Tax Planning Trusts using 643

Lately there have been several of my clients who have presented me with materials from various promotors touting a special new trust that can save taxes, particularly on the sale of a business.

While there are many issues, the bottom line is that for the most part, the advice being promoted here fits the definition of an abusive trust scheme as set forth by the IRS.  The IRS knows all about these schemes.  Please see IRS guidance here:

(https://www.irs.gov/businesses/small-businesses-self-employed/abusive-trust-tax-evasion-schemes).

The biggest issue is the misuse of Section 643 of the code.  This section deals with the concept of DNI (Distributable Net Income), which relates to the taxation of Trusts. The basic rule for the taxation of trust is that the income and gains must be taxed to either the Settlor (as in a Grantor Trust), the Beneficiaries (as in a Beneficiary Defective Grantor Trust) or to the Trust itself (Non-Grantor Trust), or some combination of the above. 

While this is simplified, it is important to understand that creating a trust does not somehow create the ability to indefinitely defer or avoid income taxes, regardless of how it is drafted. This claim is in fact one of the main markers of an abusive trust scheme.

The promoters on the material I have had the opportunity to review use a common tactic for abusive schemes, which is to reference an accurate authoritative source (such as citing the IRS code section itself), and then to misrepresent what that code section actually means.  This is effective since the plain meaning is easy to misunderstand by a layperson.  The fact is that the taxpayer is not free to interpret the meaning any way they want and is given very detailed and clear guidance from the IRS, as well as case law from other taxpayers who have attempted various interpretations.  

In one case, the promoter cites Section 643 and then implies that the Trustee can arbitrarily determine, in good faith, how to allocate the income and somehow can magically allocate it to capital, therefore making it non-taxable.  This is simply not accurate.

In actuality, the procedures for determining DNI, Income and all other factors related to trust taxation are spelled out explicitly in the IRS Treasury regulations (https://www.law.cornell.edu/cfr/text/26/1.643(a)-3). The Trustee cannot, as the promotional material has suggested, simply make the determination “in good faith” any way they choose. 

It should also be emphasized, as stated above, that the IRS is very aware of these abusive trust schemes, as evidenced by the dedicated page above detailing the various schemes, and also explained in this on point article (https://freemanlaw.com/the-irss-renewed-focus-on-abusive-trust-arrangements/).  I suggest reading the entire article which also addresses the DNI. It points out that:

"Generally, after the IRS identifies a promoter, it will request a list of the promoter’s clients through either an administrative summons or a judicial subpoena.  Armed with this information, the IRS can begin civil and criminal examinations of each promoter’s clients’ tax returns."

I have personally witnessed this many times and it is simply a matter of time before the IRS finds these promoters, and hence the clients.  I would also point out that the IRS has committed $80 Billion dollars to hire thousands of new auditors (https://www.bloomberg.com/news/articles/2022-08-22/the-irs-getting-87-000-agents-won-t-mean-more-audits-now), so engaging in an abusive trust structure now would be exceedingly inadvisable. 

It goes without saying that these trusts cannot offer the benefits outlined in the promotional material I have reviewed and if it were attempted to be used as recommended, would clearly be seen as an abusive trust, thus offering no asset protection and no tax savings, and likely significant back taxes, penalties and fees. I would not recommend using any of these types of trusts in any way without first receiving expert tax advice from your own tax professional.

Some magic key words to be careful of are: Constitutional Trust, Common Law Trust, Contract Trust, Basic Trust, 643 Trust.  I am sure more iteration are to come as the promoters evolve their naming conventions to stay ahead of the bad press these trusts always garner.

This article is very generic and clearly does not cover every possible trust or situation and of course should not be relied upon a legal advice for your specific situation.  However, I do think it is safe to say that if a trust offers tax benefits that seem too good to be true, then they probably are!