Trusts can be a valuable financial planning tool when they are created through the correct legal channels. Sham trusts, in comparison, are invalid legal trusts that are created for an unlawful purpose.

The IRS defines a sham trust as an abusive trust without a legitimate purpose or economic substance. For tax purposes, a sham trust is disregarded as all income and expenses are assigned to the activity's true owner.

To determine if a trust is a sham, courts will generally look at a trust's contents rather than its structure. Sham trusts generally have a lack of independence, and trustees don't have access to assets.

Four Factor Test

Tax courts have adopted a four-factor test to determine if a trust is a sham.

• Does the taxpayer's relationship to the property transferred into a trust materially change following the trust's creation?
• Does the trust have an independent trustee?
• Does any economic interest pass on to beneficiaries of the trust?

and

• Is the taxpayer bound by restrictions imposed by the trust agreement or the law of trusts?

Based on these factors, one indicator of a sham trust is when a grantor, not a trustee, has complete control over the assets. Another indicator is the absence of legitimate beneficiaries.

Tax Evasion

The IRS considers sham trusts to be a tax evasion scheme. Regarding legitimate trusts, the IRS has commented that they don't transform taxpayer's expenses into deductions. They also don't attempt to avoid tax liability by overlooking the actual owner of income and assets or the true nature of transactions.

Legitimate trusts don't transform a taxpayer's personal, living, or educational expenses into deductible items. They don't seek to avoid tax liability by ignoring either the true ownership of income and assets or the true substance of transactions.

A sham trust is a type of tax fraud that can result in penalties, fines, and imprisonment. Individuals are often generally expected to pay any unpaid taxes, which can involve additional fines and penalties as well as interest.

If you have questions about creating trusts and their tax benefits, call Senior Partner, Tax Controversy Attorney, and former IRS attorney Brandon A. Keim at (602) 200-7399 or contact him online to discuss your options.