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By Steven B. Gorin, Esq. Thompson Coburn LLP, St. Louis, MO
Private Letter Ruling 201038004 informs us about trusts deemed partially owned by beneficiaries. Thus, it does not help in the area of sales to irrevocable grantor trusts, although it helps focus on some issues.
The IRS ruled that a beneficiary with the right to withdraw income would be taxable on the income under §678. Any undistributed income, that was not yet added to principal, would be includible in the beneficiary's estate as a general power of appointment. Any income that had been added to principal and constituted a lapse in excess of the greater of $5,000 or 5% of the trust's assets would be includible in the beneficiary's estate under §2036, since the beneficiary was deemed to have transferred that part of the accumulated income and also retained the right to the income in that transferred property.
The ruling did not address whether any capital gains later realized on the principal that constituted accumulated income would be taxable to the beneficiary under §678(a)(2).
The ruling did not address the gift tax consequences of the lapse, which presumably would be an incomplete gift (except in 2010 per §2511(c)) because of the beneficiary's retained general power of appointment.
Consider instead giving the beneficiary a hanging power so that the power can lapse in a way that does not make any of the lapsed income includible in the beneficiary's estate. That might help not only for estate tax purposes but also for protection from future creditors.
This structure has the advantage of allowing the trust's income to be accumulated income tax-free (to the trust, since the beneficiary is taxable personally on the income), with only the excess income, if any, being included in the beneficiary's estate. Given that income yields tend to be significantly lower than 5%, perhaps none of the accumulated income will ever included in the beneficiary's estate.
On the other hand, significant income tax benefits might be lost to the family as a whole. Trustee fees would be fully deductible if this were a nongrantor trust. Trustee fees attributable to the grantor trust portion would be deductible, if at all, as miscellaneous itemized deductions subject to the 2% floor and also disallowed for purposes of the alternative minimum tax.
For more information, in BNA's Tax Management Portfolios, see Danforth and Zaritsky, 819 T.M., Grantor Trusts, and in Tax Practice Series, see ¶6120, Estate and Trust Income Taxation, General Rules.
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