Defective grantor trusts: new IRS ruling enhances estate planning.

• Author: Josephs, Stuart R.
• Position: Federal Tax Tips - Internal Revenue Service

Rev. Rul. 2004-64 (IRB 2004-27, July 6, 2004) favorably answered the question of whether a trust's grantor would not be making gifts to the trust's beneficiaries if the grantor pays the income tax on the trust's income in the right circumstances.

Facts

In year 1, U.S. citizen G establishes and funds an irrevocable inter vivos trust (Trust) for the benefit of G's descendants. As the governing instrument requires, G appoints a trustee who is not related or subordinate to G [within the meaning of Sec. 672(c)]. The Trust is governed by applicable state law.

Under the Trust's terms, G retains no beneficial interest in, or power over, Trust income or corpus that would cause the transfer to Trust to constitute an incomplete gift for federal gift tax purposes--or that would cause the corpus to be included in G's gross estate for federal estate tax purposes on G's death. But, G retains sufficient powers with respect to Trust to be treated as Trust's owner for federal income tax purposes.

Comment: Trusts containing these features also are called intentionally defective trusts.

During year 1, Trust receives $100,000 of taxable income. Under Sec. 671, G includes this $100,000 in his taxable income. Consequently, G's year 1 personal income tax liability increases by $25,000. G dies in year 3. At G's death, the fair market value of Trust's assets is $1,500,000.

Three Situations

In Situation 1, neither state law nor the Trust's governing instrument contains any provision requiring or permitting the trustee to distribute to G amounts sufficient to satisfy G's income tax liability attributable to including Trust's income in G's taxable income. Thus, G pays this additional $25,000 liability from his own funds.

In Situation 2, Trust's governing instrument requires the trustee to reimburse G, from Trust income or principal, for the amount of tax attributable to the inclusion of all, or part, of Trust's income in G's taxable income. Accordingly, the trustee distributes $25,000 to G to reimburse him for this $25,000 liability.

In Situation 3, Trust's governing instrument states that if G is treated as the owner of any portion of Trust for any tax year, the trustee may, in the trustee's discretion, distribute to G for the tax year income or principal sufficient to satisfy G's personal income tax liability attributable to including all, or part, of Trust's income in G's taxable income. In exercising this discretion, the trustee distributes $25,000 to G to...