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avoidance, General, sham, Taxation, Trustee liability, Trusts

US Sham trust decision

The judgment in Full-Circle Staffing, LLC, Watchman Investment Trust, Financial & Tax Services, Inc., Trustee, Tax Matters Partner, Et Al. v Commissioner of Internal Revenue (Full Circle) is a consolidated judgment of the United States Tax Court.

The background facts are complicated but can be summarised as follows:

  • Mr and Mrs Pudlo restructured their freight forwarding business interests on advice following an Inland Revenue Service audit.  It was later determined that they were naïve, but not dishonest with respect to paying income tax on business income that was given to charity (as to 11%) with the balance reinvested in the business
  • The structure included a limited partnership, an irrevocable trust (Watchman) and a charitable trust (Lighthouse)
  • Watchman was a discretionary trust settled by a nominee settlor with a third party corporate service provider acting as trustee. The Pudlos were initially named as beneficiaries; subsequently the sole beneficiary was Lighthouse (described in the decision as a vehicle through which the Pudlos could make anonymous charitable donations)
  • Watchman was funded by the Pudlos
  • Watchman’s trustee was expressly prohibited from participating in Limited (the business in which it was a 94% shareholder)
  • Watchman did not have a bank account and so funds to be paid to it were paid by way of cheque from Limited, which would be endorsed to Lighthouse.

Editor’s note: the facts have been simplified to focus on the sham aspects of the decision rather than the US tax implications.

The structure adopted was tax effective. During the years in question $900,000 (11% of reported income) was paid to charity.  However, no tax was paid in respect of the charitable distributions or the income from the freight forwarding business.

While the decision could be considered simply by reference to its tax effects, it is of interest that the sham findings were largely attributable to the control retained by the Pudlos.

In New Zealand a sham is a pretence: a document that does not evidence the true common intention of the parties.  See Ben Nevis Forestry Ventures Ltd v Commissioner of Inland Revenue.  Clayton v Clayton the Supreme Court noted at [115] that:

“We do not consider that Mr Clayton’s reliance on his advisors in relation to the VRPT and his lack of knowledge of the legal ramifications of the trust structure and the terms of the trust deed itself leads to the conclusion that the VRPT deed is a sham. Mr Clayton’s reliance on his advisors does not indicate any lack of intent on his part to create a trust, nor does his lack of knowledge of the legal detail. The fact that the trust deed gives Mr Clayton powers that amount in effect, to a general power of appointment does not indicate that when entering into the VRPT deed, Mr Clayton in fact intended to create a structure different from that set out in the terms of the VRPT deed itself.”

However, given the recent decision in MezhProm Bank v Pugachev, which related to 5 New Zealand foreign trusts, whether intention can be considered entirely separately to retention of absolute control, such that a trust where absolute control is retained remains valid because a trust is intended, may warrant re-visiting.

In the Full-Circle decision the United States Tax Court approached the question of sham from a tax perspective by reference to:

  • whether the taxpayer’s relationship to the property transferred to the trust materially changed after the trust’s creation

  • whether the trust has an independent trustee

  • whether an economic interest passed to other trust beneficiaries, and

  • whether the taxpayer feels bound by the restrictions imposed by the trust agreement or the law of trusts.  See Markosian v. Commissioner

If a trust lacks economic substance apart from tax considerations, the trust is a sham and is not recognized for Federal tax purposes.  See Full-Circle at p 29.  However, a trust can be a sham for tax purposes, but remain See Full-Circle at p. 28.

To establish whether a trust has economic substance the relevant consideration is whether the [settlor’s] relationship to the property transferred to the trust materially changes.  See Full-Circle at p.29 and at p.30 where it is noted that:

For purposes of the economic substance of a trust, the Court looks to the economic realities of the trust arrangement to determine who is the true creator, grantor, or settlor of the trust; we look beyond the named settlor to the true settlor. Zmuda v. Commissioner

The absence of an independent trustee was significant in that there was no one to protect the beneficiaries interests. [Editor’s note: from a Commonwealth perspective this aspect of the test essentially references the inherent jurisdiction of the [High Court] to protect beneficiaries’ interests and the question as to whether a trust is intended.]

The practical aspects of the decision echo the judgment in Rosebud Trustee, where matters such as inappropriate interpolation of family members, lack of a bank account and third party control were indicia of a sham.

The ability to loan trust principal or income without adequate security or other consideration indicated that the taxpayer was not bound by the restrictions imposed by the trust.  This echos the true effects arguments raised in MezhProm Bank v Pugachev.  An observation further underscored by the tax judges need to review any factors that shed light on the “parties’ true intent” including “the parties’ agreement, their conduct in the agreement’s execution, their statements, the testimony of disinterested persons, the relationship of the parties, their respective abilities and capital contributions, the actual control of income, the purposes for which the income is used…”

The decision is useful and while it can be limited to its tax pedigree, it is suggested that the number of factors of sham that are reflected in other jurisdictions mean that while jurisdictional sensibilities must be observed there is value in casting a wide net when consider the indicia of sham.

Also see Tax Court Rules That Trust is a Sham.




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