The Department of Justice recently indicted promoters of allegedly abusive tax-shelter schemes involving trusts. How can trusts—often indispensable tax-planning tools—be built to fulfill their financial potential and yet withstand scrutiny as the IRS zeroes in on high-net-worth clients?
“The IRS is doing more audits of [wealthy] taxpayers and those taxpayers tend to have more trusts than others do. For that reason, we’re seeing more audits involving trusts,” said David Handler, partner in the Trusts and Estates Practice Group of Kirkland & Ellis LLP in Chicago.
“Complex estate planning techniques, most of which utilize trusts, have always found themselves under the microscope,” said Katie Sheehan, wealth strategist and managing director at Crestwood Advisors in Boston.
Trusts under increased scrutiny include complex structures that provide income and estate/gift tax benefits such as grantor retained annuity trusts and intentionally defective grantor trusts, said Sophia Duffy, associate professor of business planning at the American College of Financial Services in King of Prussia, Pa. She added that early proposals of the 2020 Biden tax plan included restricting or eliminating some of the loopholes that make trusts attractive to wealthy clients and business owners.
“Since 2020, the attention has shifted from changing the regulation around trusts toward more enforcement against tax evaders,” Duffy added.
Typical promotions of abusive tax schemes involving trusts include those promising 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; and reduction or elimination of self-employment taxes and gift and estate taxes, according to the IRS.
CLients should avoid advisors who push trusts that they claim “to be exempt from income taxes, or making other claims that sound too good to be true,” Handler said. “In the eyes of the IRS, 99.9% of trusts are not abusive. The abusive ones make news.”
Thomas Pontius, senior financial planner at Kayne Anderson Rudnick in Los Angeles, stressed that all trust income needs to be reported.
“While it’s acceptable to fund trusts with assets and open a bank account in the name of the trust, so long as the trust provisions allow it, any income generated by assets in a trust still needs to be reported on the appropriate tax return,” he said.
David Goldstein, partner at the New York-based law firm Farrell Fritz, said advisors need to understand the terms of the agreement governing the trust. “Understand the key terms of the trust agreement, including who the beneficiaries are, what powers are given to the trustees and the limitations imposed on who can serve as trustee.”