Chief Counsel Discusses Trust Structure Marketed as a Tax Shelter

In a Generic Legal Advice Memo (GLAM), Chief Counsel discusses a nongrantor trust structure marketed as a tax shelter. Chief Counsel concluded that the trust’s promotional materials mistakenly interpret Code Sec. 643 to remove certain trust income from current taxation. (Legal Advice Issued by Associate Chief Counsel 2023-006, 8/18/2023)

Trust structure.

The trust is a nongrantor trust created by a third party who nominally funds the trust. The taxpayer is not a named beneficiary of the trust but fully funds the trust by selling assets to the trust in return for a promissory note.

The promotional materials claim that the asset sale is a nontaxable event because the trust retains the taxpayer’s basis in the assets. The trust leases back any income producing assets to the taxpayer or to an entity owned or controlled by the taxpayer.

The structure, which is being promoted by attorneys, accountants and enrolled agents, claims to provide significant tax and asset protection advantages to individual taxpayers.

Promotional materials.

According to the GLAM, the materials promoting this nongrantor trust structure claim that the income generated by the trust is not subject to current federal income tax if the trustee (1) allocates such income to corpus, and (2) doesn’t make any distributions to the beneficiaries.

To support the assertion that all income from the taxpayer’s sale or exchange of capital assets is excluded from federal income tax, the materials quote Code Sec. 643(a)(3).

To support the claim that the trustee may characterize any trust income as an “extraordinary dividend,” which is not subject to current taxation so long as the trustee allocates such income to corpus, the materials cite to Code Sec. 643(a)(4).

Out of context.

The memo concludes that the promotional materials support the claimed tax benefits of the trust by reading Code Sec. 643 out of context. According to Chief Counsel, Code Sec. 643 defines the “accounting income” of a trust, not its taxable income.

Moreover, the materials don’t address the basic rules for calculating a nongrantor trust’s taxable income.

Generally, a nongrantor trust is a separate taxpayer that computes its gross income in much the same way an individual does. The primary difference is that a trust may deduct distributions to beneficiaries. However, a trust’s beneficiary distribution deduction is limited to (1) amounts the trust actually pays to beneficiaries during the tax year, or (2) the “distributable net income” of the trust.

If the trust excludes all capital gains and extraordinary dividends from income, then the trust subtracts those amounts from distributable net income (DNI). Thus, contrary to the promoters’ claims, the trust will recognize income on its capital gains and dividends unless those amounts are distributed or deemed to be distributed to the trust’s beneficiaries.

For more information about deductions when calculating DNI, see Checkpoint’s Federal Tax Coordinator ¶ C-2610.