Trusts are an important tool for managing and distributing assets. They are frequently used for estate planning and charitable purposes. But when used to improperly protect assets and avoid taxation, they can expose the person using the trust to criminal penalties. All income a trust receives is taxable to the trust or its grantor. Meanwhile, trust income is not taxable to the beneficiary. This can be manipulated to conceal income and evade taxes.
If the IRS believes a trust has been used to improperly avoid taxation, they beneficiary and grantor could be subject to prosecution. Trusts are not a valid means of avoiding taxation. A trust should never be created solely to reduce tax liability. Furthermore, just like a business, a trust must properly account for its expenses and deductions.
Spendthrift trusts can be created to protect assets from creditors, but when created to avoid taxation, they are generally illegal. If an individual creates a trust for his own benefit while retaining control and attempting to claim spendthrift protection, the IRS is likely to view this as abusive. Not only will the trust be subject to taxation, but depending on the scheme, the creator of the trust could be subjecting himself to criminal prosecution.
One example of trust abuse that the IRS prosecutes is charitable trust abuse. A creator of a charitable trust sometimes seeks to evade income tax by claiming a charitable purpose while distributing income to either the grantor or his family members. The trust then claims that these payments are deductible as charitable expenses. Charitable deductions are not proper when the owner of the trust receives the benefit from the trust and should not be made without receiving an exemption letter from the IRS.
But there is nothing illegal in using a trust properly to gain tax advantages. And while trusts can take many forms, the basic test to determine if a trust is legal or illegal is simple. If the trust conceals income rather than managing and distributing assets, it is most likely an illegitimate trust that will invite IRS scrutiny. A trust that attempts to make the taxpayer’s ordinary living expenses tax deductible is not legitimate. Nor is a trust that attempts to disguise the source and ownership of income. The substance of a trust, not the form determines whether or not the income is taxable. Taxpayer’s who attempt to disguise the substance of income in the form of a trust are more likely to be prosecuted than actually save on their tax bill.