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  The Tax Prophet Newsletter Issue #5, November, 2003

In This Issue:
Introduction
Grantor Transfers
Adverse Income Tax Consequences
Family Planning Opportunities
Conclusion

IRREVOCABLE TRUSTS - The Basics

 
Introduction An irrevocable trust is an arrangement in which the grantor departs with ownership and control of property usually during his lifetime. The transfer is sometimes referred to as an inter vivos (Latin for during one's lifetime) or a "living" trust. Usually this involves a gift of the property to the irrevocable trust. The irrevocable trust then stands as a separate taxable entity and pays tax on its accumulated income. Irrevocable trusts typically receive a deduction for income that is distributed on a current basis. Because the grantor must permanently depart with the ownership and control of the property being transferred to an irrevocable trust, such a device has limited appeal to most taxpayers.



Grantor Transfers A grantor's use of irrevocable trusts to avoid taxation of income, and to provide for accumulation of income to provide for beneficiaries at a later date, has been limited under the current tax system. The Revenue Reconciliation Act (RRA) of 1993 has made irrevocable trusts subject to faster tax rate escalation than individual taxpayers. For example, Irrevocable trusts are taxed at 35 percent on taxable income in excess of $10,000 (check). For filers of joint returns, the 35% percent rate does not begin until taxable income is $300,000 (check.



Adverse Income Tax Consequences Ironically, the impact of RRA changes will not severely impact Irrevocable trusts whose grantors or beneficiaries are already in the highest tax percent bracket; they will affect the smaller estates of middle and upper-middle income taxpayers, whose grantors and beneficiaries are in lower tax brackets. To avoid being taxed at the higher rates, Irrevocable trust income can be reduced by increasing distributions to beneficiaries, reducing the amount of taxable income produced by the Irrevocable trust assets, or having the trust invest in assets that produce capital gain (maximum tax rate is only 28 percent) rather than ordinary income.



Family Planning Opportunities Since an Irrevocable trust is taxed as a separate entity on accumulated income, it is sometimes desirable to create as many Irrevocable trusts as possible for purposes of accumulating income at the lower tax brackets. However, two or more Irrevocable trusts will be treated as one trust if the Irrevocable trusts have substantially the same grantor and primary beneficiaries, and federal tax avoidance is the principal purpose of the trusts. Code §643(f).

Although limited in recent years, income splitting among family members through family Irrevocable trust arrangements remains a valid way of reducing overall family income tax. Although an assignment of income from one family member to another is not sufficient, an outright transfer of income-producing property Irrevocable trust can achieve income splitting. If the family member to be benefited lacks the ability to manage the assets, you can use a Irrevocable trust. If the beneficiary is a minor, you may consider the creation of a custodial account under the applicable state's Gifts to Minors Act or the Uniform Transfers to Minors Act instead of a Irrevocable trust.



Conclusion The use of irrevocable trusts in sophisticated tax planning involves a multitude of complex tax rules. You should consult with a tax planning professional to obtain the optimal tax results.

Additional Information: For additional information on irrevocable trusts and estate planning in general, see the Tax Prophet's Section on Estate Planning.





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All contents copyright © 1995-2003 Robert L. Sommers, attorney-at-law. All rights reserved. This internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.