The Tax Court Rules Trusts Were Tax Shams, 4 Factor Test

The Tax Court Rules Trusts Were Tax Shams, 4 Factor Test

The Tax Court Rules Trusts Were Shams, 4 Factor Test

Each year, our international tax lawyers receive many questions on the validity of foreign trusts. A foreign trust comes in all types of shapes and sizes and oftentimes, one of the key issues is whether or not the structure is legitimate or not to determine whether it is treated as a trust for U.S. tax purposes. For example, is the trust a Stiftung that may have been created with the intent to operate as a business but has no significant business purpose and thus deemed a trust — or possibly a Sociedad Anonima with no business purpose other than to protect the assets of the S.A.?

Alternatively, is the trust an offshore asset protection trust that can be found in countries such as the Cayman Islands and Nevis? But, just as foreign trusts have their own sets of problems with the IRS, so do U.S. trusts — especially those that the IRS deems to be abusive or not intended for legitimate purposes. In the recent 2024 U.S. Tax Court case of Aldridge, the Tax Court determined that the trusts were not legitimate and served no economic substance and thus should be disregarded for federal income tax purposes. This would result in a significant amount of income for the taxpayers for the years that they try to defer income by way of the trusts. Let’s take a look at some of the key aspects of the ruling from the Tax Court as to why the trusts were considered invalid.

*We have additional resources to assist you on other U.S. trust issues such as 643(b) Trust and the Non-Grantor irrevocable Complex Discretionary Spendthrift Trust.

Taxpayers Were Already Indicted and Convicted of Tax Fraud

In this particular case, the U.S. government had lodged a criminal investigation against taxpayers that resulted in an indictment that included filing false tax returns and tax fraud, and ended up serving time in prison. The focus of the tax court cases was specifically to address the issue of the trusts, whether they were legitimate, and if Taxpayers owe taxes for income that should have been reported.

Do the Trusts Have any Substance?

In the case of Aldridge, the Tax Court took the position that the trusts (there were multiple trusts) lacked economic substance and thus lacked a valid purpose other than tax avoidance. This illustrates the first key important factor in evaluating a trust, which is to determine whether the trust has any purpose to it. In other words, if the sole purpose of a trust is to defer tax, with no other purpose then typically that trust would be disregarded for tax purposes. That is not to say that the overall result of a trust cannot be to defer or avoid tax, but there must be a legitimate purpose for the trust, such as a charitable remainder trust, life insurance trust, or any other type of trust.

Four Key Factors to Consider

The court used the four-factor test to evaluate the legitimacy of the trusts in concluding that the trusts lacked economic substance. Let’s review the court’s ruling:

• • • “In deciding whether to disregard a trust for federal income tax purposes, the Court considers four factors relating to the trust to determine whether a trust lacks economic substance:

      • (1) whether the taxpayer’s relationship to the property transferred to the trust materially changed after the trust’s creation;

      • (2) whether the trust has an independent trustee;

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

      • (4) whether the taxpayer feels bound by the restrictions imposed by the trust agreement or the law of trusts. Markosian, 73 T.C. at 1243–44; Wegbreit v. Commissioner, T.C. Memo. 2019-82, at *52, aff’d, 21 F.4th 959 (7th Cir. 2021). If a trust lacks economic substance apart from tax considerations, the trust is a sham and is not recognized for federal tax purposes. See Zmuda, 79 T.C. at 720–22; Markosian, 73 T.C. at 1241; Wegbreit, T.C. Memo. 2019-82, at *52. Consideration of each of these four factors supports a conclusion that the trusts constituting the Aldridge Family Trust System lack economic substance and are shams.”

Whether the taxpayer’s relationship to the property transferred to the trust materially changed after the trust’s creation

• • • “First, the relationship between petitioners and their property did not differ in any material respect following the creation of the trusts. Petitioners continued to reside in the same home, drive the same vehicles, wear the same clothing, and retain full unfettered access to all of their personal property. Petitioners paid their personal expenses out of the bank accounts titled to Liberty Commerce Group Trust, CMI Trust, the Aldridge Family Trust, and Lorbert Trust. Petitioners’ business activities did not change in any material sense following the creation of the trusts, either.”

Whether the trust has an independent trustee

• • • “Second, none of the trusts had an independent trustee. Petitioners, or entities they controlled, served as cotrustees of CMI Trust, the Liberty Commerce Group Trust, Excalibur Trust, Lorbert Trust, the Aldridge Family Trust, and Alliance Financial Trust during the years at issue. The trusts were operated in concert with one another, under the same administrative and management entity and with funds routinely transferred from one entity to another. There was no independent party who exercised any meaningful role in the operation of any of the trusts. Rather, petitioners controlled all aspects of the trusts during the years at issue.”

Whether an economic interest passed to other trust beneficiaries

• • • “Third, no economic interest passed to other beneficiaries. During the years at issue, the beneficiary of the Aldridge Family Trust was petitioners’ minor child, while the beneficiary of the other trusts was the Aldridge Family Trust. In reality, however, little to no economic benefit passed to the beneficiaries. No return was filed by petitioners’ minor child reporting income received from the trust, and the Aldridge Family Trust reported no income paid to him. Rather, the trusts were operated for the economic benefit of petitioners. Petitioners used the trusts’ funds to pay the mortgage on their home, purchase motorcycles and other vehicles, and pay their personal expenses, including food, clothing, and vacations.”

Whether the taxpayer feels bound by the restrictions imposed by the trust agreement or the law of trusts

• • • “Finally, petitioners have not shown that they acted as though they were bound by the restrictions imposed by the trust agreement or the law of trusts. Although petitioners purported to observe certain trust formalities, such as by maintaining separate bank accounts, maintaining minutes of trust decisions, and insisting on signing trust-related documents with “T” next to their names, they disregarded their obligations as trustees in other, more substantive ways.”

Court Rules Against Petitioners

• • • “The evidence clearly and convincingly shows that petitioners possessed fraudulent intent with respect to their underpayment of tax for each of the years at issue. Respondent’s determination of fraud penalties for the years at issue is sustained.”

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.