Trust Tricks for Estate Planning Professionals

Most trusts for estate planning are revocable. Usually, individuals and families put their assets into a revocable trust to avoid probate and to make their estates easier to manage. For some purposes, such as to protect assets from creditors or to avoid giving beneficiaries control of the assets, an irrevocable trust is preferred. Irrevocable trusts must be carefully drawn up to create the tax treatment the grantor desires for the assets in the trust and the income generated by the assets. This post may guide an estate planner to the various tax laws that allow control over tax treatment of the trust or give an individual considering a trust for estate planning an overview of the choices being made by the trust drafter.

A revocable trust created by a taxpayer is transparent for tax purposes. The grantor or settler continues to pay tax on the trust income on his, her or their personal Form 1040 as if the trust assets still individually owned. However, that is not the case for all trusts.

When the grantor of a revocable trust dies, the situation changes. The trust will probably become an irrevocable trust that will have to file a trust income tax return, Form 1041. Trusts that are created as irrevocable trusts may be required to file a Form 1041 as soon as they are executed and funded.

An irrevocable trust may shift the tax burden for the income away from the grantor so that it falls on the beneficiaries. It may also avoid the federal estate tax (FET) gross estate, so that the assets pass to the beneficiaries without being subject to FET. There are advantages to having the income remain on the grantor’s tax return and advantages to keeping the assets in the grantor’s FET estate. By carefully including certain provisions in an irrevocable trust it is possible to control who pays the tax on the income and whether the assets are in or out of the grantor’s FET estate. The following is a checklist of Internal Revenue Code provisions that can be used to turn on or off inclusion of the trust corpus in the FET gross estate and to turn on or off grantor-trust status for income tax. This may help an estate planner sort out the alternatives.

To keep property out of grantor’s FET gross estate, the transfer must be irrevocable and the grantor may not retain benefits, rights or powers described in:

IRC § 2035 (gift within three years of death)
§ 2036 (retained life estate or beneficial use)
§ 2037 (transfer on death or reversionary interest)
§ 2038 (revocable transfers and powers of appointment)
§ 2039 (annuities)
§ 2040 (JTWROS)
§ 2041 (general power of appointment)
§ 2042 (life insurance owned by decedent)

The same provisions may be used to create inclusion of trust corpus in the gross estate in for basis step-up purposes, to avoid capital gains tax after death.

The grantor will be taxed on income if he or she retains one of these powers:

§ 673 (reversion)
§ 674 (power to control beneficial enjoyment)
§ 675 (administrative powers)
§ 676 (power of revocation)
§ 677 (income for benefit of grantor)

Including one or more of the above powers in an otherwise irrevocable trust may avoid tax on the trust, itself, and keep the tax on the grantor. “Administrative powers,” in particular may have very little effect on the trusts functioning or objectives. These powers may include a power retained by the grantor or the grantor’s spouse to borrow against the trust income or corpus without adequate interest or security or to substitute property of equivalent value. The grantor does not have to exercise the above powers, but including them in the trust document results in the preferred tax treatment. Such a trust may be referred to as an intentionally-defective grantor trust, or IDGT, the trust being “defective” because the income falls back on the grantor for tax purposes.

This being the election season, there will be candidates braying about the need to simplify the tax code. Much of the call for simplification is election rhetoric – bovine manure, in plain language. As the grantor-trust rules show, there is no simple way to tax income or estates in the real world. There are ways that the tax code may be improved, but flat-taxers, like flat-earthers, are not in touch with reality. Until we have a flat tax, it is important to draw up estate plans with tax effects in mind. With careful drafting, taxpayers can have an estate plan that minimizes the tax that they and their beneficiaries have to pay.


John B. Payne, Attorney
Garrison LawHouse, PC
Dearborn, Michigan 313.563.4900
Pittsburgh, Pennsylvania 800.220.7200
©2012 John B. Payne, Attorney

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