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Score a triple win when a trust fails

by on
in Small Business Tax,Small Business Tax Deduction Strategies

Sometimes, it makes sense to intentionally do things “the wrong way” in the tax world. This could be one of those times.

Strategy: Set up an intentionally defective trust (IDT). As the name implies, the arrangement is designed to fail the tax rules for “nongrantor trusts.” In the end, however, the IDT is a triple tax winner.

The time may be ripe to set up an IDT because interest rates are currently low.

Basic premise: Typically, you might shift assets to an irrevocable trust that is set up for designated beneficiaries. You aren’t taxed on the earnings if you give up all control over the assets transferred to the trust. Plus, the assets are removed from your taxable estate.

Generally, this is good news if you are in the top 35% federal income tax bracket. But it can be bad news if you’re in a lower tax bracket or the trust earns a substantial amount of income each year. Reason: The income tax brackets for trusts are highly compressed. In other words, the dollar amounts within each bracket are relatively small when compared to the tax brackets for individuals. Therefore, the higher tax rates kick in much faster (see chart below).

Let’s say you’re a joint filer in the 25% tax bracket. If you establish a trust that earns $25,000 of income in 2009, the tax is $7,726. However, if the income was taxed to you in your 25% tax bracket, it would be only $6,250—or $1,476 less. Over a trust term of 10 years, this amounts to a tax difference of almost $15,000.

Instead of doing things the usual way, you can include language in the trust that causes it to be taxed as a grantor trust. For instance, you might grant certain rights or powers. This will cause the trust income to be taxed to you instead of the trust, even though you’re not receiving any income from it.

Let’s look at what you’ve accomplished with the IDT:

Income tax:
As shown in the example above, there may be less tax if the trust is branded as a grantor trust than the trust would have to pay. Furthermore, the trust can generate more earnings if it grows without any tax erosion.    

Gift tax:
The gift tax liability for the remainder interest is based on the assumed IRS interest rate at the time the trust is created. When interest rates are relatively low, the gift-tax consequences are favorable (see box).

Estate tax:
If the trust is set up properly, the funds are removed from your taxable estate.

However, if too many strings are attached to the deal, the trust assets may be included in your estate. For example, if you retain the right to change beneficiaries in midstream, the trust assets will be subject to estate tax.

Tip: There are a few other technical pitfalls to avoid, so use an estate planning pro to create the IDT.

2009 tax brackets for trusts

The tax rates for estates and nongrantor trusts for 2009 are:
If taxable income is:
The tax is:
Of the amount over:
$2,300 or less
More than $11,150


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