The Basic Idea What's In a Name?
Why? -- the Numbers Why -- the Qualitative Difference
Conclusion

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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