In Vlach v. Comm'r, T.C. Memo. 2013-116 (April 30, 2013), the Tax Court held that a series of trusts created by a physician to hold his personal and business assets and activities were shams that must be ignored for federal tax purposes. In particular, the court noted:
A. The trust documents were purchased from an abusive trust promoter,
B. The taxpayers executed the forms without variation and without seeking independent legal or tax advice,
C. The taxpayers employed a return preparer referred by the promoter,
D. The trusts never paid a salary to the physician even though he provided medical services on behalf of the trust,
E. The trust funds were used to pay the physician's personal expenses,
F. The taxpayers' relationship to the trusts' assets did not materially change after the trusts were created,
G. No economic interest passed to anyone other than the taxpayers, and
H. No documents imposed any meaningful restriction on the taxpayers' use of the trusts' property.
The court rejected the claim that the trusts were created for asset protection, noting that the taxpayers never established that the trusts actually owned the medical equipment and real estate purportedly rented by them, or that the trust structure offered more protection against potential lawsuits than the corporate form used to operate the doctor's medical practice.
A trust recognized as valid under state law isn't necessarily also recognized for income tax purposes. For instance, tax law isn't necessarily satisfied with the informality permissible under state trust law. Clear evidence of the trust's existence, and actual consistent treatment of the funds as trust funds manifestly separate from those of the settlor is required. The use of the terms “trust”, “trustee”, and “beneficiaries” isn't conclusive. Nor is any weight given to elaborate trust documents if they are part of a canned, mass-produced package that is marketed for a fee.
A trust will be ignored for tax purposes if it's considered a sham. Thus, a trust that has no economic substance apart from tax considerations will be disregarded for tax purposes, and the income of the trust will be taxed to the person who controls the trust. The Tax Court considers the following factors in deciding whether a trust lacks economic substance:
(1) whether the taxpayer's relationship to the property differed materially before and after the trust's formation;
(2) whether the trust had an independent trustee;
(3) whether an economic interest passed to other trust beneficiaries;
(4) whether the taxpayer felt bound by any restrictions imposed by the trust itself or by the law of trusts.
The Tax Court also considers whether the taxpayer has a basic understanding of the trust's operations.
Asset protection whatever form it takes is serious business and those who are interested must seek advice from a knowledgeable practitioner and avoid those who purport to provide solutions which have no economic consequence and is nothing more that paper shuffling.