Court Evaluates Factors and Finds Trust a Sham
The Tax Court in Full Circle Staffing, LLC found that an irrevocable trust was created for tax-avoidance purposes because the trust lacked economic substance, and therefore, all income attributable to the trust was taxable to the taxpayers.
The taxpayers, the Pudlos, were husband and wife and owned a freight business since 1988. In 2003, the Pudlos’ restructured the business by transferring it to a newly formed limited partnership. Simultaneous with the restructuring, the Pudlos established an irrevocable trust and a charitable trust that was classified as a private foundation. The Pudlos owned 5% of the limited partnership, the irrevocable trust owned 94% of the limited partnership, and a corporation related to the Pudlos owned a 1% interest as the general partner.
The Pudlos were the beneficiaries of the irrevocable trust, and immediately after its formation contributed their beneficial interests in the irrevocable trust to the charitable trust. The Pudlos were trustees of the charitable trust. The irrevocable trust’s assets consisted solely of the interest in the limited partnership. The trustee of the irrevocable trust was the Pudlos’ former CPA.
In filing the tax returns for the partnership, Schedules K-1 were issued to the Pudlos, the irrevocable trust, and the corporate general partner. In preparing the income tax return for the irrevocable trust, distributable net income deductions were taken for distributions made from the irrevocable trust to the charitable trust. These deductions zeroed out the income of the irrevocable trust.
The Pudlos characterized the distributions from the irrevocable trust to the charitable trust as royalty payments. The charitable trust avoided tax liability on the distributions from the irrevocable trust by relying on the exclusion of royalty income from the definition of unrelated business taxable income under Section 512(b)(2) . The charitable trust distributed some of the distributions from the irrevocable trust to charitable organizations.
The IRS audited the Pudlos income tax returns and argued that the irrevocable trust was a sham. Therefore, the Pudlos should be taxable on the income of the partnership as the true owners of the partnership. The IRS issued a notice of deficiency, and the Pudlos filed a petition in Tax Court.
The court stated that while taxpayers are generally free to structure their affairs to minimize taxes, an entity that lacks economic substance may be deemed a sham and disregarded for federal tax purposes. In deciding whether to disregard a trust for federal tax purposes, the court considered four factors relating to the trust to determine whether the trust lacks economic substance. The four factors are:
- Whether the taxpayer’s relationship to the property transferred to the trust materially changed after the trust’s creation.
- Whether the trust has an independent trustee.
- Whether an economic interest passed to the trust beneficiaries.
- Whether the taxpayer acted in accordance with any restrictions imposed by the trust agreement or the law.
The court applying this four-factor test found that the irrevocable trust was a sham, and thus disregarded for federal income tax purposes, resulting in the Pudlos being liable for tax on the income of the partnership.
The court found with respect to the first factor that the Pudlos’ control over the freight business did not materially change after the creation of the irrevocable trust. The court stated that in determining the economic substance of a trust, an examination must be made to ascertain who is “the true creator, grantor, or settlor of the trust; [and] look beyond the named settlor to the true settlor.” The court noted that although the attorney who drafted the trust documents was the named creator, the Pudlos funded the irrevocable trust and maintained control of the freight business which was the sole asset of the irrevocable trust.
As to the second factor, the court found that the trustee of the irrevocable trust, an entity controlled by the former CPA of the Pudlos, was not an independent trustee because the trustee failed to have a meaningful role in the trust’s operation. The court explained that while the trust documents gave the trustee sole authority to make disbursements, the trustee had access to the trust’s funds only with the Pudlos consent. Because the irrevocable trust did not even have a checking account, the sole action of the trustee was to endorse checks from the limited partnership over to the charitable trust, and therefore the irrevocable trust served solely as a mere conduit to the charitable trust.
With respect to the third factor, the court held that an economic interest did not pass to the irrevocable trust’s beneficiary, the charitable trust, because the vast majority of the income of the partnership was not transferred to the irrevocable trust and its beneficiary, the charitable trust, but rather was transferred to other businesses controlled by the Pudlos. The court, therefore, found that the Pudlos retained an economic interest in the irrevocable trust assets, the partnership, and therefore assets had not in effect passed to the irrevocable trust.
Finally, as to the fourth factor, the court examined whether the Pudlos respected the restrictions placed on the trust assets by the trust agreement. The trust agreement prohibited loans of trust assets with adequate consideration, interest, or security. The court held that the Pudlos violated these prohibitions when they transferred partnership income to other related entities controlled by the Pudlos.
Ultimately the court concluded that because the four factors weigh against the finding of a valid trust, the irrevocable trust was held to be formed for tax avoidance purposes. As such, the irrevocable trust was ignored and all income attributable to the irrevocable trust was taxable to the Pudlos.
This case gave a clear recitation of the factors to be considered in determining whether a trust is a sham that will be ignored for tax purposes. The court is also clear in articulating how the rules were to be applied to the facts of this case. This case also highlights, once again, the importance of following literally all the formalities of a transaction or arrangement. While the IRS can always assert the substance-over-form argument even if all the formalities are in fact followed, by not following such formalities taxpayers only make it easier for the IRS to challenge an arrangement or transaction.
1 TCMemo 2018-66.
Frank Baldino is an estates and trusts attorney who helps people throughout the greater Washington, DC area protect assets for their families and future generations through careful estate tax planning. For more information, contact Frank at (301) 657-0175 or [email protected].
This article originally appeared in the November 2018 edition of Estate Planning, a monthly periodical directed to estate planning professionals that offers readers the newest and most innovative strategies for saving taxes, building wealth, and managing assets.