Sniffing out abusive trust arrangements
By Kay Bell • Bankrate.com

As the tax code has grown, and grown more complex over the years, scam perpetrators have devised more convincing ways to attract and trap taxpayers. Nowadays, promises of trust arrangements are a common ploy.

Trusts are a legitimate and frequently used financial planning tool, where a taxpayer's money is controlled and managed by an independent trustee. But not all trusts are trustworthy. Tax specialists note that individuals should closely examine any proposed trust arrangement.

The Internal Revenue Service reports that promoters of abusive tax transactions are increasingly urging taxpayers to transfer assets into trusts. They promise a variety of benefits, such as the reduction of income subject to tax, deductions for personal expenses paid by the trust and reduction of gift or estate taxes. But, warns the IRS, abusive trust arrangements will not produce the advertised tax benefits and could leave the taxpayer in bigger tax trouble.

Trusts that pass IRS muster
Trusts that surviving IRS scrutiny generally are part of estate planning, are used to transfer assets to charities, or allow the trustee to manage assets for minors and those unable to handle their financial affairs.

Under a legal trust arrangement, you must give up control over income and assets. An independent trustee is designated to hold legal title to the trust assets and to independently control and manage them. Taxes must be paid on the income or assets held in trust, including the income generated by any trust property.

A fraudulent trust only has the appearance of a trust, according to the IRS. It is typically promoted by the promise of tax benefits or avoidance but makes no substantive change in the taxpayer's control over or benefit from income or assets. In some fraudulent trust arrangements, tax officials note that the taxpayer indirectly controls the activities of the trust through the designated trustee.

Trust buyer beware
The IRS warns taxpayers to be suspicious of trusts that claim to make personal living expenses deductible, promise to create charitable deductions for the taxpayer or that manage to eliminate taxes for the filer while he or she still controls the trust's assets.

Promoters of the arrangements routinely advertise the plans at investment or tax seminars, says the IRS. The trusts may have names that refer to constitutional issues, fairness, equity, or patriotic themes, the agency adds, and often the names are similar to common business organizations and legitimate trusts.

If you have doubts about investing in a trust, or any other promised tax savings program, the IRS says to call one of its offices or seek a second opinion from a tax professional. Legitimate operators should have no problem with clients doing their investment and tax homework.

Penalties for all involved
Such due diligence is crucial. The sellers of fraudulent trusts certainly face fines and possible jail sentences, but buyers aren't off the hook either.

IRS investigators will look long and hard to determine if the purchaser was truly an unwitting victim or a willing fraud participant. Even if investigators find a taxpayer isn't part of the scheme, the IRS will still expect the filer to pay the proper taxes and interest, and can levy added fines.

Those fines can be hefty. Civil sanctions can include a penalty up to 75 percent of the underpayment of tax due to any fraud. Criminal convictions may result in fines up to $250,000 and up to five years in prison. These sanctions are in addition to collecting the tax you should have paid in the first place.

So if you discover that you are using an abusive trust arrangement, tax officials say you should correct the situation with this year's filing and amend returns for any prior years in which the trust was used.

And be sure to let IRS criminal investigators know of your misfortune by calling the agency's toll-free fraud hotline at 1-800-829-0433. They're always interested in the latest schemes because they know when it comes to eliminating tax liability, if it sounds too good to be true, it usually is.

-- Updated March 1, 2004