The Non-Grantor, Irrevocable, Complex, Discretionary, Spendthrift Trust

Section 643(b) Trust Promoters

Let’s start out by explaining that the Internal Revenue Service hates abusive tax schemes. For centuries, promoters, attorneys, and other tax professionals across the globe have been developing questionable tax promotions designed to entice taxpayers into believing that they can avoid taxes by operating within the nuances of the different tax codes and/or tax regulations. One recent example is the Malta pension plan being treated as a Roth IRA, in which taxpayers would invest millions of dollars into these non-employment-based retirement plans, with the idea that they could generate tax-free distributions. This resulted in the Internal Revenue Service and Department of Justice launching a full-court press on both the civil and criminal front. Recently, the Internal Revenue Service issued a memorandum about a new trust promotion that has been circulating through social media — which is referred to as a Non-Grantor Irrevocable Complex Discretionary Spendthrift Trust. Essentially, the promotional material presents the trust as a safe and legal method for taxpayers to achieve tax-free distributions from the trust. This is done by manipulating the definition of DNI as it is applied to the term ‘income’ — but the IRS says no-dice.

Let’s briefly review what the memorandum provides, but first — what is a Non-Grantor Trust?

Taxation of a Non-Grantor Trust (NGT)

When it comes to non-grantor trusts as opposed to grantor trusts, the baseline concept is that the taxpayer who contributed the property to the NGT is no longer the owner of the asset. As a result, the person who contributed the assets is typically not taxed on the income. Rather, the trust and beneficiaries of the trust who receive distributions are taxed on the income. In addition, if the trust is irrevocable, then it is very difficult to remove the contributed property from the trust, absent rules involving decanting the trust and other trust exchanges.

As you may suspect, the reason why some taxpayers are weary about forming an irrevocable, non-grantor trust is that the trust can no longer be revoked and the taxpayer does not have complete power over the assets of the trust. So in a perfect world, a trust would be created so that the taxpayer is not taxed on the income but still has control over the trust and gains protection from creditors — enter the Non-grantor, irrevocable, complex, discretionary, spendthrift trust”

We will identify portions of the IRS memorandum and summarize the content:

• • • “Description of the Structure”

      • • The structure claims to provide significant tax and asset protection advantages to individual taxpayers (described herein as the “Taxpayer”). The structure is being promoted by a combination of attorneys, accountants, enrolled agents, and unlicensed tax advisors.

        • The promotional materials consist primarily of a series of presentations (some of which can be found on various social media platforms), informational websites, short documents, and short legal opinions.

        • The materials state that the trust being offered complies with Scott on Trusts, the Uniform Trust Code, the Restatement of Trusts (Third), and the Code. Some materials specifically note that the trust is “section 643 compliant”. The materials describe the trust by its purported characteristics, typically a combination of the terms “non-grantor,” “irrevocable,” “discretionary,” “complex” (or “complex with simple provision”), “section 643,” and “spendthrift.”1 In many variations, promotional materials refer to the trust structure as a “Non-Grantor, Irrevocable, Complex, Discretionary, Spendthrift Trust”. While there is some inconsistency among the materials, the basic form and mechanics of the structure are described here.”

What is IRC Section 643?

Title 26 refers to the definition of income for tax purposes for certain trusts and estates. Subsection A refers to Distributable Net Income which is a complicated concept, but in a nutshell, it is what is considered to be income for trust distribution deduction purposes. In other words, when a trust files its tax return it is able to deduct its DNI from its overall income. It gets infinitely more complicated from here, depending on whether it is a U.S. trust or foreign trust and whether it involves the throwback rule and DNI versus UNI. But for purposes of this discussion, the idea is certain types of income are deductible from the trust if they qualify as DNI.

• • • ‘”Formation and Oversight”

      • • • “A third-party settlor, acting on behalf of Taxpayer, creates and nominally funds a trust with legal documents that are provided by the promoter.

          • Taxpayer is appointed the “Compliance Overseer” with power to add and remove trustees and change beneficiaries of the trust.

          • The promotional materials are inconsistent as to whether Taxpayer, a third-party, or both serve as trustee.

          • In the case of a third-party serving as trustee, it is unclear whether the third-party would be an independent trustee.

          • Taxpayer is not a named beneficiary of the trust.

            • In some variations, Taxpayer’s spouse and/or children are specifically named as beneficiaries but are subject to change by the Taxpayer.

          • The trust instrument gives the trustee sole discretion to make distributions of income or principal to beneficiaries (“discretionary distributions”).

            • It is unclear whether the Taxpayer, serving in the role of Compliance Overseer, is given a power to direct the trustee to make or withhold discretionary distributions to beneficiaries.

          • The trust is a self-styled “spendthrift” trust or “spendthrift trust organization.” There are no provisions that allow any party to revoke the trust by distributing trust assets back to the donor in termination of the trust. An accompanying letter described as a legal opinion (“legal opinion letter”) states that the trust is in “in compliance with the IRC” and thereby must obtain an Employer Identification Number (EIN) and file Form 1041, “U.S. Income Tax Return for Estates and Trusts” (in addition to any other filing requirements) annually as a complex trust.

          • A subsequently dated legal opinion letter from the same source notes that the trust is “not subject to turn over orders by any court. This limits the liability of Beneficiaries and Trustees of the Trust. It also makes the corpus of the Trust unreachable by creditors.”

Understanding the Formation of an NGICDST

The key to understanding the concept of this type of Trust is to understand how it is formed. Essentially what happens is the taxpayer meets with a promoter, and the promoter refers them to an accountant or a law firm — or something in between. The trust is formed by a third party with nominal funds.  The taxpayer who pays to form the trust does not become the trust owner or beneficiary of the trust, but is considered a ‘compliance overseer’ — a term which is designed to mean a million different things to a million different people, depending on what context it is being used in.

There is also a trustee who is appointed, but it is unclear whether the trustee is appointed by the taxpayer — and what type of control the taxpayer maintains over the trust.  In addition, the taxpayer who wants to create the trust is also not a beneficiary of the trust, but in some scenarios, family members may be appointed as beneficiaries.

So in essence what is happening, is that the taxpayer contributed property to a non-grantor irrevocable trust but is using a back door method to maintain some control over the trust acting as the compliance overseer and avoiding taxes.

What does a ‘Spendthrift Provision’ in a Trust Mean?

The main two concepts behind a trust being ‘Spendthrift’ are that beneficiaries do not have full access to the corpus (because the taxpayer who owns the assets is concerned about their ability to not deplete all of the assets as well) as well as the trust being able to defend against creditors. This is common in situations in which a wealthy person puts assets into a trust for younger beneficiaries, but limits their access to the main corpus.

• • • “Funding”

      • • “The trust is primarily funded by Taxpayer selling assets to the trust in exchange for a promissory note (styled as a “demand note” in certain materials)

        • The promotional materials do not discuss issues relating to the trust’s initial capital, creditworthiness, or ability to make payments on the promissory note. Nor do the materials outline requirements related to the terms of the note, such as having a defined period for repayment. Certain materials do discuss the requirement for debt instruments of the trust to charge adequate interest (not specifically in relation to the demand note). Certain materials claim that the sale of assets to the trust is a non-taxable event, noting that the trust’s purchase price is the “book value” of the assets rather than their fair market value, such that the trust retains Taxpayer’s basis in the assets.

        • Further, there is a presumption that any of the Taxpayer’s business assets (including real estate, equipment, or intangible property) sold to the trust will be leased back to Taxpayer or an 2 Examples of assets appropriate for funding the trust by ‘sale’ include equipment, real estate, computers, websites, handbooks, copyrights, trademarks, and proprietary operating systems. POSTU-105921-22 4 entity owned or controlled by Taxpayer. A few variations recommend that (1) Taxpayer transfer up to a 90% interest in a limited liability company (“LLC”) (or another type of business entity) owned by Taxpayer to the trust, (2) the Taxpayer will cause the LLC to sell certain assets (including intellectual property (IP)) to the trust, and (3) Taxpayer will cause the LLC to lease back those assets and IP from the trust for a payment that is approximately equal to 70% of the monthly income of the LLC.”

How is the NGICDST Trust Funded?

How the trust is funded and the income generated from the trust for tax purposes is what catches the eye of the IRS. In this type of scenario, the taxpayer sells assets to the trust in exchange for a promissory note. To put it into context, imagine that the taxpayer has a $5 million asset. The taxpayer then sells the asset to the trust in exchange for a demand/promissory note.  One of the big concerns here is that the IRS believes that these assets are not being sold for fair market value, but rather a lower value — and book value is typically much lower than fair market value. 

The NGICDST also contains a leaseback provision and may include the formation of an LLC or other business entity that is transferred to the trust.

In essence, the trust is designed to muddy up the waters sufficient to make it look like all assets are being exchanged for equal value one way or another, and while the taxpayer does not own the assets, he will have use of those assets by way of lease back provisions and other related mechanisms — while serving as the ‘Compliance Overseer’

• • • “Income earned by the trust”

      • • The promotional materials claim that almost none of the income generated by the trust is subject to current federal income tax if the trustee allocates such income to corpus and refrains from making distributions to beneficiaries. The legal basis for these assertions regarding federal income taxation rely on § 643 of the Code. To support the assertion that all income from the sale or exchange of capital assets (“capital gains”) is excluded from federal income tax, the materials quote § 643(a)(3), without context (emphasis in original): “IRC Section 643(a)(3) Capital Gains and Losses – gains from the sale or exchange of capital assets shall be EXCLUDED to the extent that such gains are allocated to corpus and not (A) paid, credited, or required to be distributed to any beneficiary during the taxable year . . .”

        • Next, the materials claim that the trustee may characterize any remaining trust income as an “extraordinary dividend”, which the materials claim is not subject to current taxation so long as the trustee allocates such income to corpus. The materials find support for this claim in § 643(a)(4): “if a fiduciary has the sole and absolute authority to designate something as extraordinary dividends or taxable stock dividends, and that designation is paid to the corpus of the trust and not subject to distribution, then it is not income to the trust according to Rule 643 [sic].”

        • The accompanying legal opinion letters do not expound on this assertion, claiming only that the trust structure “provides the exclusion of extraordinary dividends and taxable stock dividends from items of gross income because the structure allows the Trustee to allocate these dividends to the corpus of the Trust.” Another memorandum styled as a legal opinion letter simply states, “[c]apital gains, extraordinary dividends and taxable

        • Several promoters rely on a private letter ruling issued by this office as support for their claim that extraordinary dividends described in § 643(a)(4) are not subject to current taxation. Some materials refer to this ruling as “Private Letter Ruling # PLR-133314-14 issued May 8, 2015” or “IRS Private Letter Ruling 133314-14” See PLR 201519012. This private letter ruling held that a certain distribution that a trust received from an LLC pursuant to a settlement agreement is considered an extraordinary dividend “excluded from the definition of “income” within the meaning of § 643(b) (emphasis added).

How is the NGICDST Income Taxed?

With this type of trust, the ultimate goal is to protect the assets while delivering an income stream to the original taxpayer without any tax liability. In order to do so, the promotional materials rely on section 643. The idea is that the promoters of this trust take the position that certain Capital Gains and Dividends are excluded from federal income tax in accordance with 643(a)(3) — but it is not in the proper context.

As mentioned earlier in the article, it is important to note that DNI refers to the deductions the trust can take for certain types of income generated from the trust with respect to DNI and not income in general.  They also take the position that certain extraordinary dividends and a Private Letter Ruling exempt this type of income from taxation — which the IRS disputes and claims this type of reading of the PLR was taken completely out of context.

As provided by the IRS:

• • • Contrary to the claims of the promotors, the trust will recognize income on its capital gains and dividends, except to the extent those amounts are distributed or deemed to be distributed to its beneficiaries. The promotional materials support their claims about the tax benefits of their structure by reading subsections of § 643 out of context. The materials do not address § 641 which provides the basic rule that the trust’s taxable income is computed as it is for individuals, with certain modifications. Instead, the materials look to § 643(a) for guidance as to the definition of “taxable income”. In so doing, the materials fail to consider the beginning of that section, which expressly states that the section defines “distributable net income” rather than “taxable income.”

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