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Promotional Materials for Marketing Trust Based Shelter Erroneously Confuses Various Definitions of Income for Trust Income Taxation

Promoters of questionable tax schemes often distribute a “legal analysis” to potential victims. While these analyses might sound authoritative, they can sometimes resemble the output of ChatGPT in full hallucination mode. These analyses are typically designed to sound sufficiently authoritative to intimidate any tax professional who isn’t well-versed in the specific area of taxation being addressed.

In AM 2023-006,[1] the IRS targets a marketed trust tax structure. This structure aims to shelter nearly all income from assets transferred to the trust from federal income tax. The “legal analysis” supporting this program leans heavily on conflating the various forms of “income” associated with such trusts. It incorrectly treats distributable net income (DNI), taxable income, and accounting income as if they were synonymous concepts.

The memorandum broadly describes the programs as follows:

The structure claims to provide significant tax and asset protection advantages to individual taxpayers (described herein as the “Taxpayer”). The structure is being promoted by a combination of attorneys, accountants, enrolled agents, and unlicensed tax advisors. The promotional materials consist primarily of a series of presentations (some of which can be found on various social media platforms), informational websites, short documents, and short legal opinions. The materials state that the trust being offered complies with Scott on Trusts, the Uniform Trust Code, the Restatement of Trusts (Third), and the Code. Some materials specifically note that the trust is “section 643 compliant”. The materials describe the trust by its purported characteristics, typically a combination of the terms “non-grantor,” “irrevocable,” “discretionary,” “complex” (or “complex with simple provision”), “section 643,” and “spendthrift.” In many variations, promotional materials refer to the trust structure as a “Non-Grantor, Irrevocable, Complex, Discretionary, Spendthrift Trust”. While there is some inconsistency among the materials, the basic form and mechanics of the structure are described here.[2]

In a footnote, the memo adds:

In some iterations of the promotional materials, the trust is additionally described as “copyrighted.” This appears to be a reference to a specific model or form of trust instrument that is being sold or licensed, and not a tax or legal characteristic of the trust.[3]

How the Promoter Claims the Program Works

The trust in question is formed as follows under the proposed program:

A third-party settlor, acting on behalf of Taxpayer, creates and nominally funds a trust with legal documents that are provided by the promoter. Taxpayer is appointed the “Compliance Overseer” with power to add and remove trustees and change beneficiaries of the trust. The promotional materials are inconsistent as to whether Taxpayer, a third-party, or both serve as trustee. In the case of a third-party serving as trustee, it is unclear whether the third-party would be an independent trustee.[4]

The beneficiary provisions are summarized below:

Taxpayer is not a named beneficiary of the trust. In some variations, Taxpayer's spouse and/or children are specifically named as beneficiaries but are subject to change by the Taxpayer. The trust instrument gives the trustee sole discretion to make distributions of income or principal to beneficiaries (“discretionary distributions”). It is unclear whether the Taxpayer, serving in the role of Compliance Overseer, is given a power to direct the trustee to make or withhold discretionary distributions to beneficiaries. The trust is a self-styled “spendthrift” trust or “spendthrift trust organization.” There are no provisions that allow any party to revoke the trust by distributing trust assets back to the donor in termination of the trust.[5]

Finally, the promoter provides a legal opinion letter to “prove” to the taxpayer and perhaps even their tax professional that this provides miraculous tax benefits that no one else before the promoter has ever been able to uncover under IRC provisions that haven’t changed in decades.

An accompanying letter described as a legal opinion (“legal opinion letter”) states that the trust is in “in compliance with the IRC” and thereby must obtain an Employer Identification Number (EIN) and file Form 1041, “U.S. Income Tax Return for Estates and Trusts” (in addition to any other filing requirements) annually as a complex trust. A subsequently dated legal opinion letter from the same source notes that the trust is “not subject to turn over orders by any court. This limits the liability of Beneficiaries and Trustees of the Trust. It also makes the corpus of the Trust unreachable by creditors.”[6]

Now comes the time to get assets into the trust.  The plan describes how this is to be done:

The trust is primarily funded by Taxpayer selling assets to the trust in exchange for a promissory note (styled as a “demand note” in certain materials). The promotional materials do not discuss issues relating to the trust’s initial capital, creditworthiness, or ability to make payments on the promissory note. Nor do the materials outline requirements related to the terms of the note, such as having a defined period for repayment. Certain materials do discuss the requirement for debt instruments of the trust to charge adequate interest (not specifically in relation to the demand note).[7]

What type of assets should be sold to the trust?  In a footnote the memo provides a list of assets often suggested to be sold to this “miracle” trust in the promotional materials.

Examples of assets appropriate for funding the trust by ‘sale’ include equipment, real estate, computers, websites, handbooks, copyrights, trademarks, and proprietary operating systems.[8]

Naturally, a challenge with selling valuable assets to the trust is that the fair market value of these assets is likely higher than the taxpayers’ basis, potentially resulting in a gain on the sale. Instead of relying on the note’s conspicuous omission of payment terms (which could imply, perhaps, that the principal might never be paid if the sale qualified as an installment sale), some promoters have a “solution” to bypass this gain. They advise the taxpayer to sell the property to the trust at “book value”, which matches the taxpayer’s basis in the assets.

Certain materials claim that the sale of assets to the trust is a non-taxable event, noting that the trust’s purchase price is the “book value” of the assets rather than their fair market value, such that the trust retains Taxpayer’s basis in the assets. Further, there is a presumption that any of the Taxpayer’s business assets (including real estate, equipment, or intangible property) sold to the trust will be leased back to Taxpayer or an entity owned or controlled by Taxpayer. A few variations recommend that (1) Taxpayer transfer up to a 90% interest in a limited liability company (“LLC”) (or another type of business entity) owned by Taxpayer to the trust, (2) the Taxpayer will cause the LLC to sell certain assets (including intellectual property (IP)) to the trust, and (3) Taxpayer will cause the LLC to lease back those assets and IP from the trust for a payment that is approximately equal to 70% of the monthly income of the LLC.[9]

And Now the Tax Magic Happens (at Least Per the Promoter)

Now we observe how the structure deftly transforms what would typically be taxable income into “non-income.” This is achieved by having the trustee allocate items of taxable income to the trust corpus. They then exploit what appears to be the previously overlooked by generations of tax experts the capability of IRC §643(a)(4) to use that label—deeming the item as allocable to trust corpus—to erase any tax liability related to that income.

The promotional materials claim that almost none of the income generated by the trust is subject to current federal income tax if the trustee allocates such income to corpus and refrains from making distributions to beneficiaries. The legal basis for these assertions regarding federal income taxation rely on §643 of the Code.

To support the assertion that all income from the sale or exchange of capital assets (“capital gains”) is excluded from federal income tax, the materials quote §643(a)(3), without context (emphasis in original):

“IRC Section 643(a)(3) Capital Gains and Losses — gains from the sale or exchange of capital assets shall be EXCLUDED to the extent that such gains are allocated to corpus and not (A) paid, credited, or required to be distributed to any beneficiary during the taxable year . . .”

Next, the materials claim that the trustee may characterize any remaining trust income as an “extraordinary dividend”, which the materials claim is not subject to current taxation so long as the trustee allocates such income to corpus. The materials find support for this claim in §643(a)(4):

“if a fiduciary has the sole and absolute authority to designate something as extraordinary dividends or taxable stock dividends, and that designation is paid to the corpus of the trust and not subject to distribution, then it is not income to the trust according to Rule 643 [sic].”

Were ChatGPT human, it would marvel at the ingenious way these individuals have assembled such an impressively authoritative-sounding, yet irrelevant, set of IRC sections to bolster their arguments. But for those seeking an official IRS document (which, in truth, is equally irrelevant to the matter), some promoters go above and beyond, as referenced in a footnote to the IRS memo:

Several promoters rely on a private letter ruling issued by this office as support for their claim that extraordinary dividends described in §643(a)(4) are not subject to current taxation. Some materials refer to this ruling as “Private Letter Ruling # PLR-133314-14 issued May 8, 2015” or “IRS Private Letter Ruling 133314-14” See PLR 201519012. This private letter ruling held that a certain distribution that a trust received from an LLC pursuant to a settlement agreement is considered an extraordinary dividend “excluded from the definition of “income” within the meaning of §643(b) (emphasis added).[10]

However, these opinion letters offer no further details on why the cited references support their claims. Instead, they merely present broad marketing assertions about this “remarkable” strategy.

Trust and the Many Types of Income

If you find yourself skeptical about this purported tax-reducing method and harbor suspicions regarding the touted results, trust those instincts. At first glance, these claims may seem substantiated. Indeed, if you examine only the precise citations they provide, you'll see that these references do exist and appear to affirm what the promoters allege.

The crux lies in interpretation. While those citations do convey what the promoters suggest, their implications aren’t as the promoters would have you believe. The promoters expect readers to assume that every mention of “income” in the provided materials and their document carries the same definition. The critical misconception they’re banking on is that all references to “income,” regardless of context or modifier, bear an identical definition.

But they don’t.

“Income” is a notably ambiguous term within the context of trusts and income taxes. Readers must exercise caution to discern the precise meaning of “income” relevant to the context of the text they are reviewing.

  • Income, when unmodified, pertains to trust income calculated under the pertinent state principal and income act and the trust document. This distinction determines whether an item is viewed as trust income or trust corpus. IRC §643(b) indicates that when the term "income" appears in the majority of the IRC sections referencing trusts (with significant exceptions being provisions related to grantor trusts) this is the meaning being referenced:

    (b) Income. For purposes of this subpart and subparts B, C, and D, the term “income”, when not preceded by the words “taxable”, “distributable net”, “undistributed net”, or “gross”, means the amount of income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law. Items of gross income constituting extraordinary dividends or taxable stock dividends which the fiduciary, acting in good faith, determines to be allocable to corpus under the terms of the governing instrument and applicable local law shall not be considered income.

  • Accounting income is the term the IRS employs in its instructions and other documents to denote the unmodified income reference in IRC §643(b). The agency introduces this modifier to minimize confusion regarding which definition is being invoked. However, the IRC itself does not adhere to this convention. As explicitly highlighted in IRC §643(b), in IRC text found in the key trust sections the unmodified term refers to income determined under the trust document and the applicable state principal and income act.

  • Gross income refers to the expansive definition provided in IRC §61, which initially classifies all wealth increments as income. This serves as the foundation for determining taxable income.

  • Taxable income, as delineated in IRC §63, is gross income (less any items exempted from tax under other IRC provisions) minus the deductions permitted in Chapter 1 of the IRC.

  • Distributable net income (DNI) as computed under IRC §643(a), originates from taxable income. This figure primarily functions as a cap on the trust or estate’s income distribution deduction for disbursements to non-charitable beneficiaries of the trust or estate. While DNI might influence whether an item of income will be included in the taxable income of the trust or, rather, one or more of its beneficiaries, it doesn’t determine if such an item is subject to tax.

The legal opinion and promotional materials exploit the various uses of the term “income” in trust taxation to craft an illusion of taxable income vanishing. However, much like on a magician’s stage where the assistant doesn’t genuinely disappear (only to reappear with the magician’s next gesture), the purported disappearance of income in this context is merely a sleight of hand.  A tax liability will continue to exist with or without the use of the trust structure.

Many tax advisors fall for this illusion due to their limited or even absent formal education on trust income tax matters. As long as they’re presented with material that resembles a thorough analysis, they can be easily misled by the ruse. But, much like a magician, the promoter ensures that no one peers behind the curtain where the truth would be evident. Let’s examine the actual law, and see how the promoter’s illusion dissolves when these provisions are properly understood.

The IRS Describes the Law

The IRS notes that IRC §641(a) provides the basic structure for the income taxation of a trust:

Section 641(a) generally provides that the tax imposed by §1(e) applies to the taxable income of estates or of any kind of property held in trust including income which, at the discretion of the fiduciary, may be either distributed to the beneficiaries or accumulated.

Section 641(b) provides, in part, that the taxable income of a trust shall be computed in the same manner as in the case of an individual, except as otherwise provided in this part [§§641 through 685]. The tax shall be computed on such taxable income and shall be paid by the fiduciary.[11]

The IRS delves into an analysis of distributable net income, the definition that the materials use as a smokescreen, aiming to befuddle the reader and divert attention from the fact that there’s no real tax wizardry at play.

Section 643(a) defines the term “distributable net income”, for purposes of this part [§§641-685] as meaning, with respect to any taxable year, the taxable income of the estate or trust computed with certain modifications listed in §§643(a)(1) through (7).

Section 643(a)(3) provides that gains from the sale or exchange of capital assets shall be excluded [from “distributable net income”] to the extent that such gains are allocated to corpus and are not (A) paid, credited, or required to be distributed to any beneficiary during the taxable year, or (B) paid, permanently set aside, or to be used for the purposes specified in §642(c).

Section 643(a)(4) provides that for purposes only of subpart B [§§651 and 652] (relating to trusts which are required to distribute current income only (i.e., “simple” trusts)) there shall be excluded [from “distributable net income”] those items of gross income constituting extraordinary dividends or taxable stock dividends which the fiduciary, acting in good faith, does not pay or credit to any beneficiary by reason of his determination that such dividends are allocable to corpus under the terms of the governing instrument and applicable local law.[12]

The IRS references IRC §643(b) and highlights the type of income affected by the trust’s correct categorization of an item as an item of corpus. Notably, the affected income isn’t gross or taxable income.

Section 643(b) provides that for purposes of subparts A, B, C, and D [§§641-668], the term “income,” when not preceded by the words “taxable,” “distributable net,” “undistributed net,” or “gross,” means the amount of the income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law. Items of gross income constituting extraordinary dividends or taxable stock dividends which the fiduciary, acting in good faith, determines to be allocable to corpus under the terms of the governing instrument and applicable local law shall not be considered income.

Section 1.643(a)-0 of the Income Tax Regulations provides that the term “distributable net income” has no application except in the taxation of estates and trusts and their beneficiaries. It limits the deductions allowable to estates and trusts for amounts paid, credited or required to be distributed to beneficiaries and is used to determine how much of an amount paid, credited, or required to be distributed to a beneficiary will be includible in that beneficiary’s gross income. It is also used to determine the character of distributions to the beneficiaries. Distributable net income means for any taxable year, the taxable income (as defined in §63) of the estate or trust, computed with the modifications described in §§643(a)(1) through (7) and the regulations thereunder.[13]

In conclusion, the IRS addresses the income distribution deduction and the application of DNI.

Section 661(a) provides that in any taxable year a deduction is allowed in computing the taxable income of a trust (other than a trust to which subpart B applies), for the sum of (1) the amount of income for such taxable year required to be distributed currently, and (2) any other amounts properly paid or credited or required to be distributed for such taxable year, but such deduction shall not exceed the distributable net income of the estate or trust.[14]

The IRS Conclusion on the Proper Tax Treatment of the Trust

The IRS starts by unequivocally presenting its overarching conclusion, catering to those who favor skimming the executive summary.

Contrary to the claims of the promotors, the trust will recognize income on its capital gains and dividends, except to the extent those amounts are distributed or deemed to be distributed to its beneficiaries.[15]

The IRS initially pulls back the curtain that promoters would prefer tax advisors and taxpayers to avoid, focusing on Section 641. They highlight the out-of-context application of provisions from IRC §643(a) while also pointing out the conspicuous oversight of IRC §643(b) in the subsequent subsection.

The promotional materials support their claims about the tax benefits of their structure by reading subsections of §643 out of context. The materials do not address §641 which provides the basic rule that the trust’s taxable income is computed as it is for individuals, with certain modifications. Instead, the materials look to §643(a) for guidance as to the definition of “taxable income”. In so doing, the materials fail to consider the beginning of that section, which expressly states that the section defines “distributable net income” rather than “taxable income.”[16]

The memorandum then delves into the general income taxation of trusts and estates.

A non-grantor trust is considered a separate taxable entity for income tax purposes. A non-grantor trust computes its gross income in much the same manner as an individual. Most deductions and credits allowed to individuals are also allowed to estates and trusts. However, there is one primary distinction. A trust is allowed an income distribution deduction for distributions to beneficiaries. See §§651 and 661. A trust’s deduction for distributions to beneficiaries is limited to the lesser of (1) amounts that the trust properly pays or credits to beneficiaries during the taxable year (or amounts that are required to be paid or credited to the beneficiaries during the taxable year under the trust instrument if not actually distributed) or (2) the “distributable net income” of the trust.[17]

Next, the memorandum addresses the fundamental purpose of distributable net income.

Section 643 defines the concept of the “distributable net income” (or “DNI”) of the trust. DNI not only limits the amount that the trust can deduct for distributions to beneficiaries, but it also determines the amount on which the beneficiaries can be taxed as a result of those distributions. See §§652 and 662. The income distribution deduction of the trust coupled with the gross income inclusion to beneficiaries ensures the income of the trust is taxed either to the entity or to the beneficiaries, but not to both.[18]

The computation of DNI is discussed next by the author of the memorandum.

Under §643(a), DNI is calculated by making certain modifications to the trust’s taxable income. Some of these modifications include subtracting certain items of gross income from DNI that may not be distributable to beneficiaries who are entitled to receive trust “income”. This, in turn, depends on the economic rights of trust beneficiaries determined under the trust instrument and applicable local law for the taxable year at issue. As background, a trustee apportions items of gross income or tax-exempt receipts of the trust between two different classes of beneficiaries, a class that is entitled to trust “income” as defined under the trust instrument and applicable local law (i.e., the “accounting income” of the trust), and a class of beneficiaries (sometimes referred to as “remainder beneficiaries”) entitled to certain amounts of gross income allocated to trust “corpus” or “principal”. Gross income that is allocated to trust principal can be accumulated by the trust for distribution in subsequent taxable years or at the time of the trust’s termination. Gross income that is allocated to trust income is either distributed to beneficiaries in the current taxable year or, depending on the terms of the trust instrument, can be accumulated by the trust for distribution in subsequent taxable years.

If a trust excludes all capital gains and extraordinary dividends from income within the meaning of §643(b), that simply means that the trust will subtract those capital gains and extraordinary dividends from DNI under §643(a), so long as those amounts are not actually distributed to the beneficiaries. In turn, subtracting those amounts from DNI simply means that trust has a lower threshold for the deduction that it can take for distributions to beneficiaries authorized by §651 (for simple trusts) or §661 (for complex trusts). If a non-grantor trust does not make (and is not required to make) any distributions to its beneficiaries, then it is not entitled to any “income distribution deduction”. Therefore, all of the income attributable to capital gains and extraordinary dividends must be reported by the non-grantor trust as income on Form 1041.[19]

The memorandum now turns its attention to the promotional material’s conflation of distributable net income with the income subject to taxation for the trust.

The promoters of this structure mistakenly assume that income in §643(b) refers to the taxable income of the trust. However, the first sentence of §643(b) provides that, within the parts of the Code encompassing §§641 through 668, any references to “income” without preface refers to the accounting income of the trust rather than another concept of income such as “taxable income”. References to other types of income will be denoted by their full name, such as “distributable net income” or “taxable income”. See e.g., §641 describing rules related to the computation of “taxable income”.[20]

Recommendations of the Memorandum

The memorandum outlines recommendations for the IRS on how to approach cases involving structures similar to those detailed in the document.

In each case using this structure, as a threshold matter, the trust’s income tax returns should be examined to ensure that (a) the trust is reporting all of its taxable income, including capital gains and any income that is described as an extraordinary dividend, and (b) ensure that the trust is disallowed any deduction claimed with respect to such income solely because the trustee, acting in good faith, has allocated such income to the corpus of the trust.[21]

A footnote in the document highlights some of the tax return reporting suggestions made by the promotional materials.

Certain promotional materials include a description of tax reporting used in this structure as shown on the Form 1041. This sample From 1041 reflects that capital gains and other amounts of gross income characterized as extraordinary dividends are included as part of the trust's “total income”, however, the sample Form 1041 shows that the trust claims a deduction on line 15a (other deductions not subject to 2% floor) in an amount that corresponds to the amount included in income. These promotional materials suggest that, in some variations, a statement is included with the return to explain this deduction.[22]

[1] AM 2023-006, August 18, 2023, https://www.irs.gov/pub/lanoa/am-2023-006.pdf (retrieved August 19, 2023)

[2] AM 2023-006, August 18, 2023

[3] AM 2023-006, August 18, 2023

[4] AM 2023-006, August 18, 2023

[5] AM 2023-006, August 18, 2023

[6] AM 2023-006, August 18, 2023

[7] AM 2023-006, August 18, 2023

[8] AM 2023-006, August 18, 2023

[9] AM 2023-006, August 18, 2023

[10] AM 2023-006, August 18, 2023

[11] AM 2023-006, August 18, 2023

[12] AM 2023-006, August 18, 2023

[13] AM 2023-006, August 18, 2023

[14] AM 2023-006, August 18, 2023

[15] AM 2023-006, August 18, 2023

[16] AM 2023-006, August 18, 2023

[17] AM 2023-006, August 18, 2023

[18] AM 2023-006, August 18, 2023

[19] AM 2023-006, August 18, 2023

[20] AM 2023-006, August 18, 2023

[21] AM 2023-006, August 18, 2023

[22] AM 2023-006, August 18, 2023