For some time, promoters have shopped around an arrangement known as a “section 643(b) trust,” known alternatively as a “non-grantor, irrevocable, complex, discretionary, spendthrift trust.” On August 9, 2023, IRS Chief Counsel issued a Memorandum that shoots down many of the contentions raised by the promoters relating to the tax benefits of these arrangements. The full Memorandum can be found here. Taxpayers who have entered into these types of arrangements should take careful note of the IRS Chief Counsel Memorandum and should discuss its implications with a tax professional.
The Trust Arrangement
According to the IRS, the section 643(b) Trust is as follows:
A third-party settlor, acting on behalf of the Taxpayer, creates and nominally funds a trust with legal documents that are provided by the promoter. Taxpayer is appointed the ‘Compliance Overseer’ with power to add and remove trustees and change beneficiaries of the trust. The promotional materials are inconsistent as to whether Taxpayer, a third-party, or both serve as trustee. In the case of a third-party serving as trustee, it is unclear whether the third-party would be an independent trustee.
Taxpayer is not a named beneficiary of the trust. In some variations, Taxpayer’s spouse and/or children are specifically named as beneficiaries but are subject to change by the Taxpayer. The trust instruments gives the trustee sole discretion to make distributions of income or principal to beneficiaries (‘discretionary distributions’). It is unclear whether the Taxpayer, serving in the role of Compliance Overseer, is given a power to direct the trustee to make or withhold discretionary distributions to beneficiaries. The trust is self-styled ‘spendthrift’ trust or ‘spendthrift trust organization.’ There are no provisions that allow any party to revoke the trust by distributing assets back to the donor in termination of the trust.
* * *
The trust is primarily funded by Taxpayer selling assets to the trust in exchange for a promissory note . . . Certain materials claim that the sale of assets to the trust is a non-taxable event, noting that the trust’s purchase price is the ‘book value’ of the assets rather than their fair market value, such that the trust retains Taxpayer’s basis in the assts. Further, there is a presumption that any of the Taxpayer’s business assets (including real estate, equipment, or intangible property) sold to the trust will be leased back to Taxpayer or an entity owned or controlled by Taxpayer. A few variations recommend that (1) Taxpayer transfer up to a 90% interest in a limited liability company (LLC) (or another type of business entity) owned by Taxpayer to the trust; (2) the Taxpayer will cause the LLC to sell certain assets (including intellectual property (IP)) to the trust; and (3) Taxpayer will cause the LLC to lease back those assets and IP from the trust for a payment that is approximately equal to 70% of the monthly income of the LLC.
* * *
The promotional materials claim that almost none of the income generated by the trust is subject to current federal income tax if the trustee allocates such income to corpus and refrains from making distributions to beneficiaries. The legal basis for these assertions regarding federal income taxation rely on § 643 of the Code.
* * *
The Memorandum concludes that the promoters’ claims lack merit because the promoters read the subsections of section 643 “out of context.” Indeed, according to the Memorandum, the promoters do not address at all section 641 of the Code, which requires a trust’s taxable income to be computed in the same manner as an individual (subject to some modifications). Moreover, the Memorandum notes that the promoters seemingly fail to address at all relevant portions of section 643, such as language limiting the definition of “distributable net income” and not “taxable income.” With respect to section 643(b), the Memorandum also provides:
The promoters of this structure mistakenly assume that income in § 643(b) refers to the taxable income of the trust. However, the first sentence of § 643(b) provides that, within the parts of the Code encompassing §§ 641 through 668, any references to ‘income’ without preface refers to accounting income of the trust rather than another concept of income such as ‘taxable income’. References to other types of income will be denoted by their full name, such as ‘distributable net income’ or ‘taxable income’.
The Memorandum then recommends that IRS examiners challenge these types of arrangements. Specifically, the Memorandum recommends that IRS examiners ensure that all income generated from the trust be reported as taxable income, including capital gains and extraordinary dividends, and for the IRS examiner to deny any deduction claimed by the trust for income allocated by the trustee to corpus of the trust.
The Memorandum is important in at least two material respects. First, the Memorandum acknowledges that the IRS is well-aware of the section 643(b) trust arrangement. Second, the Memorandum provides an outline of how the IRS will treat the arrangement, i.e., by including the income that was omitted and/or by disallowing various deductions claimed by the trust. Regrettably, the courts are not forgiving when taxpayers rely on the advice of a promoter in claiming a position on a tax return. In many cases, these taxpayers are required to pay all of the tax and interest from prior years, plus significant civil penalties. This is generally because taxpayers are responsible for the items that they report on their own return, particularly if the court concludes that the position advocated by a third party was “too good to be true.” Also, advice from the promoter of a transaction is generally seen as biased and, therefore, not independent. Accordingly, taxpayers who entered into these arrangements should consult with an independent tax professional.