Trust Distributions

If you transfer entity interests in 2012 any entity distributions paid after the transfer should be paid to the then record owner which will be the trust. Prior to transfer of a flow through entity to the trust all distributions should be paid to the then member of record, you, in your personal capacity. Some transfers may result in an interim closing of the entities books and a pro-ration between you and the trust.

Since most dynasty trusts, DAPTs and BDITs (Beneficiary Defective Irrevocable Trusts), are grantor trusts, all income will be reported on your personal income tax return. Your CPA should file a form 1041 tax return for the trust including a statement that income earned by the trust is reported on your personal return. President Obama has recommended legislation undermining grantor trust benefits.
 Distributions to fund tax payments are common. Example: Family S corporation distributes 40% of income so shareholders as a distribution so each will have enough cash to pay income taxes. The estate plan of transferring interests to a trust will complicate this mechanism. Once the flow through entity interests have been transferred to the trust all distributions must be made to the dynasty trust as the record owner (member, partner, S shareholder). That won’t infuse funds into your bank account for you to pay your income tax on the earnings of the flow through entity. The income, however, will still pass to your personal return since the trust is likely a grantor trust.
The optimal means of handling this situation from a tax and asset protection perspective is to not make any distribution from the trust to fund your income taxes because the tax payments you make will reduce the size of your estate. This is one of the key leveraging benefits of these trusts being structured as a grantor trusts. The greater the unreimbursed tax burn the lower your estate. 
Some advisers include a provision in such trusts permitting the trustee to reimburse you for income taxes paid (this is OK under some state laws, like Delaware). Other advisers shun such provisions because of concerns the IRS will argue that there was an implied agreement to reimburse for taxes if the provision were activated. Like many complex tax issues – ask different advisers and you’ll get different opinions.
 So, like the old Wendy’s commercial, “Where’s the beef?” Well Clara, here it is, and they’re Hot ’N Juicy:
Salary and compensation may still be paid from the entities given or sold to the trust, when appropriate. Distributions may be able to be made to your spouse from your trust. Distributions may be able to be made from your spouse’s trust to you and perhaps your spouse (if it’s a DAPT – a Domestic Asset Protection Trust of which your spouse is a beneficiary and the grantor). The trust could make a loan for adequate interest to your or perhaps your spouse. This is a great mechanism as it retains the values intact inside the protective envelope of the trust, and if properly handled like a loan should not seem to raise the specter of the tools the IRS uses to pull these transfers back into your estate.
Caution, if any of the above possible distributions follow a pattern or appear to correlate with your tax or other expenditures the IRS may argue that there was an implied understanding between the trustee and family on these distributions. This could be used as a means to disregard the trust and pull all trust assets back into your estate.
The valuation of the interests to be transferred may have to consider forthcoming distribution, and if there is a pattern of making distributions so members can pay income tax on their pro-rata share of income, that pattern of payments may be viewed as reducing discounts.

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