Tax 7-4 Analyze a situation involving a trust to determine whether its income is taxed to the grantor, the trust entity, or some other person.

Question 1

Trusts

Examine each of the following situations to determine if the trust’s income is taxable to the grantor, the trust, or some other person.

Fred Kearney established a Constitutional Freedom Trust from a kit he received in the mail. He placed all of his assets in the trust and assigned all of his earned income to the trust. In return, the trust will take care of the financial needs of Fred and his family.

Identify to whom the income is taxable and explain your response.

(LO 7-4)

Answer 1

The income is taxable to Fred; the income is used for his (the grantor’s) benefit.

Question 2

Trusts

Examine each of the following situations to determine if the trust’s income is taxable to the grantor, the trust, or some other person.

Rita Martin created an irrevocable trust for the benefit of her three minor sons. She named her bank and her attorney as co-trustees. The trust property earned $100,000 in the first year and had taxable income of $80,000 after deducting expenses. This income was left to accumulate for future distribution to each son equally when the youngest son attains age 18.

Identify to whom the income is taxable and explain your response

(LO 7-4)

Answer 2

The income is taxable to the trust. All accumulated income is taxed to the trust entity since Rita has retained no prohibited powers and there are no current beneficiaries of the income.

Question 3

Trusts

Examine each of the following situations to determine if the trust’s income is taxable to the grantor, the trust, or some other person.

Violet Haas created a trust for the benefit of her older sister, Miriam. The trust is to last for Miriam’s lifetime or until Violet revokes the trust. Violet knows that her sister will have ongoing financial difficulties and would only revoke the trust in the event of her own financial difficulties.

Identify to whom the income is taxable and explain your response.

(LO 7-4)

Answer 3

The income is taxable to Violet as grantor because she has a power of revocation over the trust.

Question 4

Trusts

Examine each of the following situations to determine if the trust’s income is taxable to the grantor, the trust, or some other person.

Charlotte Pierce created a trust for the benefit of her 16-year-old grandson. The trust income is to be used to pay for his college education. The trust pays all income annually to the grandson, with the principal reverting to Charlotte in 12 years or upon the death of the grandson, whichever occurs first.

Identify to whom the income is taxable and explain your response.

(LO 7-4)

Answer 4

The income is taxable to Charlotte because a reversionary interest is retained in the trust principal.

Question 5

Trusts

Examine each of the following situations to determine if the trust’s income is taxable to the grantor, the trust, or some other person.

Steve Angotti created an irrevocable trust for the benefit of his two brothers and their sons. Steve is the trustee. The trust must pay all income annually to the beneficiaries. The trustee has the right to distribute any part of the trust corpus to any one of the beneficiaries without the consent of the others.

Identify to whom the income is taxable and explain your response.

(LO 7-4)

Answer 5

The income is taxable to Steve because he (as trustee and grantor of the trust) may exercise a power of disposition over the trust corpus without the consent of an adverse party.

Question 6

Trusts

Examine each of the following situations to determine if the trust’s income is taxable to the grantor, the trust, or some other person.

Boris Michelvich created an irrevocable trust for the benefit of his destitute aunt. Boris is the trustee and is allowed to borrow against the trust at any time at a 2% interest rate without providing security. Current market rates of interest average 7%.

Identify to whom the income is taxable and explain your response.

(LO 7-4)

Answer 6

The income is taxable to Boris because the grantor is afforded preferential treatment in borrowing provisions and is thus indirectly benefited.

Question 7

Trusts

Examine each of the following situations to determine if the trust’s income is taxable to the grantor, the trust, or some other person.

Jim Sturgeon created an irrevocable trust for the benefit of his children. Jim named his bank as trustee and gave the trustee complete investment authority. Included in the investment authority is the right to purchase insurance on the grantor’s life or the life of the grantor’s spouse. The bank recently used all of the income from the trust, without the children’s approval, to purchase substantial amounts of life insurance on Jim and his spouse.

Identify to whom the income is taxable and explain your response.

(LO 7-4)

Answer 7

The income is taxable to Jim. Income from the trust is used to purchase life insurance on the life of the grantor (Jim) and his spouse; therefore, it falls within grantor trust rules.

Question 8

Trusts

1. Identify situations in which a grantor retains rights over a trust so that the grantor trust rules apply.

(LO 7-4)

Answer 8

a. The grantor retains a reversionary interest over the corpus of the trust in excess of 5% of the value of property transferred into the trust.
b. The grantor can exercise a power of disposition over either the trust’s income or corpus without the consent of an adverse party.
c. The grantor directly or indirectly retains certain administrative powers that may be exercised for his or her benefit.
d. The grantor reserves the right to revoke the trust.
e. Deemed grantor on a 2503(c) trust Return

Question 9

Trusts

2. Identify a situation regarding income from a trust such that the grantor trust rules apply.

(LO 7-4)

Answer 9

Grantor trust rules apply when income from a trust is used or may be used for the grantor’s benefit, such as purchasing life insurance on the grantor or grantor’s spouse.

Question 10

Trusts

3. Examine each of the following situations to determine if the trust’s income is taxable to the grantor, the trust, or some other person.
   a. Fred Kearney established a Constitutional Freedom Trust from a kit he received in the mail. He placed all of his assets in the trust and assigned all of his earned income to the trust. In return, the trust will take care of the financial needs of Fred and his family.

Identify to whom the income is taxable and explain your response.

(LO 7-4)

Answer 10

The income is taxable to Fred; the income is used for his (the grantor’s) benefit.

Question 11

Trusts

3. Examine each of the following situations to determine if the trust’s income is taxable to the grantor, the trust, or some other person.
   b. Rita Martin created an irrevocable trust for the benefit of her three minor sons. She named her bank and her attorney as co-trustees. The trust property earned $100,000 in the first year and had taxable income of $80,000 after deducting expenses. This income was left to accumulate for future distribution to each son equally when the youngest son attains age 18.

Identify to whom the income is taxable and explain your response.

(LO 7-4)

Answer 11

The income is taxable to the trust. All accumulated income is taxed to the trust entity since Rita has retained no prohibited powers and there are no current beneficiaries of the income.

Question 12

Trusts

3. Examine each of the following situations to determine if the trust’s income is taxable to the grantor, the trust, or some other person.
   c. Violet Haas created a trust for the benefit of her older sister, Miriam. The trust is to last for Miriam’s lifetime or until Violet revokes the trust. Violet knows that her sister will have ongoing financial difficulties and would only revoke the trust in the event of her own financial difficulties.

Identify to whom the income is taxable and explain your response.

(LO 7-4)

Answer 12

The income is taxable to Violet as grantor because she has a power of revocation over the trust.

Question 13

Trusts

3. Examine each of the following situations to determine if the trust’s income is taxable to the grantor, the trust, or some other person.
   d. Charlotte Pierce created a trust for the benefit of her 16-year-old grandson. The trust income is to be used to pay for his college education. The trust pays all income annually to the grandson, with the principal reverting to Charlotte in 12 years or upon the death of the grandson, whichever occurs first.

Identify to whom the income is taxable and explain your response.

(LO 7-4)

Answer 13

The income is taxable to Charlotte because a reversionary interest is retained in the trust principal.

Question 14

Trusts

3. Examine each of the following situations to determine if the trust’s income is taxable to the grantor, the trust, or some other person.
   e. Steve Angotti created an irrevocable trust for the benefit of his two brothers and their sons. Steve is the trustee. The trust must pay all income annually to the beneficiaries. The trustee has the right to distribute any part of the trust corpus to any one of the beneficiaries without the consent of the others.

Identify to whom the income is taxable and explain your response.

(LO 7-4)

Answer 14

The income is taxable to Steve because he (as trustee and grantor of the trust) may exercise a power of disposition over the trust corpus without the consent of an adverse party.

Question 15

Trusts

3. Examine each of the following situations to determine if the trust’s income is taxable to the grantor, the trust, or some other person.
   f. Boris Michelvich created an irrevocable trust for the benefit of his destitute aunt. Boris is the trustee and is allowed to borrow against the trust at any time at a 2% interest rate without providing security. Current market rates of interest average 7%

Identify to whom the income is taxable and explain your response.

(LO 7-4)

Answer 15

The income is taxable to Boris because the grantor is afforded preferential treatment in borrowing provisions and is thus indirectly benefited. Return

Question 16

Trusts

3. Examine each of the following situations to determine if the trust’s income is taxable to the grantor, the trust, or some other person.
   g. Jim Sturgeon created an irrevocable trust for the benefit of his children. Jim named his bank as trustee and gave the trustee complete investment authority. Included in the investment authority is the right to purchase insurance on the grantor’s life or the life of the grantor’s spouse. The bank recently used all of the income from the trust, without the children’s approval, to purchase substantial amounts of life insurance on Jim and his spouse.

Identify to whom the income is taxable and explain your response.

(LO 7-4)

Answer 16

The income is taxable to Jim. Income from the trust is used to purchase life insurance on the life of the grantor (Jim) and his spouse; therefore, it falls within grantor trust rules.

Question 17

Trusts

3. Examine each of the following situations to determine if the trust’s income is taxable to the grantor, the trust, or some other person.
   h. Several years ago, William Feeney created a Section 2503(c) trust for the benefit of his son, Steve. The trust was established to allow William and his wife to make gifts of the annual gift tax exclusion amount ($10,000 per spouse) every year. This year, Steve turned 21 years old and had the right to revoke the trust, but he chose to allow it to continue until he is 25 years old. No part of the income was paid out to Steve, as his parents were paying all of his living and education expenses.

Identify to whom the income is taxable and explain your response.

(LO 7-4)

Answer 17

The income is taxable to Steve; he is the deemed grantor on the 2503(c) trust subsequent to his turning age 21 since he has the power to appropriate corpus for his own benefit.

Question 18

Trusts

Module Check

5. Marc Handle created an irrevocable trust for the benefit of his dependent children and his wife, Mary. Marc named a local bank as trustee of the trust and authorized the bank to invest in stocks, bonds, and certificates of deposit. All funds in the trust are currently invested in high-yielding bonds. The provisions of the trust require that all income be paid annually and used for the needs of Mary and the children.

Which one of the following taxpayers must pay tax on the income from the trust?

the trust, because it is irrevocable and the grantor receives no benefits

Marc, because his spouse is an income beneficiary

Mary, because she can receive all income from the trust annually

the children, because they are paid unearned income in excess of $2,100

(LO 7-4)

Answer 18

Marc, because his spouse is an income beneficiary

If the grantor’s spouse is the income beneficiary, then the trust income is subject to the grantor trust rules. In this case, the income is taxed to Marc, as grantor of the trust.

Question 19

Trusts

Module Check

13. Jim Sturgeon created an irrevocable trust for the benefit of his children. Jim named his bank as trustee and gave the trustee complete investment authority. Included in the investment authority is the right to purchase insurance on the grantor’s life or the life of the grantor’s spouse. Without the children’s approval, the bank recently used all of the income from the trust to purchase substantial amounts of life insurance on Jim and his spouse.

Who is taxed on the income from the trust?

Jim

the children

the trust

(LO 7-4)

Answer 19

Jim

The income is taxable to Jim. Income from the trust was used to purchase life insurance on the life of the grantor (Jim) and his spouse; therefore, it falls under the grantor trust rules.

Question 20

Trusts

Module Check

14. Violet Haas created a trust for the benefit of her older sister, Miriam. The trust is to last for Miriam’s lifetime or until Violet revokes the trust. Violet knows that her sister will have ongoing financial difficulties, and thus Violet plans to revoke the trust only if she experiences financial difficulties of her own.

Who is taxed on the income from the trust?

Violet

Miriam

the trust

(LO 7-4)

Answer 20

Violet

The income is taxable to Violet as grantor because she has the power to revoke the trust

Question 21

Trusts

Module Check

19. If the grantor of a trust retains power over the assets placed in the trust, then the trust income is taxed to the

beneficiary.

trust.

grantor.

(LO 7-4)

Answer 21

grantor.

If the grantor retains power (the right to revoke, for example) over the assets placed in the trust, then the trust income is taxed to the grantor of the trust.

Question 22

Trusts

Module Check

21. Which one of the following will not result in application of the grantor trust rules?
    a. The trust income is used or may be used for the grantor’s benefit.
    b. The trust income may be used to discharge a legal obligation of the grantor.
    c. The trust income is used to pay life insurance premiums on the life of the grantor.

(LO 7-4)

Answer 22

The trust income may be used to discharge a legal obligation of the grantor.

The grantor trust rules will apply only if the trust income is actually used to discharge a legal obligation of the grantor.

Question 23

Practice Test 2

Trusts

53. Mary Richards created an irrevocable trust for her two minor sons. She named her bank as trustee. The trust property earned $75,000 in the first year and had taxable income of $68,000 after deducting expenses. This income was left to accumulate for future distributions to be made to each son equally when the youngest son attains age 18.

To which one of the following will the income of the trust be taxable?

the sons equally

the oldest son after attaining age 18, then to the sons equally after the youngest son attains age 18

Mary

the trust

(LO 7–4)

Answer 23

the trust

The trust will pay the taxes since the trust is irrevocable and no distributions are allowable until the youngest son attains age 18.

Question 24

Practice Test 2

Trusts

54. Mark Spout created an irrevocable trust for the benefit of his dependent children. Mark named the local bank as trustee of the trust and authorized it to invest in stocks, bonds, and negotiable certificates of deposit. Included in the investment authority is the right to use trust income to purchase insurance on Mark’s life. This year, the trustee uses all of the income from the trust to pay premiums on life insurance on Mark. All funds are currently invested in high-yielding bonds paying 4% semiannual interest on a face value of $100,000.

Which taxpayer must pay tax on the income of the trust, and why?

a. the bank, because of its broad authority as trustee
b. the children, because they are the designated beneficiaries
c. the trust, because it is irrevocable with no benefits to the grantor
d. Mark, because the income is (or may be) used to purchase insurance on Mark’s life

(LO 7–4)

Answer 24

d. Mark, because the income is (or may be) used to purchase insurance on Mark’s life

If the trust income is, or may be, used to purchase insurance on the life of the grantor or the grantor’s spouse, then the trust is a grantor trust.