In a recent Chief Counsel Advice Memorandum[1] (“CCM”), the office of the IRS Chief Counsel debunks the income taxation, or lack thereof, found in promotional materials promoting a structure known as a “Non-grantor, irrevocable, complex, discretionary, spendthrift trust”, with a note that the structure may be referred to by several other similar but slightly different names. The CCM focuses on the income taxation of the proposed structure under IRC §643, noting that the structure does not avoid tax as the promotional materials claim.
Scope of the CCM: What’s Addressed and What’s Not
The CCM is clear that it does not address nor opine on any other aspects of the proposed structure outside of the taxation issue under IRC § 643, and specifically does not advise on the following issues which might also be problematic with the structure:
- Whether some or all of these structures could be recharacterized as grantor trusts under §671[2] (the fact of which would eliminate the alleged taxation structure outlined in the promotional materials);
- The legitimacy of certain promotional materials that advise taxpayers to treat certain taxable trust distributions as deductible payments of trust expenses or the treatment of sales to the trust;
- The gift, estate, or generation-skipping transfer (GST) tax consequences of the structure. Specifically, the CCM does not address whether transfers to or from the trust are “taxable gifts” as defined in §2511;
- The “asset protection” benefits, including whether state or federal courts will find that the terms of the trust provide protection from the claims of creditors including claims pertaining to federal tax debts;
- Whether any of the gross income of the trust constitutes an “extraordinary dividend” under §643(b);
- Whether, in any particular case, the existence of the trust might be challenged as a threshold matter under “sham trust” principles; and
- Whether the transaction in general is a “reportable transaction” provided in Treas. Reg. §1.6011-4 under any of the various categories therein including as a “confidential transaction” or “transaction with contractual protection.”
Structural Overview of the Proposed Trust
As far as the structure of the trust, while it takes on slightly different forms in different promotional materials, the general structure is as follows:
- A third party sets up an irrevocable trust on behalf of the taxpayer, with the taxpayer appointed as a “Compliance Overseer” and having certain powers including adding and/or removing Trustees as well as adding and/or removing beneficiaries.
- The taxpayer is not himself or herself a beneficiary of the trust, though in some of the materials, the taxpayer’s spouse and/or children/descendants are.
- The Trustee is given the sole discretion over distributions of both principal and income, though it is not clear whether the taxpayer, as Compliance Overseer, can veto this or alternatively direct it.
- The trust is set up as a self-styled “spendthrift trust”, which in short, means it purports to provide asset protection benefits.
- The trust is then funded by the taxpayer selling assets to the trust. The CCM notes that the materials do not discuss issues relating to the trust’s initial capital, creditworthiness, or ability to make payments on the promissory note, nor do they discuss the terms of the promissory note. Additionally, some materials claim the sale is not taxable, as the trust’s purchase price is the “book value” of the assets rather than their fair market value, such that the trust retains the taxpayer’s basis in the asset.
- Once sold, the materials presume that, in the case of business assets, the trust will lease the assets back to the taxpayer.
Once the trust is in place, the materials state none of the current income of the trust is currently taxable as long as the trustee allocates such income to corpus. The materials rely on §643(a)(3) which reads in part “Gains from the sale or exchange of capital assets shall be excluded 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.” What the materials and the advisors behind them fail to point out, and what the CCM does point out, is that §643(a) only governs the calculation of Distributable Net Income (“DNI”) which simply determines whether the trust itself, or a beneficiary who received a distribution, pays the tax, not the taxability of the income itself. While this is an oversimplification of the mechanics of DNI, the overriding result of DNI is that it determines who is liable for the tax for certain items of income.
Misinterpretation of §643
In its analysis, the CCM starts with the basics, noting that §61 says that gross income includes income from whatever source derived, and §63, which states taxable income is gross income minus allowable deductions. Under §641(a), the taxable income of a trust may be held in trust or distributed. §641(b) requires the taxable income of a trust to be computed in the same manner as in the case of an individual, subject to certain exceptions found in §§641-685, and further requires the fiduciary to compute and pay such tax. §643(a) defines DNI, which as noted above (although oversimplified), provides for whether the trust or a beneficiary who received a distribution is liable for the tax on trust income. The promotional materials at issue fail to address §641 and take §643(a) wholly out of context, as they fail to consider the fact that §643(a) has nothing to do with taxable income, but only defines DNI. As noted above, DNI has no bearing on whether tax is due, but simply who is liable for the tax, the trust itself, or the beneficiary.
Correct Taxation of the Proposed Trust
Under general tax principles as cited above, including under §641, the trust is liable for all of its taxable income that is not deducted as part of DNI. Under the promotional materials, §643(a)(3) allows capital gains to be allocated to principal, thus bypassing DNI, assuming the remaining requirements of §643(a)(3) are satisfied. The result of this is not avoidance of tax currently, as the promotional materials claim, but the requirement that such gains are not part of DNI and instead are taxable to the trust itself under §641.
Dangers of Misguided Trust Structures
This might seem like common sense that you cannot eliminate income tax through the use of a trust, but these materials come up again and again as promoters seek to enrich themselves at the cost of putting taxpayers in bogus and unsustainable structures and tax positions. It may not be too much longer before the structure discussed in the CCM ends up on the IRS Dirty Dozen List[3] and/or as a potentially listed transaction like the so called “Monetized Installment Sale”[4], another structure that is often promoted as a canned product.
Conclusion and Take-Away
While there are a plethora of valid planning strategies that can potentially minimize or defer tax liabilities, it is critical for taxpayers to exercise caution and perform thorough due diligence before committing to any pre-packaged structures, such as those detailed in promotional materials discussed in the CCM and those frequently associated with other canned structures such as the Monetized Installment Sale. Taxpayers are strongly encouraged to solicit expert tax advice regarding these transactions and structures. In many cases, exploring alternative strategies that are more reliable and less aggressive may prove to be a more prudent course of action, still availing themselves of certain tax benefits without such a high level of risk. .
[1] CCA 2023-006; https://www.irs.gov/pub/lanoa/am-2023-006-508v.pdf
[2] For a discussion of what a grantor trust is and powers that might cause a trust to be a grantor trust, please see the following: Allen, Charles J., My Favorite Presentation from Heckerling (discussion a presentation on grantor trusts by Samuel A. Donaldson), https://www.esapllc.com/heckerling-2020/
[3] https://esapllc.com/irs-dirty-dozen-2023/
[4] https://www.irs.gov/newsroom/treasury-and-irs-issue-proposed-regulations-identifying-certain-monetized-installment-sales-as-listed-transactions ; Note that the “Monetized Installment Sale” structure also finds itself on the IRS Dirty Dozen List cited above.
