Carol has been promoted several times, and she may be named a partner next year. Thus, she will be subject to higher marginal income tax rates than in the past. Carol's colleague Isaiah has told her about a "college education trust" from which he pays tuition and fees for his children. He has implied that there are sizable tax advantages to setting up a trust for this purpose.
Carol is considering establishing a similar trust to pay tuition for her own children. She believes that the trust will be able to deduct the tuition payments, something that she cannot currently do on her Form 1040. Write a memo for the tax research file addressing Carol's ideas.
SOLUTION
TAX FILE MEMORANDUM
Date: November 2, 2015
From: Reed Rawlings
Subject: Grantor trust rules
Carol’s ideas are contrary to the tax law. College tuition payments generally are nondeductible personal expenditures. § 262(a)
By using a trust as a fiduciary entity in this plan, Carol also brings into play the grantor trust rules of §§ 671 – 679. Where the grantor retains the right to make investment and distribution decisions, the trust is ignored for Federal income tax purposes. Thus, trust income and deductions are attributed directly to Carol, the owner of the trust assets.
The donor can retain the following powers without making the entity a grantor trust.
Invade corpus for the benefit of a beneficiary.
Withhold income from a beneficiary during the beneficiary’s disability or minority.
Allocate items between entity accounting income and corpus.
Choose charitable beneficiaries.
But if the grantor uses the income of the trust to satisfy his/her legal obligations, the grantor trust rules apply. If the tuition payments are one of Carol’s legal obligations, she is taxed on trust income used for this purpose. The entity itself cannot deduct such payments. Under these circumstances, there is no income tax benefit to establishing such a trust.