As published in Texas Lawyer, November 2010. Written by Pete Benenati and Shannon G. Guthrie.
Many Americans, especially the wealthy, seek to abide by the Internal Revenue Code while also reducing taxes. One tool estate-planning lawyers have in their arsenal is the beneficiary-grantor trust.
For purposes of this article, we will assume that some form of estate tax will apply, even though current tax laws provide that there is no estate tax for tax year 2010. The gift tax remains applicable for the tax year 2010.
Understanding a beneficiary-grantor trust requires some general background about income tax and estate planning rules. Income tax may result when an individual sells an asset for more than his basis — basis generally being what he or someone else paid for it, with some adjustments. A trust is a taxpayer and is subject to income taxes earned on its assets (including capital gains). Finally, if an individual gives away an asset but keeps its benefit, it will be included in his estate for transfer-tax purposes.
Given those rules, can an individual sell an asset to a trust of which he is the beneficiary and not recognize gain — i.e., not be subject to income tax on the profit? He can, and lawyers should know how to help him do so.
A grantor is simply the creator of a trust. The grantor-trust rules, found at Internal Revenue Code §§671-678, sometimes tax a trust beneficiary on the trust income.
In a beneficiary-grantor trust an individual (the grantor) creates a trust for another individual’s benefit (the beneficiary). For example, parents create a trust for their child, permitting distributions for the child’s health, education, maintenance and support. The child is the primary beneficiary and also serves as trustee of the trust. The parents make a gift to the trust of no more than $5,000. The lawyer structures the trust so the child has the right to withdraw the $5,000 when the parents contribute that money and also so the child knows about the right of withdrawal.
Quite often, the child never exercises this withdrawal power. Because the child has given up a right to remove available funds, the $5,000 stays in the trust, where it is held and managed for the child’s benefit. The child, who is also the trustee, gets to decide not only how to invest the $5,000 but how to make distributions under the standard of health, education, maintenance and support. The child-trustee also has the power, exercisable in his will, to dispose of the remaining trust assets to a class of individuals and entities that can include family members and charities but not himself, his estate, his creditors or his estate’s creditors.
By giving up the right to remove the $5,000 yet continuing to control the disposition of the assets left inside the trust, the child becomes the taxpayer for income generated by the $5,000 and, as a result, includes all items of income and deductions on his personal income tax return. But the child doesn’t really own the trust assets. As a result and under current Texas law, the trust’s assets are not subject to the claims of the child’s creditors. It is almost the perfect trust: It is for the child’s benefit, the child is in control as trustee, but the assets are protected from the child’s creditors and are not part of the child’s estate for estate tax purposes.
Further, because the child is treated as the owner of the trust for income tax purposes, if he lends money or sells assets to the trust, he does so without income tax consequences, because the trust and the lender or seller are the same person. Yet, again, the child remains the beneficiary of the trust.
This strategy is quite useful where the child owns an interest in an entity that is expected to increase substantially in value. Usually, the child wants to protect the increased value from his creditors — including the government, should a death tax apply — but also receive the benefit of the asset. The child sells
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