Using administrative powers to create income tax defective trusts.

• Author: Flynn, Maura P.

For many years, practitioners have advised clients to use trusts for certain reasons, not the least of which is to facilitate a transfer of assets out of a large estate. If an irrevocable trust is created and the grantor does not retain any of the "tainting" powers described in Secs. 671 through 678, the trust is its own taxpaying entity. In recent years it has become popular to make these trusts "defective" for income tax purposes in order to facilitate transactions between the grantor and the trust. However, just which powers available in Secs. 671-678 are best to accomplish this goal have been the subject of much debate. Some powers make the grantor taxable on income of the trust only, while others cause the entire trust to be treated as if owned by the grantor. It is the latter type that is often sought by taxpayers and their advisers.

The concept of transactions with defective trusts is based on Rev. Rul. 85-13, issued in response to Rothstein, 735 F2d 704 (2d Cir. 1984). In this case, the court allowed a transfer of trust assets in exchange for an unsecured note from the grantor to be treated as a sale for Federal income tax purposes. The court recognized the Sec. 675(3) violation, but reasoned that this required only that the trust income and deductions be reported by the grantor; the trust was otherwise a separate entity. The grantor received a basis step-up as a result. The IRS quickly responded in Rev. Rul. 85-13 by stating it would not follow Rothstein. The ruling stated that a sale cannot occur between a grantor and a trust over which the grantor is deemed the owner; therefore, transactions like that in Rothstein would not be viewed as sales for Federal income tax purposes.

Recognizing the potential...