Significant Efforts Have Been Made to Combat Abusive Trusts,
But Additional Improvements Are Needed to Ensure Fairness and Compliance
Objectives Are Achieved
February 2002
Reference
Number: 2002-30-050
This report has cleared the Treasury Inspector General for Tax Administration disclosure review process and information determined to be restricted from public release has been redacted from this document.
February
27, 2002
MEMORANDUM
FOR COMMISSIONER, SMALL BUSINESS/SELF-EMPLOYED DIVISION
FROM: Pamela J. Gardiner /s/ Pamela J.
Gardiner
Deputy Inspector General for
Audit
SUBJECT: Final Audit Report - Significant Efforts
Have Been Made to Combat Abusive Trusts, But Additional Improvements Are Needed
to Ensure Fairness and Compliance Objectives Are Achieved (Audit # 200130014)
This
report presents the results of our review of the Internal Revenue Service’s
(IRS) efforts to combat abusive trusts.
The overall objective of this review was to determine whether the IRS
has an effective program to identify domestic trusts with a potential for
noncompliance.
In
summary, since 1997 the IRS has made
significant efforts to combat abusive trusts.
It
has addressed abusive trust issues through a national strategy that includes
the IRS Criminal Investigation function, the Small Business/Self-Employed
(SB/SE) Division’s Compliance function, the Office of Chief Counsel, and the
Department of Justice. The IRS has
emphasized the identification of abusive trust promotions and the use of civil
and criminal enforcement actions.
Further, the IRS has increased its examination of U.S. Income Tax Returns for Estates and Trusts (Forms
1041)
from 567 in Fiscal Year (FY) 1997 to over 4,400 in FY 2000. As a result, proposed tax assessments
involving abusive trusts and related returns increased from $8 million in FY
1997 to over $467 million in FY 2000.
Additional
improvements are needed, however, to ensure that the IRS achieves its goal of
combating abusive trusts. First, the
assessment of penalties may vary depending on the facts and circumstances of,
and the IRS examiner working on, the case. A review of abusive trust-related returns
from the IRS’ Audit Information Management System, closed during the first
quarter of FY 2001, showed that the IRS may not be consistently assessing the
accuracy-related penalty. The review
showed the IRS assessed the accuracy-related or fraud penalty on only 26
percent of the returns. If the IRS
assessed the accuracy-related penalty based on the additional tax assessments
of $467 million, additional penalty assessments could range from an estimated
$69.1 to $138.2 million over a 2-year period.
Second, one of the methods that the IRS’ National Trust
Initiative uses to accomplish its primary goal of combating abusive trusts is
pre-filing and outreach activities.
However, the IRS does not have performance measures to determine if its
pre-filing and outreach activities are increasing taxpayer compliance. Finally, the IRS does not have a system to capture results
of Form 1041 examinations that would identify emerging abusive trust
issues.
Management’s Response: IRS management has agreed to the
recommendations presented and is proposing a number of actions to address the
problems identified in our report. The
Director, Compliance Policy, SB/SE Division, will develop new penalty tables to
provide a tool for monitoring the application of the accuracy-related penalty;
SB/SE Division Counsel will review the 1998 Advisory Opinion and determine
whether updating and/or submitting it to the Office of Chief Counsel is needed;
and the Director, Research, SB/SE Division, will consider a special study to
analyze examination outcomes on unagreed cases and taxpayer behavior patterns
after examination. Also, the Director,
Compliance Policy, SB/SE Division, will develop a system to capture Form 1041 examination data.
Management
did not fully concur with the outcome measures listed in the report and stated
that each closed case would have to be reviewed to determine if the examiner
had properly considered the accuracy-related penalty. The Commissioner, SB/SE Division, responded that since these were
closed cases, the retrieval cost and time were prohibitive to make this
determination.
Office
of Audit Comment: The IRS does not
maintain a system of records on proposed penalties. Our conclusions on the applicability of the accuracy-related
penalty were based on a statistically valid random sample of closed cases,
documentation from the IRS’ Trust Forum that the penalty was being used as a
“bargaining chip,” examiners using the Office of Chief Counsel opinion to waive
penalties as they see fit, and the IRS’ Abusive Trust Guide (ATG). The significantly low rate of assessing the accuracy-related
penalty (26 percent) suggests that the IRS, in contrast to the ATG, is not
assessing the penalty in “most” cases.
The ATG states, “In most
abusive trust cases, either the negligence or substantial understatement
penalty should be asserted against the grantor.” (emphasis added) In addition, the ATG states, “reasonable
cause for penalty abatement would not ordinarily be accepted.”
Management’s
complete response to the draft report is included as Appendix VI.
Copies of this report are also being sent to the IRS managers who are affected by the report recommendations. Please contact me at (202) 622-6510 if you have questions or Gordon C. Milbourn III, Assistant Inspector General for Audit (Small Business and Corporate Programs), at (202) 622-3837.
Significant
Efforts Have Been Made to Combat Abusive Trusts
Consistency Is Needed in Assessing Penalties for Abusive Trusts
Appendix I – Detailed Objective, Scope, and Methodology
Appendix II – Major Contributors to This Report
Appendix III – Report Distribution List
Appendix IV – Outcome Measures
Appendix V – Examples of Abusive Trusts
Appendix VI – Management’s Response to the Draft Report
According to the Journal of Accountancy more than $4.8 trillion in wealth will be inherited or transferred from 1 generation to the next by the year 2015, with much of it transferred through a variety of trusts. A trust is a form of ownership that completely separates responsibility and control of assets from all the benefits of ownership. It is controlled and managed by a designated independent trustee.
The Internal Revenue Service (IRS) anticipates that almost 3.7 million U.S. Income Tax Returns for Estates and Trusts (Form 1041) will be filed for Calendar Year 2001. Trust returns are now the third most frequently filed income tax return, behind individual and corporate returns.
An abusive trust arrangement generally involves a promoter who claims that owners are allowed to both retain full benefit of business or personal assets and reduce or eliminate taxes. Abusive trust arrangements often involve more than one trust. For example, a person may put business assets in an unincorporated business trust, transfer business equipment to an equipment trust, place his or her home in a family residence trust, and set up a foreign trust to hold the other trust units and to receive trust income. Examples of abusive trusts are included in Appendix V.
The IRS has warned the public about abusive trust arrangements. IRS instructions for Form 1041 state that “Certain trust arrangements purport to reduce or eliminate Federal taxes in ways that are not permitted under the law.” The instructions further state that “These promised benefits are inconsistent with the tax rules applicable to abusive trust arrangements.”
We performed the audit at the Small Business/Self-Employed (SB/SE) Division Headquarters in Washington, D.C. We also visited the IRS offices in Dallas, Texas, and Denver, Colorado. The audit was performed between February and August 2001 in accordance with Government Auditing Standards.
Detailed information on our audit objective, scope, and methodology is presented in Appendix I. Major contributors to the report are listed in Appendix II.
Since 1997, the IRS has made significant efforts to combat abusive trusts. Abusive trust issues are being addressed through a nationally coordinated strategy that includes the IRS Criminal Investigation function, the SB/SE Division’s Compliance function, the Office of Chief Counsel, and the Department of Justice. The IRS has emphasized the identification of abusive trust promotions and the use of civil and criminal enforcement actions.
Further, the IRS established a National Trust Initiative to promote fairness to all taxpayers by addressing areas of noncompliance. The National Trust Initiative developed goals to:
· Examine additional trust returns and conduct research to help identify compliance trends among trusts.
· Identify and prosecute promoters of fraudulent trust schemes.
· Inform the public about the use of trusts and how to identify abusive trust schemes.
· Enhance the skills of examiners on trust issues.
To meet the goal to examine additional returns, the SB/SE Division’s Compliance Policy function has committed additional staff to the Abusive Trust Program. The function allocated 96 direct Compliance staff years during Fiscal Year (FY) 2001, which represented an increase of 21 percent over FY 2000.
Committing these additional resources enabled the IRS to increase its examinations of Forms 1041 from 567 in FY 1997 to over 4,400 in FY 2000. These additional examinations yielded a substantial increase in proposed tax assessments, averaging $104,000 per return. Figure 1 shows that IRS tax assessments involving abusive business trusts and related returns have increased from $8 million in FY 1997 to over $467 million in FY 2000.
Figure 1 was
removed due to its size. To see the
figure, please go to the Adobe PDF version of the report on the TIGTA Public
Web Page.
The SB/SE Division’s Strategy, Research and Performance Management function is performing a Grantor and Non-Grantor Domestic Trust Research Study. The purpose of this study is to provide compliance information on taxpayers filing Forms 1041 with Beneficiary’s Share of Income, Deductions, Credits, etc. (Schedule K-1), in order to profile the trust market segments, size the abusive trust market, and identify emerging issues. To date, the research group has determined the number of abusive trusts to involve between 5,000 and 10,000 tax returns.
To identify the promoters of abusive trusts, the SB/SE Division’s Reporting Compliance function established an Abusive Tax Shelter web site, exclusively for the use of IRS employees, that details information on abusive trusts. The web site also contains a database link that collects information on promoters of abusive trusts. As of June 2001, the SB/SE Division’s Reporting Compliance function had identified 35 promoters of abusive domestic trusts; an additional 53 leads involving promoters were being analyzed.
The IRS has been involved in various pre-filing and outreach activities to inform the public regarding abusive trust arrangements. Some of these activities involve public speaking engagements, television interviews, magazine and newspaper articles, Form 1041 instructions, notices, and brochures.
As a way to enhance the skills of examiners and share knowledge, a Trust Forum is available on the Intranet web site, which allows IRS employees to post questions on trust issues. Any employee experienced in the subject matter can answer these questions. The SB/SE Division’s Reporting Compliance function management anticipates their staff will use this web site to share knowledge and experiences with other employees nationwide. In addition, management anticipates the result will help ensure uniform taxpayer treatment when performing trust examinations.
In another effort to enhance the skills of examiners, the SB/SE Compliance function has also provided employees the opportunity to enhance their technical skills through several trust-related training courses. For example, in FY 2000, 24 courses were conducted covering Fiduciary Income Tax, Abusive Trusts, Trust Law, and Foreign and Offshore Entities. As of June 2001, an additional 41 classes had been conducted.
One of the IRS’ Strategic Goals is to ensure that the law is applied fairly and uniformly to all taxpayers. The IRS uses penalties to ensure fairness of the tax system by justly penalizing the noncompliant taxpayer.
The IRS’ policy on penalty administration requires “…a penalty system that is designed to
ensure consistency and accuracy of results in light of the facts and the
law.” The IRS’ Abusive
Trust Guide (ATG) recommends, “In most abusive trust cases, either
the negligence or substantial understatement penalty should be asserted against
the grantor.” The Guide also states
that negligence is defined in the Internal Revenue Code (I.R.C.) as any
careless, reckless, or intentional disregard of the rules and regulations or a
failure to make a reasonable attempt to comply with the tax code.
However, the assessment
of penalties for trust returns may vary depending on the facts and circumstances
of, and the examiner working on, the case.
The IRS’ examiners in at
least two locations have expressed their concern about conflicting guidance on
assessing accuracy-related penalties.
For example, in the IRS Trust Forum, two examiners from two of the IRS’
former District Offices stated that penalties were being used as a “bargaining
chip” in their respective districts.
The IRS does not maintain a
system of records on proposed penalties.
A review of 162 randomly selected abusive trust-related returns from the
IRS’ Audit Information Management System, closed during the first quarter of FY
2001, showed that the IRS may not be consistently asserting the
accuracy-related penalty. On 103 cases
where additional tax was assessed, the IRS
assessed the accuracy-related or fraud penalty in only 27 (26 percent)
cases. In FY 2000, the Abusive Trust
Program proposed over $467 million in additional tax assessments on 4,484 tax
returns. These proposed assessments
averaged $104,208 per return. If
this ratio of assessing the accuracy-related penalty is representative of the
population, then an additional $69.1 to $138.2 million in penalties also could
have been assessed over a 2-year period.
In our opinion, conflicting guidelines may be causing this
infrequent and inconsistent assessment of penalties on abusive trust
cases. Specifically, in contrast to the IRS policy and the
ATG, examiners may have been waiving the penalties as they see fit based on an
Advisory Opinion issued by the IRS’ Office of Chief Counsel in the former
Western Region. The advisory opinion
states in part,
…if a taxpayer voluntarily amends his returns or
cooperates with the IRS in settling the cases during the audit process, the
examiner has the option of waiving such penalties as they see fit. However, if the taxpayer does not cooperate
and the case is closed unagreed, appropriate penalties will be assessed.
The Advisory Opinion that is being used as the basis to not assess appropriate penalties may, in fact, have very limited authority. The Advisory Opinion was issued in response to a “question concerning settlement of penalties against taxpayers who participate in abusive trust schemes” submitted by the former Western Region Trust Coordination Committee. This Advisory Opinion was not issued through the National Office of Chief Counsel for a formal Chief Counsel Advice (CCA) document.
I.R.C. § 6110 provides for the public inspection of Office of Chief Counsel determinations, including rulings, determination letters, technical advice, and memoranda. While CCA documents are not legal precedent, the Congress believed the public was entitled to know the rules applied in its dealings with the IRS. The Congress wanted all taxpayers to have access to the “considered view of the Office of Chief Counsel’s national office on significant tax issues.”
Without a consistent approach for assessing penalties, the IRS cannot ensure that penalties for taxpayers are fairly or consistently applied. In addition, there is a risk that not penalizing these taxpayers could result in further noncompliance because they may simply move to other abusive arrangements.
The SB/SE Division’s Director, Compliance Policy, should:
1.
Ensure the Abusive Trust
Program consistently applies the accuracy-related penalty in accordance with
IRS policy, to help ensure fair and equitable taxpayer treatment.
2. Provide examiners with formal guidance on the appropriate application of the accuracy-related penalty, to help ensure its consistent application.
3. Request that the Advisory Opinion issued by the Office of Chief Counsel in the former Western Region be reviewed by the IRS’ Headquarters Office of Chief Counsel, to help ensure fairness to all taxpayers and compliance with provisions of I.R.C. § 6110.
Management’s Response: The Director, Compliance Policy, is
developing new Penalty Tables to provide a tool for monitoring the application
of the I.R.C. § 6662 penalty.
The SB/SE Division Counsel will review the 1998 Advisory Opinion and determine whether updating and/or submitting it to the Office of Chief Counsel is needed.
Management did not fully concur with the outcome measures listed in the report and stated that each closed case would have to be reviewed to determine if the examiner had properly considered the accuracy-related penalty. The Commissioner, SB/SE Division, responded that since these were closed cases, the retrieval cost and time were prohibitive to make this determination.
Office of Audit Comment: The IRS does not maintain a system of records on proposed penalties. Our conclusions on the applicability of the accuracy-related penalty were based on a statistically valid sample of closed cases, documentation from the IRS’ Trust Forum that the penalty was being used as a “bargaining chip,” examiners using the Office of Chief Counsel opinion to waive penalties as they see fit, and the IRS’ ATG. The significantly low rate of assessing the accuracy-related penalty (26 percent) suggests that the IRS, in contrast to the ATG, is not assessing the penalty in “most” cases. The ATG states, “In most abusive trust cases, either the negligence or substantial understatement penalty should be asserted against the grantor.” (emphasis added) In addition, the ATG states, “reasonable cause for penalty abatement would not ordinarily be accepted.”
The IRS has been involved in various pre-filing and outreach activities to educate the public regarding abusive trust arrangements. However, the IRS does not have a method to determine if its pre-filing and outreach activities are actually increasing taxpayer compliance.
For example, the IRS uses the success of its pre-filing and outreach activities as a measure in its compliance program. However, a decrease in the number of abusive trust returns does not necessarily mean there is an increase in overall compliance. Rather, these taxpayers may have found new ways to shelter their income through other abusive arrangements.
The Government Performance and Results Act of 1993 (GPRA) required agencies to set performance goals and report annually on actual performance compared to these goals. Without effective measures to determine the success of its activities, the IRS risks losing the opportunity to effectively communicate and educate the public. This may result in less revenue collected.
The IRS has acknowledged in its Strategic Plan that it does not have reliable, up-to-date measures of overall compliance. Enforcement revenue has been used as a strategic measure. However, enforcement revenue figures do not provide an overall measurement of changes in taxpayer compliance.
4. The SB/SE Division’s Director, Reporting Compliance, should identify compliance measures that will determine not only changes in the abusive trust compliance levels but also whether the taxpayer behavior has actually changed.
Management’s Response: The SB/SE Division’s Research function is considering a special study to analyze follow-up years for Abusive Trust cases closed in FY 2000. This study will analyze examination outcomes on unagreed cases closed to Appeals, Collection outcomes, and taxpayer behavior patterns after examination.
Abusive trust arrangements are
varied and difficult to identify using the current IRS systems. In particular, the IRS does not have a
system to track and identify emerging abusive trust issues. Changes in tax laws, technology, filing
patterns, and trends have created the need for the IRS to update and modify its
approach to addressing abusive trusts.
For example, procedures for
classifying trust tax returns had not been updated for more than 20 years. In January 2001, as part of the National
Trust Initiative, the IRS updated its Form 1041 Classification Guide and Desk
Reference to assist classifiers and examiners in identifying potential audit
issues on trust tax returns. However,
the classification of Forms 1041 is not automated and continues to be a labor-intensive
process.
This has occurred because current
data collection systems used by the IRS do not provide managers with the
necessary information to effectively identify emerging issues and assist with
the allocation of examination resources.
The IRS uses the Midwest Automated Compliance System (MACS), which
contains information from tax returns posted to the IRS’ Masterfile. Although this system includes all filed
returns, it does not have analytical tools for return selection.
Likewise, the IRS uses the Audit Information Management Systems (AIMS) to maintain and control its examination inventory. Project codes are used to identify known issues for the returns selected for examination. However, these codes do not provide for the identification of new issues identified during the examination.
The General Accounting Office’s Standards for Internal Control in the
Federal Government state, “Program managers need both operational and
financial data to determine whether they are meeting their agencies’ strategic
and annual performance plans and meeting their goals for accountability for
effective and efficient use of resources.”
It further states, “Pertinent information should be identified,
captured, and distributed in a form and time frame that permits people to
perform their duties efficiently.”
Without pertinent information on
abusive trust issues, the IRS will have difficulty in determining its success
in reducing abusive trusts and preventing future non-compliance. In
addition, the IRS will not be able to effectively plan and allocate its
resources to maximize examination results.
5.
The SB/SE Division’s Director, Compliance Policy, should
develop a system to capture the results of Form 1041
examinations that would provide management with information to help identify
emerging abusive trust issues and future noncompliance and to help allocate
resources to maximize audit results.
Management’s Response: Compliance Policy and Support Services are developing an experimental system to capture Form 1041 examination data.
Appendix I
Detailed Objective, Scope, and Methodology
Our overall objective was to determine whether the Internal Revenue Service (IRS) has an effective program to identify domestic trusts with a potential for noncompliance. Specifically, we evaluated the methodology that the IRS has to increase taxpayer compliance. In addition, we evaluated the system the IRS uses to measure the results of its efforts in reducing noncompliance and identifying potential areas for examination. The following steps were performed to accomplish the audit objective:
I. To determine what methodology the IRS had planned to increase taxpayer compliance, we:
A. Reviewed the IRS’ Communication Plan to determine if the IRS has developed an effective outreach program for educating the public about abusive trusts to increase voluntary compliance.
B. Determined methods used to disseminate information to the public regarding abusive trusts.
II. To determine if the IRS had a system for determining appropriate treatment of abusive trusts, measuring the effectiveness in reducing noncompliance and identifying potential areas for examination, we:
A. Interviewed the IRS’ Small Business/Self-Employed (SB/SE) Division’s Compliance function management to determine if the IRS has planned an effective management information system to measure the success of its efforts in reducing noncompliance and protecting revenue.
B. Interviewed
the SB/SE Division’s Compliance function management to determine whether the
IRS has developed a nationwide classification system that would identify
potential areas for abusive trusts and aid in the selection of U. S. Income Tax
Returns for Estates and Trusts (Form 1041) for examination.
C.
Reviewed the Internal Revenue
Manual, the IRS’ Abusive Trust Guide, the Internal Revenue Code, and
instructions available on the IRS’ Intranet web sites for determining the appropriate
use of penalties for abusive trust cases.
D.
Selected a statistically
valid random sample of 162 from a universe of 789 abusive trust-related returns
on the IRS’ Audit Information Management System, closed during the first
quarter of Fiscal Year 2001, and analyzed Masterfile data to determine if the
accuracy-related or fraud penalty was assessed on those returns with additional
tax assessments. The actual closed case
files were not reviewed to determine whether the penalty was considered.
Appendix II
Major Contributors to This Report
Gordon C. Milbourn III, Assistant Inspector General for
Audit (Small Business and Corporate Programs)
Philip Shropshire, Director
Edmond
G. Watt, Audit Manager
Carole
E. Connolly, Senior Auditor
Donna
Saranchak, Senior Auditor
Appendix III
Commissioner N:C
Deputy Commissioner, Small Business/Self-Employed
Division S:DC
Chief Counsel, Small Business/Self-Employed Division S:CC
Director, Compliance, Small Business/Self-Employed Division S:C
Director, Customer Account Services, Small
Business/Self-Employed Division S:CAS
Director, Internal/External Stakeholders, Compliance Policy, Small Business/Self-Employed
Division S:C:CP:I
Director, Reporting Compliance, Small Business/Self-Employed Division S:C
Director, Taxpayer Education and Communication, Small Business/Self-Employed
Division S:TEC
Chief Counsel CC
National Taxpayer Advocate
TA
Director, Legislative Affairs CL:LA
Director, Office of Program Evaluation and Risk Analysis N:ADC:R:O
Office of Management Controls N:CFO:F:M
Audit Liaisons:
Commissioner, Small Business/Self-Employed
Division S
Director, Compliance, Small
Business/Self-Employed Division S:C
Appendix IV
This appendix presents detailed information on the measurable impact that our recommended corrective actions will have on tax administration. This benefit will be incorporated into our Semiannual Report to Congress.
· Increased Revenue/Revenue Protection – Potential; $69.1 million in penalties assessed on abusive trust tax returns; over a 2-year period, $138.2 million (see page 4).
Methodology Used to Measure the Reported Benefit:
The IRS does not maintain a system of records on proposed penalties. We selected a statistically valid random sample of 162 from a universe of 789 abusive trust-related returns from the Internal Revenue Service’s (IRS) Audit Information Management System’s closed examinations for the first quarter of Fiscal Year (FY) 2001. On 103 cases where additional tax was assessed, the IRS assessed the accuracy-related or fraud penalty on only 27 tax returns (26 percent). In the remaining 76 returns (74 percent), the accuracy-related or fraud penalty was not assessed.
In FY 2000, the Abusive Trust Program proposed over $467 million in additional tax assessments on 4,484 tax returns. The proposed assessments averaged $104,208 per return. The total applicable accuracy-related penalty (20 percent) on the $467 million in additional tax assessment would be approximately $93.4 million. When this ratio of assessing the accuracy-related penalty is applied to the $467 million assessed in FY 2000, then IRS could have assessed approximately $69.1 million (74 percent of the $93.4 million) in additional penalty assessments. We applied the ratio of assessing the accuracy-related penalty because there was no evidence that the processes and procedures had changed between FY 2000 and the first quarter of FY 2001. For purposes of determining quantifiable outcome measures, we used the lower percentage (20 percent) for the accuracy-related penalty amount that could be assessed.
Finally, the IRS’ practice of infrequently assessing the accuracy-related penalty continued through FY 2001. Therefore, we calculated the outcome measure for a 2-year period to be approximately $138.2 million ($69.1 million for each year).
Appendix V
The owner of a business transfers the business to a trust. The business trust then makes payments, which are characterized as deductible business expenses or deductible distributions, to “unit holders.” These payments reduce the amount of taxable income, which results in little or no tax being due.
An equipment trust is formed to hold equipment that is rented or leased to the business trust, often for inflated rates. The business trust then reduces its income by claiming deductions for payments to the equipment trust.
The owner of the family residence transfers the residence, including furnishings, to a trust. The trust claims to be a rental business and rents the residence to the owner, who is the caretaker of the property. The trust may attempt to deduct depreciation and the expenses of maintaining and operating the residence.
The owner transfers assets or income to a trust claiming to be a charitable organization. The trust or payments made by the owner to the “charitable organization” pay for personal, educational, or recreational expenses. The payments are then claimed as “charitable” deductions.
These trusts often are located in foreign countries that impose little or no tax on trusts and also provide financial secrecy. Typically, abusive foreign trust arrangements enable taxable funds to flow through several trusts or entities until the funds are ultimately distributed or made available to the original owner. The trust promoter claims that this distribution is tax-free. In fact, the income from a foreign trust arrangement is fully taxable.
Appendix VI
The response was removed due to its size. To see the complete response,, please go to the Adobe PDF version of the report on the TIGTA Public Web Page.