The last few years have seen the proliferation of so-called section 643(b) trusts. Although there are various iterations of these trust arrangements, a common purpose seems to permeate each of them: the elimination or deferral of income tax, usually related to passive income earned within the trust. According to the promoters, these trust arrangements receive special tax benefits—and hence, their name—from section 643(b) of the Internal Revenue Code.
Given the age of section 643(b), the rise in their popularity now is somewhat surprising. Indeed, the predecessor of section 643(b)—which had substantially similar statutory language to the provision as it stands today—was enacted as part of the 1954 Code, making it roughly 70 years old. And according to its legislative history, section 643(b) was enacted by Congress solely as a means to clarify the different references to income used throughout the trust tax code—in section 643(b)'s case, the clarification of fiduciary accounting income.
Regardless of its new-found popularity amongst promoters, these trust arrangements have caught the watchful eye of the IRS. Specifically, on August 9, 2023, IRS Chief Counsel issued a Memorandum on section 643(b) trusts—also referred to as "non-grantor, irrevocable, complex, discretionary, spendthrift trust"—firmly indicating that these trust agreements did not give rise to any tax savings at all. Because many of these trusts also feed off of language in section 643(a)(3) (relating to capital gains) and section 643(a)(4) (relating to a simple trust's extraordinary dividends or taxable stock dividends), the Memorandum also dispelled any contention that these provisions gave rise to any tax benefits as well.
To understand the Memorandum, it is helpful to have a general understanding of Subchapter J of the Internal Revenue Code. Under section 641(a), a trust must pay income tax on its "taxable income," which serves as the default rule. However, Subchapter J recognizes in certain instances that the burden of the tax should pass to others. For example, a grantor may be taxed on trust income items if the trust constitutes a grantor trust under the grantor-trust rules. Moreover, in certain situations, Subchapter J passes the burden of the tax—rather commonsensically—to the trust beneficiaries, particularly if the beneficiaries receive the income items as a distribution from the trust.
Section 643(b) does not modify these general rules related to trust taxation. Rather, that provision states in its entirety:
For purposes of this subpart and subpart B, C, and D, the term 'income,' when not preceded by the word 'taxable,' 'distributable net income,' 'undistributed net,' or 'gross,' means the amount of income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law. Items constituting extraordinary dividends or taxable stock dividends which the fiduciary, acting in good faith, determines to be allocable to corpus under the terms of the governing instrument and applicable law shall not be considered income.
In interpreting section 643(b), promoters hang their hat on the last sentence, arguing that certain passive income earned in the trust is "not . . . income" if a trustee allocates these income items to the trust's principal. However, the IRS Chief Counsel Memorandum notes that such an interpretation completely reads out the first sentence of section 643(b), which states that the definition of "taxable income" remains undisturbed.
As mentioned before, many section 643(b) trusts also incorporate the language of section 643(a)(3) and (a)(4) into the trust agreements. Section 643(a)(3) provides that gains from the sale or exchange of capital assets are excluded from the definition of distributable net income (DNI) to the extent such gains are, among other things, allocated to the trust's corpus. Similarly, section 643(a)(4) provides that extraordinary dividends and taxable stock dividends are excluded from DNI if certain requirements are satisfied. Although these provisions seemingly suggest that capital gains, extraordinary dividends, and taxable stock dividends may be "excluded," the exclusion only relates to the computation of DNI and not taxable income. As the IRS Chief Counsel Memorandum notes, DNI is a separate concept from taxable income.
The Memorandum serves as an important warning to taxpayers of the IRS' awareness of these trusts and the agency's intent to attack them. Taxpayers who enter into these trust arrangements should also be aware that the IRS has a long and successful history of fighting abusive trust arrangements. For example, more than thirty years ago, the IRS became aware of a trust arrangement promoted by the Aegis Company (Aegis), a company selling trust arrangements across the United States for roughly $10,000 to $50,000. The trust arrangements had some variations, but the primary trust scheme consisted of a business trust, an asset management trust, and a charitable trust. According to Aegis, entering into this trust arrangement alone resulted in significant tax savings.
In the 1990s, the IRS discovered the Aegis trust scheme and initiated a criminal investigation. At one point, IRS-Criminal Investigation even sent an undercover agent to a promoter's office to pose as an interested client of the trust arrangement. After the IRS obtained sufficient evidence regarding the participants and promoters of the trusts, the government successfully indicted the promoters. Many of the promoters were sentenced to significant jail time for their participation in the trust scheme.
Regrettably, the taxpayers who participated in the Aegis trust scheme did not fare much better with the IRS, although many did avoid criminal jail sentences. According to numerous court cases, these taxpayers incurred significant out-of-pocket costs in hiring a tax professional to represent them against the IRS and also in paying the IRS the outstanding taxes, interest, and penalties they owed for their participation in the trusts.
In sum, taxpayers should take notice of the IRS Chief Counsel Memorandum. Yes, the federal courts and IRS have recognized that trusts have legitimate and lawful uses. But when trusts are being used improperly for tax evasion, the IRS will utilize its resources to go after participants in abusive trust schemes. Based on the Memorandum, the IRS' crosshairs are currently on section 643(b) trust arrangements.
Originally Published by Forbes
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