Question

This year Maria transferred $600,000 to an irrevocable trust that pays equal shares of income annually to four cousins (or their estates) for the next eight years. At that time, the trust is terminated and the corpus of the trust reverts to Maria. Determine the amount, if any, of the current gifts and the taxable gifts if the relevant interest rate is 6 percent and Maria is married and elects to gift-split with her spouse?

Answer 1

Here maria is creating irrevocable trust that pays equal income annually to four cousins and after eight year the principal amount is transferred to the maria and her husband equally i.e., $ 300,000 each. So, firstly we need to know something about trust taxation provisions to answer this probem.

Initially when trust is created, capital is contributed to the trust out of income or assets, which at that time is not taxable in the hands of trust or contributor. This is based on assumption that contribution would have already been taxed in the hands of contributor before contribution to the trust. If contribution is not taxed before contribution in the hands of contributor then it needs to be first taxed in hands of contributor and after that contributed to the trust. Now after this we need to know about taxation of trust income, which is taxed in hands of beneficiary who receives that income. If trust income is retained and not distributed, then that income will be taxed in hands of trust. Lastly we need to know about the provision of principal distribution of trust. When trust is terminated and principal is distributed, then that amount is not taxable in hands of receiver or trust. This is based on the assumption that amount would already have been taxed before the creation of the trust and taxing the amont again would lead to double taxation of same amount.   

Based on above provisions initial transfer of $ 600,000 will not be taxable in hands of trust or maria. Interest income of $ 36,000 ($600,000 * 6%) is distributed by trust to cousins. Individual shares of cousins will be $ 9,000 ($ 36,000 / 4). This interest will be taxed in hands of cousins, trust will not pay any tax on interest distributed. Lastly, amount distributed on termination of trust will not be taxable in hands of maria, her spouse or trust.