5 Issues that Can Lead to IRS Scrutiny of “Abusive Trust Arrangements”

The Internal Revenue Service (IRS) is actively targeting estate planners, grantors, trust administrators and beneficiaries suspected of utilizing abusive trust arrangements to evade federal tax liability. Those who utilize abusive trust arrangements can face IRS audits—and these audits can lead to civil or criminal penalties depending on the IRS’ findings. Here, New Jersey tax lawyer Kevin E. Thorn, Managing Partner of Thorn Law Group, discusses five issues that may lead to IRS scrutiny.

1. Distributable Net Income (DNI) Tax Liability

Distributable net income (DNI) is the portion of a trust’s income that is allotted to the trust’s beneficiaries. Improper allotment of DNI for purposes of avoiding tax liability, incorrect calculation of the trust’s distribution deduction and various other issues can lead to an IRS audit focused on determining whether an estate plan amounts to an “abusive trust tax evasion scheme.”

2. Failure to Report Gift or Estate Tax Liability

Failure to property report gift and estate tax liability is a common issue related to proper trust administration. While these errors often result from an inadequate understanding of the Internal Revenue Code, this does not stop the IRS from labeling failure to report gift or estate tax as an “abusive” practice.

3. Use of Foreign Trusts

Although there is nothing inherently unlawful about using foreign trusts for estate planning purposes, the IRS often views estate plans that utilize foreign trusts with skepticism. In particular, the IRS scrutinizes the use of foreign trusts for possible attempts to shield assets from the U.S. government. Failure to report offshore assets will often trigger an IRS audit that leads to a broader examination of a trust’s activities and filings.  

4. Vertically Layered Trusts

The IRS frequently looks into arrangements that involve vertically layered trusts. When doing so, it seeks to determine if, “[t]he goal is to use inflated or nonexistent deductions to reduce taxable income to nominal amounts.” Common red flags for the IRS in vertically layered trust arrangements include:

• Establishing multiple trusts that each hold different assets
• Distributions flowing from one trust to another
• Use of rental agreements, fees for services, and purchase and sale agreements to shift assets between layered trusts

5. Depreciation and Deductions for Grantors’ Personal Expenses

Just like business entities, trusts are taxable entities separate and apart from their owners—and they need to be treated as such. When a taxpayer takes deductions for personal expenses paid by a trust, or when a trust claims depreciation deductions for a grantor’s personal expenses, residence or furnishings, this is likely to be flagged as a sign of a potential abusive trust arrangement.

Schedule a Confidential Consultation with New Jersey Tax Lawyer Kevin E. Thorn

New Jersey tax lawyer Kevin E. Thorn, Managing Partner of Thorn Law Group, represents estate planners, trust administrators and other clients regarding federal tax compliance. He also represents entities and individuals during IRS audits. If you need legal representation for a trust-related tax matter, please call 201-355-8202, email ket@thornlawgroup.com or contact us online to arrange a confidential initial consultation.