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Set Up Your Trust To ''Fail'' On Purpose

The tax climate might be right to set up an intentionally defective irrevocable trust, or IDIT. This unusual arrangement may be especially beneficial in light of new legislation affecting federal income, gift, and estate taxes.

Normally, someone creating a trust might transfer assets, such as cash or securities, to it and name loved ones as the income beneficiaries. By handing over assets to the trust, you avoid tax on any future earnings. That can be particularly helpful for someone in the top 35% income tax bracket. Instead of being taxed to you, income tax on trust assets is paid by the trust, with tax rates starting at 15%. But income tax brackets for trusts are compressed, with only the first $2,300 of trust income taxed at that 15% rate in 2011. The trust reaches the top 35% bracket with just $11,350 of income. That means a trust could pay substantially more tax on earnings than you would as an individual.

To avoid that situation, the trust could be structured to be intentionally “defective,” so that trust income is taxable to you instead of to the trust. For instance, you might retain the right to withdraw funds from the trust for a limited period of time—for example, for 30 days. This so-called “Crummey power” is frequently included in IDIT documents.
Keep in mind that the money you transfer to the trust—and then ultimately to your heirs—constitutes a potentially taxable gift. However, the size of that gift is calculated using an assumed IRS interest rate at the time the trust is created. When interest rates are low—as they have been during the past few years—the gift will be smaller than it would otherwise be. And generous exemptions from gift tax liability could reduce or eliminate your tax.
Also, under the new 2010 Tax Relief Act, the federal exemption from estate tax and gift tax exemption has been reunified—so that it doesn’t matter whether gifts are made before or after you die—and the exempt amount has been increased to $5 million. So even if a portion of that total is used up by the transfer to the IDIT, you’re likely to have a substantial amount left to reduce estate taxes.
In most cases, you must give up all control of trust assets for them not to be considered part of your estate. But the tax law provides an exception for a Crummey provision, and so IDIT assets usually can be considered safely removed from your estate. These are complex arrangements, however, that need to be structured carefully. We can work with your attorney to create a trust that fits your needs.

This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice.

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