The Advantage of Sprinkle Trusts
Wouldn’t it be great if the inheritance you leave your children can be used for multiple generations while at the same time minimizing the income taxes they pay? This can be accomplished with a sprinkle trust.
Assume that Benny creates a trust that upon his passing his held in further trust for his daughter Susan. Susan is the trustee, so she has complete control over the investments held in the trust. Instead of Susan being the only beneficiary, however, Benny’s trust provides that Susan can distribute the interest, dividends, and rents that her trust share generates not only to herself, but also to her children (and one day to her grandchildren!)
Suppose that Susan’s trust share generates $75,000 in income this year. Also assume that Susan’s combined federal and state income tax bracket is 39%. If Susan distributes the income to herself, she pays income tax of $29,250. Her son Rob needs money for a down payment on a home. If Susan kept the income and paid the tax, she could then make a gift of $45,750 to Rob net of the income tax she paid. Under federal gift tax law, Susan can only make a tax free gift of $16,000 to Rob, so she must file a gift tax return that reduces her federal gift/estate tax exemption by $29,750 (computed as $45,750 net of tax less the $16,000 exemption amount).
Instead of keeping the income for herself, following the terms of the trust her father established for her, she distributes the income directly to Rob, whose marginal tax bracket is 20%. The distribution is not a gift from Susan to Rob, it is a distribution of income. Rob pays income tax of $15,000 which is about half of what Susan would have paid. Rob has $60,000 to use as a down payment instead of $47,750 which was what would have remained after Susan paid taxes instead of Rob. Because it’s a distribution of income and not a gift, Susan doesn’t have to file a gift tax return and consume part of her federal exemption.
What if Benny was worried that Susan’s children would put pressure on her to distribute the trust income to them rather than to herself? The trust share can be drafted to include Benny’s intent that Susan’s interest and welfare be first considered before the trustee distributes income to anyone else.
Because Susan is an interested trustee, meaning that she is the person making the decisions and is a beneficiary, there is a conflict of interest. Normally, a more remote beneficiary could raise that issue and cause Susan difficulty.
But there’s another provision that can be used to mitigate beneficiary challenges. This has to do with who the trust benefits after Susan’s death. Normally, it flows down the lineal line of descendants to the next generation. Benny would have his attorney draft that provision in. He would also, however, give Susan a testamentary power of appointment.
A testamentary power of appointment allows Susan to change who the beneficiaries are following her death. The power of appointment can be wide or narrow. Normally, to exclude the assets from Susan’s estate for federal estate tax purposes that power of appointment would be limited to Benny’s descendants, their spouses and charities. If a power of appointment is so limited, then the assets may be excluded from Susan’s estate for federal estate tax purposes.
Why is a well drafted power of appointment so important? Simply put it gives those you love and trust the ability to change what would otherwise be an irrevocable provision after your death. If Susan saw the need to redistribute the wealth, perhaps because one child needs it more than another, or maybe another child has drug or alcohol dependency problems, Benny would want her to be able to adjust the provisions as necessary.
Another great reason is that by giving Susan this power, her children and grandchildren are unlikely to challenge how she decides to sprinkle the trust benefits among them. They would know that should they become a thorn in Susan’s side, she could disinherit them from the trust.
A sprinkle trust can be a valuable tool for beneficiary income tax planning. Those clients who wish to “keep things simple” by mandating outright distributions rather than a continuing trust limit their loved one’s ability to mitigate income taxes.
©2022 Craig R. Hersch – The Sheppard Law firm. Learn more at floridaestateplanning.com
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