Abusive Trusts

Abusive Trusts – Danger Signs

Because we put together a lot of Trusts, people bring us their Trusts ideas.  This is actually a wonderful resource which we welcome.  At the same time, some of the ideas that are brought to us are simply bad and even dangerous.  Although these are sometimes characterized as abusive trusts, it is really abusive people that exploit and co-opt the Trust.  There are no bad Trusts that beat up on innocent people.  There are only people who use Trusts for right or for wrong.  Responsibility and accountability for the abuse of a Trust lies with the people, not with the entity.

One of the biggest indicators of danger is when a Trust promoted as a means of avoiding income taxes.  The IRS lovingly refers to these as “abusive trust tax evasion schemes.”  The promotors of such abusive schemes generally promise some sort of magical elimination of income taxes.

Sadly, the “abuse” often comes in the form of misusing an otherwise legitimate Trust device.  For example, a Charitable Remainder Trust or Charitable Gift Annuity is a well established device for giving to charity.  There are certain valid tax benefits that come from giving to charity which may include tax deductions and avoidance of capital gains on appreciated assets.  However, there must be an actual gift to a valid charity, and not just a sham for disguising personal benefits as some sort of pretend charitable activity.

Trusts legitimately designed to own or operate a business, or own a home, or give to charity, or protect assets can be abused in an attempt to avoid income taxes.  As a result, not only is the otherwise valid trust rendered useless for its legitimate purpose, in the end, it does not avoid income taxes.  It just gets everyone involved in trouble.

Legitimate Alternatives

It is important to note that tax planning is not the same as tax evasion.  Legitimate tax planning can manage and sometimes modify who pays the tax, when the tax is paid, and what the resulting tax rate is, but it almost never completely avoids a tax.  That is the difference between abusive trusts and their legitimate counterparts.

An interesting example of tax planning is the timing of when to transfer or sell an inherited property.  If a parent, while living, transfers their house to a child, the house will have a carry forward cost basis.  When the parent dies, there will be no step up in basis.  When the child sells the home, the gain above the carry forward cost basis will be taxable.  If the same parent kept the house for life and conveyed it to the child by Will or Trust at death, there would be step up in cost basis to the fair market value as of the date of death.  The child could then sell the house without triggering a tax.  This is tax planning.

Although doing it right is not an “abusive trust”, the same elements can be put together in an abusive fashion.  If the parent conveyed the house to the child while living, and then died, and the child still claimed a step up in cost basis, that would be tax evasion.  Same parent, same child, same house, same transfer from one to the other, but whether or not there is a tax depends on when the transfer happened relative to death.  The timing matters, and changes the tax liability.  Whether or not there is legitimate tax planning or abuse depends on how the taxes are reported and paid.  Properly reporting and paying taxes when due keeps legitimate planning legitimate.

Pigs Get Fat, Hogs Get Slaughtered

Do what you can within the bounds of the law to minimize your taxes, but otherwise, just pay your taxes!  Take all the deductions and expenses that the law permits.  If there is more than one way to do something, or more than one time in which it can be done, do the planning required to work within the law to minimize the tax burden.  But in the end, pay your taxes.

Years ago, I had a client who had to pay $1 million in income taxes.  I made a snarky remark about how awful that must be.  The client was very blunt in his response.  He said, “Would you shut up?  You don’t know what you’re talking about.  The fact that I am paying a million dollars in taxes means I did really good this year.  I want to do that good every year.  My goal is to not pay any more in taxes than the law requires of me, but to pay as much as I possibly can.”

Be the pig that makes money and pays taxes as required, and you’ll get fat.  Be the hog that tries to avoid the unavoidable, and you’ll get slaughtered.