Improper Subtrust Funding

What could happen if you do not properly fund the subtrust?


A great deal of postmortem planning is possible if the consequences of the actions involved in subtrust funding are understood. Improper subtrust funding may result in serious adverse tax and nontax consequences, including:

a.   Loss of S corporation election by not making distributions within the prescribed time period and/or distributing to a subtrust that does not qualify for the S corporation election.

b.   Loss of all or part of the marital deduction, resulting in estate tax.

c.   Immediate capital gains in funding particular types of pecuniary gifts.

d.   A possible immediate taxable gift by transfer into an irrevocable trust.

e.   Potential taxation of part of the credit trust on the second death under IRC §2036(a).

f.    Acceleration of gain on funding of income in respect to a decedent (IRD) items.

g.   Potential unintended carrying out of distributable net income (DNI) on funding of pecuniary amount.

h.   Loss of all or part of IRC §121 exclusion of gain from sale for later sale of the personal residence by improper placing of house in wrong trust.

i.    Loss of all or part of the IRC §2631 GST exemption.

j.    Failure to “pack” a credit trust by not using IRC §2032A.

k.   Failure to use discounts on funding at the first death.

l.    Loss of ability to take discounts on the second death.

m.  Unnecessarily losing step-up in basis on second death for assets funded into the credit trust.

n.   An unhappy client if opportunities were lost because of the way assets were allocated between trusts (e.g., allocating all tax-free municipal bonds to the credit trust).

o.   Discovery by irrevocable trust beneficiaries that an improper allocation of assets resulted in a particular beneficiary’s not receiving the share that he or she would have received had a proper allocation been made.

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