Tax Courts Rules that Trust is a Sham

A recent Tax Court case, Full-Circle Staffing, LLC, et al. v. Commissioner of Internal Revenue, in which the court found the taxpayers’ trust to a be a sham, is a severe reminder that common law economic substance doctrines are even more vital in tax income cases due to the changes to federal gift and estate tax, showcasing the importance on coordinating estate and trust planning with income tax objectives.

The taxpayers in question reorganized their business, in which included an irrevocable trust nicknamed Watchman. The taxpayers were beneficiaries, the lawyer-draftsperson settlor, and a third party corporate service provider trustee. The trustee of Watchman was expressly prohibited from participating in the management and operation of Limited, a limited partnership that was funded by all the assets of the taxpayers previous S corporation. Because of this type of structure the majority of income from Limited went to Watchman, taking substantial distribution deductions, despite not actually distributing all of its income to Lighthouse (the taxpayers’ nonexempt charitable trust).

To determine whether Watchman lacked economic substance, the Tax Court applied a four-factor test: (1) whether the taxpayer’s relationship to the property transferred to the trust materially changed after the trust’s creation; (2) whether the trust had an independent trustee; (3) whether an economic interest passed to the trust beneficiaries; and (4) whether the taxpayer felt bound by the restrictions imposed by the trust agreement or the law of trusts.

See Eric Fischer & Samantha S. Smith, Tax Courts Rules that Trust is a Sham, Wealth Management, May 30, 2018.

Special thanks to Jim Hillhouse (Professional Legal Marketing (PLM, Inc.) for bringing this article to my attention.