The Pure Equity Trust: a Tax Bomb for the Unwary

• Publication year: 1997
• Pages: 47
• Citation: Vol. 26 No. 4 Pg. 47

26 Colo.Law. 47 Colorado Lawyer 1997.

1997, April, Pg. 47. The Pure Equity Trust: A Tax Bomb for the Unwary

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47

Vol. 26, No. 4, Pg. 47

The Colorado Lawyer
April 1997
Vol. 26, No. 4 [Page 47]

Specialty Law Columns
Estate and Trust Forum
The "Pure Equity Trust": A Tax Bomb for the Unwary
by James F. Ingraham

Column Eds.: M. Kent Olsen, a sole practitioner in Denver - (303) 321-6872; Dennis Whitmer of Colorado State Bank, Denver - (303) 863-4457; Column Ed. for Elder Law: Linda Smoke, a sole practitioner in Denver - (303) 733-1520

This column is prepared by the CBA Trust and Estate Law Section. This month's article was written by James F Ingraham, Denver, a shareholder of Zisman and Ingraham, P.C (303) 320-0023

The mass selling of living trusts as commodities, sometimes by organizations that purport to protect the interests of senior citizens, has been of concern to estate practitioners for decades. Consumers looking for simplicity in their financial affairs may be easily swayed by a sales pitch for a one-size-fits-all trust package promising to cure all problems associated with the management and transfer of wealth at death.1

Living trusts have been marketed in standardized form packages, some of which are better and some much worse than others. Trusts that promise much and deliver little except legal headaches and tax problems are particularly abusive. This article discusses the most problematic of such trusts - the "pure equity trust,"2 which has been promoted heavily in Colorado and elsewhere. This type of trust has been marketed as a living trust for protecting assets, saving taxes, avoiding probate and operating a business; yet such trusts, as generally used, do none of these things.

Background

The pure equity trust is not new. It has existed for decades in one form or another. At various times and places, this type of trust has been marketed and sold under the names of "ABC Trust," "Constitutional Trust," "Contract Trust," "Family Estate Trust," "Sovereign Trust" and "Unincorporated Business Organization" ("UBO"). Modeled after the Massachusetts business trust,3 the pure equity trust is simply a repackaged version of an old idea, which surfaces every ten or fifteen years under a new name.

The pure equity trust is identified primarily by the absence of named beneficiaries. Instead, the trust instrument creates "units of beneficial interest," which provide the holder or holders thereof with certain distribution rights in the trust benefits.

Promotional Efforts

Pure equity trusts are sold door to door and through seminars conducted in suburban and rural hotels by salespersons often linked to tax protestor or patriot organizations. Farmers, doctors, veterinarians, and other owners of property are usually the primary targets of trust promoters, who point out that the rich have used trusts for many years for tax advantages, and that there is no reason why others should not take advantage of the opportunity. Promoters stress that individuals have a constitutional right to use such trusts, and that their use may even be considered an act of patriotism.4

Promotional materials for pure equity trusts fraudulently assert that transferring assets to such a trust prior to death means no probate administration, no court costs, no attorney fees, no executor fees, no estate or inheritance taxes, no administration fees, no appraisal fees, no waiting periods, no forced sale of assets, and no public disclosure. A legal opinion declaring the validity of such trusts is usually presented, citing precedents having little connection to the assertions made. Promoters contend that they have access to research that has taken decades to compile and that most estate planning attorneys, being unfamiliar with the legal precedents involved, would probably express a negative view of such trusts if consulted for a second opinion.5

Characteristics

The pure equity trust is usually created for a stated term of from twenty to twenty-five years and during that time purports to be irrevocable. In most cases, the user fills four key roles: grantor, trust employee, trustee, and beneficiary. The grantor generally assigns to the trust the exclusive use of his or her "lifetime services," which are then leased out by the trust, for which the trust is compensated by the grantor's employer. Other property is transferred as well, including the grantor's personal residence, income-producing real estate, securities, business assets, and sometimes even the business itself as a sole proprietorship.

In exchange for these transfers, the grantor receives certificates representing all of the units of beneficial interest in the trust issued in accordance with the terms of the governing instrument. Sometimes, these certificates entitle the holder to a pro rata share of distributed income. In other cases, distribution of income and principal is left to the discretion of the trustees. In addition, the grantor generally serves as trust manager, entitling him or her to a salary and the use of certain trust property, such as the family residence.6

A Tax Time Bomb

A myriad of tax benefits are claimed by promoters of these trusts, including the avoidance of income tax and the availability of deductions to the trust otherwise unavailable to individual taxpayers. Promoters claim that no federal gift tax is incurred on the transfer of property to the trust and, on the death of the holder of such interests, none of the beneficial units are subject to federal or state death taxes.7 Except for the assertion that no gift tax is due, these claimed benefits are false. Thus, trust consumers are victimized, the tax collection process is undermined, and the cost of tax compliance is increased.8

In 1975, the Internal Revenue Service ("IRS") issued four companion revenue rulings intended to address the issues presented by the use of pure equity trusts for tax avoidance.9 These are discussed below, each under its appropriate subject heading.

Assignment of Personal Service Income

The first of the 1975 revenue rulings was Revenue Ruling 75-257,10 involving a taxpayer/grantor who assigned all of his real and personal property and the exclusive use of his "lifetime services" to a "pure equity/constitutional/family estate trust," of which the taxpayer, his wife, and a third party were designated as trustees. The ruling held that income from services performed by the taxpayer for his employer, X corporation, was taxable to the taxpayer individually and not to his family trust.

This ruling was based on the well-known "fruit and tree doctrine" expressed by the U.S. Supreme Court in Lucas v. Earl;11 namely, that income (the fruit) will be taxed to the individual (the tree) who earned it. This holding represents the first principal of income taxation.12 Income is attributed to the person...