When it comes to tax strategies, if something sounds too good to be true, it probably is. It is especially important for advisors to have a high-level understanding of what to watch out for when their clients are inevitably pitched sham or high-risk tax-planning strategies. In the world of trust planning, two schemes are currently circulating that advisors should be able to recognize so they can effectively advise their clients of the potential risks involved.

Trust 1: The “Non-Grantor Irrevocable Complex Discretionary Spendthrift Trust”

While sometimes pitched under different names, this first scheme is typically referred to as a “non-grantor irrevocable complex discretionary spendthrift trust.” The basic proposition goes something like this: If a taxpayer transfers assets to one of the promoted trusts, no income tax will need to be paid on income earned by the trust so long as (i) the income comes from capital gains or is classified by the trustee as “extraordinary dividends,” and (ii) no distributions are made to trust beneficiaries. The promoter will typically advertise these as “income-tax-free” vehicles, at least until some tax may have to be paid when distributions are finally made to trust beneficiaries. Sounds enticing, doesn’t it?

To arrive at their ill-advised solution, promoters of this scheme rely on an out-of-context interpretation of Section 643 of the Internal Revenue Code (IRC or Code). IRC § 643(a)(3) states, “[g]ains from the sale or exchange of capital assets shall be excluded to the extent that such gains are allocated to corpus and are not paid, credited, or required to be distributed to any beneficiary during the taxable year.” IRC § 643(a)(4) provides, “[t]here shall be excluded those items of gross income constituting extraordinary dividends … which the fiduciary, acting in good faith, does not pay or credit to any beneficiary by reason of his determination that such dividends are allocable to corpus.” On its face, looking at just these two provisions, it seems like the promoters might have it right.

Of course, statutes always need to be interpreted in context. The context here is that IRC § 643 does not define taxable income—it defines distributable net income (DNI). DNI is just a figure used for determining the deduction that is allowable for distributions to beneficiaries authorized by IRC § 651 (for simple trusts) and IRC § 661 (for complex trusts). Taxable income for a trust is determined under IRC § 641. And under § 641, capital gains and extraordinary dividends would be included in the taxable income of the trust for a given year. So, the idea of indefinitely deferring income tax falls apart rather quickly once the statutes are read in context.

IRS Office of Chief Counsel Memorandum, AM 2023-006 specifically addresses this type of sham trust in more detail and warns taxpayers of the risks associated with reporting these trusts as promoters suggest. It is important to note that these types of trusts on their face are not invalid, but rather, the promoter’s suggested method in income tax reporting of each year is.

Trust 2: Monetized Installment Sale Trust

The second trust to watch out for is less of a sham and more of a known high-risk structure, for which the IRS has indicated its disapproval. The strategy, referred to by the IRS as a “monetized installment sale,” is a transaction that attempts to characterize a cash sale of appreciated property as an installment sale so that taxable gain can be deferred. The IRS has included this type of structure on its “Dirty Dozen” list of common tax schemes being misused by promoters and has issued proposed regulations that would make this type of trust structure a “listed transaction.”

Typically, these transactions are proposed to taxpayers contemplating the sale of their business, though they can be used in the sale of other assets as well. The aim is to take advantage of the installment sale treatment provided by IRC § 453. In their typical form, installment sales don’t bother the IRS. As long as a seller is receiving the proceeds of a sale from a buyer over a term of years, then the Code allows the taxpayer to recognize gain over the same terms of years. However, promoters of the monetized installment sale structure claim that taxpayers can have their cake and eat it, too.

Here are the key components of this structure:

1. the seller identifies a buyer for their business/asset;
2. the seller sells the business/asset to an intermediary trust in exchange for an installment note;
3. the trust immediately re-sells the business/asset to the buyer;
4. the seller borrows from a third-party lender an amount equal to the value of the installment note (and potentially secured by the installment note); and
5. the trust makes payments to the seller on the installment note and the seller in turn funnels the payments to the third‑party lender.

The net result is that the seller has access to the full sale proceeds via the third-party loan while they defer payment of the capital gains tax. The IRS views the economic substance of this transaction as a straightforward cash sale of the asset, thereby requiring all capital gains taxes to be paid in the year the transaction takes place.

As with all tax schemes, advisors should be vigilant in identifying promoters who offer products rather than customized planning and promise tools with nearly unlimited tax avoidance or deferral tools. Remember, if it sounds too good to be true, it probably is.