It's possible for transfers to a trust to be completed gifts for gift and estate tax purposes, even though that trust may still be treated as a grantor trust for income tax purposes, so that the income of the trust is taxable to the grantor even though retained in the trust or distributed to beneficiaries of the trust.
By paying taxes on trust income, the grantor in effect makes additional transfers to the trust beneficiaries without the payment of gift tax, since she is paying her own tax liability and not the trust's liability. Such a trust is often called an "Intentionally Defective Grantor Trust," because the grantor intentionally violates one or more of the grantor trust rules. (See below for a list of provisions that can be used to make the grantor liable for taxes on a trust's income without causing the trust's assets to be included in the grantor's estate.)
However, if, under the trust agreement or applicable local law, the grantor must be reimbursed by the trust for the income tax attributable to the inclusion of the trust's income in the grantor's taxable income, then the full value of the trust's assets is includible in the grantor's gross estate for estate tax purposes.
Example 1: On Jan. 2, 2005, your client establishes and funds an irrevocable inter-vivos trust for the benefit of her children. The trust agreement requires that the trustee be a person not related or subordinate to your client. Your client appoints a trustee who satisfies this requirement. Under the terms of the trust, your client retains no beneficial interest in, or power over, the trust's income or principal that would cause the transfer to the trust to be an incomplete gift for gift tax purposes, or that would cause the principal of the trust to be included in her gross estate for estate tax purposes when she dies.
The trust does include, however, provisions that cause your client to be treated as the owner of the trust under the grantor trust rules for income tax purposes. Thus, she is liable for any income tax attributable to the trust's income. Thus, even though your client is not a beneficiary of the trust, any income tax that she pays that is attributable to the trust's income is paid in discharge of her own income tax liability.
Neither the trust agreement nor state law requires or permits the trustee to distribute to your client amounts needed to satisfy her income tax liability that is attributable to the inclusion of the trust's income in her taxable income.
Assume that in 2005, the trust receives taxable income of $50,000 that your client must include in her taxable income, and that this $50,000 is taxed to her at an average rate of 30 percent. As a result, your client's personal income tax liability for 2005 increases by $15,000 (30 percent of $50,000). She pays this additional tax liability from her own funds. When your client dies, no part of the trust's assets will be includible in her gross estate, since she did not retain the right to have property of the trust used to pay her legal obligation to pay taxes on the income of the trust.
Example 2: The facts are the same as in Example 1, except that the trust agreement requires the trustee to reimburse your client from the trust's income or principal for the amount of income tax she pays that is attributable to the trust's income. Thus, the trustee distributes $15,000 to your client to reimburse her for the total income taxes of $15,000 that she owes as a result of including the income of the trust in her own taxable income. Since your client has retained the right to have property of the trust used to discharge her own legal obligation, on her death, the full value of the trust's assets will be included in her gross estate.
The result would be the same if, under applicable local law, the trustee must, unless the trust agreement provides otherwise, reimburse your client for her income tax liability that is attributable to the inclusion of all or part of the trust's income in her taxable income, and the trust agreement does not provide otherwise.
Suppose the trust agreement, or applicable local law, gives the trustee discretion to reimburse the grantor for the part of the grantor's income tax liability that is attributable to the trust's income. The existence of that discretion, whether or not exercised, will not, by itself, cause the value of the trust's assets to be includible in the grantor's gross estate.
However, this discretion may cause inclusion of the trust's assets in the grantor's gross estate when combined with other facts such as:
* An understanding or pre-existing arrangement between the grantor and the trustee regarding the trustee's exercise of this discretion; or,
* A power retained by the grantor to remove the trustee and name the grantor as successor trustee; or,
* An applicable local law that subjects the trust assets to the claims of the grantor's creditors.
Example 3: The facts are the same as in Example 1, except that the trust agreement provides that the trustee may, in the trustee's discretion, distribute to your client for the tax year, income or principal sufficient to satisfy her personal income tax liability attributable to the inclusion of all or part of the trust's income in her taxable income. There is no express or implied understanding between your client and the trustee regarding the trustee's exercise of discretion, and the trustee is not related or subordinate to the grantor. The trustee exercises this discretionary power and distributes $15,000 to your client to reimburse her for the $15,000 of additional income tax that she must pay as a result of including the trust's income in her taxable income.
Under these circumstances, the trustee's discretion to satisfy your client's obligation would not alone cause the inclusion of the trust's assets in your client's gross estate for estate tax purposes. This is the case regardless of whether or not the trustee actually reimburses your client from the trust's assets for the amount of income tax that she pays that is attributable to the trust's income. The result would be the same if the trustee's discretion to reimburse your client is granted under applicable state law rather than under the trust agreement.
Example 4: Your client created a trust and retained the power, acting in a non-fiduciary capacity, to reacquire the trust assets by substituting property of an equivalent value. Thus, he was treated as the owner for income tax purposes. Your client designated his wife as trustee and another individual as trust protector. Under the trust agreement, a trustee who was not related or subordinate to the grantor, could, in the trustee's discretion, make distributions to the Internal Revenue Service or to a state agency to satisfy any income tax liability of the grantor that was attributable to the trust's income. If there was no trustee serving who was not related or subordinate, then a trust protector who was not related or subordinate had the same discretion to make distributions in satisfaction of the grantor's income tax liability attributable to trust income.
The trustee's or trust protector's discretionary power was not treated as a retention by the grantor of the right to the income or enjoyment of the trust property. Accordingly, the trust property will not be includible in the grantor's gross estate by reason of the trustee's or trust protector's authority.
Observation: A trust protector is an additional party to a trust who is not a trustee, but who does have certain powers over the trust, such as the power to remove and replace the trustees, or the power to change the location of the trust.
Trust protectors are often used in connection with foreign asset protection trusts, although their use is not necessarily confined to them. By appointing an individual with whom the grantor is friendly, such as his attorney or accountant, as trust protector, the grantor can keep practical control over a foreign trust without jeopardizing the trust's ability to insulate the grantor's assets from the claims of creditors.
Dodging estate tax
The following are some provisions that can be put in a trust agreement to make the grantor the owner of the trust for income tax purposes, but not for estate tax purposes.
* Give the grantor or another person, in a nonfiduciary capacity, the power to acquire trust property by substituting other property of an equivalent value. This power is probably used often to create an IDGT.
* Name as the trustee a related or subordinate person, e.g., the grantor's spouse, parent or sibling, who is not a beneficiary of the trust, and give that person the power to distribute income and principal among a class of beneficiaries. The payment of principal should not be limited to a reasonably definite standard, as this will prevent the trust's capital gains from being taxed to the grantor. There should be no understanding between the grantor and the trustee as to how distributions are to be made, since that will cause the trust's assets to be included in the grantor's estate for estate tax purposes under the retained life estate rule.
* Give a non-adverse third party, i.e., someone other than the grantor or a trust beneficiary, a power to add beneficiaries to the trust (other than after-born or after-adopted children).
* Give a non-adverse, third-party trustee, i.e., someone other than the grantor, the grantor's spouse or a trust beneficiary, the power to pay trust income to the grantor's spouse. The trust instrument should contain a provision that trust income may not be used to discharge the grantor's obligation to support his spouse, as the grantor's relief of a support obligation will cause the trust assets to be included in the grantor's estate.
Bob Rywick is an executive editor at RIA, in New York, and an estate planning attorney.
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