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 common law:
- Certainty of intention – The person creating the trust must intend to create the trust, and intention must be supported by actions.
- 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 certainty.
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.
- Documentation – 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 beneficiaries.
- Accounting – 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 statements completed.
- 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.
- Distributions – 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.
- Contributions – 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.
- Attribution – 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 trust" rules.
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 process.
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.