Kids Trust Tax Trap: Please give me the IRS Section which does not allow a trustee to have the power to make a discretionary distribution of income or principal to a minor which would be tantamount to a discharge of a legal obligation of the trustee.
Let's first give a little background to the problem so other visitors can understand the issue. A common planning technique is for a parent to set up an education trust for a minor child. The trust holds and invests assets or cash which the parent typically gives the trust each year, hoping to build a nest egg to pay for college, or for future use by the child (e.g. to start a business or buy a home, etc.). Although the media focuses most attention on 529 plans which do have significant benefits, trusts are superior as an approach for many taxpayers, especially high net worth taxpayers. Your question raises a significant issue in this type of planning. If a parent serves as a trustee of the trust a tax problem can occur. For example, mom sets up the trust and makes gifts to the trust. Dad serves as sole trustee. In his capacity as trustee the trust document can reserve to Dad as trustee the right to spend trust money on things like clothing and medical care, or education (although in some states paying for college may not be subjected to this problem). Since these expenditures effectively discharge (pay for) obligations and responsibilities Dad had as a parent, Dad is effectively using trust money to pay for his obligations. The solution in some instances is for Dad to be a co trustee with another person, say one of mom or Dad's siblings, and prohibit Dad from making distributions that discharge his legal obligation of support and instead have the sibling do it.
Treasury Regulation Section 1.662(a)-4 provides that amounts paid from a trust to discharge someone's legal obligation of support is included in the gross income of that person even if that person is not the grantor.
Another authority should also be considered. Under Treasury Regulation Section 1.671-1(c) the grantor of a trust is taxed on all trust income to the extent trust income is used to discharge the grantor's legal obligation of support.
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