Case — Economic Substance and Attribution of Trust Income

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TL Case Summ

THE QUESTION

Is income from property transferred to a trust taxable to the trust or the trust’s manager?

THE DISPUTE

Taxpayer Says: Assets were sold to the trust and the income is attributable to the trust.

Internal Revenue Service Says: The trust is a sham and should be disregarded.

THE LAW

From Gregory v. Helvering, 293 U.S. 465, 469 (1935): Taxpayers have the right to conduct transactions in such a manner and form as to minimize or altogether avoid the incidence of taxation by whatever means the law permits.

From Zmuda v. Commissioner, 79 T.C. 714, 719 (1982), affd. 731 F.2d 1417 (9th Cir. 1984): This right, however, does not bestow upon taxpayers a right to structure a paper entity to avoid taxation when that entity is without economic substance. If the creation of a trust lacks economic effect and alters no cognizable economic relationship, the Court may ignore the trust as a sham.

THE CAUSE OF THE DISPUTE

A trust is a legal method of asset ownership that can be useful for tax purposes, such as estate planning. Under a typical trust arrangement, you grant a trustee control over the income and assets you place in the trust. The trust is subject to tax on the income (including income generated by the property held in trust), and any tax must be paid by the trust, the beneficiary, or you, as grantor or transferor.

Sham trusts are trusts created in an attempt to achieve tax benefits with no meaningful change in control over income or assets by hiding the true ownership or disguising the substance of transactions.

Generally, four factors can be used to decide whether a trust has economic substance for tax purposes:

(1) your relationship to the transferred property before and after the trust’s creation;

(2) whether you appointed an independent trustee;

(3) whether economic interest passed to other trust beneficiaries; and

(4) whether you followed restrictions placed on the trust’s operation as set forth in the trust documents.

In this case, the taxpayer established a trust that appointed various family members as trustees. The trust issued a promissory note in exchange for real estate received from the taxpayer, including a personal residence and two businesses. Taxpayer argues the trust is legitimate, the transfer was a sale, and the income from the properties should be attributed to the trust.

The IRS says the trust is a sham because no payments were made on the promissory note, no restrictions were placed on use of the property transferred to the trust, and use of the property did not change after the transfer. In addition, the trustees were not independent, and the taxpayer managed all operations of the trust, made all decisions pertaining to trust activities, and co-mingled trust and personal assets.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 38KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Sorry, wrong answer :(
Right answer!
For the IRS. The trust lacks economic substance and must be disregarded for Federal income tax purposes. The income is attributable to the taxpayer.