Trust Tax Rules
In a broad sense, Trusts are either recognized as separate taxable entities or they are disregarded. For most taxpayers, when a Trust is disregarded, it is because the Trust is treated as a Grantor Trust under the rules described below. Taxes are paid either by the person who established the trust (the “Grantor”), or by the Beneficiary.
Medicaid Trusts, including special needs trusts, may be taxed either as grantor or non-grantor trusts depending on the circumstances surrounding their creation. [1] Usually, the most important tax questions are:
1. Who pays the tax on income earned by the trust?
2. If the trust owns a home, can capital gains taxation be minimized or avoided upon sale of the home; and
3. Can a potential step-up in basis be preserved with respect to appreciated capital assets.
Medicaid trusts, other than special needs trusts, are frequently drafted as Intentionally Defective Grantor Trusts (IDGTs). Because they are used as part of a Medicaid asset protection plan, they are sometimes referred to as MIDGTs.[2] The tax purposes for using a MIDGT include shifting assets beyond the reach of Medicaid’s eligibility rules, without (i) losing the step-up in basis at death for capital assets; (ii) losing the Section 121 exemption on the sale of a home; or (iii) shifting income to someone in a higher tax bracket. The tax purpose for IDGTs is frequently to freeze the value of appreciating assets; because the grantor continues to pay taxes on any income earned, the assets inside the trust essentially appreciate tax-free. The non-tax purposes for using a trust generally include protecting the assets from claims against the beneficiaries (e.g., divorce, bankruptcy, etc.).
As discussed below, there are times when it is desirable to have the trust disregarded for income tax purposes (Section 671 through 679), estate tax purposes (Section 2036–2038), or both.
The Tax Rate For Trusts
As a general rule, though, under the current tax Code, Trusts pay a higher tax rate than individuals because the income tax brackets for Trusts are compressed. For that reason, most planners for middle class families prefer Grantor Trusts, which are discussed below. See income tax rate for trusts in 2021.
Application of the Tax
Section 641(a)
The tax imposed by section 1(e) shall apply to the taxable income of estates or of any kind of property held in trust, including—
(1) income accumulated in trust for the benefit of unborn or unascertained persons or persons with contingent interests, and income accumulated or held for future distribution under the terms of the will or trust;
(2) income which is to be distributed currently by the fiduciary to the beneficiaries, and income collected by a guardian of an infant which is to be held or distributed as the court may direct;
(3) income received by estates of deceased persons during the period of administration or settlement of the estate; and
(4) income which, in the discretion of the fiduciary, may be either distributed to the beneficiaries or accumulated.
Computation and Payment of the Tax
Section 641(b) provides: The taxable income of an estate or trust shall be computed in the same manner as in the case of an individual, except as otherwise provided in this part. The tax shall be computed on such taxable income and shall be paid by the fiduciary. For purposes of this subsection, a foreign trust or foreign estate shall be treated as a nonresident alien individual who is not present in the United States at any time.
Taxable Year
As a general rule, the taxable year for a trust is the calendar year. Section 644(a).
Deductions
Section 642 generally provides that a trust is allowed a deduction of $100. Section 642(b)(2)(A).
A trust which, under its governing instrument, is required to distribute all of its income currently shall be allowed a deduction of $300. Section 642(b)(2)(B).
Section 642(b)(2)(C) provides:
(i) In general a qualified disability trust shall be allowed a deduction equal to the exemption amount under section 151(d),[3] determined—
(I) by treating such trust as an individual described in section 151(d)(3)(C)(iii), and
(II) by applying section 67(e) (without the reference to section 642(b)) for purposes of determining the adjusted gross income of the trust.
(ii) Qualified disability trust For purposes of clause (i), the term “qualified disability trust” means any trust if—
(I) such trust is a disability trust described in subsection (c)(2)(B)(iv) of section 1917 of the Social Security Act (42 U.S.C. 1396p),[4] and
(II) all of the beneficiaries of the trust as of the close of the taxable year are determined by the Commissioner of Social Security to have been disabled (within the meaning of section 1614(a)(3) of the Social Security Act, 42 U.S.C. 1382c(a)(3)) for some portion of such year. A trust shall not fail to meet the requirements of subclause (II) merely because the corpus of the trust may revert to a person who is not so disabled after the trust ceases to have any beneficiary who is so disabled.
Deduction for Trusts Distributing Current Income
Section 651(a) provides for a deduction as follows:
In the case of any trust the terms of which—
(1) provide that all of its income is required to be distributed currently, and
(2) do not provide that any amounts are to be paid, permanently set aside, or used for the purposes specified in section 642(c) (relating to deduction for charitable, etc., purposes),
there shall be allowed as a deduction in computing the taxable income of the trust the amount of the income for the taxable year which is required to be distributed currently. This section shall not apply in any taxable year in which the trust distributes amounts other than amounts of income described in paragraph (1).
Subsection (b) of Section 651 limits the deduction as follows: If the amount of income required to be distributed currently exceeds the distributable net income of the trust for the taxable year, the deduction shall be limited to the amount of the distributable net income. For this purpose, the computation of distributable net income shall not include items of income which are not included in the gross income of the trust and the deductions allocable thereto.
Section 652(a) provides that amounts deducted under Section 651(a) are included in the gross income of the beneficiary to whom income must be distributed.
Deduction for Trusts Accumulating Income or Distributing Corpus
Section 661(a) provides: In any taxable year there shall be allowed as a deduction in computing the taxable income of an estate or trust (other than a trust to which subpart B applies), the sum of—
(1) any amount of income for such taxable year required to be distributed currently (including any amount required to be distributed which may be paid out of income or corpus to the extent such amount is paid out of income for such taxable year); and
(2) any other amounts properly paid or credited or required to be distributed for such taxable year;
but such deduction shall not exceed the distributable net income of the estate or trust.
Section 662 provides for inclusion of deducted amounts in the gross income of the beneficiary.
Grantor Trusts
In very general terms, a Grantor Trust is a disregarded entity for tax purposes. That is an oversimplification, but it works in explaining the concept. In other words, the IRS ignores the Trust and looks through it to find another taxpayer. In most cases the other taxpayer is the person who created the Trust, known as the Grantor. The reason for this tax treatment is because the Grantor retained one or more rights which, according to the IRS, cause the grantor to control the Trust.
Originally the Grantor Trust Rules were designed to enhance tax collections. Individual tax rates were higher than those paid by Trusts, so the Grantor Trust rules were created to identify certain Trusts as “defective,” meaning they were not taxed as separate entities under the rules described above. Beginning during the Reagan Presidency, individual tax rates began to fall and now individual tax rates are typically lower than those paid by Trusts. For that reason, many taxpayers prefer to pay at the individual rate. Now drafters create “intentionally defective” Trusts. The phrase intentionally defective sometimes causes taxpayers concern, but the phrase simply indicates that the Trust was designed to be taxed at the individual’s tax rate for income tax purposes, but it not in his or her estate for estate tax purposes.[5]
One reason why Trusts are structured as Grantor Trusts is because there are ancillary effects when the IRS treats property as if it was still owned by the Grantor. One of such effect is the ability to use the capital gains tax exemption applicable to the sale of a home. Another is the ability to give heirs a stepped-up basis for capital gains tax purposes when capital assets are inherited.
General Rule – § 671
Section 671 provides:
Where it is specified in this subpart that the grantor or another person shall be treated as the owner of any portion of a trust, there shall then be included in computing the taxable income and credits of the grantor or the other person those items of income, deductions, and credits against tax of the trust which are attributable to that portion of the trust to the extent that such items would be taken into account under this chapter in computing taxable income or credits against the tax of an individual. Any remaining portion of the trust shall be subject to subparts A through D. No items of a trust shall be included in computing the taxable income and credits of the grantor or of any other person solely on the grounds of his dominion and control over the trust under section 61 (relating to definition of gross income) or any other provision of this title, except as specified in this subpart.
Regulation 1.671-2(e) generally treats anyone who creates or funds a trust as the Grantor.
Definitions – § 672
Section 672 defines a number of terms used elsewhere in the Grantor Trust Rules. They are as follows:
(a) Adverse party
For purposes of this subpart, the term “adverse party” means any person having a substantial beneficial interest in the trust which would be adversely affected by the exercise or nonexercise of the power which he possesses respecting the trust. A person having a general power of appointment over the trust property shall be deemed to have a beneficial interest in the trust.
(b) Nonadverse party
For purposes of this subpart, the term “nonadverse party” means any person who is not an adverse party.
(c) Related or subordinate party
For purposes of this subpart, the term “related or subordinate party” means any nonadverse party who is—
(1)the grantor’s spouse if living with the grantor;
(2)any one of the following: The grantor’s father, mother, issue, brother or sister; an employee of the grantor; a corporation or any employee of a corporation in which the stock holdings of the grantor and the trust are significant from the viewpoint of voting control; a subordinate employee of a corporation in which the grantor is an executive.
For purposes of subsection (f) and sections 674 and 675, a related or subordinate party shall be presumed to be subservient to the grantor in respect of the exercise or nonexercise of the powers conferred on him unless such party is shown not to be subservient by a preponderance of the evidence.
(d) Rule where power is subject to condition precedent
A person shall be considered to have a power described in this subpart even though the exercise of the power is subject to a precedent giving of notice or takes effect only on the expiration of a certain period after the exercise of the power.
(e) Grantor treated as holding any power or interest of grantor’s spouse
(1) In general
For purposes of this subpart, a grantor shall be treated as holding any power or interest held by—
(A)any individual who was the spouse of the grantor at the time of the creation of such power or interest, or
(B)any individual who became the spouse of the grantor after the creation of such power or interest, but only with respect to periods after such individual became the spouse of the grantor.
(2) Marital status
For purposes of paragraph (1)(A), an individual legally separated from his spouse under a decree of divorce or of separate maintenance shall not be considered as married.
(f) Subpart not to result in foreign ownership
(1) In general
Notwithstanding any other provision of this subpart, this subpart shall apply only to the extent such application results in an amount (if any) being currently taken into account (directly or through 1 or more entities) under this chapter in computing the income of a citizen or resident of the United States or a domestic corporation.
(2) Exceptions
(A) Certain revocable and irrevocable trusts
Paragraph (1) shall not apply to any portion of a trust if—
(i)the power to revest absolutely in the grantor title to the trust property to which such portion is attributable is exercisable solely by the grantor without the approval or consent of any other person or with the consent of a related or subordinate party who is subservient to the grantor, or
(ii)the only amounts distributable from such portion (whether income or corpus) during the lifetime of the grantor are amounts distributable to the grantor or the spouse of the grantor.
(B) Compensatory trusts
Except as provided in regulations, paragraph (1) shall not apply to any portion of a trust distributions from which are taxable as compensation for services rendered.
(3) Special rules
Except as otherwise provided in regulations prescribed by the Secretary—
(A) a controlled foreign corporation (as defined in section 957) shall be treated as a domestic corporation for purposes of paragraph (1), and
(B) paragraph (1) shall not apply for purposes of applying section 1297.
(4) Recharacterization of purported gifts
In the case of any transfer directly or indirectly from a partnership or foreign corporation which the transferee treats as a gift or bequest, the Secretary may recharacterize such transfer in such circumstances as the Secretary determines to be appropriate to prevent the avoidance of the purposes of this subsection.
(5) Special rule where grantor is foreign person
If—
(A)but for this subsection, a foreign person would be treated as the owner of any portion of a trust, and
(B)such trust has a beneficiary who is a United States person,
such beneficiary shall be treated as the grantor of such portion to the extent such beneficiary has made (directly or indirectly) transfers of property (other than in a sale for full and adequate consideration) to such foreign person. For purposes of the preceding sentence, any gift shall not be taken into account to the extent such gift would be excluded from taxable gifts under section 2503(b).
(6) Regulations
The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of this subsection, including regulations providing that paragraph (1) shall not apply in appropriate cases.
Reversionary Interests – § 673
(a) General rule
The grantor shall be treated as the owner of any portion of a trust in which he has a reversionary interest in either the corpus or the income therefrom, if, as of the inception of that portion of the trust, the value of such interest exceeds 5 percent of the value of such portion.
(b) Reversionary interest taking effect at death of minor lineal descendant beneficiary
In the case of any beneficiary who—
(1) is a lineal descendant of the grantor, and
(2) holds all of the present interests in any portion of a trust,
the grantor shall not be treated under subsection (a) as the owner of such portion solely by reason of a reversionary interest in such portion which takes effect upon the death of such beneficiary before such beneficiary attains age 21.
(c) Special rule for determining value of reversionary interest
For purposes of subsection (a), the value of the grantor’s reversionary interest shall be determined by assuming the maximum exercise of discretion in favor of the grantor.
(d) Postponement of date specified for reacquisition
Any postponement of the date specified for the reacquisition of possession or enjoyment of the reversionary interest shall be treated as a new transfer in trust commencing with the date on which the postponement is effective and terminating with the date prescribed by the postponement. However, income for any period shall not be included in the income of the grantor by reason of the preceding sentence if such income would not be so includible in the absence of such postponement.
Power to Control Beneficial Enjoyment – § 674
(a) General rule
The grantor shall be treated as the owner of any portion of a trust in respect of which the beneficial enjoyment of the corpus or the income therefrom is subject to a power of disposition, exercisable by the grantor or a nonadverse party, or both, without the approval or consent of any adverse party.
Subsection (a) establishes a general rule, providing that Trusts are treated as Grantor Trusts. The remainder of Section 674 indicates when that general rule does not apply.
(b) Exceptions for certain powers
Subsection (a) shall not apply to the following powers regardless of by whom held:
(1) Power to apply income to support of a dependent
A power described in section 677(b) to the extent that the grantor would not be subject to tax under that section.
(2) Power affecting beneficial enjoyment only after occurrence of event
A power, the exercise of which can only affect the beneficial enjoyment of the income for a period commencing after the occurrence of an event such that a grantor would not be treated as the owner under section 673 if the power were a reversionary interest; but the grantor may be treated as the owner after the occurrence of the event unless the power is relinquished.
(3) Power exercisable only by will
A power exercisable only by will, other than a power in the grantor to appoint by will the income of the trust where the income is accumulated for such disposition by the grantor or may be so accumulated in the discretion of the grantor or a nonadverse party, or both, without the approval or consent of any adverse party.
(4) Power to allocate among charitable beneficiaries
A power to determine the beneficial enjoyment of the corpus or the income therefrom if the corpus or income is irrevocably payable for a purpose specified in section 170(c) (relating to definition of charitable contributions) or to an employee stock ownership plan (as defined in section 4975(e)(7)) in a qualified gratuitous transfer (as defined in section 664(g)(1)).
(5) Power to distribute corpus
A power to distribute corpus either—
(A)to or for a beneficiary or beneficiaries or to or for a class of beneficiaries (whether or not income beneficiaries) provided that the power is limited by a reasonably definite standard which is set forth in the trust instrument; or
(B)to or for any current income beneficiary, provided that the distribution of corpus must be chargeable against the proportionate share of corpus held in trust for the payment of income to the beneficiary as if the corpus constituted a separate trust.
A power does not fall within the powers described in this paragraph if any person has a power to add to the beneficiary or beneficiaries or to a class of beneficiaries designated to receive the income or corpus, except where such action is to provide for after-born or after-adopted children.
(6) Power to withhold income temporarily
A power to distribute or apply income to or for any current income beneficiary or to accumulate the income for him, provided that any accumulated income must ultimately be payable—
(A)to the beneficiary from whom distribution or application is withheld, to his estate, or to his appointees (or persons named as alternate takers in default of appointment) provided that such beneficiary possesses a power of appointment which does not exclude from the class of possible appointees any person other than the beneficiary, his estate, his creditors, or the creditors of his estate, or
(B)on termination of the trust, or in conjunction with a distribution of corpus which is augmented by such accumulated income, to the current income beneficiaries in shares which have been irrevocably specified in the trust instrument.
Accumulated income shall be considered so payable although it is provided that if any beneficiary does not survive a date of distribution which could reasonably have been expected to occur within the beneficiary’s lifetime, the share of the deceased beneficiary is to be paid to his appointees or to one or more designated alternate takers (other than the grantor or the grantor’s estate) whose shares have been irrevocably specified. A power does not fall within the powers described in this paragraph if any person has a power to add to the beneficiary or beneficiaries or to a class of beneficiaries designated to receive the income or corpus except where such action is to provide for after-born or after-adopted children.
(7) Power to withhold income during disability of a beneficiary
A power exercisable only during—
(A)the existence of a legal disability of any current income beneficiary, or
(B)the period during which any income beneficiary shall be under the age of 21 years,
to distribute or apply income to or for such beneficiary or to accumulate and add the income to corpus. A power does not fall within the powers described in this paragraph if any person has a power to add to the beneficiary or beneficiaries or to a class of beneficiaries designated to receive the income or corpus, except where such action is to provide for after-born or after-adopted children.
(8) Power to allocate between corpus and income
A power to allocate receipts and disbursements as between corpus and income, even though expressed in broad language.
(c) Exception for certain powers of independent trustees
Subsection (a) shall not apply to a power solely exercisable (without the approval or consent of any other person) by a trustee or trustees, none of whom is the grantor, and no more than half of whom are related or subordinate parties who are subservient to the wishes of the grantor—
(1)to distribute, apportion, or accumulate income to or for a beneficiary or beneficiaries, or to, for, or within a class of beneficiaries; or
(2)to pay out corpus to or for a beneficiary or beneficiaries or to or for a class of beneficiaries (whether or not income beneficiaries).
A power does not fall within the powers described in this subsection if any person has a power to add to the beneficiary or beneficiaries or to a class of beneficiaries designated to receive the income or corpus, except where such action is to provide for after-born or after-adopted children. For periods during which an individual is the spouse of the grantor (within the meaning of section 672(e)(2)), any reference in this subsection to the grantor shall be treated as including a reference to such individual.
(d) Power to allocate income if limited by a standard
Subsection (a) shall not apply to a power solely exercisable (without the approval or consent of any other person) by a trustee or trustees, none of whom is the grantor or spouse living with the grantor, to distribute, apportion, or accumulate income to or for a beneficiary or beneficiaries, or to, for, or within a class of beneficiaries, whether or not the conditions of paragraph (6) or (7) of subsection (b) are satisfied, if such power is limited by a reasonably definite external standard which is set forth in the trust instrument. A power does not fall within the powers described in this subsection if any person has a power to add to the beneficiary or beneficiaries or to a class of beneficiaries designated to receive the income or corpus except where such action is to provide for after-born or after-adopted children.
Administrative Powers – § 675
The grantor shall be treated as the owner of any portion of a trust in respect of which—
(1) Power to deal for less than adequate and full consideration
A power exercisable by the grantor or a nonadverse party, or both, without the approval or consent of any adverse party enables the grantor or any person to purchase, exchange, or otherwise deal with or dispose of the corpus or the income therefrom for less than an adequate consideration in money or money’s worth.
(2) Power to borrow without adequate interest or security
A power exercisable by the grantor or a nonadverse party, or both, enables the grantor to borrow the corpus or income, directly or indirectly, without adequate interest or without adequate security except where a trustee (other than the grantor) is authorized under a general lending power to make loans to any person without regard to interest or security.
(3) Borrowing of the trust funds
The grantor has directly or indirectly borrowed the corpus or income and has not completely repaid the loan, including any interest, before the beginning of the taxable year. The preceding sentence shall not apply to a loan which provides for adequate interest and adequate security, if such loan is made by a trustee other than the grantor and other than a related or subordinate trustee subservient to the grantor. For periods during which an individual is the spouse of the grantor (within the meaning of section 672(e)(2)), any reference in this paragraph to the grantor shall be treated as including a reference to such individual.
(4) General powers of administration
A power of administration is exercisable in a nonfiduciary capacity by any person without the approval or consent of any person in a fiduciary capacity. For purposes of this paragraph, the term “power of administration” means any one or more of the following powers:
(A) a power to vote or direct the voting of stock or other securities of a corporation in which the holdings of the grantor and the trust are significant from the viewpoint of voting control;
(B) a power to control the investment of the trust funds either by directing investments or reinvestments, or by vetoing proposed investments or reinvestments, to the extent that the trust funds consist of stocks or securities of corporations in which the holdings of the grantor and the trust are significant from the viewpoint of voting control; or
(C) a power to reacquire the trust corpus by substituting other property of an equivalent value.
Power to Revoke – § 676
(a) General rule
The grantor shall be treated as the owner of any portion of a trust, whether or not he is treated as such owner under any other provision of this part, where at any time the power to revest in the grantor title to such portion is exercisable by the grantor or a non-adverse party, or both.
(b) Power affecting beneficial enjoyment only after occurrence of event
Subsection (a) shall not apply to a power the exercise of which can only affect the beneficial enjoyment of the income for a period commencing after the occurrence of an event such that a grantor would not be treated as the owner under section 673 if the power were a reversionary interest. But the grantor may be treated as the owner after the occurrence of such event unless the power is relinquished.
Income for Benefit of Grantor – § 677
(a) General rule
The grantor shall be treated as the owner of any portion of a trust, whether or not he is treated as such owner under section 674, whose income without the approval or consent of any adverse party is, or, in the discretion of the grantor or a nonadverse party, or both, may be—
(1)distributed to the grantor or the grantor’s spouse;
(2)held or accumulated for future distribution to the grantor or the grantor’s spouse; or
(3)applied to the payment of premiums on policies of insurance on the life of the grantor or the grantor’s spouse (except policies of insurance irrevocably payable for a purpose specified in section 170(c) (relating to definition of charitable contributions)).
This subsection shall not apply to a power the exercise of which can only affect the beneficial enjoyment of the income for a period commencing after the occurrence of an event such that the grantor would not be treated as the owner under section 673 if the power were a reversionary interest; but the grantor may be treated as the owner after the occurrence of the event unless the power is relinquished.
(b) Obligations of support
Income of a trust shall not be considered taxable to the grantor under subsection (a) or any other provision of this chapter merely because such income in the discretion of another person, the trustee, or the grantor acting as trustee or co-trustee, may be applied or distributed for the support or maintenance of a beneficiary (other than the grantor’s spouse) whom the grantor is legally obligated to support or maintain, except to the extent that such income is so applied or distributed. In cases where the amounts so applied or distributed are paid out of corpus or out of other than income for the taxable year, such amounts shall be considered to be an amount paid or credited within the meaning of paragraph (2) of section 661(a) and shall be taxed to the grantor under section 662.
Person Other Than Grantor Treated as Substantial Owner – § 678
(a) General rule
A person other than the grantor shall be treated as the owner of any portion of a trust with respect to which:
(1) such person has a power exercisable solely by himself to vest the corpus or the income therefrom in himself, or
(2) such person has previously partially released or otherwise modified such a power and after the release or modification retains such control as would, within the principles of sections 671 to 677, inclusive, subject to grantor of a trust to treatment as the owner thereof.
(b) Exception where grantor is taxable
Subsection (a) shall not apply with respect to a power over income, as originally granted or thereafter modified, if the grantor of the trust or a transferor (to whom section 679 applies) is otherwise treated as the owner under the provisions of this subpart other than this section.
(c) Obligations of support
Subsection (a) shall not apply to a power which enables such person, in the capacity of trustee or co-trustee, merely to apply the income of the trust to the support or maintenance of a person whom the holder of the power is obligated to support or maintain except to the extent that such income is so applied. In cases where the amounts so applied or distributed are paid out of corpus or out of other than income of the taxable year, such amounts shall be considered to be an amount paid or credited within the meaning of paragraph (2) of section 661(a) and shall be taxed to the holder of the power under section 662.
(d) Effect of renunciation or disclaimer
Subsection (a) shall not apply with respect to a power which has been renounced or disclaimed within a reasonable time after the holder of the power first became aware of its existence.
(e) Cross reference
For provision under which beneficiary of trust is treated as owner of the portion of the trust which consists of stock in an S corporation, see section 1361(d).
Foreign trusts having one or more United States beneficiaries – § 679
Section 679 is not covered in this outline.
Transfers with Retained Life Estate – § 2036
(a) General rule
The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death—
(1) the possession or enjoyment of, or the right to the income from, the property, or
(2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.
(b) Voting rights
(1) In general
For purposes of subsection (a)(1), the retention of the right to vote (directly or indirectly) shares of stock of a controlled corporation shall be considered to be a retention of the enjoyment of transferred property.
(2) Controlled corporation
For purposes of paragraph (1), a corporation shall be treated as a controlled corporation if, at any time after the transfer of the property and during the 3-year period ending on the date of the decedent’s death, the decedent owned (with the application of section 318), or had the right (either alone or in conjunction with any person) to vote, stock possessing at least 20 percent of the total combined voting power of all classes of stock.
(3) Coordination with section 2035
For purposes of applying section 2035 with respect to paragraph (1), the relinquishment or cessation of voting rights shall be treated as a transfer of property made by the decedent.
(c) Limitation on application of general rule
This section shall not apply to a transfer made before March 4, 1931; nor to a transfer made after March 3, 1931, and before June 7, 1932, unless the property transferred would have been includible in the decedent’s gross estate by reason of the amendatory language of the joint resolution of March 3, 1931 (46 Stat. 1516).
Transfers taking effect at death – § 2037
(a) General rule
The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time after September 7, 1916, made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, if—
(1)possession or enjoyment of the property can, through ownership of such interest, be obtained only by surviving the decedent, and
(2)the decedent has retained a reversionary interest in the property (but in the case of a transfer made before October 8, 1949, only if such reversionary interest arose by the express terms of the instrument of transfer), and the value of such reversionary interest immediately before the death of the decedent exceeds 5 percent of the value of such property.
(b) Special rules
For purposes of this section, the term “reversionary interest” includes a possibility that property transferred by the decedent—
(1)may return to him or his estate, or
(2)may be subject to a power of disposition by him,
but such term does not include a possibility that the income alone from such property may return to him or become subject to a power of disposition by him. The value of a reversionary interest immediately before the death of the decedent shall be determined (without regard to the fact of the decedent’s death) by usual methods of valuation, including the use of tables of mortality and actuarial principles, under regulations prescribed by the Secretary. In determining the value of a possibility that property may be subject to a power of disposition by the decedent, such possibility shall be valued as if it were a possibility that such property may return to the decedent or his estate. Notwithstanding the foregoing, an interest so transferred shall not be included in the decedent’s gross estate under this section if possession or enjoyment of the property could have been obtained by any beneficiary during the decedent’s life through the exercise of a general power of appointment (as defined in section 2041) which in fact was exercisable immediately before the decedent’s death.
Revocable Transfers – § 2038
(a) In general
The value of the gross estate shall include the value of all property—
(1) Transfers after June 22, 1936
To the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, where the enjoyment thereof was subject at the date of his death to any change through the exercise of a power (in whatever capacity exercisable) by the decedent alone or by the decedent in conjunction with any other person (without regard to when or from what source the decedent acquired such power), to alter, amend, revoke, or terminate, or where any such power is relinquished during the 3 year period ending on the date of the decedent’s death.
(2) Transfers on or before June 22, 1936
To the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, where the enjoyment thereof was subject at the date of his death to any change through the exercise of a power, either by the decedent alone or in conjunction with any person, to alter, amend, or revoke, or where the decedent relinquished any such power during the 3 year period ending on the date of the decedent’s death. Except in the case of transfers made after June 22, 1936, no interest of the decedent of which he has made a transfer shall be included in the gross estate under paragraph (1) unless it is includible under this paragraph.
(b) Date of existence of power
For purposes of this section, the power to alter, amend, revoke, or terminate shall be considered to exist on the date of the decedent’s death even though the exercise of the power is subject to a precedent giving of notice or even though the alteration, amendment, revocation, or termination takes effect only on the expiration of a stated period after the exercise of the power, whether or not on or before the date of the decedent’s death notice has been given or the power has been exercised. In such cases proper adjustment shall be made representing the interests which would have been excluded from the power if the decedent had lived, and for such purpose, if the notice has not been given or the power has not been exercised on or before the date of his death, such notice shall be considered to have been given, or the power exercised, on the date of his death.
Basis
One of the first reasons IDGTs are used to minimizing capital gains taxation by securing a step-up in basis. IRC § 1015(a); 1014(e).
Estate Tax Inclusion under 26 U.S.C. § 2036(a)(1)
(a) General rule
The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death—
(1) the possession or enjoyment of, or the right to the income from, the property, or
(2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.
Trust assets are included in the Grantor’s estate if the trust is required to pay the Grantor’s tax liability. Rev. Rul. 2004-64. There is no inclusion if the trust instrument is silent regarding payment of taxes. Possible inclusion if the trustee has discretion to pay Grantor’s tax liability. Circumstances that would be considered include whether there was an understanding or pre-existing arrangement between the Grantor and the Trustee regarding the trustee’s exercise of discretion. Query: Whether requiring payment of taxes would be violate 38 C.F.R. § 3.276(b) which requires that the veteran relinquished all rights of ownership to avoid disregard of the transfer. (Note: The VA Rules relating to eligibility for needs-based pension aka “Aid and Attendance” changed effective October 18, 2018; see 83 F.R. 47246; under new section 3.276(a)(5)(ii) a trust is not countable unless the claimant has the ability to liquidate the trust for his or her own benefit).
Section 121 Exclusion on sale of primary residence. Generally, Section 121 provides that, under certain circumstances, gross income does not include gain realized on the sale or exchange of property that was owned and used by a taxpayer as the taxpayer’s principal residence. So what happens if a trust owns the home? The use test requires occupancy. To satisfy the ownership test, the trust must be a grantor trust with respect to income taxation, 26 U.S.C. § 671 through 679. The ownership test is stated at Treasury Reg 1.121-1(c)(3)(i) as follows:
If a residence is owned by a trust, for the period that a taxpayer is treated under sections 671 through 679 (relating to the treatment of grantors and others as substantial owners) as the owner of the trust or the portion of the trust that includes the residence, the taxpayer will be treated as owning the residence for purposes of satisfying the 2-year ownership requirement of section 121, and the sale or exchange by the trust will be treated as if made by the taxpayer.
The taxpayer may satisfy the requirements of ownership and use for periods aggregating 2 years or more may be satisfied by establishing ownership and use for 24 full months or for 730 days (365 × 2).
The definition of “income” under the tax rules is different from the definition under the public benefits rules.[6]
Qualified Disability Trusts. 642(b)(2)(C)(ii)
Crummey, 397 F.2d 82 (9th Cir. 1968)
Cristofani, 97 TC 74 (1991)
[1] D. Sandoval, Taxation of Special Needs Trusts (Part 1), 20 NAELA News 20 (2008). A non-grantor trust is taxed as a separate entity and is subject to an accelerated income tax schedule. A grantor trust is disregarded for income tax purposes and taxed to the Settlor. [2] Many MIDGTs are structured as Irrevocable Income-only Trusts (IIOTs). For estate tax purposes (which is significant where a step-up in basis is sought for capital gains tax purposes), an income-only trust takes advantage of Section 2036(a)(1), which provides that trust assets are included in the Grantor’s estate where the Grantor retains the right to income or continues to reside in the residence if real property is transferred to the trust. To preserve the Section 121 exemption, one of the income rules must also be violated (Rules 671 through 679). [3] These are the personal exemptions. For example, Section 151(d)(1) provides for a $2,000 per person exemption. It also means the exemption could be zero if the taxpayer is a dependent and the exemption is taken on someone else’s tax return. [4] A Special Needs Trust under 42 U.S.C. § 1396p(d)(4)(A), (B) or (C). [5] Robert Mason describes this as “failing” one of the rules enumerated in Sections 673 through 678. R. Mason, VA Benefits Planning with irrevocable Grantor Trusts, presented at The Best VA Benefits Training Anywhere Conference (January 7, 2011). [6] Sandoval, Taxation Part 1, supra.Resources:
