substance Doctrine: This principle denies tax benefits to transactions that lack a legitimate business purpose and have no reasonable possibility of economic profit apart from tax considerations.
• Sham Transaction Doctrine: The IRS can disregard a transaction entirely if it is found to be a “sham” with no economic reality.
• Step Transaction Doctrine: This doctrine allows the IRS to treat a series of formally separate steps as a single, integrated transaction to determine its true tax consequences. 

Importance for taxpayers

While taxpayers generally cannot argue for substance over form to recharacterize their own transactions, it is crucial for tax planning. By ensuring that the actual operations and purpose of a trust (the substance) are aligned with its legal documentation (the form), taxpayers can defend against IRS challenges. 

This is especially important in estate planning, where a legitimate trust can provide significant benefits like avoiding probate, protecting assets, and minimizing taxes. To achieve these goals, the trust must be structured carefully and maintained properly to withstand a substance-over-form analysis. 

Abusive trust tax evasion schemes – Introduction

One of the Internal Revenue Service’s priorities is to combat abusive tax avoidance schemes and the individuals who promote them. To reach the maximum audience, the IRS recognizes the importance of partnering with external stakeholders. The IRS’s external stakeholders, such as the practitioner community, have an enormous reach as well as an excellent relationship with U.S. taxpayers.

This document is one of a series of toolkits developed to assist external stakeholders in assisting the IRS. Each toolkit provides an explanation of the scheme, background, facts and law, and talking points.

In addition to helping educate the public about abusive tax avoidance schemes, external stakeholders are urged to report scheme promoters and/or any new schemes identified to the IRS’s Abusive Schemes Lead Development Center. Instructions are also included in the toolkit.

The IRS Stakeholder Liaison Team would like to acknowledge that the creation of this abusive scheme toolkit has been a collaborative effort by the Small Business/Self-Employed Division, Large Business & International Division, Criminal Investigation, the Office of Chief Counsel, and the Office of Communications and Liaison.

Background

Substantial wealth is transferred from one generation to the next, much of which is transferred using variety of trusts. Although the vast majority of these transfers are legitimate, there is widespread potential for fraud.

In the last few years, the Internal Revenue Service has detected a proliferation of abusive trust tax evasion schemes. These promotions are targeted towards wealthy individuals, small business owners, and professionals such as doctors and lawyers.

Abusive trust arrangements typically are promoted by the promise of such benefits as:

• Reduction or elimination of income subject to tax.
• Deductions for personal expenses paid by the trust.
• Depreciation deductions of an owner’s personal expenses paid by the trust.
• Depreciation deductions of an owner’s personal residence and furnishings.
• A stepped-up basis for property transferred to the trust.
• The reduction or elimination of self-employment taxes.
• The reduction or elimination of gift and estate taxes.

Abusive trust arrangements often use trusts to hide the true ownership of assets and income or to disguise the substance of transactions. Although these schemes give the appearance of separating responsibility and control from the benefits of ownership, as would be the case with legitimate trusts, the taxpayer in fact controls them.

These arrangements frequently involve more than one trust, each holding different assets of the taxpayer (the taxpayer’s business, equipment, home, automobile, etc.), as well as interests in other trusts. The trusts are vertically layered, with each trust distributing income to the next layer. Funds may flow from one trust to another trust by way of rental agreements, fees for services, purchase and sale agreements, and distributions. The goal is to use inflated or nonexistent deductions to reduce taxable income to nominal amounts.

Although the individual abusive promotions vary, two basic schemes have been identified:

• The domestic package, and
• The foreign package.

These schemes are often promoted by a network of promoters and sub-promoters who have charged $5,000 to $70,000 for their packages. This fee enables taxpayers to have trust documents prepared, to utilize foreign and domestic trustees as offered by promoters, and to use foreign bank accounts and corporations. In some instances, tax return preparer services are also made available.

Taxpayers should be aware that abusive trust arrangements will not produce the tax benefits advertised by their promoters and that the IRS is actively examining these types of trust arrangements. Furthermore, in appropriate circumstances, taxpayers and/or the promoters of these trust arrangements may be subject to civil and/or criminal penalties.

Abusive foreign trust schemes

Abusive foreign trusts are often formed in foreign countries that impose little or no tax on trusts and also provide financial secrecy. These are usually “tax haven” countries, supposedly outside the jurisdiction of the U.S. 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 actuality, the income from these arrangements is fully taxable.

Foreign packages often begin with an Asset Management Company, a business trust, and then distribution of income to several trust layers. These schemes also involve offshore bank accounts and International Business Corporations (IBCs). A typical abusive foreign trust scheme has the following steps:

• Asset Management Company
  In many promotions, taxpayers are advised to create asset management companies (AMCs). The AMC, which lists the taxpayer as the director, is formed as a domestic trust. An individual on the promoter’s staff is usually the trustee of the AMC, but the taxpayer quickly replaces this individual. The purpose of the AMC is to give the appearance that the taxpayer is not managing his or her business and to start the layering process.
• Business Trust
  The next step is to form the business trust, again very similar to the domestic scheme.
• Foreign Trust One
  Next, a foreign trust is formed in a tax haven country and the income from the business trust is distributed to this trust. We will refer to this foreign trust as “foreign trust one”. In many cases, the AMC will be the trustee of foreign trust one. Because the source of income is U.S.-based and there is a U.S. trustee, this foreign trust has filing requirements as discussed earlier in this section.
• Foreign Trust Two
  The next step is to form a second foreign trust or “foreign trust two”. All income of foreign trust one is distributed to foreign trust two. Either foreign trust one or a foreign member of the promoter’s staff becomes the trustee of foreign trust two. If the trustee is foreign trust one, the taxpayer still controls foreign trust two by the fact that he/she is in control of foreign trust one’s trustee, by the directorship of the AMC. If a foreigner is the trustee of foreign trust two, the taxpayer is empowered by the promoter to overrule any decisions by this trustee. In either case, the taxpayer is in control of foreign trust two.
  Promoters will claim that since the trustee and the sources of income are now foreign, there are no U.S. filing requirements. Promoters also advise taxpayers that since the trusts are formed in tax haven countries it is impossible for the IRS to determine who is in control of the trusts. In actuality, the taxpayer has never relinquished control of their business, but has set up, with the assistance of a promoter, an elaborate scheme to subvert and evade U.S. tax laws.
• Asset Protection Trust
  Either as part of the second foreign trust or as a separate trust, an asset protection trust is formed. The taxpayer supposedly transfers all of his assets to it including his home and other assets actually located within the United States. According to the promoter, this will make the taxpayer judgment-proof. In actuality, the courts look at the economic substance of the transaction and, if the taxpayer continues to reside in his home and control his assets, those assets may be seized and sold in satisfaction of his liabilities. This definition of an asset protection trust is not meant to imply that all are formed as part of an abusive tax scheme. However, beware of any asset protection trust marketed as part of a package to reduce federal income or employment taxes. The courts can ignore such trusts and order the taxpayer’s property sold to satisfy the outstanding liabilities.