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Internal Revenue Service Criminal Investigative Division
Warning About Abusive Trust Schemes
Internal Revenue Service
Criminal Investigation Division
Summary of Abusive Trust Schemes
In the last few years the Internal Revenue Service Criminal Investigation
(CI) has detected a proliferation of abusive trust tax evasion schemes. Currently,
there are two prevalent fraudulent schemes being promoted: the "domestic
scheme" and the "foreign scheme." The domestic scheme involves a series
of trusts that are formed in the U.S., while the foreign trust scheme is
formed offshore and outside the jurisdiction of the U.S. The trusts
involved in the schemes, either foreign or domestic, are vertically layered
with each trust distributing income to the next layer. The result of
this layered distribution of income is to fraudulently reduce taxable income
to nominal amounts. Although these schemes give the appearance of the
separation of responsibility and control from the benefits of ownership,
these schemes are in fact controlled and directed by the taxpayer.
These schemes are often promoted by a network of promoters and sub-promoters
that may charge $5,000 to $70,000 for their packages. This fee enables
taxpayers to have trust documents prepared, to utilize foreign and domestic
trustees as offered by promoters, and to use foreign bank accounts and corporations. In
some instances, tax return preparer services are also made available.
Basic Trust Taxation
To understand fully the trust schemes offered today, it is important to
focus on some basic trust taxation rules.
A trust is a form of ownership, which is controlled and managed by a designated
independent trustee, that completely separates responsibility and control
of assets from the benefits of ownership. The IRS recognizes numerous
types of legal trust arrangements, and they are commonly used for estate
planning, charitable purposes, and holding assets for beneficiaries. The
independent trustee manages the trust, holds legal title to trust assets,
and exercises independent control.
All income a trust receives, whether from foreign or domestic sources, is
taxable to either the trust, the beneficiary, or the taxpayer unless specifically
exempted by the Internal Revenue Code (IRC).
A legitimate trust is allowed to deduct distributions to beneficiaries from
its taxable income, with a few modifications. Therefore, trusts can
eliminate income by making distributions to other trusts or other entities
as long as they are named as beneficiaries. This distribution of income
is key to understanding the fraudulent nature of the abusive schemes. In
fraudulent schemes, bogus expenses are charged against trust income at each
trust layer. After the deduction of these expenses, the remaining income
is distributed to another trust, and the process is repeated. The result
of the distributions and fraudulent deductions is to reduce the amount of
income ultimately reported to the IRS.
A domestic trust must file a Form 1041, U.S. Income Tax Return for Estates
and Trusts, for each taxable year. If the trust is classified
as a Domestic Grantor Trust, it is not generally required to file a Form
1041, provided that all items of income are reported by the individual
taxpayer on his own Form 1040, U.S. Individual Income Tax Return. Thus,
the individual pays the total tax liability upon the filing of his return
for that taxable year. All income received by a trust whether
from foreign or domestic sources is taxable to the trust, beneficiary,
or taxpayer unless specifically exempted by the Internal Revenue Code.
Foreign trusts are subject to special filing requirements. If a trust
has income that is effectively connected with a U.S. trade or business, it
must file Form 1040NR, U.S. Nonresident Alien Income Tax Return. Form
3520, Annual Return to Report Transactions With Foreign Trusts and Receipt
of Foreign Gifts, must be filed on the creation of or transfer of property
to certain foreign trusts. Form 3520-A, Annual Information Return
of Foreign Trusts With U.S. Owner, must also be filed annually. Foreign
trusts may be required to file other forms as well. Foreign trusts
to which a U.S. taxpayer has transferred property are treated as grantor
trusts as long as the trust has at least one U.S. beneficiary. The
income the trust earns is taxable to the transferor under the grantor trust
rules. Grantor trusts are not recognized as separate taxable entities,
because under the terms of the trust, the grantor retains one or more powers
and remains the owner of the trust income. In such a case, the trust
income is taxed to the grantor. [footnote:
A grantor is the individual placing assets into a trust.]
In addition to filing trust returns as just described, a taxpayer may be
required to file U.S. Treasury Form TD F 90-22.1, Foreign Bank and Financial
Accounts Report if the taxpayer has an interest of over $10,000 in foreign
bank accounts, securities, or other financial account. Also, a taxpayer
may be required to acknowledge an interest in a foreign bank account, security
account or foreign trust on Schedule B, Interest and Dividend Income which
is attached to Form 1040.
Abusive Domestic Trust Schemes
As stated above, the domestic trust schemes are usually offered in a series
of trusts that are layered upon one another. These trusts can include
Asset Management Company - In many promotions, taxpayers are advised
to create Asset Management Companies (AMC's). The AMC, which lists the taxpayer
as the director, is formed as a domestic trust. An individual on the
promoter's staff is usually the trustee of the AMC, but this individual is
quickly replaced by the taxpayer. The purpose of the AMC is to give
the appearance that the taxpayer is not managing his or her business and
to start the layering process.
Business Trust - The next step is to form a business trust, also
a domestic trust. In effect, the client elects to change the structure
of their business from either a sole proprietorship or corporation to a trust. The
AMC is the trustee of the business trust. False administrative expenses
may be deducted from the trust as a means to reduce taxable income. The
scheme gives the appearance that the taxpayer has given up control of their
business to a trust; however, in reality the taxpayer is still running the
day-to-day activities of their business and is controlling its income stream.
Equipment or Service Trust - An equipment or service trust is formed
to hold equipment that is rented or leased to the business trust, often at
inflated rates. The business trust reduces its income by claiming deductions
for payments to the equipment trust.
Family Residence Trust - In some instances, taxpayers are being advised
to distribute remaining income from the business trust to a family residence
trust. Family residences, including furnishings are transferred to
this trust. These trusts sometimes rent the family residence back to the
owner. These trusts may attempt to deduct non-allowable depreciation
and the expenses of maintaining and operating the residence such as gardening,
pool service, and utilities.
Charitable Trust - In many promotions, the last layer of trusts is
the charitable trust. These trusts or "charitable organizations" pay
for personal, educational, or recreational expenses on behalf of the taxpayer
or family members. The payments are then falsely claimed as "charitable" deductions
on the trust tax returns. After the personal and non-allowable expenses
are deducted from the charitable trust, any remaining balance of income,
usually nominal amounts, is distributed to the taxpayer.
Abusive Foreign Trust Schemes
Similar to the domestic arrangements, foreign packages usually start off
with an AMC, a business trust, and distribute income to several trust layers. However,
these foreign promotions also attempt to take funds offshore and outside
U.S. jurisdiction. These schemes involve offshore bank accounts, trusts,
and International Business Corporations (IBC's) created in "tax haven" countries.
[footnote: An IBC is a corporation set up offshore in jurisdictions where
the tracing of ownership by U.S. authorities of such an entity is very difficult. Due
to the difficulty in tracing the ownership of IBC's, these entities are used
quite often in tax evasion schemes.]
A typical offshore trust scheme may have the following steps:
AMC - As with the domestic arrangement, the first step in these schemes
is for the taxpayer to form an AMC.
Business Trust - The next step is to form the business trust, again
very similar to the domestic scheme.
Foreign Trust One - Next, a foreign trust is formed in a tax haven
country, and the income from the business trust is distributed to this trust. For
our purposes, this foreign trust will be referred to as "foreign trust one". In
many cases, the AMC will be the trustee of foreign trust one. Due to
the fact that the source of the income is U.S. based and there is a U.S.
trustee, this foreign trust has filing requirements as discussed above.
Foreign Trust Two -The next step is to form a second foreign trust
or "foreign trust two". All the income of foreign trust one is distributed
to foreign trust two. Either foreign trust one or a foreign member
of the promoter's staff becomes the trustee of foreign trust two. If
the trustee is foreign trust one, the taxpayer still controls foreign trust
two by the fact that he/she is in control of foreign trust one's trustee,
by the directorship of the AMC. If a foreigner is the trustee of foreign
trust two, the taxpayer is empowered by the promoter to overrule any decisions
by this trustee. In either case, the taxpayer is in control of foreign
trust two. Promoters will claim to taxpayers that since the trustee
and the source of income is now foreign, there are no U.S. filing requirements. Promoters
also advise taxpayers that since the trusts are formed in tax haven countries
it is impossible for the IRS to determine who is in control of the trusts. In
actuality, the taxpayer has never relinquished control of their business,
but has set up, with the assistance of a promoter, an elaborate scheme to
subvert and evade U.S. tax laws.
How do taxpayers involved in these schemes enjoy the fruits of their evasive
scheme since their funds are offshore? There are several methods to
repatriate the taxpayer's funds to the U.S. All of these methods, at
some point, involve the opening of foreign bank accounts.
One method is to open a foreign bank account in a tax haven country and
then issue the taxpayer either a debit or credit card from the account. These
debit or credit cards are used by the taxpayer in the U.S. to withdraw cash
and to pay for everyday expenses, like groceries, medical bills, gasoline,
and other miscellaneous expenses. Since these cards are issued from
banks located in tax haven countries, it is very difficult for the IRS to
trace these transactions back to the taxpayer.
Another method is to set up an International Business Corporation (IBC)and
transfer the funds from the foreign trusts to the IBC via foreign bank accounts. Fraudulent
loans are set up from the IBC to taxpayers and funds are wired back to the
taxpayers in the U.S. Because purported loans are claimed non-taxable,
the repatriation of funds is not reported on a U.S. tax return. In
addition, because the ownership of IBC's is documented with bearer shares
and IBC's are located in tax haven countries, it very difficult for the IRS
to prove that fraudulent loans are actually the taxpayer's income.
CI's Efforts in Combating Abusive Trusts
CI's enforcement strategy to combat these schemes is to focus primarily
on promoters and on clients who have willfully used the promotion to egregiously
evade tax. Further, fraudulent trust issues are addressed through a
national strategy that includes CI, the IRS Examination and Collection Divisions,
IRS Chief Counsel's Office, and the Department of Justice. As part
of this strategy, emphasis is placed on multi-function coordination, the
identification of fraudulent offshore promotions, and the use of civil and
criminal enforcement actions.
It is very difficult to determine precisely the amount of fraud attributable
to these schemes because of their design and inherent complexity. However,
it can be said that these schemes are directed towards taxpayers with at
least six figure incomes, and as evidenced by the individual cases detailed
later in this summary, the potential for lost tax revenue could be massive.
Because this is a new area of fraud, CI has been tracking these investigations
only since October 1998. The following statistics represent CI's efforts
on promoters, clients, and other individuals involved in abusive trust schemes
for Fiscal Year 1999.
Criminal Investigations Initiated
Avg. Months to Serve (w/prison)
Avg. Months to Serve (all Sent)
The following data on is foreign and domestic trusts investigations
as of January 31, 2000.
Open Criminal Investigations
Percent of Open Investigations on Foreign Schemes
Percent of Open Investigations on Domestic Schemes
Chappell, et al. Investigation
In May 1999, Ronald Chappell, a former CPA from Roseville, California,
was sentenced to 87 months imprisonment for defrauding the IRS by promoting
bogus trusts. In addition to Chappell, Todd Gaskill, an attorney,
Martin Goodrich, and Lloyd Winburn, a former legislative aide in Sacramento,
were sentenced to 58, 37, 63 months imprisonment respectively, for their
involvement in the scam. The men sold packages of bogus trusts to
clients and advised them how to use trusts to generate fraudulent tax deductions. Clients
of these individuals put businesses, homes, and other assets in trusts,
but in fact continued to control those assets. Clients claimed various
personal expenses related to the bogus trusts on their tax returns including
depreciation of personal residences, lawn care, house cleaning, and scholarships
for their children.
In another scheme directed at high income taxpayers, Chappell, Gaskill,
and Goodrich instructed clients to conceal income from the IRS through
a series of bank accounts in the U.S. and the Caribbean. The judge
in the case found that the trust scheme deprived the federal and state
governments of more than $2.5 million in tax revenue.
In June 1998, Louis R. Mayer of Clearwater, Florida, was sentenced to
six months imprisonment and six months of home detention after he was convicted
in February 1998 of conspiring to impede and impair the IRS from administering
the tax laws. Mayer was also convicted of six counts of aiding and
assisting in the preparation of false income tax returns.
The indictment charged Mayer, a promoter of foreign and domestic contractual
trusts, with employing a series of trusts to generate fraudulent deductions
and conceal the income of two of his clients from the IRS. These
trusts created the appearance that the clients had relinquished ownership
and control of the assets which were placed in the trust, when in fact
they still retained control. Mayer also counseled his clients to
open a series of foreign bank accounts in the Bahamas to facilitate the
return of the income to his clients. Funds from these fraudulent
trusts were transferred through a series of foreign bank accounts to avoid
detection and subsequently used by his clients to purchase high-end diamond
jewelry, several luxury cars, a 46' boat and an exotic parrot. Mayer's
clients concealed hundreds of thousands of dollars in this manner.
Hawley T. Webb, an accountant and return preparer from New Port Richey,
Florida, was also sentenced to 30 months imprisonment followed by two years
supervised release for his role in the scheme.
In June 1999, Edgar Bradley and his sons, Edgar Bradley II and Roy Bradley,
were sentenced to 60, 57, and 46 months imprisonment followed by 3 years
supervised release, respectively for conspiracy to defraud the IRS and
for failing to file tax returns. In an attempt to conceal income,
the Bradleys, who were found guilty by a Federal jury, assigned their income
to several nominees and purported irrevocable trusts that had no economic
substance. As part of the conspiracy, the Bradleys used several bank
accounts opened in trust and other names to conceal insurance commission
receipts and proceeds from the sale of certificates of deposit and coins. The
Bradleys also attempted to conceal their assets from the IRS by the conveyance
of real property from their names to purported trusts and nominees. In
addition to their imprisonment, the judge in the case ordered the Bradleys
to pay fines of $413,500 and restitution in excess of $635,000 to the IRS.
In January 1999, Pedro Ivan Rivera, a physician in Carrolton, Texas, was
sentenced to 37 months imprisonment followed by three years supervised
release and ordered to pay $414, 819 in restitution to the IRS for tax
evasion for the years 1992 to 1996. Rivera created trusts, including
one for his family residence, that he controlled and used to conceal his
income. In addition, Rivera transferred funds between trusts, offshore
corporations, and their corresponding bank accounts located in the U.S.,
Bahamas, and the Channel Islands in order to conceal taxable income.
In July 1999, James C. Morris of Cincinnati, Ohio was sentenced to 24
months imprisonment followed by 3 years of supervised release for tax evasion
and for attempting to interfere with the administration of the IRS. Morris,
who pleaded guilty, admitted that he did not file a Federal income tax
return or pay substantial tax due and owing for 1992 on the sale of certificates
of deposit. As part of his scheme, Morris used nominee trusts to
conceal his income and assets from the IRS. Morris admitted he impeded
the IRS by selling sham trusts that were used to conceal assets and income
from the IRS and others. Morris also admitted he was a member of
the Pilot Connection Society and later its successor, the Liberty Foundation,
an organization that sold so-called "untaxing packages" and assisted its
members in circumventing the filing of Federal income tax returns and payment
of Federal income tax. Morris sold these "untaxing packages" and
sham trusts through his business, Excellence in Planning Associates. In
addition to imprisonment, the judge ordered Morris to pay a $5,000 fine
and restitution to the IRS in the amount of $41,686.
Foster, et al. Investigation
Karl Foster, of Blaine Minnesota, was convicted of conspiracy to obstruct
the IRS, aiding and assisting in the filing of a false tax return and aiding
and abetting another person to obstruct and impede the IRS. In May
1998, Foster was sentenced to 78 months imprisonment followed by three
years of supervised release.
Foster was a tax consultant, who created and sold trusts designed to conceal
income and assets from the IRS. Foster advised his clients that trusts
were tax-free because they were sovereign from the U.S. He also advised
clients they were citizens of the Republic of Minnesota and therefore did
not have to pay taxes.
Two of Foster's clients were convicted of tax evasion and conspiracy to
obstruct and impede the IRS. Darlow Madge, owner of Allied Medical
Associates, was sentenced to 41 months imprisonment followed by three years
of supervised release for failing to report $741,000 in income between
1990 and 1993. Madge's son, Brian Madge, was sentenced to 20 months
imprisonment followed by two years supervised release for failing to report
approximately $80,000 in income over a two year period.
Civil and Criminal Penalties
Investors of abusive trust schemes that improperly evade tax are still liable
for taxes, interest, and civil penalties. Violations of the Internal
Revenue Code with the intent to evade income taxes may result in a civil
fraud penalty or criminal prosecution. Civil fraud can include a penalty
of up to 75% of the underpayment of tax attributable to fraud, in addition
to the taxes owed. Criminal convictions of promoters and investors
may result in fines up to $250,000 and up to five years in prison. Criminal
statutes that maybe applicable are as follows:
Title 18 USC 371, Conspiracy to Defraud the IRS
Title 26 USC 7201, Tax Evasion
Title 26 USC 7206 (1), Subscription to a False Tax Return
Title 26 USC 7206(2), Aiding or Assisting in a False Tax Return
Title 26 USC 7212(a), Corrupt or Forcible Interference with the Administration
of Internal Revenue Laws
Title 31 USC 5314, Records and Reports on Foreign Financial Agency Transactions
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