The IRC and its various sections determine the estate, gift, and income tax treatment of trusts established pursuant to local law. If the specific rules and regulations of the IRC are followed, the transfer of property to a trust will be a completed transfer for estate and gift tax purposes, and the trust will be the owner for income tax purposes as well.

There are cases where financial and estate planners may desire variations of these results. Situations arise where, from the estate's viewpoint, the trust should not be the owner of the property. Other situations may dictate that the transfer be complete for estate tax purposes, but the income continue to be taxable to the grantor. A trust established by a transfer that is still includable in the grantor's estate is known as a gift- or estate-tax defective trust. There may be advantages of making transfers to an income-tax defective trust, a trust that is complete for estate and gift tax while not complete for income tax purposes. It would be expected that there would be consistency between the income tax and estate and gift tax treatment of the same transaction.

A trust that is defective for income tax purposes should also be defective for estate tax purposes. However, the IRC provisions for income and gift and estate taxes were enacted at different times. Therefore, there is not consistency of treatment, and hence a trust can be effective for estate and gift tax purposes, but defective for income tax purposes, a divergence that invites planning opportunities.

Parents can establish an irrevocable trust for the benefit of children where the trust income is to be accumulated or the trustee has the discretionary power to accumulate or distribute the income to the children. The trust can contain certain provisions with the result that the income of the trust is taxable to the grantor even though the income is held by the trust or is payable to the children and not the grantor. The payment of the tax on this income is not considered a gift.

Establishment of Tax Defective Trusts

Income taxation of trusts follows certain general rules. Beneficiaries are subject to tax on the income distributed to them while the trust is generally taxed on capital gains retained by the trust, Where the grantor transfers property but retains an interest or control over the property transferred depending on IRC Secs. 671-679, the income generated may be taxable to the grantor as the owner of the trust property. A brief overview of some of the pertinent code sections reveals the following:

* IRC Sec. 673 provides that if the grantor retains a greater then 5% interest in either the trust corpus or income, the grantor will be treated as the owner of the trust property.

* IRC Sec. 674 provides for the grantor to be considered the owner of the trust property if a nonadverse party retains certain administrative powers.

* IRC Sec. 676 provides that the grantor is considered the owner of the trust property if a nonadverse party holds a power to revest property in the grantor or the grantor's spouse unless an adverse party must consent.

* IRC Sec. 677 provides that the grantor will be considered the owner of trust property if trust income is distributable to the grantor or spouse now or in the future. If the distribution requires the approval of an adverse party, the grantor will not be considered the trust owner.

To the extent that the grantor retains a power that violates the IRC section regarding grantor trusts, that Violation would make the grantor owner of those assets for income tax purposes. If the grantor can substitute assets for 50% of the trust property, then the grantor will be required to report 50% of all income, deductions, and credits on grantor's income tax return. There could be circumstances where the grantor retains a violating power over only the trust's ordinary income thereby resulting in the grantor paying tax on all the ordinary income of the trust but not on the tax consequences to the trust corpus. The reverse may also occur whereby the grantor is taxable on the corpus but not on the ordinary income. An example of this situation would be the old Clifford trust concept.

Creating an Income-Tax Defective Trust

IRC Sec. 675(4)(C) provides that the grantor of a trust will be treated as the owner of trust property for income tax purposes - both ordinary and corpus if any person who can exercise in a nonfiduciary capacity, without an approval of any person acting in a fiduciary capacity, a power, exercisable in a nonfiduciary capacity, to reacquire the trust property by substituting other property of equivalent value. This power should be given to someone who is not a trustee since it can be argued that a trustee holds every power in a fiduciary capacity.

Another approach involves giving a nonadverse party a power exercisable in a nonfiduciary capacity to vote stock of a corporation in which the holdings of the grantor and the trust are significant from the standpoint of voting control or a power to control or to veto the investment of trust funds by directing investments or proposed investments, to the extent that the trust funds consist of stock or corporations in which the grantor and the trust are significant from the view-point of voting control. To avoid a trust which is aim estate-tax defective, these powers should be held by someone other than the grantor.

Power to Add Beneficiaries Can Create a Defective Trust

A power granted to a nonadverse party (other than the grantor) to add beneficiaries (beyond children born or adopted) would violate of IRC Sec. 674(a). There should not be any adverse estate tax consequences provided that the grantor does not control this person's actions.

Spouse as Beneficiary

A nonadverse but independent trustee granted the unrestricted power to make distributions of income or corpus to the grantor's spouse does not make the trust estate or gift tax defective for the grantor or spouse. The existence of a possibility of such distribution to the grantor's spouse will cause the trust to be income-tax defective as to ordinary income and to corpus.

An Example

The income and estate tax advantages of an income-tax defective trust can be illustrated by the following example:

Grandmother Debbie establishes a complex trust for her one-year old grand-daughter, Katie, in 1993 and funds the trust with $200,000 in assets yielding six percent of ordinary income annually. The income is taxable to the trust, and none of it is distributed to Katie. The tax on the trusts income would be $3,907. Assuming that the trust's income compounds at a steady six-percent rate and the tax brackets remain the same, by the time Katie enters college in the year 2110, the trust would have grown to $400,527 on an after-tax basis.

Assume the same facts, except that the trust is a grantor trust. Trust income is taxable to mother Debbie at a 39% marginal rate. Grandma Debbie pays the additional $4,752 in income tax for 1993 and the tax for succeeding years. Assuming the same rate of growth, by the year 2110, the trust would have grown to $570,868 on a tax-free basis.

Because Grandmother Debbie has paid the tax on the trust's income, not only would the trust be worth $170,341 more on a tax-free basis, but the additional tax cost would have reduced the Grandmother's estate.

With Grandmother Debbie in the 39.6% tax bracket, her 1994 tax bill of $4,752 is $845 more than the $3,907 that the trust would pay using the graduated trust income tax rates. This extra tax cost is reduced, however, if the potential gift tax savings are considered. The income from a grantor trust is taxed to the grantor but the grantor is not deemed to have made a gift to the trust by paying the tax on the income.

If grantor, Debbie is in the 36% bracket, her annual income tax cost would exceed the trust's cost by only $413.

In either case, the estate tax saving can be substantially more than the income tax cost and Grandma has the personal satisfaction of having provided grandchild's college cost and more.