Tax Trusts

In addition to avoiding probate, trusts can be used in many ways to reduce income and estate taxes. One popular example of this involves shifting income from a high tax bracket individual (the parents) to lower bracket family members. Depending on the circumstances, significant tax savings can be produced with this and other planning techniques. In the estate tax area, trusts are commonly used to avoid estate taxes on life insurance proceeds and investment property.

These tax savings techniques can be accomplished because, legal ownership is separated from you and property held in a trust is not considered to be owned by you – just as we saw in the case of the Living Trust.  There is a difference however in the legal definition of “ownership” as we now attempt to accomplish a result in which the government clearly has an adverse interest. Unlike probate avoidance which actually saves the government money, using trusts for tax savings produces a direct cost in the loss of tax revenue. As we would expect, the rules concerning “ownership” are considerably less flexible and are subject to closer scrutiny when we use trusts to accomplish tax savings measures.

To illustrate, remember that the Living Trust, used for probate avoidance, can be revoked or modified at any time and the trustor can be the beneficiary of the trust. In a “Tax Trust” (designed to accomplish certain tax advantages), the benefits will not be available if the trustor has retained significant powers over the trust. Tax law does not recognize the legal distinction of a trust if the trustor retains the right to revoke the trust, or use trust property, or modify the terms of the trust or maintains similar control over trust assets. If too much power is left in the hands of the trustor, the trust is ignored for tax purposes and none of the attempted tax benefits will be accomplished. The type of trust which is ignored for tax purposes is known as a “Grantor Trust.” Grantor Trusts may be extremely useful in other situations, as we’ll see below, but to achieve desired tax results specified rules must be followed.

Download the full pdf of article