Why Abusive Trust Arrangements Provoke the Ire of the IRS

Why Abusive Trust Arrangements Provoke the Ire of the IRS

Why Cross-Border Abusive Trust Arrangements Are the Ire of IRS

Unfortunately, there is a lot of incorrect and outdated information online regarding creating domestic and cross-border trusts, how they operate, and whether income associated with these types of trusts are taxable in the U.S. Oftentimes, these types of trust arrangements are sold by non-attorney, non-tax professionals who promote these various tax schemes and scams that typically require the taxpayer to pay a large upfront sum to receive significant tax benefits on the back end. In recent years, the Internal Revenue Service has increasingly cracked down on what they refer to as abusive trust arrangements or abusive trust schemes. While it is very common with domestic trusts involving the section 643(b) trust for example, it is equally as common in the world of offshore asset and tax protection trusts. While these cross-border trusts are not necessarily illegal by design, the way they are being sold and used by U.S. taxpayers puts them into choppy waters. Let’s go through some of the basics of how a cross-border trust works and what to keep in mind if you are considering investing in an offshore trust.

What is a Cross-Border Trust?

Essentially, a cross-border trust is a trust that does not pass the court or control tests. Moving away from the technical components for a moment, a foreign trust is typically just a trust that is formed overseas under cross-border law. It does not necessarily mean that the taxpayer has to physically move their assets into that jurisdiction, but rather that the law in the country of the cross-border trust (or whichever country that the cross-border trust designates as the law for the trust) controls how the trust is managed.  There is nothing inherently illegal about having a cross-border trust, but if taxpayers are moving assets that are subject to creditors that already have judgments, liens, etc. — then moving those assets into the cross-border trust may be considered a type of fraud.

In other words, it is all about timing and when the cross-border trust was created, what is the purpose of the trust, and what assets are contained in the trust.

Is Cross-Border Trust Income Taxable?

Yes, just because assets that generate income from overseas are in a cross-border trust does not shield it from having to pay income taxes on earnings and distributions. To determine who will be taxed and how is based on whether it is a grantor trust or non-grantor trust. While there are many different types of revocable and irrevocable trusts, at the end of the day the main issue will be whether it is a grantor trust, in which the income is imputed to the grantor — even if distributed to other beneficiaries — or if it is a non-grantor trust in which the beneficiaries are taxed on the income distributions. Most cross-border asset protection-type trusts are irrevocable.

Income (DNI vs UNI) and Throwback Rule

It is important to note that the tax rules are different for income within a cross-border trust. Instead of the issue primarily just being DNI, there is a concern about income that should have been distributed but remains in the trust and then is distributed in future years. This is referred to as UNI and can lead to significant tax implications when income is distributed in the subsequent year from the year that it was earned by the trust. Compounding the complications are the application of the throwback rule and related elections.

What May Trigger an Audit?

In general, the reporting of a cross-border trust can be very complicated from an IRS perspective. That is because there are various requirements that the taxpayer must fulfill each year when they have ownership in or distribution from a foreign trust. The two main forms the taxpayer has to file is the Form 3520 and Form 3520-A. Unlike other types of international information reporting forms such as the FBAR of Form 8938, Form 3520/3520-A can be very complicated and require a much deeper dive into the trust to create the necessary balance sheets, income statements, etc. If the cross-border trust does not properly file the forms and the IRS gets wind of income implications from overseas, it can lead to an audit — noting, that when a person has a cross-border trust, they typically have other assets and investments that will require reporting on different forms such as the FBAR, Form 8938, Form 8621, etc.

Penalties

The penalties for not properly reporting across border trusts can be very onerous and can reach upwards of 35% value of property transfers and distributions as well as a percentage of the value of the trust itself. Therefore, taxpayers need to stay in compliance with their cross-border trust reporting and if they fail to do so they should consider one of the offshore amnesty programs through a system with getting into compliance.

Late Filing Penalties May be Reduced or Avoided

For Taxpayers who did not timely file their FBAR and other international information-related reporting forms, the IRS has developed many different offshore amnesty programs to assist taxpayers with safely getting into compliance. These programs may reduce or even eliminate international reporting penalties.

Current Year vs Prior Year Non-Compliance

Once a taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist who specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties. 

Need Help Finding an Experienced Offshore Tax Attorney?

When it comes to hiring an experienced international tax attorney to represent you for unreported foreign and offshore account reporting, it can become overwhelming for taxpayers trying to trek through all the false information and nonsense they will find in their online research. There are only a handful of attorneys worldwide who are Board-Certified Tax Specialists and who specialize exclusively in offshore disclosure and international tax amnesty reporting. 

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure. 

Contact our firm today for assistance.