The tax results promised by the promoters of abusive offshore schemes are often not allowable under federal tax law. Contrary to promises made in promotional materials, several well-established tax principles control the proper tax treatment of these abusive offshore schemes.
Substance -- Not Form -- Controls Taxation
The Supreme Court of the United States has consistently stated the substance rather than the form of a transaction is controlling for tax purposes.
Gregory v. Helvering, 293 U.S. 465 (1935), XIV-1 C.B. 193; Helvering v. Clifford, 309 U.S. 331 (1940), 1940-1 C.B. 105 - The court determined abusive trust arrangements may be viewed as sham transactions, and the IRS may ignore the trust and its transactions for federal tax purposes.
Markosian v. Commissioner, 73 T.C. 1235 (1980) - Held the trust was a sham because the parties did not comply with the terms of the trust and the supporting documents and the relationship of the grantors to the property transferred did not differ in any material aspect after the creation of the trust.
Zmuda v. Commissioner, 731 F.2d 1417 (9th Cir. 1984) - The income and assets of the business trust, the equipment in the equipment trust, the residence in the family residence trust, and the assets in the foreign trust were all determined to belong directly to the owner.
Special Rules Apply To Foreign Trusts
A trust is a foreign trust unless a U.S. court is able to exercise primary supervision over the trust's administration and a U.S. trustee has the authority to control all substantial decisions of the trust (IRC §§ 7701(a)(30)(E) and 7701(a)(31)(B)). IRC § 6048 imposes various obligations on foreign trusts and persons creating, transferring to, or receiving distribution from. A failure to report such transactions could result in substantial penalties being assessed under IRC § 6677. See IRC §§ 671 through 679 for grantor trust rules and IRC §§ 641 through 685 for non-grantor trust rules.
On March 18, 2010, the Hiring Incentives to Restore Employment ("HIRE") became law and included the Foreign Account Tax Compliance Act. Provisions impacting foreign trusts were part of the Act (The "Act").
The Act creates a presumption all foreign trusts have a U.S. beneficiary if a U.S. person directly or indirectly transfers property to a foreign trust.
This presumption can be challenged if it is shown the trust instrument prevents trust property from benefiting a U.S. person. This provision is effective for property transfers after March 18, 2010.
The Act also provides uncompensated use of foreign trust property by a U.S. grantor, U.S. beneficiary, will be treated as a distribution by the trust. This provision applies to loans made and uses of property after March 18, 2010.
Placing Business Activity In A Trust Does Not Avoid Tax
A trust is an arrangement where a trustee takes title to property for the purpose of protecting or conserving it for beneficiaries.
There are other arrangements which are known as trusts, but which are not classified as trusts for purposes of the Internal Revenue Code. These trusts, which are often known as business or commercial trusts, generally are created by the beneficiaries as a devise to carry on a profit-making business which normally would have been carried on through business organizations that are classified as corporations or partnerships (Treas. Reg. § 301.7701-4). Therefore, these business or commercial trusts if foreign, are taxed as either a partnership or association or as a disregarded entity (based on the facts and circumstances) or if domestic, are taxed as either a partnership or disregarded entity (Treas. Reg. § 301.7701-3).
Multiple Entities Do Not Change The Character Of Income
Generally the "character" and "source" of income are not changed by shifting income items through one or more additional entities (domestic or foreign).
- If a foreign trust is not treated as a grantor trust, distribution of its income is taxable to U.S. beneficiaries when made. Distributions of trust corpus are not taxable. IRC § 652 (simple trusts) and IRC § 662 (complex trusts) specify distributions have the same character in the hands of the beneficiaries that the income had in the hands of the trustee.
- A capital gain from a U.S. partnership remains a capital gain in the hands of the partners to that U.S. partnership, and to any persons receiving the income in additional tiers below the initial recipient.