Trust In Your Trust: How to Beat the Ugly IRS “Sham” Label

Facing an IRS accusation that your trust is a sham can come with serious consequences. Here’s how to protect yourself.

Since the Middle Ages, the wealthy have capitalized on trusts to avoid paying taxes. In the English feudal system, a knight’s property was given to the king upon the knight’s death. Quite an oppressive system if you ask me.

Fortunately, we’ve progressed since feudalism. Smart, legal tax planning strategies are helping international business owners and estate owners keep more of their hard-earned money. Trusts, in particular, are essential to international tax planning for businesses and estates.

The IRS defines a trust as “a relationship in which one person holds title to property, subject to an obligation to keep or use the property for the benefit of another.” Trusts are formed under state law and oftentimes, people will form trusts and name their spouse or children as the beneficiaries.

As an expert in international tax planning, I advise many of my clients to incorporate trusts into their tax plans and educate them on how to avoid challenges from the IRS.

The IRS’s favorite mode of attack is labeling a trust a “sham.” They commonly argue that if a trust was established for no other purpose than tax dodging, it’s invalid. In that case, the IRS has grounds to charge you unpaid tax and penalties.

Recent Tax Court Ruling Rejects a Sham Trust Theory

In February 2014, the U.S. tax court made an important ruling favoring the taxpayer and rejecting the IRS’s argument. Christopher and Lisa Marie Close, owners of an Idaho-based logging business, were accused of creating two sham trusts involving two parcels of land being used for their business. They were also facing a hefty tax liability on allegedly unreported income of $343,246 for one lot and $48,262 on another lot in 2003.

Initially, the IRS had argued the deficiency in Mr. and Mrs. Close’s reported income. Then, the IRS added the argument that both trusts were shams.

After considering the evidence, the court ruled that the IRS’s argument was “poorly developed and unconvincing.” There was little reliable evidence documenting Mr. Close’s income from the logging activities on those properties, according to the court.

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The U.S. Tax Court explains excellent tax planning in Christopher Carl Close and Lisa Marie Close v. Commissioner.

According to the court opinion, the IRS bore the burden of proof. Below is a key excerpt from the ruling:

Generally, the Commissioner’s determination of a deficiency is presumed correct, and the taxpayer bears the burden of proving that the determination is improper . . .  However, if the Commissioner raises a new matter, seeks an increase in a  deficiency, or asserts an affirmative defense, the Commissioner has the burden of proof as to the new matter or increased deficiency.

In this case, the IRS failed to prove that the Close case was considered an “extreme case” requiring the court to deem the trusts as invalid under state law.

Prove Your Trust Has “Economic Substance.”

The four factors the tax court uses to determine whether a trust has economic substance is based on the following (taken from Markosian v. Commissioner, 73 T.C. at 1243-1244 via court ruling referenced above):

  1. whether the taxpayer’s relationship to the transferred property differed materially before and after the trust’s creation;
  2. whether the trust had an independent trustee;
  3. whether an economic interest passed to other trust beneficiaries; and
  4. whether the taxpayer respected restrictions imposed on the trust’s operation as outlined in the trust documents or by the law of trusts.

Knowledge Is Power—and Protection

I encourage you to skim through the tax court case Christopher Carl Close and Lisa Marie Close v. Commissioner and take in more lessons from this case. Too often, cases like this one go unnoticed, and taxpayers don’t have the knowledge to defend themselves against an IRS challenge.

Nobody likes to be accused of creating a sham, a nullity or an invalid entity. Creating trusts and tax planning require careful consideration and protection from the sham label. From my perspective, the sham argument is overly used by the IRS. In cases where the claim is unsubstantiated, the argument itself is a sham!

If you like this post, please share it and visit the International Tax Counselors blog regularly for more expert tax advice.  Want help with your tax planning, then contact me, Brian Dooley, CPA, MBT  at [email protected] I read tax court rulings every morning and am always eager to share new lessons in tax planning.