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A trust is a legal way of holding, managing, and distributing property. A trust may be either irrevocable or revocable. State law and the trust instrument itself usually set out whether the trust is revocable. When using a trust for wealth preservation planning, a revocable trust usually is not very helpful.
Income Tax
It is important to know who will be taxed on the income generated by the trust. Income earned from trust assets will be taxed to the grantor, the beneficiary, or the trust itself. Income that is taxed to the trust is taxed at much steeper rates than income taxed to individuals. Because trust income reaches the highest tax bracket much more quickly than individual income, it is desirable to structure the trust so that income is taxed, instead, to either the grantor or the beneficiary.
Please read this section carefully because you will want to share this information with your tax accountant or other tax preparer.
For tax purposes an irrevocable trust can be treated as a simple, complex, or grantor trust, depending on the powers over the trust assets retained by the grantor or given to the trustee as set forth in the trust instrument.
A “grantor trust” is a term used in the Internal Revenue Code to describe any trust in which the grantor retains certain powers over or benefits in the trust. If a trust is a grantor trust, then the grantor is treated as the owner of the assets, the trust is disregarded as a separate tax entity, and all income is taxed to the grantor. A revocable trust, for example, is a grantor trust.
A trust subject to Internal Revenue Code §§ 651 and 652 is known as a “simple trust.” A “simple trust” is not a grantor trust or required to be treated as a grantor trust; is required to distribute all income annually; and may not distribute the corpus of the trust or make charitable contributions. A trust that is not a simple trust is known as a “complex trust” and is subject to the provisions of §§ 661-663.
Depending upon the conditions for distribution of trust income and corpus, an irrevocable asset protection trust will be either a complex trust or a simple trust.
Taxable income generated by assets held in the irrevocable trust is taxable to the trust (at trust tax rates) unless the income is taxable to the grantor (at the grantor’s rates) under the grantor trust rules. Because the irrevocable income-only trust is a grantor trust, the income the trust earns is taxable to the grantor-beneficiary even if not distributed to the grantor-beneficiary.
If the trust is not a grantor trust, the income the trust earns will be taxed to the beneficiary only if it is distributed to the beneficiary. Otherwise, it would be taxed to the trust.
Gift Tax
Whether the transfer of property into the trust is a taxable gift depends upon whether the gift is complete. For gift tax purposes, a gift is complete to the extent the donor (the person making the gift) has irrevocably parted with dominion and control over all or part of the transferred property, whether directly or indirectly, leaving the donor without the power to change its disposition, whether for the benefit of the donor or for the benefit of others.
A completed gift qualifies for the annual federal gift tax exclusion. A transfer to an irrevocable trust usually will constitute a taxable gift by the grantor unless the grantor retains a limited power of appointment or other right to determine who receives trust distributions. For example, the grantor may reserve the right to appoint the trust assets (that is, to remove trust assets out of the trustee’s hands) and give them to someone else. Reservation of that power to appoint renders the transfer to the trust an incomplete gift.
Because the trust document reserves to the Grantor a limited power of appointment, the transfer of trust assets by the Grantor to the irrevocable income-only trust is not a completed gift and therefore not subject to federal gift tax.