A Model Offshore Trust may help you indirectly to reduce your personal income tax burden. Income tax benefits during your lifetime won’t come from the structure of the Trust itself, but instead depend on how the Trust’s investments are managed.
During your lifetime, a Model Offshore Trust with any U.S. beneficiaries is classified as a “grantor trust” — which means that for all U.S. income tax purposes, you (the person who funded the Trust) are deemed still to own all of the Trust’s assets. Accordingly, you must include the Trust’s taxable income on your own tax return each year. It is as though, for income tax purposes, the Trust didn’t exist.
The grantor trust rule applies to the Trust during your lifetime even if you do not include yourself in the Beneficiary Class. The mere fact you have established a foreign trust with even one U.S. citizen or resident as a possible beneficiary ties the Trust’s income to you.
The general tax strategy for a Model Offshore Trust is to defer recognition of taxable income during your lifetime. Doing so shrinks the amount of income you must include on your own tax return. Tax deferral doesn’t prevent the Trust from investing profitably, and it doesn’t prevent the Trustee from making cash distributions to you or other members of the Beneficiary Class. Deferral simply keeps earnings from showing up on your tax return.
The income tax benefits achieved through a Trust can go beyond deferral. But the economic value of tax deferral alone can be enormous.
By postponing recognition of taxable income, a taxpayer can reinvest earnings for many years that otherwise would be lost to the tax collector immediately. This lets investment earnings accumulate at a faster, before-tax rate of compounding. Even if the taxpayer needs to spend all of his investment return each year, tax deferral can boost his spendable, after-tax cash by one-third or more.
By acknowledging your Model Offshore Trust’s status as a grantor trust and including its taxable income on your own return during your lifetime, you make the Trust non-controversial. This straightforward approach eliminates the risk of worrisome disputes with the IRS about the proper treatment of Trust income
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