ROBERT L. SOMMERS
Note: This exercise is for educational purposes only and is not intended to be legal or tax advice. Your particular facts and circumstances must be considered when applying the U.S. tax law. You should always consult with a competent tax professional with respect to your particular situation.
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Income earned by a trust could be taxed to you as the settlor (creator) of the trust, the trust or the beneficiaries. Trust income is generally taxed to the beneficiaries if it is currently distributed to them. (Remember, children under age 14 usually pay income tax at their parents' tax rate on annual investment income over $1,200.) If the income is accumulated in the trust, the trust is taxed. However, if you as trustee or settlor of this trust retain more than a very limited amount of discretionary control, the tax liability will shift to you.
In general, if you retain the right to receive the trust property (a reversionary right) or the discretion to alter, amend or revoke the trust, or have certain powers to distribute the income or principal of the trust, you will be considered the owner of the trust and will be liable for its taxes. Designating your spouse as trustee will not alter your tax liabilities.
Fortunately, you may sufficiently limit your trustee powers to shift back the taxes to either the beneficiaries or the trust. As a tax-exempt trustee, you can retain the power to distribute trust principal, if the distribution is (1) limited to education, support, maintenance or health of a beneficiary; for the beneficiary's reasonable support and comfort; to enable the beneficiary to maintain his or her accustomed standard of living; or to meet an emergency; or (2) charged against the beneficiary's share, thereby reducing that beneficiary's future distributions by the amount of the present distribution.
If you retain discretion to distribute or retain trust income, you become personally liable for the trust's taxes, although trust income which is automatically distributed to the beneficiaries on a current basis avoids this rule.
You may retain the power to temporarily withhold income from a beneficiary if, in general, that income is ultimately paid to the beneficiary, or to the current income beneficiaries (as a group) in percentage shares as stated in the trust. You may also withhold income during a beneficiary's legal disability or minority (under age 21).
In conclusion, you may be the tax-exempt trustee of an irrevocable trust for the education of your children without being considered the owner of the trust, provided you accept very limited powers to distribute the trust's principal and no discretion to distribute current income. You may also retain the power to accumulate income under certain circumstances.
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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**