When trusts are used for legitimate purposes, tax on the income generated by the trust property is paid by one of three entities depending on applicable tax laws, the type of trust, and the trust document. The three possible entities are the trust itself, the beneficiary, or the entity that transferred the property to the trust.
Legitimate trusts do not transform a taxpayer's personal, living, or educational expenses into deductible items and do not seek to avoid tax liability by ignoring either the true ownership of income and assets or the true substance of transactions.
Contrary to promises made in promotional materials, several well-established tax principles control the proper tax treatment of these abusive trust arrangements:
Substance - Not Form - Controls Taxation
The Supreme Court of the United States has consistently stated that 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; and 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 that 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.
Lucas v. Earl, 281 U.S. 111 (1930) - Stated an assignment of income does not shift the incidence of taxation - the income remains taxable to the one who actually earned it.