106-3 Types, Features, and Taxation of Trusts

Question 1

Powers of appointment

Answer 1

Often used in trusts to provide flexibility in making distributions

A power of appointment is a right given to a 3rd party permitting the person to name the recipient of property at some time in the future

Question 2

3 parties to a trust

Answer 2

1. Grantor, creator, or settlor of the trust
2. the trustee
3. the beneficiar(ies) of the trust

Question 3

Rule Against Perpetuities

Answer 3

In some states, there is a legal limitation on how long a trust may last - this is known as the rule against perpetuities

Generally, the rule states that an interest cannot last longer than 21 yrs and 9 mths after the death of someone who was alive on the date that the interest was created (i.e., a life in being)

The language within the trust will dictate how long the trust will last as well

Charitable trusts are exempt from the rule and may be held in trust forever for the benefit of the charity

Question 4

Trusts generally categorized according to these 3 things:

Answer 4

1. the powers retained or relinquished by the grantor
2. the date at which the trust becomes operative
3. the income taxation (income payout requirements) of the trust

Question 5

Revocable Trust

Answer 5

a trust that can be rescinded or amended by the grantor

Assets transferred to the trust before the grantor dies will avoid probate

Question 6

Irrevocable Trust

Answer 6

a trust where the grantor has relinquished all control over the property and cannot change the provisions of the trust

Question 7

Inter Vivos Trust

Answer 7

a trust made effective during the grantor’s lifetime

example: revocable living trust
It may also be irrevocable

Question 8

Testamentary Trust

Answer 8

Created by the decedent’s will and made effective at death

The federal gift tax does not apply to this type of trust because any transfer to this trust does not take place until the grantor’s death, but the estate tax rules do apply

Question 9

Simple Trust

Answer 9

a trust that is required to pay out all of its income to the trust beneficiaries at least annually but does not distribute any trust principal or corpus

A simple trust must distribute all of its income each year. A simple trust cannot make distributions from amounts other than current income and cannot make charitable distributions.

Question 10

Complex Trust

Answer 10

Any trust that is not a simple trust

This means any irrevocable trust where income may be accumulated within the trust entity (e.g., a discretionary trust) or where a charitable contribution is or could have been made

It must be a complex trust to distribute principal and make charitable distributions

Question 11

Sprinkling (Spray) Provisions

Answer 11

If the trustee is granted the power to direct trust income, this is referred to as a sprinkling (or spray) provision because the trustee is permitted to sprinkle the income among more than 1 beneficiary

Question 12

Spendthrift Provision

Answer 12

Used in a special needs trust or a trust where someone is concerned about the beneficiary being responsible enough

Such a clause prohibits the beneficiary from assigning the beneficiary’s interest to a creditor and denies creditors the right to demand that the trustee pay for the beneficiary’s debts

Question 13

Support Provision

Answer 13

Used in a trust, authorizes the trustee to distribute only as much income or principal from the trust as the trustee deems necessary for the support or education of the beneficiary

Question 14

1 of 3 entities/persons may be taxed on the income from the trust depending on whether it is a simple, complex, or grantor trust

Answer 14

1. The trust entity: this rule applies to complex trusts
2. The trust beneficiary: this rule applies to simple trusts
3. The trust grantor

Question 15

IRS Form 1041

Answer 15

A trust that is taxable as a separate taxable entity for federal income tax purposes must report the income from the trust on IRS Form 1041 (U.S. Income Tax Return for Estates and Trusts)

This form is due on the 15th of the 4th month after the entity’s taxable year ends and must be filed for a domestic trust that has:

1. any taxable income for the year
2. gross income of $600 or more for the year, or
3. a beneficiary who is a nonresident alien

Question 16

Calculation of the trust’s taxable income is similar to that for individuals with the following major exceptions:

Answer 16

1. A deduction is available to the trust for distributions made to the trust beneficiaries
2. A charitable deduction is allowable only for complex trusts and then only if the trust document authorizes such a distribution of income or corpus
   - no % of AGI limitations on this deduction regardless
3. The amount of the exemption allowed to the trust entity depends on whether it is a single or complex trust

Question 17

Distributable Net Income (DNI)

Answer 17

The beneficiary of a trust is taxed on an amount equal to the distribution deduction afforded the trust entity

The distribution deduction afforded the trust is limited to the lesser of DNI or the amount actually distributed to the beneficiary

Any distributions to the beneficiaries in excess of DNI are not taxable to them

DNI does not include capital gains

Question 18

Grantor Trust Rules

Answer 18

Provide that when a grantor retains certain powers of control over trust property and income, the grantor is considered to be the owner of the trust property, and the grantor (rather than the trust or beneficiaries) is taxed on the income

If a trust is a grantor trust, all trust income is taxed to the grantor.

Question 19

Section 2503(c) or minor’s trust

Answer 19

A trust used in education planning that provides for the discretionary distribution of trust income annually on the minor’s behalf with distribution of principal when the minor attains age 21

Contributions to the trust qualify for the gift tax annual exclusion

Question 20

Crumney Trust

Answer 20

A trust that provides for a limited right of withdrawal of principal annually by the beneficiary(ies)

Question 21

Support Trust

Answer 21

A trust that is funded with income-producing assets to fulfill the duty of support for a dependent child or parent

Question 22

Pourover Trust

Answer 22

A trust created during the grantor’s lifetime to hold and manage assets for the benefit of several beneficiaries

Such a trust is usually funded at the grantor’s death by the use of a pourover will

Question 23

Dynasty/generation-skipping transfer trust

Answer 23

A trust established either inter vivos or testamentary to pass grantor/decendent’s property to successive generations or lineal generations

Seeks to take advantage of the generation-skipping transfer tax exemptions

Question 24

Revocable Living Trust (RLT)

Answer 24

Probably the most popular type of trust in use today

May be established for avoidance of probate and to provide for a successor trustee in the event of the grantor’s legal incapacity

Any of the grantor’s assets that are transferred into the name of the trustee before the grantor dies avoid probate

Question 25

Irrevocable Life Insurance Trust (ILIT)

Answer 25

Trust established to remove the face value of the grantor’s life insurance policy(ies) from the gross estate for estate tax purposes

Such trust may be either unfunded or funded

Question 26

Contingent/Standby Trust

Answer 26

An RLT that is used to handle the grantor’s financial affairs if the grantor becomes legally incapacitated

Question 27

Totten Trust

Answer 27

a type of trust where the corpus is a bank account

Similar to a revocable trust because a completed transfer has not taken place until the trust is made irrevocable by the depositor’s death

At the grantor-depositor’s death, the trust avoids probate and is very similar to the POD clause

Question 28

Foreign Situs (or off-shore) trust

Answer 28

Trust that is usually established by wealthy individuals to take advantage of favorable debtor-protection laws of certain countries, such as the Isle of Man

Generally, if a trust is for asset protection, it must be irrevocable and not under the control of the grantor

Question 29

Medicaid Trust (or Medicaid Qualifying Trust)

Answer 29

A trust that is established to give the trustee the discretionary right to take money out of the trust to provide for the benefit of a Medicaid applicant up until the time of the death of the trust beneficiary

Question 30

Bypass (or B) trust

Answer 30

Nonmarital trust that permits the surviving spouse to have some interest in trust assets but not enough to warrant inclusion of those assets in the survivor’s gross estate

Question 31

Marital Trusts

Answer 31

Such trusts, include 2 basis forms: a general POA trust and/or a qualified terminable interest property (QTIP or C) trust

Question 32

Charitable Trusts

Answer 32

Similar to marital trusts, except that these trusts are established to benefit a qualified charity rather than the surviving spouse and are intended to take advantage of the unlimited charitable deduction in transfer tax law

Question 33

Section 2503(b) or mandatory income trust

Answer 33

An alternative to the Section 2503(c) trust used in education planning

The 2503(c) trust must distribute income annually to the child/beneficiary and does not require distribution of the principal (corpus) when the beneficiary attains age 21

Contributions to the trust qualify for the gift tax annual exclusion

Question 34

Grantor-retained trusts

Answer 34

Popular form of irrevocable trust established during the grantor’s lifetime and designed to allow the grantor the retention of income, or use of transferred property, for a limited period

Question 35

Health and Education Exclusion Trust (HEET)

Answer 35

A trust established during life or at death which can be used to pay the education and medical expenses of grandchildren or other skip beneficiaries without being subject to federal gift taxes or generation-skipping transfer taxes (GSTT)

Question 36

Power of appointment

Answer 36

The power to name (“appoint”) who will enjoy or own property

Powers of Appointment are often used in conjunction w/ life estates and in trusts

Question 37

General Power of Appointment

Answer 37

When the power of appointment allows the holder to appoint the property to himself, his creditors, his estate, or creditors of his estate

can appoint money for any reason and to any person

Question 38

Limited (special) power of appointment

Answer 38

Any power that is not a general power

In other words, it is any power that does not allow the power holder to appoint the property to himself, his creditors, his estate, or the creditors of his estate

Question 39

3 Major exceptions to the rule that a holder’s power to appoint property to himself, his creditors, his estate, or creditors of his estates makes the power of appointment a general power of appointment:

Answer 39

1. The holder’s power is limited by an ascertainable standard
2. The holder may exercise the power only w/ the consent of either the grantor or a 3rd party who has an interest that is adverse to that of the holder
3. The right to exercise the power each year is limited to the great of:
   A) $5,000
   B) 5% of the total value of the property subject to the power at the time of the lapse or the holder’s death

When a noncumulative general power limited by a 5 or 5 power lapses while the holder is living, there is no taxable gift

Question 40

Crumney Power

Answer 40

Such a power is included to afford the grantor of the trust the use of the gift tax annual exclusion by converting an otherwise future property interest to that of a present interest

Question 41

Which trusts avoid probate?

Answer 41

All assets in trusts that are in existence at the time of the grantor’s death avoid probate because the legal titleholder of the trust assets is the trustee, not the deceased grantor. A testamentary trust is created by the grantor’s will, so the assets pass through probate before going into the trust.