In this two-part discussion, we will first introduce the nature
and benefits of trusts in tax planning generally. Then Part II will
discuss selected traps that can often be overlooked when
undertaking tax planning that can make trust management a more
complex process. Despite the popularity of trusts in tax planning,
many taxpayers do not understand what a trust really is. More
importantly, many do not know how to properly administer and
operate a trust to achieve the desired objectives.
What is a trust?
A trust is a special legal relationship between three parties:
the settlor, the trustee(s) and the beneficiaries. A trust operates
to separate legal control and management of an asset from its
ownership. It is not an independent legal entity. A trust
must have all of the following three
"certainties" to be considered a valid trust under the
intention – The person creating the trust must
intend to create the trust, and intention must be supported by
Certainty of subject
matter – The trust must have identifiable property
conveyed by the person intending to create the trust.
Certainty of object
– The beneficiaries must be known with sufficient
Taxpayers and trustees should be aware of many factors to ensure
they are maintaining and "using" the trust appropriately
to avoid adverse income tax consequences.
– The trust deed should be prepared by a lawyer experienced
in trust law. Trustee resolutions should be prepared annually, in
addition to any other relevant communication with
A trust should have a separate bank account and maintain
records supporting the disbursements made during the year. It may
be advisable to have annual externally prepared financial
Payments – Any
income in the trust will be taxed at top marginal tax rates (which
are increasing, as outlined
here) unless the amount is paid or "made payable" to
a beneficiary. There is little ambiguity when the amount
is paid to a beneficiary in cash. For an amount to be considered
"payable," the particular beneficiary must have an
irrevocable and unconditional right under the terms of the
trust to require the trustee to pay the income.
– Beneficiaries' income is theirs to keep. If a child
beneficiary receives trust income and gives this money to their
parents, the trust income allocated to the child beneficiary could
be attributed to the parents and taxed in their income.
– No person except the settlor should make contributions to
the trust. For income tax purposes, the settlor of the trust will
be the person who contributed the majority of the fair market value
of the property to the trust. If this person is not the original
settlor, income in the trust that has been allocated to certain
beneficiaries could possibly be attributable to another taxpayer,
among other adverse income tax consequences. A "contribution
of property" can include an undocumented loan to a trust,
payment of trust expenses by a source other than the trust, and
many other items. A fair market value sale of property to a trust
generally is not considered a contribution to the trust.
Income vs. capital
– The characterization of an amount received (or deemed to be
received) by the trust as income or capital can often yield
unexpected results. Absent any special considerations in the trust
deed, trust law and income tax law can treat the distinction
differently. Under trust law, for example, redemption of shares
generally gives rise to a capital receipt. For income tax purposes,
however, a redemption may result in a deemed dividend to the trust.
If the trust deed is not carefully drafted, the dividend will be
taxed at top marginal tax rates in the trust.
If the settlor/contributor retains control over the trust property,
income attribution to the settlor/contributor can apply.
Attribution will not result from a "genuine loan" of
cash, provided the terms are independent of the trust deed. Proper
documentation is essential to avoid the "reversionary
There are many benefits to proper trust planning, but care is
required to avoid potential traps. Part II will discuss important
considerations and potential pitfalls with trust planning that
taxpayers and their advisors should evaluate during the planning
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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