Irrevocable Trust Treated as Sham

Take-Away: If an irrevocable trust is not operated as a separate legal entity, and the settlor retains extraordinary control over the trust and the income the trust generates, the trust may be ignored for income tax reporting purposes with the result that the trust’s income is attributable to the settlor of the trust.

Case: Full-Circle Staffing, LLC v Commissioner, Tax Court Memo, 2018-66 (May 17, 2018)

Facts: Spouses Richard and Mitzi ran a successful freight distribution company. On the advice of their CPA (who later lost his license for failing to file income tax returns, as a hint as to how this all turned out), they formed three separate legal entities. (1) Watchman was an irrevocable trust, of which Richard and Mitzi were 50%-50% trust beneficiaries. A separate legal entity created by their CPA was the designated trustee of Watchman trust. Richard and Mitzi’s attorney was named as the settlor of Watchman trust.(2) Lighthouse was a nonexempt charitable trust, for which Richard and Mitzi were named as both settlors and co-trustees. Lighthouse was ostensibly created to permit Richard and Mitzi to make charitable gifts anonymously. (3) Limited was a limited partnership. Limited was formed to operate Richard and Mitzi’s freight distribution business to which they transferred their business assets.

• Watchman trust held a 94% limited partnership interest in Limited transferred by Richard and Mitzi.
• Richard and Mitzi continued to own the remaining 5% limited partnership interests in Limited, as well as the 1% general partnership interest in
• Richard and Mitzi  transferred their beneficial interests in Watchman trust to Lighthouse trust.
• As a general partner of Limited, Richard controlled how income was distributed to the partners of Some of Limited’s income was diverted to other business entities that Richard and Mitzi owned. Proportionate distributions of Limited’s income were not made to Watchman trust, contrary to what the limited partnership agreement required.
• Watchman trust had no business activity. It provided no services to Watchman trust did not even have a checking account. If distributions were made from Limited to its  partners, the checks were issued to Watchman’s trustee [the family CPA] who in turn endorsed the checks over the trustees of Lighthouse [Surprise! Who were Richard and Mitzi.]
• If you followed all of this, the operating freight business was owned by a limited partnership, Richard and Mitzi owned 5% of the limited partnership interests and they were the 1% general partner who controlled the freight business now held in a limited partnership and thus they controlled the distributions from the limited partnership. Initially Watchman trust owned 94% of Limited’s limited partnership interest, but that beneficial interest of Watchman trust was then transferred to Lighthouse trust, a  non-exempt charitable trust of which Richard and Mitzi were sole co-trustees.
• ‘Following the money’, 100% of Limited’s distributions either directly went to Richard and Mitzi [ the 1% general partner or 5% limited partners], or indirectly to Richard and Mitzi, as co-trustees of Lighthouse [94% of the limited partners distribution.]

Tax Court: The Tax Court found that Watchman trust was a sham. Watchman trust lacked economic substance. To support its finding that there was no economic substance to the existence of Watchman trust the Tax Court cited the following for when a separate trust will be disregarded for tax purposes:

• The taxpayers’ [Richard and Mitzi] relationship to the Watchman trust’s assets did not materially change after Watchman trust’s creation- Richard and Mitzi still controlled the operating business held by Limited, and directly or indirectly they still received all of the freight business’s profits;
• The Watchman trust did not have an independent trustee; the CPA-trustee did not prevent Richard from acting against the interests of the beneficiary of the Watchman trust, the Lighthouse trust, nor did the CPA-trustee take part in the decision-making for Limited’s business, albeit as a limited partner; in short, the trustee did not act like an independent trustee to protect the interests of the trust beneficiary;
• No economic interest actually passed to any other trust beneficiaries, i.e. Richard and Mitzi were the initial beneficiaries of Watchman trust, and they transferred their beneficial interests, in a way, to themselves as the sole co-trustees of the Lighthouse trust; and
• Neither Richard nor the trustee acted (nor apparently felt) bound by the restrictions of the Watchman trust instrument or the laws of trusts in general.

Conclusion: The reasons provided by the Tax Court are important to keep in mind when an irrevocable trust is created that is intended to be respected for income tax reporting purposes. The factors cited by the Tax Court may also provide a clue as to how the IRS plans to implement the new proposed IRC 643(f) Regulations on disregarding multiple non-grantor trusts.