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Overview
Scope of the chapter. This chapter addresses the federal tax treatment of protective structures. It covers the grantor trust rules and their application to domestic and foreign trusts, the completeness of gifts to protective trusts, incomplete-gift nongrantor trusts, inclusion in the gross estate under sections 2036 and 2038 and its relation to creditors' access, the classification and taxation of foreign trusts, the treatment of foreign entities, insurance wrappers, state income taxation of trusts, and the design of structures that are neutral for tax purposes.
The principle of tax neutrality. A protective structure should not change the client's tax position unless a change is intended and has been separately planned. Most asset protection trusts are designed to be ignored for income tax purposes, so that the settlor continues to report the trust's income, and to be either complete or incomplete for gift tax purposes, according to whether the client wishes to remove the assets from the client's estate. A structure that unintentionally becomes a separate taxpayer, triggers gain on funding, makes an unintended taxable gift or exposes the client to the punitive regime for accumulations in foreign trusts imposes costs that will be discovered, usually in an examination, years after the structure was created. A structure that is tax-neutral by design also defeats the suggestion, often made by creditors, that the planning had a tax-evasion purpose.
The four questions. Every protective structure must answer four tax questions at its creation. First, who is taxed on its income: the settlor under the grantor trust rules, the trust itself, or the beneficiaries? Second, is the transfer to it a completed gift? Third, will its assets be included in the settlor's gross estate? Fourth, what must be reported, by whom and when? The answers are linked. A self-settled trust in which the settlor is a discretionary beneficiary is ordinarily a grantor trust for income tax purposes. Whether the transfer to it is a completed gift, and whether its assets are included in the settlor's estate, may depend on whether the settlor's creditors can reach them under the law governing the trust, which brings the asset protection analysis directly into the tax analysis.
Relation to other chapters. Information reporting is addressed in chapter 43 (see infra ch. 43), and FATCA and CRS in chapter 44 (see infra ch. 44). The exit tax and its treatment of grantor trusts are addressed in chapter 46 (see infra ch. 46). The design of self-settled trusts is addressed in chapter 18 (see supra ch. 18) and of offshore trusts in chapter 30 (see supra ch. 30). Insurance and annuity wrappers are addressed in chapter 32 (see supra ch. 32).