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The Use of "Defective" Trusts
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The Basic Idea |
What's In a Name?
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| Why? -- the Numbers
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Why -- the Qualitative Difference
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Conclusion
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The Basic Idea
Although trust income is usually taxed to the trust or the
beneficiary (see The Income Taxation of
Trusts) the Internal Revenue Code provides a string of rules
under which the grantor (creator of the trust) will be treated as
the owner of a trust and taxed on the income (and claim the
deductions), regardless of what actually happens to the income.
Suppose I put $100,000 into a trust to pay income to my
lower-bracket parent or child. Perhaps the trust only lasts five
years. Perhaps one year. Perhaps I have the power to revoke it
and get the principal back. Under these circumstances, I remain
the virtual owner of the property -- I'm trying to shift the tax
effects to someone else. When painted this extreme, you can see
why there would be situations in which I would be treated as the
"substantial owner" of the trust, and taxed on the income.
However, the rules go far beyond such obvious situations. They
extend to circumstances in which the grantor has no power, but
the trustee is a "subordinated party" (certain relatives and
employees of the grantor). Even trusts with totally independent
trustees may be affected if the trustees have certain powers.
There are a myriad of rules.
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What's In a Name?
These are sometimes called "grantor trusts" because they are
usually taxed to the grantor. However, there are circumstances
under which somebody other than the grantor will be treated as
owner, so that name's not broad enough. "Substantial owner" rules
would probably be most accurate but seems too much of a mouthful
for common acceptance.
They have also been called "Defective trusts", which is the term
I'll use here, but has an unfortunate connotation. Although a
small provision may cause a trust's income to be taxed to the
grantor (which is what we'll concentrate on) that may not be a
"defect" -- it may be a completely desirable circumstance. So
what we are dealing with is intentionally "defective" trusts.
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Why? -- the Numbers
Why would you want to be taxed on the income of a trust which
you've set up for someone else?
For one thing, remember that *somebody* has to pay tax. Beyond
that, the most important thing to realize is that the income tax
and estate tax rules are not quite identical. It is possible for
a trust to be "income tax 'defective'" but not "estate tax
'defective'" -- i.e. just because you are taxed on the trust's
income does not mean it will be included in your estate.
You (with your spouse joining in) can give $20,000 per year to a
donee (see Gift Tax). Assume:
You use part of your credit to give them $500,000.
They earn a 5% return, or $25,000.
They are in the 28% bracket and you are in the 40% bracket.
If they are taxed on the income, they will pay $7,000 tax and
keep $18,000. If you pay the tax, they will keep $25,000. And you
can still give them the $20,000 as a separate gift. You've
effectively made a $7,000 tax-free gift.
But wait a minute! You'll have to pay $10,000 tax. This is
costing the family an extra $3,000 -- or is it?
When we look at the long-term estate planning, we have to
consider the cost of getting a dollar to your beneficiary --
including the estate tax. If you don't pay the tax, it will save
you $10,000 to put in the bank. But if you're in the 50% bracket,
your beneficiaries will only see $5,000 of that -- at your death.
This way, they get $7,000 now.
The interplay of income tax and estate tax brackets may require
extensive analysis, but it can often lead to extensive savings.
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Why? -- the Qualitative Difference
This might be called a floating factor. It is an odd
occurrence which may mean nothing in most cases -- but be very
significant in some.
For tax purposes a "defective trust" and the substantial owner
thereof are the same person. You cannot sell something to
yourself. If you sell something to a trust of which you are the
substantial owner, it may be a perfectly valid sale for purposes
of transferring title and removing the asset from your estate
without a gift -- but for income tax purposes it is a non-event,
with no capital gains tax due. There are also other circumstances
in which it may be desirable to effect a sale without the tax
consequences of a sale occurring.
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Conclusion
The intentionally "defective" trust provides a valuable potential
tool in estate planning. Its applicability depends on
knowledgeable analysis of the particular circumstances.
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