Funding stale trusts: what you should know when faced with an unfunded trust.

• Author: Woodford, John
• Position: Estate planning

With the proliferation of family trusts over the last two decades, and the misinformation provided by some promoters of these trusts, tax practitioners now have to deal with more cases of unfunded--or stale--trusts.

Most of these involve the typical family trust, which has not funded any of the sub-trusts called for in the trust document after the first spouse has died. Many times the problem comes to light after several years of ignoring the trust or when the surviving spouse dies.

This situation can put tax practitioners in a very difficult position, especially if they have been the adviser for a long time and the issues were never addressed.

Whatever the circumstances leading up to this point, the tax practitioner is faced with several dilemmas, such as the filing of fiduciary tax returns; allocation of trust assets between sub-trust or beneficiaries; and the necessity to deal with all the trust beneficiaries.

What the IRS Says

The CalCPA Committee on Taxation put the question of unfunded sub-trusts to the IRS at its annual liaison meeting in November 2002. The IRS indicated that its position would depend on the particular facts and circumstances.

Still, the IRS did provide some insight into its thinking on these issues.

First, the IRS indicated that in funding these trusts, the allocation of assets to each trust should be fairly representative, so that each side gets a representative share of appreciating and non-appreciating assets.

The IRS also weighed in on filing delinquent fiduciary income tax returns. If the surviving spouse has included all of the income on their returns and there would be no change in the overall tax, then the IRS would not require these returns to be filed.

The IRS did not indicate at what level of materiality it would require administrative trust tax returns to be filed. With regard to returns for the sub-trusts, such as the survivor's, by-pass and marital trusts, the IRS wanted these returns filed based on facts and not on a "deemed" funding date. Therefore, in most cases, until the sub-trusts are actually funded, fiduciary tax returns should not be filed.

The last question put to the IRS had to do with the surviving spouse dying before the funding of the by-pass trust. The Committee on Taxation's concern was that the failure to fund the by-pass trust could cause the inclusion of all family trust assets in the estate of the second-to-die.

The IRS response again was that it depends on the particular facts and...