Taxpayers Hit with Civil Fraud Penalties for Sham Trust Arrangement

(Parker Tax Publishing March 2024)

The Tax Court held that the trusts a married couple formed as part of a tiered trust arrangement, in which all of their business and personal assets were placed, were sham entities with no economic substance and therefore, the income of the trusts was attributable to the taxpayers. The court also found that the civil fraud penalty under Code Sec. 6663(a) applied after finding that the taxpayers' fraudulent intent could be determined based on the taxpayers' long pattern of understating income, failure to file returns for any of the trusts, and awareness of their obligations under the tax law. Aldridge v. Comm'r, T.C. Memo. 2024-24.

Background

James Aldridge and Shirley Aldridge were married and filed joint returns. In 1993, after attending a seminar held by National Trust Services, the Aldridges began to place all of their business and personal assets in a tiered trust arrangement (collectively, the Aldridge Family Trust System).

The Aldridge Family Trust System was established using several steps. First, Shirley conveyed all of her interests in all real and personal property to James. Next, James formed the Aldridge Family Trust and conveyed all of his real and personal property, including all remuneration from his services, in exchange for 100 beneficial units in the trust. The declaration of trust was signed by Shirley and a representative from National Trust Services as trustees. Around the same time, the Aldridges established two other trusts, the Lorbert Trust and the Excalibur Trust. The Aldridges' personal residence and rental properties were conveyed to the Lorbert Trust, while their personal vehicles were transferred to the Excalibur Trust. The Aldridges entered lease agreements for the use of the vehicles, but no rent or other payment was ever made for the use of the vehicles.

Around 1995, James became a trust counselor for National Trust Services and Trust Educational Services, another entity promoting family trust schemes. James worked as an independent contractor, and he formed a new trust, Liberty Commerce Group Trust, out of which he operated his trust counselor business. James and Shirley were trustees of Liberty Commerce Group Trust, and its sole beneficiary was the Aldridge Family Trust. As a trust counselor, James gave seminars and presentations to prospective clients of the trust system. James's seminars discussed the purported tax benefits of family trust systems, telling potential clients that such systems could reduce or eliminate their taxes if they transferred their homes and other assets to the trust and assigned all future income to the trust.

In addition, James was employed as head of sales for Concept Marketing International (CMI), a multilevel marketing structure that sold American Silver Eagle coins. James persuaded the shareholders of CMI, Greg Rogers and Sherry Parrot, to reorganize CMI into a trust called the CMI Trust. CMI trust continued to conduct its business in the same manner as CMI had before the reorganization. The beneficiaries of the CMI trust were the Aldridges, Rogers, and Parrot. After Rogers transferred his beneficial units to Parrot, Parrott and the Aldridge Family Trust each held 50 beneficial units of the CMI Trust, and its trustees were the Aldridges and Rogers. After learning that James was marketing the trust system to CMI clients without his knowledge, Rogers no longer wished to be in business with him and resigned from his position with CMI Trust. Parrott still owned 50 beneficial units of CMI Trust, but neither she nor Rogers ever received any distributions from the trust. Rogers tried to contact the Aldridges but received no response. Rogers then attempted to sell the units but could not find a buyer. The Aldridges learned of Rogers's attempts to sell the units and, citing a provision of the trust documents prohibiting the sale of beneficial units, they voted to cancel Parrott's units. The Aldridges, consequently, now owned 100 percent of the outstanding beneficial units of CMI Trust; and neither Parrott nor Rogers received any compensation or other value for the canceled units.

The Aldridges did not file tax returns for any of the trusts for the 1996 through 2015 tax years and they never made any estimated tax payments. In addition, none of the trust beneficiaries filed returns. H&R Block prepared the Aldridges joint tax returns for each of the years at issue using information returns provided by Shirley. Beginning with their 2001 return and through their 2004 return, the Aldridges filed returns reporting zero wages for each of those years. They also began using Schedule C-EZ, Net Profit From Business, to report their purported business income as trustees. The returns reported their income, deductions, exemptions, and credits to zero out their taxable income in those years.

The IRS initially began examining the Aldridges' returns in 2002 in connection with an investigation into National Trust Services. The revenue agent assigned to the Aldridges' case determined that they had received a significant number of payments yet reported minimal income on their returns. Shortly thereafter, she referred the matter to the IRS Criminal Division. After a comprehensive criminal investigation, the IRS Criminal Division concluded that the Aldridges had filed false tax returns for years 1998 through 2004 and recommended that they be prosecuted. The Aldridges were ultimately convicted on five counts of filing false tax returns and aiding and abetting the filing of false tax returns. James served nine years in prison, and Shirley served five years and three months in prison.

In the course of the criminal investigation, the IRS determined that the trusts received unreported business income. A civil investigation followed, in which the IRS determined that the income of the trusts was attributable to the Aldridges. The IRS also determined civil fraud penalties under Code Sec. 6663. In 2010, the IRS issued a notice of deficiency, and the Aldridges petitioned the Tax Court.

Generally, trusts are taxed as separate entities from their trustees and beneficiaries under Code Sec. 641(b). Trusts may deduct amounts distributed or required to be distributed to a beneficiary, and the beneficiary is taxed on amounts received from a trust during a year to the extent of the trust's distributable net income for that year.

However, trust is disregarded for tax purposes if in substance it lacks any valid purpose but is simply a tax-avoidance device. Under Markosian v. Comm'r, 73 T.C. 1235 (1980), the Tax Court considers four factors to determine whether a trust lacks economic substance: (1) whether the taxpayer's relationship to the property transferred to the trust materially changed after the trust's creation; (2) whether the trust has an independent trustee; (3) whether an economic interest passed to other trust beneficiaries; and (4) whether the taxpayer feels bound by the restrictions imposed by the trust agreement or the law of trusts. If a trust lacks economic substance apart from tax considerations, the trust is a sham and is not recognized for federal tax purposes.

Analysis

The Tax Court held that under the four-factor test in Markosian, the trusts were shams, lacking in economic substance, and were mere alter egos of the Aldridges. Accordingly, the court disregarded the trusts for federal tax purposes and held that the Aldridges were liable for federal income tax on the trusts' income.

First, the court found that the relationship between the Aldridges and their property did not differ in any material respect following the creation of the trusts. The Aldridges continued to reside in the same home, drive the same vehicles, wear the same clothing, and retain full unfettered access to all of their personal property. The Aldridges paid their personal expenses out of the bank accounts titled to the trusts. The court also found that the Aldridges' business activities did not change in any material sense following the creation of the trusts. Second, the court noted that none of the trusts had an independent trustee. The Aldridges, or entities they controlled, served as co-trustees of the trusts during the years at issue.

Third, the court found that no economic interest passed to other beneficiaries. During the years at issue, the beneficiary of the Aldridge Family Trust was the Aldridges' minor child, while the beneficiary of the other trusts was the Aldridge Family Trust. However, the court found that in reality little to no economic benefit passed to the beneficiaries. The court observed that no return was filed by the Aldridges' minor child reporting income received from the trust, and the Aldridge Family Trust reported no income paid to him. Rather, the court found that the trusts were operated for the economic benefit of the Aldridges. The court noted that they used the trusts' funds to pay the mortgage on their home, purchase motorcycles and other vehicles, and pay their personal expenses, including food, clothing, and vacations.

Finally, the court found that the Aldridges failed to show that they acted as though they were bound by the restrictions imposed by the trust agreement or the law of trusts. Although the Aldridges purported to observe certain trust formalities, such as by maintaining separate bank accounts and maintaining minutes of trust decisions, the court found that they disregarded their obligations as trustees in other, more substantive ways. According to the court, they did not take efforts to make the trust property productive. Rather than lease the trust property to generate income, the court found that they maintained unrestricted access to trust property and complete control over how funds in the trust bank accounts were spent. In addition, the trusts allowed the Aldridges to continue to reside at the home purportedly owned by the Aldridge Family Trust, drive vehicles purportedly owned by the Excalibur Trust and use personal property owned by the Aldridge Family Trust, all without compensation.

The court also held that the Aldridges were liable for the 75 percent civil fraud penalty under Code Sec. 6663(a). In the court's view, the Aldridges' fraudulent intent could be inferred by their pattern of understating income during all six of the years at issue, and their failure to file returns for any of the trusts while receiving large sums of income. The court found that the Aldridges, who are both college educated, were fully aware of their obligations under the tax law and possessed the financial knowledge and business background to understand and comply with their obligations. Instead, the court found that they established a bogus trust arrangement in an effort to shield their substantial income and hide their assets, while filing false tax returns.

For a discussion of disregarding a trust for federal tax purposes due to lack of economic substance, see Parker Tax ¶56,105. For a discussion of civil fraud penalties, see Parker Tax ¶262,125.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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