Basic Trust Taxation Rules It is estimated that $4.8 trillion in wealth will be inherited or transferred from one generation to the next by 2015, with much of it transferred through a variety of trusts. Filings of trust returns (Form 1041) are now the third most frequently filed income tax return behind individual and corporate returns. Although the vast majority of these transfers are legal, 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.
To understand fully the trust schemes offered today, it is important to focus on some basic trust taxation rules.
A valid trust is a legal arrangement creating a separate legal entity. The duties, powers and responsibilities of the parties to this arrangement are determined by state statute and the trust agreement. To create a trust, legal title to property is conveyed to a trustee, who is then charged with the responsibility of using that property for the benefit of another person, called the beneficiary, who really has all the benefits of ownership, except for bare legal title. The IRS recognizes numerous types of legal trust arrangements, and they are commonly used for estate planning, charitable purposes, and holding of assets for beneficiaries. The trustee manages the trust, holds legal title to trust assets, and exercises independent control.
All income a trust receives, whether from foreign or domestic sources, is taxable to the trust, to the beneficiary, or to the grantor of the trust unless specifically exempted by the Internal Revenue Code (IRC).
Foreign trusts to which a U.S. taxpayer has transferred property are treated as grantor trusts as long as the trust has at least one U.S. beneficiary. The income the trust earns is taxable to the grantor under the grantor trust rules. Grantor trusts are not recognized as separate taxable entities, because under the terms of the trust, the grantor retains one or more powers and remains the owner of the trust income. In such a case, the trust income is taxed to the grantor, whether or not the income is distributed to another party.
A legitimate trust is allowed to deduct distributions to beneficiaries from its taxable income, with a few modifications. Therefore, trusts can eliminate income by making distributions to other trusts or other entities as long as they are named as beneficiaries. This distribution of income is key to understanding the nature of the abusive schemes. In the abusive schemes, bogus expenses are charged against trust income at each trust layer. After the deduction of these expenses, the remaining income is distributed to another trust, and the process is repeated. The result of the distributions and deductions is to reduce the amount of income ultimately reported to the IRS.
Filing requirements for legitimate trusts are discussed below:
- A domestic trust must file a Form 1041, U.S. Income Tax Return for Estates and Trusts, for each taxable year. If the trust is classified as a Domestic Grantor Trust, it is not generally required to file a Form 1041, provided that the individual taxpayer reports all items of income on his own Form 1040, U.S. Individual Income Tax Return. Thus, the individual pays the total tax liability upon the filing of his return for that taxable year. All income received by a trust, whether from foreign or domestic sources, is taxable to the trust, to the beneficiary, or to the grantor unless specifically exempted by the Internal Revenue Code.
- Foreign trusts are subject to special filing requirements. If a trust has income that is effectively connected with a U.S. trade or business, it must file Form 1040NR, U.S. Nonresident Alien Income Tax Return. Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Foreign Gifts, must be filed on the creation of or transfer of property to certain foreign trusts. Form 3520-A, Annual Information Return of Foreign Trusts With U.S. Owner, must also be filed annually. Foreign trusts may be required to file other forms as well.
- In addition to filing trust returns as just described, a taxpayer may be required to file U.S. Treasury Form TD F 90-22.1, Foreign Bank and Financial Accounts Report, if the taxpayer has an interest of over $10,000 in foreign bank accounts, securities, or other financial account. Also, a taxpayer may be required to acknowledge an interest in a foreign bank account, security account or foreign trust on Schedule B, Interest and Dividend Income, that is attached to Form 1040.
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About Mike Habib, EA
Mike Habib is an IRS licensed Enrolled Agent who concentrates his tax practice on helping individuals and businesses solve their IRS & State tax problems. Mike has over 20 years experience in taxation and financial advisory to individuals, small businesses and fortune 500 companies.
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