Trust funds serve any number of purposes, ranging from spendthrift funds that protect the beneficiary from his own spending habits to tax avoidance funds that give income-generating assets a home in states without income taxes. Trusts calculate taxes using similar rules as individuals, but often pass the taxable income through to the individual who gets the income. Attorneys and tax planners can find creative ways of establishing trusts to set up a tax-free fund, but the most reliable way of starting a tax-free trust fund is by taking advantage of specifically exempted income types.
Federal tax law provides special treatment for interest income earned from municipal bonds. Unlike other interest income, municipal bonds generate tax-exempt income for bondholders. A trust fund that holds municipal bonds can hold onto or distribute the interest payments free from tax. It cannot deduct any interest expenses incurred by buying the bonds on borrowed money. Similarly, any principal payments from bonds are tax free as a return of investment.
Some exchanges of property qualify for special tax treatment. A taxpayer can exchange an appreciated piece of property for similar property, such as qualified small-business stock. Taking advantage of tax-deferred exchanges allows a sophisticated trust fund manager to trade appreciated assets to increase the value of the trust’s asseets without recognizing a taxable gain. When the property is ultimately sold, the trust will have to report taxable income.
Charitable Remainder Trusts
Charitable giving receives special tax treatment under federal tax law. Trusts established to facilitate donations to charities provide a unique set of tax benefits to donors. The donor can reserve the right to annual distributions from the trust and hand over the remaining assets in the trust at the death of the donor. The trust operates tax free, and the donor only recognizes the annual distribution as taxable income. Charitable remainder trusts can sell appreciated assets and trade tax-free.
Federal tax law applies to the worldwide income of U.S. citizens and residents. Several countries have more permissive tax laws that provide attorneys and tax planners the technical components necessary to establish creative trust arrangements designed to shelter income from U.S. taxation. Taxpayers are required to disclose foreign accounts and trusts, and should be careful of arrangements that move assets offshore to reduce tax liability. The Internal Revenue Service actively investigates promoters of tax shelters, and taxpayers could wind up with huge fines and penalties from participating in international tax-free trusts.
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