39.6 Trusts in Family Planning

You establish a trust by transferring legal title to property to a trustee who manages the property for one or more beneficiaries. As the one who sets up the trust, you are called the grantor or settlor of the trust. The trustee may be one or more individuals or an institution such as a bank or a trust company.

You can create a trust during your lifetime or by your will. A trust created during your lifetime is called an inter vivos trust; one established in your will is a testamentary trust. An inter vivos trust can be revocable or irrevocable. An irrevocable trust does not allow for changes of heart; it requires a complete surrender of property. By conveying property irrevocably to a trust, you may relieve yourself of tax on the income from the trust principal. Furthermore, the property in trust usually is not subject to estate tax, although it may be subject to gift tax. A trust should be made irrevocable only if you are certain you will not need the trust property in a financial emergency.

Planning Reminder

Revocable Trusts

In a revocable trust, you retain control over the property by reserving the right to revoke the trust. As such, it is considered an incomplete gift and offers no present income tax savings. Furthermore, the trust property will be included as part of your estate. But a revocable trust minimizes delay in passing property to beneficiaries if you die while the trust is in force. When you transfer property to a trust, the property is generally not subject to probate, administration expenses, delays attendant on distributions of estates, or claims of creditors. The interests of trust beneficiaries are generally more secure than those of heirs under a will because a will may be denied probate if found invalid.

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Consult with an experienced tax professional if you are considering the use of a trust in your gift

Trust income.

Where a child is a trust beneficiary, the child reports distributable net trust income as taxable income. Distributable net income may be subject to the “kiddie tax” (24.2). Income that is accumulated for the benefit of a minor child is generally not taxable and, thus, not subject to the kiddie tax.

Grantor trusts.

The grantor of a grantor trust is taxed on the income of the trust. A trust is treated as a grantor trust where the grantor has a reversionary interest (at the time of the transfer) of more than 5% of the value of the property transferred to the trust. Under an exception, a grantor is not treated as having a reversionary interest if that interest can take effect only upon the death before age 21 of a beneficiary who is a lineal descendant of the grantor. The beneficiary must have the entire present interest in the trust or trust portion for this exception to apply.

Given the highly compressed tax brackets for trust income, a grantor may intentionally retain an interest in the trust property so that he or she will be taxed under the grantor trust rules. By setting up such a “defective” grantor trust, trust income may be subject to lower tax at the grantor’s tax bracket than under the trust rate schedule.