Chapter 30 - § 30.2 • PLANS GONE AWRY: ILL-FATED BUSINESS SUCCESSION SCHEMES

• Jurisdiction: Colorado

§ 30.2 • PLANS GONE AWRY: ILL-FATED BUSINESS SUCCESSION SCHEMES

§ 30.2.1—The "Common Business Organization Trust"

Western and Midwestern states seem particularly susceptible to what has variously been known as the "family," "constitutional," or "pure" trust, and most recently as the "common business organization trust." George v. Commissioner⁸ illustrates the pitfalls of these schemes. George practiced osteopathic and homeopathic medicine from his home in Scottsdale, as well as at other locations. In 1993, on the advice of a Mr. Chisum, who was neither a lawyer nor an accountant, but rather a self-styled "consultant on establishing and operating trusts," George transferred his home to The Stepping Stone Land Trust in return for 100 "capital units" in the trust. George continued to live in the house and make mortgage payments; he did not make rent payments to the trust. George then formed the Arivada Medical Enterprises Trust, with his friend Chisum as trustee. In 1994, George assigned his 100 capital units in the first trust to the second trust. He continued to operate his medical practice in the same manner as before, but asked clinics and other third parties for whom he provided services to make payments to Arivada rather than to him directly. Although Chisum was the trustee, George had a trust checkbook and a signature stamp for Chisum. He paid personal and household expenses from the trust, but never paid rent to the trust for his use of the house. There were no employment agreements or lease agreements between the doctor and the trusts. Arivada filed fiduciary income tax returns as a simple trust and claimed that it had distributed its income to two entities, neither of which had a tax identification number. George reported a small amount of income from the trust. The U.S. Tax Court found that the trust arrangement was a sham, as George had retained all meaningful control over the trust. The result was deficiencies in George's federal income taxes of $24,295 for 1993 and $27,893 for 1994, and accuracy-related penalties under I.R.C. § 6662(a) for negligence of $4,859 for 1993 and $5,578 for 1994. Even had George papered his trail better, it seems likely that the court would have reached a similar conclusion.

Two similar business trust cases, the Zachman cases, held that the taxpayers, and not their trusts, were taxable on trust income because the trusts, which were created to hold their farm assets and real and personal property, lacked substance. One particularly interesting aspect of the Zachman cases is that "as part of the judgment against them, the promoters were ordered to supply the IRS with the names and addresses of all purchasers of the 186 business trusts on file with the state's Secretary of State which list them or their corporation as corporate trustees." So ultimately, the very people who sold these schemes became instrumental in their downfall.⁹ Unfortunately, legitimate tax advisors are unlikely to come across taxpayers who have bought into these shams until long after the fact; the Zachmans, for example, obtained their tax advice in their doctor's waiting room!

These cases remind practitioners that the IRS continues its pursuit of abusive trusts.¹⁰ Perhaps more important than getting clients to competent tax advisors is learning to recognize the differences between the many legitimate uses of trusts and those that are clearly abusive. The key is economic substance. In other words, if one wants a trust arrangement to be respected, it has to act like a trust. Among the questions to ask are:

• Did the grantor-taxpayer's relationship to the property change after the purported transfer into the trust?
• Did the grantor's position vis-à-vis the property differ materially before and after the trust's formation?
• Does the trust have a truly independent trustee?
• Does an economic interest pass to other beneficiaries of the trust?
• Did the taxpayer feel bound by any restrictions imposed by the trust or by the law of trusts?

Elaborate schemes involving offshore trusts are often touted as providing tax savings, asset protection, and effective business succession. These approaches should be subjected to the same analysis to determine whether they are substantial or shams. Similarly, the "sham trust" line of cases provides practitioners with guidance in the business arena. Business organizational and operational documents do little good unless they are observed in practice; then and only then will they have economic substance, and then and only then will they have any effect on valuation of the business interests.

The IRS is waging a major campaign against trusts it has labeled as abusive. It has collaborated with the U.S. Department of Justice to bring criminal charges against some purveyors of these schemes. Business owners should beware of fast talkers who sell expensive systems that sound too good to be true: they almost certainly are.

§ 30.2.2—Waiting Too Long to Make a Gift

A classic...