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Abusive Trusts
 MISC-DOC, 2000ARD 197-2
IRS Criminal Investigation Division Summary of Abusive Trust Schemes
April 2000
Internal Revenue Service
Criminal Investigation Division
Summary of Abusive Trust Schemes
Introduction
In the last few years the Internal
Revenue Service Criminal Investigation (CI) has detected a proliferation of
abusive trust tax evasion schemes. Currently, there are two prevalent fraudulent
schemes being promoted: the "domestic scheme" and the "foreign
scheme." The domestic scheme involves a series of trusts that are formed in
the U.S., while the foreign trust scheme is formed offshore and outside the
jurisdiction of the U.S. The trusts involved in the schemes, either foreign or
domestic, are vertically layered with each trust distributing income to the next
layer. The result of this layered distribution of income is to fraudulently
reduce taxable income to nominal amounts. Although these schemes give the
appearance of the separation of responsibility and control from the benefits of
ownership, these schemes are in fact controlled and directed by the taxpayer.
These schemes are often promoted by a
network of promoters and sub-promoters that may charge $5,000 to $70,000 for
their packages. This fee enables taxpayers to have trust documents prepared, to
utilize foreign and domestic trustees as offered by promoters, and to use
foreign bank accounts and corporations. In some instances, tax return preparer
services are also made available.
Basic Trust Taxation
To understand fully the trust
schemes offered today, it is important to focus on some basic trust taxation
rules.
A trust is a form of ownership, which
is controlled and managed by a designated independent trustee, that completely
separates responsibility and control of assets from the benefits of ownership.
The IRS recognizes numerous types of legal trust arrangements, and they are
commonly used for estate planning, charitable purposes, and holding assets for
beneficiaries. The independent trustee manages the trust, holds legal title to
trust assets, and exercises independent control.
All income a trust receives, whether
from foreign or domestic sources, is taxable to either the trust, the
beneficiary, or the taxpayer unless specifically exempted by the Internal
Revenue Code (IRC).
A legitimate trust is allowed to
deduct distributions to beneficiaries from its taxable income, with a few
modifications. Therefore, trusts can eliminate income by making distributions to
other trusts or other entities as long as they are named as beneficiaries. This
distribution of income is key to understanding the fraudulent nature of the
abusive schemes. In fraudulent schemes, bogus expenses are charged against trust
income at each trust layer. After the deduction of these expenses, the remaining
income is distributed to another trust, and the process is repeated. The result
of the distributions and fraudulent deductions is to reduce the amount of income
ultimately reported to the IRS.
A domestic trust must file a Form
1041, U.S. Income Tax Return for Estates and Trusts, for each taxable
year. If the trust is classified as a Domestic Grantor Trust, it is not
generally required to file a Form 1041, provided that all items of income are
reported by the individual taxpayer on his own Form 1040, U.S. Individual
Income Tax Return. Thus, the individual pays the total tax liability upon
the filing of his return for that taxable year. All income received by a trust
whether from foreign or domestic sources is taxable to the trust, beneficiary,
or taxpayer unless specifically exempted by the Internal Revenue Code.
Foreign trusts are subject to special
filing requirements. If a trust has income that is effectively connected with a
U.S. trade or business, it must file Form 1040NR, U.S. Nonresident Alien
Income Tax Return. Form 3520, Annual Return to Report Transactions With
Foreign Trusts and Receipt of Foreign Gifts, must be filed on the creation
of or transfer of property to certain foreign trusts. Form 3520-A, Annual
Information Return of Foreign Trusts With U.S. Owner, must also be filed
annually. Foreign trusts may be required to file other forms as well. Foreign
trusts to which a U.S. taxpayer has transferred property are treated as grantor
trusts as long as the trust has at least one U.S. beneficiary. The income the
trust earns is taxable to the transferor under the grantor trust rules. Grantor
trusts are not recognized as separate taxable entities, because under the terms
of the trust, the grantor retains one or more powers and remains the owner of
the trust income. In such a case, the trust income is taxed to the grantor. 1
In addition to filing trust returns
as just described, a taxpayer may be required to file U.S. Treasury Form TD F
90-22.1, Foreign Bank and Financial Accounts Report if the taxpayer has
an interest of over $10,000 in foreign bank accounts, securities, or other
financial account. Also, a taxpayer may be required to acknowledge an interest
in a foreign bank account, security account or foreign trust on Schedule B, Interest
and Dividend Income which is attached to Form 1040.
Abusive Domestic Trust Schemes
As stated above, the domestic trust
schemes are usually offered in a series of trusts that are layered upon one
another. These trusts can include the following:
l Asset
Management Company - In many promotions, taxpayers are advised to create
Asset Management Companies (AMC's). The AMC, which lists the taxpayer as the
director, is formed as a domestic trust. An individual on the promoter's staff
is usually the trustee of the AMC, but this individual is quickly replaced by
the taxpayer. The purpose of the AMC is to give the appearance that the
taxpayer is not managing his or her business and to start the layering
process.
l Business
Trust - The next step is to form a business trust, also a domestic trust.
In effect, the client elects to change the structure of their business from
either a sole proprietorship or corporation to a trust. The AMC is the trustee
of the business trust. False administrative expenses may be deducted from the
trust as a means to reduce taxable income. The scheme gives the appearance
that the taxpayer has given up control of their business to a trust; however,
in reality the taxpayer is still running the day-to-day activities of their
business and is controlling its income stream.
l Equipment
or Service Trust - An equipment or service trust is formed to hold
equipment that is rented or leased to the business trust, often at inflated
rates. The business trust reduces its income by claiming deductions for
payments to the equipment trust.
l Family
Residence Trust - In some instances, taxpayers are being advised to
distribute remaining income from the business trust to a family residence
trust. Family residences, including furnishings are transferred to this trust.
These trusts sometimes rent the family residence back to the owner. These
trusts may attempt to deduct non-allowable depreciation and the expenses of
maintaining and operating the residence such as gardening, pool service, and
utilities.
l Charitable
Trust - In many promotions, the last layer of trusts is the charitable
trust. These trusts or "charitable organizations" pay for personal,
educational, or recreational expenses on behalf of the taxpayer or family
members. The payments are then falsely claimed as "charitable"
deductions on the trust tax returns. After the personal and non-allowable
expenses are deducted from the charitable trust, any remaining balance of
income, usually nominal amounts, is distributed to the taxpayer.
Abusive Foreign Trust Schemes
Similar to the domestic arrangements,
foreign packages usually start off with an AMC, a business trust, and distribute
income to several trust layers. However, these foreign promotions also attempt
to take funds offshore and outside U.S. jurisdiction. These schemes involve
offshore bank accounts, trusts, and International Business Corporations (IBC's) 2
created in "tax haven" countries.
A typical offshore trust scheme may
have the following steps:
l AMC
- As with the domestic arrangement, the first step in these schemes is for the
taxpayer to form an AMC.
l Business
Trust - The next step is to form the business trust, again very similar to
the domestic scheme.
l Foreign
Trust One - Next, a foreign trust is formed in a tax haven country, and
the income from the business trust is distributed to this trust. For our
purposes, this foreign trust will be referred to as "foreign trust
one". In many cases, the AMC will be the trustee of foreign trust one.
Due to the fact that the source of the income is U.S. based and there is a
U.S. trustee, this foreign trust has filing requirements as discussed above.
l Foreign
Trust Two - The next step is to form a second foreign trust or
"foreign trust two". All the income of foreign trust one is
distributed to foreign trust two. Either foreign trust one or a foreign member
of the promoter's staff becomes the trustee of foreign trust two. If the
trustee is foreign trust one, the taxpayer still controls foreign trust two by
the fact that he/she is in control of foreign trust one's trustee, by the
directorship of the AMC. If a foreigner is the trustee of foreign trust two,
the taxpayer is empowered by the promoter to overrule any decisions by this
trustee. In either case, the taxpayer is in control of foreign trust two. Promoters
will claim to taxpayers that since the trustee and the source of income is now
foreign, there are no U.S. filing requirements. Promoters also advise
taxpayers that since the trusts are formed in tax haven countries it is
impossible for the IRS to determine who is in control of the trusts. In
actuality, the taxpayer has never relinquished control of their business, but
has set up, with the assistance of a promoter, an elaborate scheme to subvert
and evade U.S. tax laws.
How do taxpayers involved in these schemes enjoy the fruits of their evasive
scheme since their funds are offshore? There are several methods to repatriate
the taxpayer's funds to the U.S. All of these methods, at some point, involve
the opening of foreign bank accounts.
l One
method is to open a foreign bank account in a tax haven country and then issue
the taxpayer either a debit or credit card from the account. These debit or
credit cards are used by the taxpayer in the U.S. to withdraw cash and to pay
for everyday expenses, like groceries, medical bills, gasoline, and other
miscellaneous expenses. Since these cards are issued from banks located in tax
haven countries, it is very difficult for the IRS to trace these transactions
back to the taxpayer.
l
Another method is to set up an International Business Corporation (IBC) and
transfer the funds from the foreign trusts to the IBC via foreign bank
accounts. Fraudulent loans are set up from the IBC to taxpayers and funds are
wired back to the taxpayers in the U.S. Because purported loans are claimed
non-taxable, the repatriation of funds is not reported on a U.S. tax return.
In addition, because the ownership of IBC's is documented with bearer shares
and IBC's are located in tax haven countries, it very difficult for the IRS to
prove that fraudulent loans are actually the taxpayer's income.
CI's Efforts in Combating Abusive Trusts
CI's enforcement strategy to combat
these schemes is to focus primarily on promoters and on clients who have
willfully used the promotion to egregiously evade tax. Further, fraudulent trust
issues are addressed through a national strategy that includes CI, the IRS
Examination and Collection Divisions, IRS Chief Counsel's Office, and the
Department of Justice. As part of this strategy, emphasis is placed on
multi-function coordination, the identification of fraudulent offshore
promotions, and the use of civil and criminal enforcement actions.
It is very difficult to determine
precisely the amount of fraud attributable to these schemes because of their
design and inherent complexity. However, it can be said that these schemes are
directed towards taxpayers with at least six figure incomes, and as evidenced by
the individual cases detailed later in this summary, the potential for lost tax
revenue could be massive.
Because this is a new area of fraud,
CI has been tracking these investigations only since October 1998. The following
statistics represent CI's efforts on promoters, clients, and other individuals
involved in abusive trust schemes for Fiscal Year 1999.
Criminal Investigations Initiated 67
Prosecution Recommendations 57
Indictments/Informations 35
Incarceration Rate 85.7%
Avg. Months to Serve (w/prison) 35
Avg. Months to Serve (all Sent) 30
The following data is on foreign and
domestic trusts investigations as of January 31, 2000.
Open Criminal Investigations 130
Percent of Open Investigations on 55%
Foreign Schemes
Percent of Open Investigations on 45%
Domestic Schemes
Criminal Convictions
Chappell, et al. Investigation
In May 1999, Ronald Chappell, a
former CPA from Roseville, California, was sentenced to 87 months imprisonment
for defrauding the IRS by promoting bogus trusts. In addition to Chappell, Todd
Gaskill, an attorney, Martin Goodrich, and Lloyd Winburn, a former legislative
aide in Sacramento, were sentenced to 58, 37, 63 months imprisonment
respectively, for their involvement in the scam. The men sold packages of bogus
trusts to clients and advised them how to use trusts to generate fraudulent tax
deductions. Clients of these individuals put businesses, homes, and other assets
in trusts, but in fact continued to control those assets. Clients claimed
various personal expenses related to the bogus trusts on their tax returns
including depreciation of personal residences, lawn care, house cleaning, and
scholarships for their children.
In another scheme directed at high
income taxpayers, Chappell, Gaskill, and Goodrich instructed clients to conceal
income from the IRS through a series of bank accounts in the U.S. and the
Caribbean. The judge in the case found that the trust scheme deprived the
federal and state governments of more than $2.5 million in tax revenue.
Mayer Investigation
In June 1998, Louis R. Mayer of
Clearwater, Florida, was sentenced to six months imprisonment and six months of
home detention after he was convicted in February 1998 of conspiring to impede
and impair the IRS from administering the tax laws. Mayer was also convicted of
six counts of aiding and assisting in the preparation of false income tax
returns.
The indictment charged Mayer, a
promoter of foreign and domestic contractual trusts, with employing a series of
trusts to generate fraudulent deductions and conceal the income of two of his
clients from the IRS. These trusts created the appearance that the clients had
relinquished ownership and control of the assets which were placed in the trust,
when in fact they still retained control. Mayer also counseled his clients to
open a series of foreign bank accounts in the Bahamas to facilitate the return
of the income to his clients. Funds from these fraudulent trusts were
transferred through a series of foreign bank accounts to avoid detection and
subsequently used by his clients to purchase high-end diamond jewelry, several
luxury cars, a 46' boat and an exotic parrot. Mayer's clients concealed hundreds
of thousands of dollars in this manner.
Hawley T. Webb, an accountant and
return preparer from New Port Richey, Florida, was also sentenced to 30 months
imprisonment followed by two years supervised release for his role in the
scheme.
Bradley Investigation
In June 1999, Edgar Bradley and his
sons, Edgar Bradley II and Roy Bradley, were sentenced to 60, 57, and 46 months
imprisonment followed by 3 years supervised release, respectively for conspiracy
to defraud the IRS and for failing to file tax returns. In an attempt to conceal
income, the Bradleys, who were found guilty by a Federal jury, assigned their
income to several nominees and purported irrevocable trusts that had no economic
substance. As part of the conspiracy, the Bradleys used several bank accounts
opened in trust and other names to conceal insurance commission receipts and
proceeds from the sale of certificates of deposit and coins. The Bradleys also
attempted to conceal their assets from the IRS by the conveyance of real
property from their names to purported trusts and nominees. In addition to their
imprisonment, the judge in the case ordered the Bradleys to pay fines of
$413,500 and restitution in excess of $635,000 to the IRS.
Rivera Investigation
In January 1999, Pedro Ivan Rivera, a
physician in Carrolton, Texas, was sentenced to 37 months imprisonment followed
by three years supervised release and ordered to pay $414, 819 in restitution to
the IRS for tax evasion for the years 1992 to 1996. Rivera created trusts,
including one for his family residence, that he controlled and used to conceal
his income. In addition, Rivera transferred funds between trusts, offshore
corporations, and their corresponding bank accounts located in the U.S.,
Bahamas, and the Channel Islands in order to conceal taxable income.
Morris Investigation
In July 1999, James C. Morris of
Cincinnati, Ohio was sentenced to 24 months imprisonment followed by 3 years of
supervised release for tax evasion and for attempting to interfere with the
administration of the IRS. Morris, who pleaded guilty, admitted that he did not
file a Federal income tax return or pay substantial tax due and owing for 1992
on the sale of certificates of deposit. As part of his scheme, Morris used
nominee trusts to conceal his income and assets from the IRS. Morris admitted he
impeded the IRS by selling sham trusts that were used to conceal assets and
income from the IRS and others. Morris also admitted he was a member of the
Pilot Connection Society and later its successor, the Liberty Foundation, an
organization that sold so-called "untaxing packages" and assisted its
members in circumventing the filing of Federal income tax returns and payment of
Federal income tax. Morris sold these "untaxing packages" and sham
trusts through his business, Excellence in Planning Associates. In addition to
imprisonment, the judge ordered Morris to pay a $5,000 fine and restitution to
the IRS in the amount of $41,686.
Foster, et al. Investigation
Karl Foster, of Blaine Minnesota, was
convicted of conspiracy to obstruct the IRS, aiding and assisting in the filing
of a false tax return and aiding and abetting another person to obstruct and
impede the IRS. In May 1998, Foster was sentenced to 78 months imprisonment
followed by three years of supervised release.
Foster was a tax consultant, who
created and sold trusts designed to conceal income and assets from the IRS.
Foster advised his clients that trusts were tax-free because they were sovereign
from the U.S. He also advised clients they were citizens of the Republic of
Minnesota and therefore did not have to pay taxes.
Two of Foster's clients were
convicted of tax evasion and conspiracy to obstruct and impede the IRS. Darlow
Madge, owner of Allied Medical Associates, was sentenced to 41 months
imprisonment followed by three years of supervised release for failing to report
$741,000 in income between 1990 and 1993. Madge's son, Brian Madge, was
sentenced to 20 months imprisonment followed by two years supervised release for
failing to report approximately $80,000 in income over a two year period.
Civil and Criminal Penalties
Investors of abusive trust schemes
that improperly evade tax are still liable for taxes, interest, and civil
penalties. Violations of the Internal Revenue Code with the intent to evade
income taxes may result in a civil fraud penalty or criminal prosecution. Civil
fraud can include a penalty of up to 75% of the underpayment of tax attributable
to fraud, in addition to the taxes owed. Criminal convictions of promoters and
investors may result in fines up to $250,000 and up to five years in prison.
Criminal statutes that maybe applicable are as follows:
l Title 18 USC 371, Conspiracy to Defraud the IRS
l Title 26 USC 7201, Tax Evasion
l
Title 26 USC 7206(1), Subscription to a False Tax Return
l
Title 26 USC 7206(2), Aiding or Assisting in a False Tax Return
l
Title 26 USC 7212(a), Corrupt or Forcible Interference with the Administration
of Internal Revenue Laws
l
Title 31 USC 5314, Records and Reports on Foreign Financial Agency
Transactions
1A
grantor is the individual placing assets into a trust.
2An
IBC is a corporation set up offshore in jurisdictions where the tracing of
ownership by U.S. authorities of such an entity is very difficult. Due to the
difficulty in tracing the ownership of IBC's, these entities are used quite
often in tax evasion schemes.
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