IRS Memo Concludes That Certain Promoters Are Misrepresenting Trust Income Tax Rules

According to the IRS, attorneys, accountants and others are mistakenly claiming that a certain type of trust structure will not get hit with a tax on any earned income, including capital gains, and are misinterpreting regulations governing the income earned by trusts, the IRS said in said in AM 2023-006 released on August 18, 2023.

The marketed trust structure involves 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. 

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. 

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.” 

The marketing materials for these trust structures,
which typically promote them with terms such as
"non-grantor," "irrevocable," "discretionary" and
"complex," misinterpret the beginning of
Internal Revenue Code Section 641,
which provides the basic rule that
the trust's taxable income is computed
as it is for individuals, with certain modifications,
the Internal Revenue Service said in AM 2023-006. 

"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," the IRS said.

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