The IRS Scrutinizes Abusive Trusts: Tax Examinations & Penalties

The IRS Scrutinizes Abusive Trusts: Tax Examinations & Penalties

The IRS Scrutinizes Abusive Trusts 

In recent years, the Internal Revenue Service has significantly increased enforcement of trust compliance for taxpayers residing in the United States and abroad, who are owners or beneficiaries of domestic and foreign trusts. Oftentimes, trust owners and trust beneficiaries misconstrue their annual trust tax and reporting requirements. Usually, this is not the fault of the taxpayer in so much as they have been goaded into purchasing various trust and tax scheme promotions by unscrupulous tax promoters who make it seem like the taxpayer can avoid having to pay income taxes on business and personal income that they generate, by simply flowing the income through a trust — or several trusts.

This is common in situations involving:

      • Business Trusts,

      • Private Family Foundations,

      • Multi Retirement Schemes,

      • OAPTs,

      • 643(b) Trusts, and

      • Non-Grantor Irrevocable Complex Discretionary Spendthrift Trusts.

Increased IRS Scrutiny of Trusts

Recently, the U.S. government has pursued several civil and criminal investigations and prosecutions on matters involving sham trusts and other related schemes. In addition, the IRS has publicized its intent to go after taxpayers involved in Malta Retirement Schemes (a new round of criminal and civil investigation has begun) and IRC 643(b) trusts. Likewise, the Internal Revenue Service has also ramped up audits and examinations of taxpayers who are owners of beneficiaries of U.S. and foreign trusts.  Let’s walk through some of the important aspects of:

      • Why the IRS is scrutinizing abusive trusts,

      • What taxpayers can do to prepare in case they find themselves under audit or examination, and

      • How Taxpayers can proactively get into compliance before they find themselves under IRS examination or investigation.

First, What is an Abusive Trust Scheme?

It is important to understand that when the IRS refers to trust compliance, they are not referring to your typical revocable grantor trust that many taxpayers have for rental properties or basic estate planning purposes. Rather the Internal Revenue Service is going after trusts that are designed to artificially reduce or eliminate tax liability through sham arrangements. These types of sham trusts come in all different flavors and oftentimes the nucleus of the sham starts with tax promoters who offer tax promotions at various conferences and seminars worldwide. While these tax promoters sell these plans as legitimate tax avoidance, the IRS sees it differently and takes the position that these promoters have crossed the line into improper tax avoidance and tax fraud. Here are some of the recent sham trust arrangements that have caught the ire of the IRS:

Section 643(b) Trusts

With a 26 U.S.C. 643(b) trust,  tax promoters sell taxpayers on the idea that they can manipulate the concept of income in conjunction with the distributable net income definition — and making it seem like certain income would not be taxable. This type of trust has been all the rave on various social media sites — and the IRS has let it known that this trust arrangement is improper and can lead to fines and penalties.

Offshore Asset Protection Trust (OAPT)

The OAPT is an Offshore Asset Protection Trust. These are irrevocable trusts that are set up in countries such as Nevis in which assets are placed into the foreign trust for protection against creditors. If a creditor wants to challenge the trust assets and litigate against one of these trusts, oftentimes the taxpayer has to file a lawsuit in the country where the trust is located – where there are various legal hurdles set up to make it difficult to file a lawsuit, such as having to put up a huge bond if a creditor wants to file a lawsuit.

Malta Retirement Scheme

Many taxpayers have set up retirement trusts through Malta Retirement Schemes in which the taxpayer invests millions of dollars of post-tax income and assets that have unrealized capital gains. The taxpayers create these trusts using a loophole that was previously found in the United States/Malta Tax Treaty (which was subsequently closed with a 2021 Competent Authority Agreement). Taxpayers claim their withdrawals from these retirement schemes are tax-free as long as certain protocols are met, such as waiting for a certain age and only withdrawing a certain amount percentage of the investment.

Charitable Remainder Annuity Trust (CRAT)

Another type of trust that the IRS is going after is sham Charitable Remainder Annuity Trusts. Here, the purchaser of the promotion contributes property to the trust, but artificially increases or (steps up) the basis of the contributed asset — similar to when a person receives an inheritance. By doing so, when the trust sells the asset and acquires a Single Premium Immediate Annuity, the taxpayer only reports a small portion of the annuity as income by claiming that a majority of the distribution is just a return of basis since the asset that was contributed to the CRAT had a fair market value almost identical to the adjusted basis.

What Forms are Required to Report a Foreign Trust?

There are various international information reporting forms that a taxpayer may have to file to report their foreign trust. Oftentimes, two of the most common foreign trust forms of a taxpayer will have to file Form 3520 and Form 3520-A. The Form 3520-A is used to report ownership of a foreign trust, whereas Form 3520 is used to report ownership of a foreign trust as well as to report any distributions received from the foreign trust. There is no de minimis rule when it comes to reporting distributions, so even small distributions from foreign trusts are typically reportable on Form 3520-A.

Depending on whether or not the taxpayer received a Non-Grantor/Grantor Foreign Trust Distribution Statement will impact what options they have to report the income. Taxpayers must be aware that these forms have different due dates, and that the failure to file these forms may result in significant fines and penalties. Typically, if the taxpayer wants to file an extension for Form 3520 they would seek an extension for their tax return (such as using Form 4868) whereas if the taxpayer is seeking an extension for Form 3520-A then they have to file separate IRS Form 7004.

Do Any Foreign Trust Exceptions Apply?

Some foreign trusts may qualify for an exception so that they do not have to be reported for Forms 3520 or 3520-A. If necessary, the taxpayer must still report the trust on forms such as the FBAR and Form 8938 — but these forms are typically less complicated than Forms 3520 and 3520-A. For example, if the foreign trust is an RSRP or an RRIF from Canada then typically under Revenue Procedure 2014-55, Forms 3520 and 3520-A are not required.

Alternatively, some Foreign Tax Favored Retirement Trusts and Foreign Tax Favored Non Retirement Trusts may also receive an exception for having to be included on Forms 3520 and 3520-A. Initially, this exception was introduced in Revenue Procedure 2020-17 and this was further substantiated in the recent proposed foreign trust regulations that were released in early May of 2024. For trusts that qualify for the exception, they do not have to file Forms 3520/3520-A for the trust, but there are very strict requirements for qualifying for the exception and oftentimes taxpayers who have abusive or sham-type trusts have invested a significant amount of money in this type of scheme which phases it out of the ability to claim the exception.

Domestic Trust Reporting

When the trust is domestic — and presuming that it is a non-grantor trust — then there are different types of IRS forms the taxpayer may have to file depending on this specific type of trust that is being reported as well as if there were any specific elections made regarding the trust.

IRS Has Increased Trust Examinations

The Internal Revenue Service has significantly increased the enforcement of trust compliance which includes ramping up the number of audits and examinations that they are pursuing. Taxpayers who buy into some of these tax schemes have to be careful because once the promoters get in trouble, it is only a matter of time before they provide the IRS or Department of Justice when with their list of customers or people who have acquired this scheme.

Because even when if the Promoter tells you that there is no way they would ever provide your information to the IRS if it means the difference between possibly avoiding jail time or doing 10 years you can best believe that a tax promoter would sell you on a $50,000 tax scheme is the same type of promoter that would be willing to give all of your information to the IRS if it would help save their hide.

If you do receive an audit notice, it is important not to respond to the IRS immediately but to take note of the due date and then reach out to a specialist to assist you. Taxpayers who were under audit or examination for trust-related issues may want to speak with a Board-Certified Tax Law Specialist to make sure they can hire an attorney who can represent them and has the experience they claim they have instead of just running around online claiming to be an expert even though they are not Board Certified and have less than 15 to 20 years of experience.

Recent Case Rulings

There have been some recent cases involving abusive and sham trusts that further illustrate the intense scrutiny that the IRS and Department of Justice are going after abusive trusts. Here are some links to prior summaries that are international tax law specialist team has written on matters involving abusive and sham trusts, including Business Sham Trusts/Private Foundations and CRAT Sham Trusts. We have also summarized issues involving the Malta Retirement Scheme, Section 643(b) Trusts, and Non-Grantor Irrevocable Complex Discretionary Spendthrift Trust.

Late Filing Penalties May be Reduced or Avoided

For Taxpayers who did not timely file their FBAR and other international information-related reporting forms, the IRS has developed many different offshore amnesty programs to assist taxpayers with safely getting into compliance. These programs may reduce or even eliminate international reporting penalties.

Current Year vs Prior Year Non-Compliance

Once a taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist who specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties

Need Help Finding an Experienced Offshore Tax Attorney?

When it comes to hiring an experienced international tax attorney to represent you for unreported foreign and offshore account reporting, it can become overwhelming for taxpayers trying to trek through all the false information and nonsense they will find in their online research. There are only a handful of attorneys worldwide who are Board-Certified Tax Specialists and who specialize exclusively in offshore disclosure and international tax amnesty reporting. 

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure

Contact our firm today for assistance.