When creating a trust for your loved ones, choosing the right trustee might seem like a straightforward decision. After all, who better to manage assets for your grandchildren than their own parent? However, in the complex world of estate planning, this seemingly logical choice could lead to unintended tax consequences that might undermine your entire estate plan.

The Hidden Tax Trap in Family Trustee Selection

Picture this: You’ve decided to create a trust for your grandchild, and you’re considering appointing your adult child (the grandchild’s parent) as trustee. It feels natural – they know the family dynamics, understand your values, and have your grandchild’s best interests at heart. However, the Internal Revenue Code (IRC) sees this situation differently, and that’s where things get interesting.

Understanding IRC § 672(c): The “Related or Subordinate Party” Rule

The IRS has a particular concern about keeping wealth in the family – specifically, whether you’re truly giving up control of the assets you’re putting into the trust. Under IRC § 672(c), certain people are automatically considered “related or subordinate parties” who might be under your influence. This includes:

• Your spouse
• Your children (and other descendants)
• Your parents and siblings
• Your employees
• Corporations you control (and their employees)

Here’s where it gets tricky: When you appoint your adult child as trustee, the IRS presumes they’ll act according to your wishes rather than independently. It’s like having a puppet show where you’re suspected of pulling the strings, even if that’s not your intention.

The Estate Tax Implications: Why This Matters

This presumption of control can lead to a significant problem: estate tax inclusion. In other words, the IRS might treat the trust assets as if they still belong to you for estate tax purposes. This could happen in two ways:

1. Under IRC § 2036, the IRS might argue you’ve kept a “life estate” in the trust property because your child-trustee is presumed to follow your wishes about how to use the trust assets.
2. Under IRC § 2038, the IRS could claim you’ve retained the power to “alter, amend, revoke, or terminate” the trust through your influence over your child-trustee.

Either scenario could result in the trust assets being counted as part of your taxable estate – precisely the outcome you were trying to avoid by creating the trust in the first place.

Smart Solutions for Better Trust Planning

Don’t worry – there are several ways to achieve your goals while avoiding these tax pitfalls. Here are some alternatives we often recommend:

1. Independent Corporate Trustee: While this might feel less personal, it provides the strongest protection against estate tax inclusion.
2. Trusted Family Friend or Professional Advisor: Someone who knows your family but isn’t related by blood or employment can be an excellent choice.
3. Committee Approach: Consider creating a trustee committee that includes both family members and independent parties, providing a balance of personal insight and professional oversight.
4. Limited Role Strategy: Your child could serve as a limited purpose trustee, with an independent trustee handling distributions and other sensitive decisions.

Making the Right Choice for Your Family

At the Law Offices of Shann M. Chaudhry, ESQ. we understand that trustee selection involves balancing complex family dynamics with technical tax requirements. The key is finding a solution that honors your wishes for your family’s future while protecting your estate from unnecessary taxation.

We’re here to help you navigate these waters and design a trust structure that works for your unique situation. Whether you’re just starting to think about estate planning or need to review an existing trust, we can help ensure your plan accomplishes your goals without running afoul of tax regulations.

Next Steps

Ready to discuss your trust planning options? Contact us to schedule a consultation. We’ll help you understand all your choices and create a plan that protects both your assets and your family relationships.

Remember: A trust is only as good as its trustee. Let’s make sure yours is structured for success from the start.

This blog post is for informational purposes only and does not constitute legal advice. Please contact our office to discuss your specific situation.