Abusive Trust Schemes: Pure Trusts, Sham Trusts and the IRS Warnings
In Short
Abusive Trust Schemes are trust arrangements sold with claims that moving a business, home or investments into a trust will reduce or eliminate income or self-employment tax. The IRS says these claims are false, and promoters commonly target business owners and high earners through seminars and social media.
TL;DR
- The IRS says transferring assets to a trust gives no additional tax benefit, and income stays taxable to the person who earns it [1][2].
- Common forms include pure or constitutional trusts, equipment and family residence trusts, and layered offshore trusts [1][3].
- A 2023 Chief Counsel memorandum rejects promoter claims that a non-grantor trust can exclude its capital gains and dividends from tax under section 643 [4].
- If the person who sets up a trust keeps control, the grantor trust rules tax the income to that person [1][5].
- Civil fraud penalties reach 75% of the underpayment, and criminal charges are possible [2][6].
Quick Facts
| Legal Reference | IRC §§641–679 |
|---|---|
| Complexity | Medium |
| Audit Risk | Very High |
| Setup Cost | Often high promoter fees for trust documents |
| Time to Implement | Promoted as quick setup; IRS disputes can last years |
| Illustrative Example | Illustrative example, not a projection. A promoter sells a business owner a package of trusts for $40,000. The owner transfers the business to a trust while keeping full control, the trust leases equipment from a second trust at inflated rates, and the home is placed in a third trust that deducts utilities and repairs. The owner reports little income. Under the IRS's position, the income is still taxable to the owner, the personal expenses are not deductible, and the owner can face back taxes, interest and penalties. Actual outcomes depend on the facts. |
Key Numbers & Limits
| Item | Limit or Rule | Notes |
|---|---|---|
| Form 1041 Filing Threshold | $600 of trust income, or any non-resident alien beneficiary | Grantor trusts may follow other reporting [1]. |
| Civil Fraud Penalty | 75% of the underpayment attributable to fraud | IRC §6663 [6]. |
| Criminal Exposure | Fines up to $250,000 and/or up to five years in prison | As described by the IRS [2]. |
What Is Abusive Trust Schemes?
Abusive trust schemes are arrangements that use one or more trusts to hide who really owns and controls income or assets, with the claim that this reduces or eliminates income tax, self-employment tax or estate tax [1][2]. The IRS says that a taxpayer cannot transfer income into a trust to escape tax on it: income earned by one person cannot be assigned to another for federal income tax purposes [1].
The IRS describes two broad packages. A domestic package uses a series of U.S. trusts, such as a business trust — also marketed as a pure, constitutional or unincorporated business organization — that appears to own the business, an equipment or service trust that leases items back at inflated rates, and a family residence trust that deducts the costs of the owner's home [1]. A foreign package adds layers of offshore trusts and shell companies to hide income [1][3].
A newer variation is sold as a non-grantor, irrevocable, complex, discretionary, spendthrift trust, sometimes described as section 643 compliant. In memorandum AM 2023-006, the IRS Office of Chief Counsel explained that promoters read section 643 out of context: allocating capital gains or dividends to trust principal does not make them tax free, and a trust that makes no distributions reports that income on Form 1041 [4].
Trusts themselves are legitimate and widely used for estate planning, charitable giving and managing property for family members. The difference is control and substance. Under the grantor trust rules, if the person who creates a trust keeps certain powers or benefits, the trust's income is taxed to that person [1][5]. A real non-grantor trust requires giving up significant control over the income and assets [2].
How Does Abusive Trust Schemes Work?
- A promoter, often through seminars, websites or social media, sells trust documents and a plan for a fee [2][4].
- The buyer transfers a business, home, equipment or investments to one or more trusts while, in practice, keeping control of them [1][4].
- Income is split among the trusts, and personal costs are recast as trust expenses, depreciation or lease payments [2].
- The trusts and the owner report little or no taxable income, sometimes claiming capital gains are excluded under section 643 [4].
- If the IRS examines the arrangement, it can treat the trusts as shams or as grantor trusts, tax the income to the owner and disallow personal deductions [1][4].
The Good: What Are the Benefits of Abusive Trust Schemes?
The Bad: What Are the Drawbacks of Abusive Trust Schemes?
- The promised tax savings do not exist under the IRS's position, so promoter fees buy nothing [1][2].
- Trust tax brackets are compressed, so a non-grantor trust that keeps its income can pay more tax than an individual would.
- Multiple trusts add filing duties, bank accounts and records [1].
- Transfers to an irrevocable trust can have real legal effects, such as giving up ownership, even when the tax claims fail.
The Ugly: What Are the Serious Risks of Abusive Trust Schemes?
- The IRS can disregard sham trusts and tax all income to the person who controls it, with back taxes and interest [1][4].
- A civil fraud penalty of 75% of the underpayment attributable to fraud can apply [6].
- The IRS describes criminal penalties of fines up to $250,000 and/or up to five years in prison for those convicted [2].
- The IRS has featured abusive trust arrangements, often with layers of trusts and offshore shell companies, on its Dirty Dozen list [3].
Who Uses Abusive Trust Schemes?
Who It's Commonly Used By
What Are the Key Rules & Requirements for Abusive Trust Schemes?
- Income is taxable to the person who earns it and cannot be assigned to a trust to avoid tax [1].
- If the grantor keeps certain powers or benefits, the trust's income is taxed to the grantor [1][5].
- A trust with $600 of income, or a non-resident alien beneficiary, generally files Form 1041 [1].
- Allocating capital gains to trust principal does not exclude them from the trust's taxable income [4].
- Personal living expenses do not become deductible because a trust pays them [2].
- Fraud penalties are 75% of the underpayment attributable to fraud [6].
What Are Common Mistakes & Red Flags With Abusive Trust Schemes?
- Promises that a trust will eliminate income tax or self-employment tax [2].
- Keeping full control of a business or home after transferring it to a trust [1].
- Trusts that deduct the costs of the owner's personal residence [1][2].
- Claims that a trust is section 643 compliant or copyrighted [4].
- Layers of trusts, offshore companies or foreign bank accounts with no business reason [3].
- Promoters who sell standard trust packages with their own legal opinion letters [4].
Frequently Asked Questions
What Is an Abusive Trust?
It is an arrangement that uses one or more trusts to hide who owns and controls income or assets, with false claims that this reduces or eliminates tax. The IRS says income stays taxable to the person who earns it [1][2].
Do Pure Trusts or Constitutional Trusts Avoid Taxes?
No. The IRS lists business trusts, also marketed as pure or constitutional trusts, among abusive domestic trust schemes. A trust does not remove tax on income the owner earns or controls [1].
Can a Non-Grantor Trust Exclude Capital Gains Under Section 643?
No, according to Chief Counsel memorandum AM 2023-006. Section 643 defines distributable net income; it does not exclude capital gains from a trust's taxable income. A trust that does not distribute the income reports it on Form 1041 [4].
Sources
- Abusive Trust Tax Evasion Schemes — Questions and Answers — Internal Revenue Service
- Abusive Trust Tax Evasion Schemes — Talking Points — Internal Revenue Service
- Abusive Tax Shelters, Trusts, Conservation Easements Make IRS' 2019 Dirty Dozen List of Tax Scams to Avoid (IR-2019-47) — Internal Revenue Service
- Chief Counsel Memorandum AM 2023-006, Non-Grantor, Irrevocable, Complex, Discretionary, Spendthrift Trust — Internal Revenue Service, Office of Chief Counsel
- 26 U.S. Code §671 — Trust Income, Deductions, and Credits Attributable to Grantors and Others as Substantial Owners — Legal Information Institute, Cornell Law School
- 26 U.S. Code §6663 — Imposition of Fraud Penalty — Legal Information Institute, Cornell Law School
Primary sources only: the Internal Revenue Code, Treasury regulations and official agency guidance. Read how Zentavos researches these reports.