Put an income producing asset into a trust like that and you have the pre-tax income going to the next generation with the grantor paying the income tax.
Most trusts (non-grantor trusts) pay tax on capital gains and accumulated income that stays in the trust, while the beneficiaries pay tax on income that is distributed to them.
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When structured as a grantor trust, the tax benefit of donations should pass back to the person who created the trust when those donations are made, but the creditor would have to first unwind the trust before attempting to clawback donations.
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The grantor therefore gains a degree of tax relief, while the assets are transferred to the trust.
That is, from an income tax perspective, income, deductions and credits at the trust level are captured on the personal income tax return of the grantor.
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The estate planner intentionally creates a trust that allows for the severing of the estate tax link without severing the income tax link with the grantor.
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Estate planners have been using grantor trusts for the past two decades, but they always had to warn clients that the IRS might consider the income tax payments by the grantor to be further taxable gifts to the beneficiaries of the trust.
Using such trusts a grantor (parent) can pay income tax on trust income accumulating for the benefit of children and descendants.
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Transactions between the grantor and the trust are ignored for income tax purposes.
In a "grantor trust, " for example, the tax is paid by the person who sets up the trust, so it doesn't drain assets from the trust itself, says Alan Kufeld, a certified public accountant at Rothstein Kass's family-office group.
Also, there can be an installment sale (when the value of the asset is low) to a defective grantor trust that is a completed transfer but not taxed for income tax purposes.
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It would be, but for one thing: The income tax people at the IRS disregard transactions between a taxpayer and a grantor trust.
On July 6 it released a "revenue ruling" that clears up long standing gift and estate tax issues relating to an estate-planning tool--irrevocable grantor trusts--widely used by wealthy families.
Even more hidden are complex provisions such as a grantor trust proposal targeting certain sales transactions (particularly business sales), and elimination of several Generation Skipping Tax planning benefits.
This bill would require consistent valuation for transfer and income tax purposes, modify the rules on valuation discounts, and require 10-year minimum term for Grantor Retained Annuity Trusts (GRATS).
Very popular over the last ten years and different from the defective grantor trust discussed above, grantor retained annuity trusts (GRATs) have been used to transfer appreciating assets to future generations free of gift tax.
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