Recent changes to federal gift and estate tax, which doubled the exemption amounts from $.49 million to $11.18 million in 2018, have placed an increased emphasis on coordinating estate and trust planning with income tax objectives. A recent Tax Court case, Full-Circle Staffing, LLC, et al. v. Commissioner of Internal Revenue, serves as a reminder that common law economic substance doctrines remain an area of focus in income tax cases. In Full Circle Staffing, the Tax Court disregarded a trust as a sham due to certain indirect controls the taxpayers retained over trust assets and distributions. As it did in the recent Estate of Powell, 148 T.C. 18 (2017) case when the Tax Court applied a broad standard to collapse a series of transactions it viewed as abusive, notwithstanding that the case could have been resolved on narrower grounds.
A Questionable Structure
The taxpayers, a married couple, were in the freight forwarding business and had operated their business through an S corporation since 1988. In 2003, in conjunction with a business expansion, the taxpayers reorganized their entity structure, forming three separate entities: (1) a limited partnership, “Limited,” (2) an irrevocable trust, “Watchman,” and (3) a nonexempt charitable trust, “Lighthouse.”
- Limited was formed to operate the taxpayers’ freight forwarding business and was funded with all of the assets of the taxpayers’ former S corp. The S corp was Limited’s general partner, and through it, the taxpayers managed and controlled Limited in all respects, including controlling the amount and timing of distributions. The taxpayers also retained a 5 percent limited partner interest in Limited.
- Watchman was an irrevocable trust that named the attorney-draftsperson as settlor and a third-party corporate service provider as trustee. The trust was fully discretionary and named the taxpayers as the initial beneficiaries. The trust agreement cited asset protection, privacy and governance motivations for the trust’s creation. Watchman was funded by the taxpayers with a 94 percent limited partner interest in Limited and other business interests. The trustee of Watchman was expressly prohibited from participating in the management and operation of Limited.
- Lighthouse was formed as a joint vehicle through which the taxpayers could make anonymous charitable donations and was funded by the taxpayers with their beneficial interests in Watchman (thereby making Lighthouse the sole beneficiary of Watchman). The taxpayers were the sole trustees of Lighthouse. Because Watchman didn’t have a bank account, the taxpayers would issue a check from Limited to Watchman, which Watchman’s trustee would then endorse to Lighthouse for deposit in its bank account.
The result of using this business structure was that a majority of the income of Limited flowed through to Watchman, rather than to the taxpayers. Watchman, in turn, took substantial distribution deductions, despite not actually distributing all of its income to Lighthouse. Watchman characterized the purported distributions as royalty income, presumably in an attempt to avoid the application of the unrelated business income tax on Lighthouse. During the years at issue, Lighthouse distributed approximately $900,000 to charity, accounting for just 11 percent of its reported income. The net result of this structure was that little to no tax liability was reported with respect to the freight forwarding business.
Four-Part Sham Trust Analysis
The Tax Court stated that although taxpayers are generally free to structure their affairs to minimize taxes, when the entity lacks economic substance, the courts may consider the business form a sham and disregard it for federal tax purposes. Importantly, the Court didn’t limit the application of its holding to federal income taxes. Had the transactions at issue included an estate planning element, the breadth of the Tax Court’s holding presumably would have eliminated any transfer tax advantages of the structure.
To determine whether Watchman lacked economic substance, the Tax Court applied a four-factor test: (1) whether the taxpayer’s relationship to the property transferred to the trust materially changed after the trust’s creation; (2) whether the trust had an independent trustee; (3) whether an economic interest passed to the trust beneficiaries; and (4) whether the taxpayer felt bound by the restrictions imposed by the trust agreement or the law of trusts.
As to the first factor, the Tax Court noted that the taxpayers’ relationship to the freight forwarding business didn’t change after Watchman’s formation. Although the trust documents identified the attorney-draftsman as the settlor, the taxpayers in fact funded Watchman and, though their continued ownership of Limited’s general partner, retained control over the activities and income of the freight forwarding business.
The Tax Court also acknowledged that the corporate trustee of Watchman played no meaningful role in the operation of the trust, due in part to its inability to interact with the underlying assets in any way. While the trust agreement gave the trustee sole authority to make distributions, it could only do so when the taxpayers chose to make distributions from the partnership. When distributions were made, the trustee’s only role was to endorse the distributions over to Lighthouse, another entity controlled by the taxpayers. Thus, the taxpayers, not the trustee, determined whether to distribute funds to Lighthouse and in what amounts.
As to the third and fourth factors, the Tax Court determined that an economic interest didn’t pass to Lighthouse and that the taxpayers, through their retained control of the underlying entities, effectively violated the few restrictions imposed under Watchman’s trust agreement. Because each of the factors in the four-factor test indicated that Watchman wasn’t a valid trust, the Tax Court found that the trust was formed for the purpose of tax avoidance and therefore lacked economic substance. As such, all partnership income attributable to Watchman was actually taxable to the taxpayers.
As in the recent Powell case, which disregarded a family partnership under a broad retained-control analysis rather than resting solely on certain technical deficiencies, the Tax Court declined to resolve Full-Circle Staffing on narrow grounds. To reach its desired result, the Tax Court could have simply held that Watchman was a grantor trust. Because the taxpayers retained effective dispositive control over Watchman’s assets, the trust could have been a grantor trust under Internal Revenue Code Section 674, and because the taxpayers retained broad administrative control over Watchman’s assets, the trust could have been a grantor trust under IRC Section 675. Indeed, this was the rationale cited by the Internal Revenue Service in its original notices of deficiency.
Nonetheless, the Tax Court chose to sham out the trust in its entirety for all federal tax purposes. Because the structure at issue in Full-Circle Staffing seemed to be motivated solely by income tax considerations, the depth of the downfall was limited to the imposition of unpaid income taxes, interest and penalties. However, had the structure involved estate planning elements, the Tax Court’s holding also could have had transfer tax implications. As income tax and transfer tax planning elements become increasingly intertwined, Full-Circle Staffing serves as an important reminder of the Tax Court’s willingness to apply broad economic substance doctrines to unwind transactions that appear to have a tax avoidance purpose.
Eric Fischer and Samantha S. Smith are New York-based attorneys in the Private Client/Trusts and Estates Group of Skadden, Arps, Slate, Meagher & Flom LLP.