Wilmington NC CPA Tax Preparation of IRS Form 1041 and NC A101 | Trust Scams

Some folks filing Form 1041 and NC A101 try innovative ways to work the loopholes in IRS and NC Department of Revenue tax code. IRS Regulations are open to interpretation. Tax audits, tax court cases and Private Letter Rulings sometimes lead to changes in the IRS Code for Form 1041,and susequently for NC A101. But the IRS just closes off entire areas of interpretation by labeling them scams. These five Trust scams, presented below, would cause a tax audit if presented on the Form 1041 tax returns. A good CPA tax preparer is knowledgable on tactics the IRS labels as scams. Further, a great CPA tax preparer knows the areas where challenges to the current IRS Regulations may be successful, through knowledge of recent tax court cases and Private Letter Rulings. There is often a period of time where tax regs say one thing but other evidence suggests this will change eventually. When clients have issues falling into this transitional phase, CPAs should help clients evaluate the potential tax refund against the risks involved.

After an introduction to Trusts, we present five common situations the IRS considers scams [sic]. IRS Form 1041 and NC A101 tax preparation is probably more subject to tax audits than other returns. To understand the trust scams, it is important to focus on some basic trust taxation rules.

“IRS Form 1041 tax preparation is specialized. While we advocate self preparation of many tax forms when appropriate, Form 1041 probably deserves attention from your local Wilmington NC CPA. If you don’t have a CPA yet, or just want a second opinion on a Trust taxation issue, please call us for a free initial consult at (910) 399-2705.”
-Gary Bode, CPA - Wilmington NC Tax Accountant

IRS.gov

A valid trust is a legal arrangement creating a separate legal entity. The duties, powers and responsibilities of the parties to this arrangement are determined by state statute and the trust agreement. To create a trust, legal title to property is conveyed to a trustee, who is then charged with the responsibility of using that property for the benefit of another person, called the beneficiary, who really has all the benefits of ownership, except for bare legal title. The IRS recognizes numerous types of legal trust arrangements, and they are commonly used for estate planning, charitable purposes, and holding of assets for beneficiaries. The trustee manages the trust, holds legal title to trust assets, and exercises independent control.

All income a trust receives, whether from foreign or domestic sources, is taxable to the trust, to the beneficiary, or to the grantor of the trust unless specifically exempted by the Internal Revenue Code (IRC).

A legitimate trust is allowed to deduct distributions to beneficiaries from its taxable income, with a few modifications. Therefore, trusts can eliminate income by making distributions to other trusts or other entities as long as they are named as beneficiaries. This distribution of income is key to understanding the nature of the abusive schemes. In the abusive schemes, bogus expenses are charged against trust income at each trust layer. After the deduction of these expenses, the remaining income is distributed to another trust, and the process is repeated. The result of the distributions and deductions is to reduce the amount of income ultimately reported to the IRS.

Filing requirements for legitimate trusts are discussed below:

• A domestic trust must file a Form 1041, U.S. Income Tax Return for Estates and Trusts, for each taxable year. If the trust is classified as a Domestic Grantor Trust, it is not generally required to file a Form 1041, provided that the individual taxpayer reports all items of income on his own Form 1040, U.S. Individual Income Tax Return. Thus, the individual pays the total tax liability upon the filing of his return for that taxable year. All income received by a trust, whether from foreign or domestic sources, is taxable to the trust, to the beneficiary, or to the grantor unless specifically exempted by the Internal Revenue Code.

Abusive Domestic Trust Schemes: IRS Form 1041

Domestic trusts are trusts created in the U.S. Here are some common abusive domestic trust schemes:

• Business trust

This involves the transfer of an ongoing business to a trust. Also called an unincorporated business organization, a pure trust or a constitutional trust, it gives the appearance that the taxpayer has given up control of his or her business. In reality, through trustees or other entities controlled by the taxpayer, he or she still runs the day-to-day activities and controls the business’s income stream. Such arrangements provide no tax relief. The courts have held that the business income is taxable to the taxpayer under a variety of legal concepts, including lack of economic substance (sham theory), assignment of income, or that the arrangement is a grantor trust. In some circumstances, the trust could be taxed as a corporation.

• Equipment or service trust

This trust is formed to hold equipment that is rented or leased to the business trust, often at inflated rates. The business trust reduces its income by claiming deductions for payments to the equipment trust. This type of arrangement has the same pitfalls as the business trust, and it will result in no tax reduction.

• Family residence trust

Taxpayers transfer family residences and furnishings to a trust, which sometimes rents the residence back to the taxpayer. The trust deducts depreciation and the expenses of maintaining and operating the residence including gardening, pool service and utilities. The courts have consistently collapsed these types of trusts, taxing income to the taxpayer and disallowing personal expenses.

• Charitable trust

Taxpayers transfer assets or income to a trust claiming to be a charitable organization. The trust or organization pays for personal, education or recreation expenses on behalf of the taxpayer or family members. The trust then claims the payments as charitable deductions on its tax returns. These alleged charitable organizations often are not qualified and have no IRS exemption letter; hence, contributions are not deductible. Charitable deductions are not allowed when the donor receives personal benefit from the alleged gift.

• Asset protection trust

These trusts are promoted as a means of avoiding liability for judgments against an individual or business. However, beware of any asset protection trust marketed as part of a package to reduce federal income or employment taxes. The courts can ignore such trusts and order the taxpayer’s property sold to satisfy the outstanding liabilities.

If you’d like a free initial consult with a proactive tax accountant in a Wilmington NC CPA firm, please consider calling us at (910) 399-2705.