Grantor trusts

Grantor trusts allow the person who creates the trust to retain certain powers over the administration of the trust, often up to and including the power to revoke the trust and regain ownership of trust property while that person is living. If, for example, the grantor names him- or herself, or his or her spouse during the grantor’s lifetime, as trustee, you’re looking at a grantor trust. Likewise, if the grantor or the grantor’s spouse is an income beneficiary, the trust is grantor. The key to identifying a true grantor trust doesn’t necessarily rest on the grantor’s power to revoke the trust but rather on the grantor’s keeping control, however tenuous, over the property inside the trust.

In a grantor trust, the grantor is typically not only grantor but also a trustee; he or she is usually beneficiary of not only the trust’s income but also as much of the principal (the property funding the trust) as he or she needs at any given time. (To understand the complete distinction between principal and income, check out Chapter 12.) Generally, in a grantor trust, the existence of the trust is ignored for income tax purposes, and the grantor declares all items of income and deduction on his or her income tax return. In most cases, the trust doesn’t even have its own Tax Identification Number (TIN, the trust equivalent of a Social Security number) because the trust doesn’t need to file its own tax return.

Non-grantor trusts

Non-grantor trusts are trusts over which the grantor has given up all right, title, and interest in the property funding the trust. Although the trust may be revocable (can be dissolved), at least during the grantor’s lifetime, the grantor may not terminate the trust; only the trustee, who must be someone other than the grantor, may. In a non-grantor trust, the grantor (and the grantor’s spouse), in addition to not being a trustee, also may not be named as a present interest beneficiary or as a remainderman (a person or entity who receives what’s left of the trust’s property when the trust terminates or ends).

Even though a trust, when it’s first established, may begin as a grantor trust or an intentionally defective grantor trust (see the next section), at the grantor’s death, all trusts become non-grantor trusts. If you haven’t obtained a Tax Identification Number for the trust prior to the grantor’s death, you should take care of that now. See Chapter 18 for how to obtain a TIN. Remember, come December 31 of the year of the grantor’s death, you’re responsible for filing a Form 1041 for the non-grantor trust that succeeds the grantor trust in existence up until the date of death.

Intentionally defective grantor trusts

In an intentionally defective grantor trust (IDGT), the grantor creates a trust that looks like a non-grantor-type trust: The grantor makes an irrevocable gift of property into the trust, sets up the trust for the benefit of his or her children or grandchildren, and names someone other than himself or herself as trustee. The difference is that the grantor retains the right to substitute other property of equal value for the property he or she initially funds the trust with, in order to intentionally create a defect; the income tax treatment for this trust changes into something that’s not entirely a grantor trust but not really a non-grantor trust, either.

In fact, when you’re administering an IDGT, you must obtain a TIN and file a Form 1041 every year. On the face of the Form 1041, you get to write the following: “Under the terms of the trust instrument, this is a grantor trust. In accordance with Sections 671-678 IRC, 1986, all income is taxable to the Grantor. Statements of income, deduction, and credits are attached.” How’s that for lively prose? Before you file the Form 1041, make sure that you attach those required statements. The grantor then includes all those items on his or her personal return.

An intentionally defective grantor trust is frequently used to hold real estate and closely held businesses. Why on earth would anyone want a defective grantor trust? It’s an estate-planning strategy that, among other purposes, “freezes” the value of property transferred into the trust for estate tax purposes; having the grantor be liable for the income tax removes the income tax paid from the grantor’s estate for estate tax purposes. That’s because, unlike the grantor trust income tax rules that make the income includible on the grantor’s Form 1040, the property is effectively transferred out of the decedent’s estate for estate and gift tax purposes at the time it’s transferred to the trust. Gift tax, if any, is paid on the value of the property on the date it’s transferred into the trust. No estate tax is due when the grantor dies.

Using an intentionally defective grantor trust is a fairly nifty technique, but not one to be undertaken by amateurs. If you think this might be a route that makes sense for you, please find a qualified estate and trust attorney to help you draft the trust and do the initial funding.

Trusts created during lifetime

As they craft their estate plans, many people want to retain the greatest amount of control possible over their estates during their lives and after their deaths. In order to do so, many create inter vivos trusts, which are trusts governed by a legal document other than their last wills. As their Latin names suggest, these trusts are created “among the living” during the grantor’s lifetime. So basically because an inter vivos trust is governed by an instrument other than the will, its provisions remain private, unlike the will, which becomes public knowledge after it’s filed for probate administration. That’s why inter vivos trusts are important to families who have substantial assets or who are in the public eye and don’t want everyone knowing what they’re worth.

A grantor may fund inter vivos trusts either during his or her life or after his or her death. If funded during the grantor’s lifetime, you, the trustee, need to check the instrument carefully to see if the trust falls under the grantor trust rules explained earlier in the “Grantor trusts” section, or under the intentionally defective grantor trust rules to determine whether to report the income on the grantor’s Form 1040 or on a Form 1041 for the trust. Inter vivos trusts may be revocable (often referred to as living trusts) or irrevocable; after the grantor’s death, they’re all irrevocable.

A grantor often uses inter vivos trusts to remove property from his or her estate, at least for probate purposes (check out Chapter 6 for more on probate), and in other cases, for both probate and estate tax purposes. For example, if the trust was treated as a non-grantor or intentionally defective grantor trust during the grantor's lifetime (see the previous sections). If, however, the trust was treated as a grantor-type trust during the grantor’s lifetime, be sure to include all property inside the trust when making estate tax calculations.

Trusts created under a last will

Although the idea of a trust for which no probate court supervision is necessary may seem attractive to you, having the court keeping its beady eyes on a rancorous family isn’t always the worst idea. And, in our experience, nothing can turn a family situation uglier in a hurry than the death of a wealthy parent or grandparent. In cases where a grantor suspects that life may become unpleasant for his or her trustees after his or her death, choosing a testamentary trust, or a trust whose provisions are contained in, and a part of, the decedent’s last will, over an inter vivos trust, can be a wise decision. Testamentary trusts are only funded after the grantor’s death and are therefore always non-grantor-type trusts.

Unlike inter vivos trusts, where accounting standards are sometimes lax, testamentary trusts must usually provide the probate court with an annual account, depending on what state you’re probating the estate in. Check with the probate court involved to be sure of its requirements because trustees who fail in their duty to prepare and file these annual accounts when required may be sanctioned by the probate court, usually with just a slap on the wrist, but sometimes with a fine or in very rare circumstances a contempt-of-court citation.

Probate accounts are a matter of public record, and anyone with the time and energy to go looking for them, from trust beneficiaries, disinherited heirs, or even newspaper reporters nosing around for some dirt, may access them.

Still breathing: Living trusts

Living trusts, or trusts created and funded during the grantor’s lifetime, are an estate-planning technique designed to remove assets from the grantor’s estate, either directly to his or her heirs upon the grantor’s death or into his or her trust without ever setting foot in a probate court. These probate-avoidance trusts almost always begin their lives as revocable trusts and are usually treated as grantor trusts for income tax purposes. Most living trusts are clearly identifiable because the grantor fills all the roles during his or her lifetime: grantor, trustee, and beneficiary.

If you’ve created a living trust, your goal should be to transfer as many of your assets as you can into the trust during your lifetime. You may not be able to shift every asset, such as those items you hold jointly with someone else. If the joint owner is your spouse, and you both really want that specific property to be held in trust, you may opt to transfer full ownership to one or the other of the owners, or split it into two separate pieces, with each of you retaining half. After ownership is vested in only one name, you may then proceed to transfer the property into the name of the trust.

Either the grantor or someone given the grantor’s power of attorney can transfer assets into a living trust. Living trusts also have provisions that handle the incapacity of one trustee and the appointment of a predetermined successor, or a procedure for determining a successor. This means that in the case of the grantor’s mental or physical incapacity, provisions in a living trust instrument can enable a trusted friend, relative, or advisor whom the grantor has selected in advance to assume the trusteeship and take over control of the grantor’s assets without the probate court having to appoint a guardian or conservator (see Chapter 2 for more information on guardianship and conservatorship).

Many living trust instruments are written in such a way that, upon the grantor’s death, the trust instrument governing the trust remains the same, but new provisions regarding the trust’s administration come into force. A trust designed to continue beyond the grantor’s death becomes irrevocable at death, and the provisions contained in the trust instrument can no longer be changed or revoked. This now-irrevocable trust will have new trustees and new beneficiaries (remember, while it was a living trust, the grantor was probably also the trustee and the beneficiary) and it will require a new TIN.

Tackling Totten Trusts

Although it’s much simpler than a living trust (and involves much less documentation), a Totten Trust (some states call it a payable-upon-death account) is still an estate-planning technique designed to move assets from the grantor’s estate, either directly to his or her heirs upon his or her death, or into his or her trust without ever setting foot in a probate court, only this time there’s no trust instrument. Instead, with the Totten Trust, the grantor opens a specific bank or brokerage account by using specific, formulaic language, and filling out specific paperwork that the bank or brokerage firm provides. For example, Sue Smith may have $10,000 she wants to give to her niece, Ellen Smith, at Sue’s death and not a moment sooner. To do this, she can put the $10,000 into a bank account entitled “Sue Smith, in trust for Ellen Smith.” For as long as Sue Smith lives, she can add to this account, take money out of it, or even close it entirely. When she dies, any money still in the account now belongs to Ellen Smith.

With this type of trust, the income earned is taxed to the grantor, and these accounts use the grantor’s Social Security number to report any earnings. No separate tax returns are necessary. Upon the grantor’s death, no probate is necessary for the assets contained in the account.

Because a Totten Trust doesn’t have a trust instrument, each Totten Trust account a grantor opens has its own paperwork.

Not all states recognize Totten Trusts, and many that do have restrictions and regulations for them. If you’re thinking of setting up one or more yourself, check with the bank or brokerage firm beforehand to make sure that your state honors the payable-upon-death designation and to see what restrictions, if any, apply to this type of account in your state. If your state doesn’t honor the payable-upon-death designation, the person you name as the successor will still inherit the property, but only after it passes through the probate court.

Going incognito: Nominee trusts

One reason grantors use living trusts to transfer ownership of assets from themselves to their heirs is to maintain privacy and keep that transfer from becoming a matter of public record in the probate court. However, placing real estate into that same trust may negate that purpose. Many states require that real property held in trust record not only the deed but also the trust instrument at the registry of deeds. If you live in one of those states, don’t fear! You may still own property in the name of a trust — you just need a different type of trust.

Nominee trusts are a type of trust designed to hold real estate and only real estate. The trustee for the trust has very limited powers; instead, the beneficiaries actually control what happens in the trust (including whether to sell the property). To prevent the world from knowing who the beneficiaries are, a Schedule of Beneficial Interest, which lists the names and percentage ownership of each of the beneficiaries, is attached to the original nominee trust instrument but not to the copy recorded at the registry of deeds. That way, although the names of the nominee trust, its trustee, and the property that’s in trust are all matters of public record, the names of the people who actually control the property aren’t.

Because nominee trusts are disregarded entities for income tax purposes and don’t require separate tax returns, the beneficiaries actually claim any income or deductions that the real estate produces on their personal income tax returns. If the real estate in question is property that the transferor ideally would have liked to place in his or her living trust, he or she can name the trustees of the living trust as the beneficiary of the nominee trust in states that recognize nominee trusts. In other states, a nominee partnership is used instead; the partners are typically the trustees of the living trust.

Making gifts to an irrevocable trust

When a grantor funds an irrevocable trust (a trust that the grantor can’t change or terminate) with property during his or her lifetime, and the grantor is neither a trustee nor beneficiary of the trust, he or she is giving up all right, title, and interest to that property — the legal definition of a gift. Depending on the size of the gift, the grantor may have gift tax and/or generation-skipping transfer tax (see Chapter 17) consequences as a result of the transfer.

If the grantor is making a taxable transfer to an irrevocable trust (and by taxable, we mean any amounts over and above the amount of the annual exclusion, which is $14,000 in 2013 and is adjusted annually for inflation), he or she will have to complete a Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, giving the name and taxpayer ID number of the trust, and showing the size of the gift. Unless the amounts involved are huge, the grantor probably won’t actually pay a tax on the transfer; this Form 709, however, becomes part of his or her permanent tax records. Together with any other taxable transfers the grantor makes during his or her lifetime, this gift will be included when calculating the grantor’s taxable estate which, in turn, will be used to determine the total estate tax due upon the grantor’s death.

Married couples may opt to minimize gift tax consequences by so-called gift-splitting, where the two spouses each show one-half of the gift on their Forms 709 (you’re not allowed to file a joint Form 709), even if they didn’t own the gifted property jointly. Splitting gifts between husbands and wives doubles the amount of annual exclusion gifts available to the grantor and reduces the amount of any taxable transfer. For instance, in 2013 the two spouses could transfer $28,000 (2 × the $14,000 exclusion amount), no matter whose assets actually were transferred.

If the transfer is to a trust for the benefit of a skip person (your grandchild, a more distant relative, or a nonrelated person who is more than 37½ years younger than the grantor), you also have to complete the generation-skipping part of Form 709.

Property the grantor gifts irrevocably into a trust keeps the same basis, or acquisition cost and acquisition date, as it had in the grantor’s hands unless the asset is worth less on the date of the gift than the grantor’s original basis. In this case, the basis will be the lower of cost or market value at the time of transfer. This information is crucial in determining whether there’s a taxable gain or loss when the trustee disposes of the property. It’s best to give these records to the trustee at the time the gift is made, and then the trustee should be certain to maintain good and complete records going forward.

Getting the maximum tax benefit out of dying: Marital trusts

Leaving a trust (or more than one, in many cases) behind for your husband or wife after you die isn’t a sign that you don’t think he or she can handle your money; instead, it’s a crafty tax technique designed to minimize the taxes paid on your estate at your death and also those due and payable after your spouse’s death. Welcome to the world of marital trusts, where a funded trust means that the grantor has already died and his or her spouse is still alive.

No matter what type of marital trust you’re administering, the value of that trust on the surviving spouse’s date of death is included in his or her estate tax calculations after he or she dies. Even though you may have avoided paying estate taxes on it after the first spouse’s death, you probably won’t avoid paying taxes the second time if the surviving spouse’s estate, including this trust, is large enough.

All marriages aren’t alike; neither are all marital trusts. You may encounter a variety of options depending on a number of factors, like the size of the estate, whether the surviving spouse is a U.S. citizen, or whether the spouse surviving is from a second or subsequent marriage.

Protecting the estate tax exemption: Credit shelter trusts

Under the transfer tax system in the United States, a person can transfer part (sometimes all, depending on size) of his or her estate without paying any tax on that transfer. During life, you’re allowed to make annual gifts (sometimes referred to as annual exclusion gifts — $14,000 in 2013, adjusted annually for inflation in $1,000 increments) that fly under the transfer tax system radar without counting against this nontaxable portion. But at death, all the decedent’s assets are added up (including property transferred in excess of annual exclusion gifts) and subjected to estate tax. At this point, whatever portion of that allowable tax-free transfer (also called the applicable exclusion amount) the decedent didn’t use during lifetime is subtracted from the total estate. This portion of the estate funds the credit shelter trust (sometimes referred to as the bypass trust or family trust), or the trust that holds the amount of assets equal to the remaining applicable exclusion amount. Not coincidentally, this is the same value of assets on which the corresponding tax would equal the amount of the unified credit available to the estate if those assets were to be taxed. (For a more in-depth discussion of unified credit, see the “Understanding the unified credit” sidebar.)

Before funding the credit shelter trust, obtain copies of the decedent’s most recent gift tax return, which should show how much, if any, of the unified credit the decedent used while alive. If the decedent wasn’t too generous during lifetime, you have the full amount ($5,250,000 in 2013, adjusted annually for inflation). If the return does include taxable gifts, subtract the total gifts (not the credit assigned to the tax assessed on those gifts) from the total amount of the estate that’s exempt from taxation to arrive at the amount you can use to fund this trust.

Grandpa (or Grandma) knows best: Grandchildren’s trusts

If you’re not sure whether your children are ready to handle large sums of money, chances are good you’re even more convinced that your grandchildren aren’t ready. Grandchildren’s trusts are like children’s trusts in almost every respect except one: Transfers made into trusts created for grandchildren are subject to the generation-skipping transfer (GST) tax. (Check out Chapter 17 and the nearby sidebar, “Skipping generations,” for more on this tax.) And remember, any GST tax you pay is in addition to any gift taxes or estate taxes owed on the transfer.

Grantors often create these trusts to provide funds for a specific purpose, such as education or the purchase of a home. These trusts often allow the trustee a great deal of discretion when choosing to make a distribution for another purpose. As with children’s trusts, the grantors often create them with an end plan in place so the principal is distributed to the beneficiary at specific ages.

Better safe than sorry: Insurance trusts

Many grantors hold assets, such as a company they own or the family farm, that can’t readily go into a trust. But those items still have real value and are part of the total estate when calculating estate taxes. Of course, if that type of asset represents the bulk of the decedent’s estate, the estate may not have enough cash to pay the tax man when the time comes. Enter the insurance trust, a type of irrevocable trust funded during the grantor’s lifetime. An insurance trust uses insurance policies (plus a small amount of cash) as the only type of asset. The trust owns the insurance policies on the life of the grantor, and the trust is the sole beneficiary. In fact, insurance trusts are a reasonably inexpensive way to make sure that adequate funds are available to pay the cash needs of a decedent’s estate that may be otherwise short of cash, without forcing a fire sale of other assets that may not be readily marketable.

When the grantor dies, the proceeds from the insurance policies are paid into the trust. Money is then available to pay the debts of the decedent and the estate, including any estate taxes due. If the trust is structured correctly and the premiums have been paid by using the grantor’s annual exclusion from gift tax or some of his or her lifetime annual exclusion, the face value of the life insurance policies on the grantor’s death isn’t included in the grantor’s estate for estate tax purposes.

It’s only a name, not a description: Crummey trusts

In a Crummey trust, creating the illusion that the beneficiaries have the right to use the gift at the time it’s given (a present interest) is the key. Without a present interest, the grantor can’t use the annual exclusion to eliminate any gift tax consequences.

Crummey trusts are named for Crummey v. Commissioner, a court case decided in the U.S. Ninth Circuit Court of Appeals in 1969. The case enabled a grantor to make a gift into trust of a present interest in property that wasn’t really a present interest gift, while claiming an annual gift tax exclusion for it at the same time.

In a Crummey trust, the grantor transfers money equal to or less than the annual exclusion amount into a trust set up for the benefit of his or her children and/or grandchildren. When the gift is made, the trustee sends a letter to all the named beneficiaries informing them of the gift and telling them they have a right to withdraw some or all of that gift within a specified period of time, usually 30, 45, or 60 days. When the beneficiaries fail to take the money out of the trust during this period (and the grantor, trustee, and beneficiaries all understand that the beneficiaries won’t be asking for their money), their ability to do so lapses, and the money now remains inside the trust and is available to pay life insurance premiums. This ability to withdraw the contributions at the time they’re made, even though no one ever exercises their right to do so, creates the present interest required for annual exclusion gifts and is called a Crummey power.

In a Crummey trust, the trustee is responsible for investing the cash, allowing it to grow over time. At some date far in the future, distributions may be made to the beneficiaries, many times to pay for education or the purchase of a new home. In some cases, the trust terminates at a specific date or when the beneficiaries reach certain ages, with the principal being paid out to the beneficiaries. In others, the trust may operate long after the contributions have been made to it, paying income and/or principal to the beneficiaries according to their needs.

Many grandparents have paid for their grandchildren’s college educations by funding Crummey trusts for them. Although these trusts aren’t afforded any income tax breaks (unlike specifically designated college savings accounts such as Section 529 plans or Coverdell Education Savings Accounts), Crummey trusts may be far more flexible than either of those accounts. With a Crummey trust, the principal doesn’t have to be used to pay for education, and the distributions are discretionary. So the grandchild who may land a four-year free ride for whatever reason won’t have a mountain of unnecessary college savings, and the grandchild who may otherwise qualify for outright grant or scholarship money won’t be penalized because of money that has been explicitly set aside for his or her education.

Keeping a finger in the pie: Grantor-retained interest trusts

Sometimes, grantors want to put specific property into trust but aren’t sure that they’re ready to lose the benefit from that property yet. Welcome to the world of grantor-retained interest trusts, where the grantor makes the gift of property into trust but holds back an interest, either in the income from the property or the use of the property for a specified period of time.

Because the grantor hangs onto an interest in the property transferred for a period of time, you may be tempted to view these trusts as grantor trusts, discussed earlier in this chapter, so that no gift tax returns would be required because the grantor didn’t give up complete control of the property in question. Grantor-retained interest trusts are more of a hybrid, though — although the grantor keeps an interest, that interest is finite, and the transfer of property into one of these trusts constitutes a gift that requires filing Form 709. But the value of the taxable gift isn’t the same as the value the property had in the hands of the grantor. Instead, the gift tax value is the value of the property at the date of the gift, less the value of the grantor’s retained interest.

Why bother with grantor-retained interest trusts? To reduce taxes. Using these trusts can substantially reduce the transfer tax value of property by using today’s values instead a higher value years down the road, which will result in a higher tax. This isn’t foolproof: Sometimes values shrink rather than expand. But, while you should never make any estate planning decision purely based on the tax consequences, we’ve both been involved with plenty of these trusts where large potential transfer tax bills were almost entirely eliminated because the grantor created a grantor-retained interest trust.

Grantor-retained interest trusts come in many varieties. Among the most popular are the following:

• Grantor-retained Annuity Trusts (GRATs): The grantor transfers property into trust and receives a regular, fixed payment from it, based on a percentage of the initial value of the transfer, for a period of years.
• Grantor-retained Income Trusts (GRITs): The grantor transfers property into this trust but holds onto the income earned by the trust for a period of years. At the end of the period, the property either distributes out to the beneficiaries, or remains in trust, but now the beneficiaries receive the income.
• Grantor-retained Unitrusts (GRUTs): The grantor transfers property into trust, and like with a GRAT, retains the right to receive an annual payment from the trust for a period of years. Instead of a fixed annuity amount determined when the trust is initially funded, the unitrust payment changes annually, and is calculated based on an asset valuation done on a specific day each year. In many cases, that date is the second business day of the calendar year. (Don’t ask — we’re just responsible for telling you the rules, not for making them.)
• Qualified Personal Residence Trusts (QPRTs): The grantor transfers his or her home into the trust, retaining the right to live there, rent free, for a period of years. After the specified period ends, the property now belongs to the named beneficiaries (usually the children but sometimes the grandchildren), and it’s up to those beneficiaries whether to allow the grantor to remain in the residence. It’s very important, though, that the grantor now pays the new owners market rent for that house if he or she continues to live in the home. Otherwise, the IRS may decide that the grantor never actually made the gift and therefore still owns the house.

The rules for structuring a grantor-retained interest trust, and for determining the gift tax value of the property transfers into the trust, aren’t for the weak of heart. If not done correctly, the IRS may come along at any time and disallow the gift. Unlike income tax returns, which have a specified statute of limitations beyond which time the IRS may not question the return unless they suspect fraud, gift tax returns remain open items with the IRS until the taxpayer’s death. The IRS can still question gifts made 30 years ago, changing valuations or even disallowing them entirely. If you’re thinking of setting up one of these trusts for yourself, find an expert estate planner with plenty of experience to draft the necessary documents and prepare the gift tax returns. And if you’ve been named as trustee of one, get a second opinion and have a professional of your choice review the trust instrument. That way, if the document is fine, and the valuations are dandy, you’re only out a relatively small fee. But if you do have a problem, your expert will, hopefully, find it and correct it before the IRS catches on.

Split-interest charitable trusts

Split-interest charitable trusts are trusts where the grantor retains an interest in the trust property. The grantor may create a trust enabling him or her to receive payments during his or her lifetime, or for a period of years, after which the remaining trust property is given to charity (so-called charitable remainder trusts). Or the trust may permit set payments to charity from the income and principal for a period of years (the charitable lead interest). After that period expires, the remaining trust principal is distributed to the remaindermen, or to the people entitled by the trust instrument to receive whatever’s left after the charitable lead interest expires (so-called charitable lead trusts). The four major types of split interest trusts are

• Charitable Lead Annuity Trusts (CLATs): Charity receives a fixed annual payment every year. Payments are calculated as a percentage of asset value as of the date the grantor gifts the property into the trust.
• Charitable Lead Unitrusts (CLUTs): Charity receives annual payments, calculated on a percentage of the assets (valued as of the second business day of the year) for a fixed number of years.
• Charitable Remainder Annuity Trusts (CRATs): The grantor receives payments for life, based on a percentage of the value of the assets on the date the trust is funded.
• Charitable Remainder Unitrusts (CRUTs): The grantor receives payments for life that are fixed annually, based on a percentage of the value of the assets (which are usually valued on the second business day of each year).

All CLATs, CLUTs, CRATs, and CRUTs must file annual income tax returns. What makes this an interesting exercise is that these forms aren’t typically fiduciary income tax returns like the ones described in Chapter 18. Instead, Form 5227, Split-Interest Trust Information Return is your form of choice. Note that Form 5227 is an information return only; no tax is ever due. If the trust you’re administering is a remainder trust, you have to give a Schedule K-1 from the trust return to the income beneficiary, who will then be responsible for including on his or her personal Form 1040 all items of income and deduction shown on the K-1. We discuss how to complete Schedule K-1 in Chapter 20.

Don’t fail to file your tax returns, including any required state returns. Just because you’re not paying any tax doesn’t mean that the IRS doesn’t want to see what’s happened during the year. Failure to file the Form 5227 carries a hefty filing penalty, calculated on the number of days it’s late, and maxing out at a whopping $50,000 per return, and the IRS very rarely abates it. It figures if you’re swift enough to figure out the positive estate and income tax consequences of setting up one of these trusts, you’re also swift enough to make sure that you file the tax returns on time. Although ignorance on other tax matters may sometimes earn you some IRS sympathy, it doesn’t here.

Non-operating charitable foundations

You may have heard of the Ford Foundation, the Rockefeller Foundation, and (more recently) the Gates Foundation. These are non-operating charitable foundations (sometimes also referred to as family foundations), which are established by some very philanthropic folks in order to further their charitable goals. Although these foundations may be incorporated and be run by the full gamut of corporate officers and directors, they may also be governed by a trust instrument and trustees. For many smaller foundations, the trust route is the way to go because the tax reporting requirements are the same and they don’t have any corporate filing obligations.

Qualified Subchapter S Trusts (QSSTs)

In a Subchapter S corporation, the shareholders (not the corporation) pay the income tax on income the corporation earns. The corporate income tax return (Form 1120S, U.S. Income Tax Return for an S Corporation) shows all the income for the year, and then splits it among all the shareholders on Schedule K-1. Each shareholder than declares his or her portion of the income on Form 1040. Because trusts, in general, don’t fall under the list of approved shareholders, if a trust wants to become a qualified shareholder, it must be certain to pass all the income out to its income beneficiary. Welcome to the world of Qualified Subchapter S Trusts, or QSSTs.

In order for a trust to be a QSST, it must meet the following conditions:

• The Subchapter S income must be distributed 100 percent to the trust’s income beneficiary because that income must be declared on individual tax returns, not on trust tax returns. So in order for a trust to own S shares, it must pay out all its income to its income beneficiary. Or, if the trust is a grantor trust and doesn’t have a separate tax return, the grantor declares all items of income on his or her Form 1040.
• A QSST may only have one income beneficiary, who must be a U.S. citizen or resident, during the lifetime of that beneficiary. If the trust beneficiary is a nonresident alien (a citizen of another country who doesn’t live in the U.S.) or a corporation, that trust can’t be a QSST.

One trust instrument may create multiple QSSTs. If a trust instrument creates these so-called separate shares, each of the shares may qualify as a Subchapter S shareholder, provided, of course, that the mandatory income beneficiaries fulfill the other requirements for S shareholders.

If only it were as easy as knowing that the trust and the beneficiary are qualified S shareholders. Unfortunately, you have to let the IRS know. Seek advice sooner rather than later from a qualified professional (attorney, CPA or Enrolled Agent) to make sure that the QSST election is filed on time (typically 2½ months after the S corporation’s year-end). Failure to file these elections jeopardizes not only the trust’s election but also the entire S corporation’s existence as an S corporation. Remember, an S corporation that has even one disqualified shareholder stands to lose its S designation, leaving it liable for double taxation, first on corporation income and then on the dividends paid to the shareholders.

Electing Small Business Trusts (ESBTs)

Although QSSTs must have one mandatory income beneficiary who is a U.S. citizen or resident (see the preceding section), Electing Small Business Trusts (ESBTs) may have multiple income beneficiaries, and the trust doesn’t have to distribute all income. Instead, in an ESBT, the following apply:

• All beneficiaries must be individuals, estates, or charitable organizations.
• The S stock may not be purchased by the trust.
• The trust may not be a QSST or a tax-exempt trust.
• Each potential income beneficiary counts toward the total allowable number of shareholders any S corporation may have.

In an ESBT, the trustee (not the beneficiary) makes the election, notifying the IRS where the corporation files its tax return of the name, address, and TIN for each trust beneficiary. Usually, you must file ESBT elections within 2½ months of the corporation’s year-end.

Like QSSTs, ESBTs are tricky beasts best not attempted on your own, at least while you’re getting going. Making a mistake here jeopardizes not only the status of the trust’s election but also of the corporation’s S election. And if you think messing up a trust tax return is bad, just wait until you have a bunch of angry former S shareholders hunting you down because they now have to pay more taxes due to your error.