MSTR Cat

Trust Law/Level V · Tax and legacy/5.2 Annuity and unitrust structures/Lesson 6

Tax-motivated trusts and the anti-abuse rules

How the IRS separates legitimate trust planning from abusive trust schemes, and the warning signs that help readers recognise them.

Education, not legal advice. Trust law changes from country to country and state to state, and the right structure depends on your situation. Anything you sign should be drafted or reviewed by a qualified lawyer where you live.

The lean path

The cheapest, lowest-tax, simplest and most private route the law allows, best first. Each step names the rule it rests on and the condition that keeps it lawful.

  1. No trust lawfully erases income tax while the owner keeps control and use (Notice 97-24); the low-cost lawful option is a revocable living trust, which changes nothing for tax but avoids probate, with income still reported on the grantor’s own Form 1040.
  2. Real savings come only from transfers the Code allows that actually give up control: the $19,000 annual exclusion in 2026, direct tuition or medical payments under §2503(e) and charitable gifts; personal costs stay non-deductible under IRC §262 whatever entity pays them.
  3. Anyone already in a ‘pure’ or ‘constitutional’ trust scheme can file a qualified amended return before IRS contact, which keeps the added tax out of the 20% accuracy-related penalty (Treas. Reg. §1.6664-2(c)); it does not cure a fraudulent position, which faces 75% under §6663.
  4. A non-grantor trust with $600 or more of gross income files Form 1041 and issues Schedule K-1s; distributing income to beneficiaries in lower brackets is lawful, but a trust the owner still controls can be disregarded as a sham (Markosian, 73 T.C. 1235).

MaterialsIRS Notice 97-24, ‘Certain Trust Arrangements’, free on irs.govThe IRS page ‘Abusive trust tax evasion schemes: questions and answers’Any promotional material or proposal for a trust arrangement you are reviewingLesson 5.1.5, on grantor trusts

Wonder

  1. Why does moving income into a trust not, by itself, change who is taxed on it?
  2. When can the IRS ignore a trust altogether?
  3. Who faces penalties when an abusive trust scheme comes to light?

Explore

  1. Trusts have many legitimate tax uses, and the Internal Revenue Code sets rules for them: who pays income tax on trust income (the trust, a beneficiary or, for a grantor trust, the grantor under IRC §§671–679), and how gifts and estates are taxed. In Notice 97-24 (1997), the IRS warned about something different: ‘abusive trust arrangements’ promoted with promises of tax benefits ‘with no meaningful change in the taxpayer’s control over or benefit from’ their income or assets. The notice said it should not cause concern about legitimate uses such as estate planning, genuine charitable gifts and holding property for minors.
  2. The notice gave five examples, often combined: a business trust that takes over a business and makes payments to cut its taxable income; equipment or service trusts that charge the business inflated rents or fees; a family residence trust that claims to rent the owner’s home back and deduct its costs; a purported charitable trust that pays personal costs such as a child’s tuition; and a ‘final trust’, often abroad, that collects the others’ income. Promised benefits included deductions for personal expenses, depreciation on a home, a stepped-up basis and lower self-employment, gift and estate tax.
  3. Settled principles defeat these schemes. Substance, not form, controls tax results (Gregory v. Helvering, 1935), and a trust can be disregarded as a sham: in Markosian v. Commissioner, 73 T.C. 1235 (1980), the parties ignored the trust’s terms and their relationship to the property did not change in any material way. The step-transaction doctrine, a related court-made rule, can treat a planned series of steps as one transaction. Under the grantor trust rules, an owner who keeps control or benefit is taxed on the trust’s income anyway, and personal expenses stay non-deductible (IRC §262).
  4. Some promoters sell a ‘pure trust’, also called a constitutional, common-law or contract trust, claiming it is a private contract that federal tax law cannot reach. IRS Chief Counsel advice in 1998 called the notion that a pure trust is not subject to federal tax law ‘false’, citing the Sixteenth Amendment’s power to tax incomes ‘from whatever source derived’. The Code has no special category for such trusts: they are taxed under the ordinary rules or ignored and taxed to the real owner. The IRS question-and-answer page adds that income earned by one person cannot be assigned to another for federal income tax.
  5. Notice 97-24 says participants and promoters may face civil and, in appropriate cases, criminal penalties. Participants owe the tax with interest and may face the 20% accuracy-related penalty (IRC §6662) or the 75% civil fraud penalty (IRC §6663). Promoters can face penalties for promoting abusive tax shelters (IRC §6700) and for aiding and abetting understatements of tax (IRC §6701), as well as court injunctions (IRC §7408). Foreign trusts carry their own reporting duties and penalties. The IRS question-and-answer page gives contacts for reporting a promotion or promoter.
  6. Warning signs drawn from the IRS materials include: promises to cut or eliminate income, self-employment, gift or estate tax while the owner keeps the same control and use; personal living costs paid through a trust and deducted; a trustee who simply follows the owner’s directions, sometimes with pre-signed checks; chains of trusts passing money among themselves, often ending offshore; and claims that a trust sits outside the tax laws. Legitimate planning works within the Code and usually changes who controls or benefits from property. This lesson describes the IRS’s position; it does not assess any particular arrangement.

Key facts

  • IRS Notice 97-24 (1997) warns of abusive trust arrangements promising tax benefits with no meaningful change in the owner’s control or benefit.
  • Notice 97-24 describes five examples: business, equipment or service, family residence, charitable and ‘final’ trusts.
  • Substance over form controls taxation, and a trust may be disregarded as a sham (Markosian v. Commissioner, 73 T.C. 1235 (1980)).
  • Under the grantor trust rules (IRC §§671–679), an owner who keeps control or benefit is taxed on the trust’s income.
  • IRS Chief Counsel advice (1998) called the notion that a ‘pure’ or ‘constitutional’ trust is outside federal tax law false.
  • Participants and promoters of abusive trust schemes may face civil and criminal penalties, including under IRC §§6662, 6663, 6700 and 6701.

Exercise nine, six, three, one

9CollectList up to 9 claims made in a trust promotion or proposal you are reviewing (some have fewer), such as promised tax savings, who will be trustee, what the owner keeps using and where the trust would be based.
6ClusterSort them into 6 categories: income tax claims, estate and gift tax claims, deduction claims, control and use, trustee arrangements, and offshore or multi-trust features.
3DistillReduce the 6 categories to 3 groups: claims consistent with the tax rules described here, claims matching warning signs in Notice 97-24, and claims you would ask an independent tax adviser about.
1CrystallizeWrite 1 sentence explaining, in your own words, why a trust that changes nothing about who controls and benefits from property changes nothing about who is taxed.

Fact check

Dates, figures and claims checked against the published sources listed below.

Open in the interactive academy →

PT ES ZH JA KO RU DE FR MS