Treasury Sets Its Sights on 'Artificial Advantages' of Some Kinds of Trusts

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WASHINGTON -- Bank trust departments can expect to be adversely affected if the Treasury Department's tax plan comes to fruition.

The plan would, Treasury says, remove "the artificial tax advantages of trusts and would cause decisions regarding the creation of trusts to be based on non-tax considerations."

The Treasury plan takes aim at trusts that take advantage of the lower tax rates usually enjoyed by children under 14 and at grantor and non-grantor trusts.

Banks could benefit, however, from an aspect of the Treasury plan that would index interest income so as to wash out the effects of inflation. Treasury proposes to index income by excluding a fractional amount of interest receipts from income. It would deny a deduction for a corresponding fraction of interest payments. The fractional exclusion would be based on the annual rate of inflation.

If Treasury assumes that lenders are entitled to a real 6% annual return, for example, this would mean that at an annual inflation rate of 10%, only 62% of interest income or outlays would be either taxable or deductible. But home mortgage interest on the principal residence would be fully deductible, though the claimed deduction would be linked to fair market value. As a practical matter, the Treasury plan would also allow most taxpayers to deduct up to $5,000 more before running into new proposed limitations. Distribution Deduction Denied

Treasury also proposes to place estates on the same taxable year as the decedent, thereby eliminating selection of a taxable year that defers taxation of an estate's income. Treasury would deny a distribution deduction to prevent income-splitting between the estate and beneficiaries but permit estate income to be taxed under a separate rate schedule. In certain circumstances, an executor could choose to have the estate taxed as if it were a post-death trust.

James McLaughlin, a counsel and trust specialist for the American Bankers Association, said that if Treasury's proposal is enacted, "it will have significant impact on the way people plan their estates and establish trusts." He noted that the Treasury proposal is "very much an adoption" of the proposals for income taxation of trusts put forward by the American Law Institute last May.

Treasury basically wants to unify estate and gift taxes. It would compute the gift tax on a tax-inclusive basis, leaving the net amount for the donee. Treasury would also revise the method of valuing property for gift tax purposes.

J. Stoddard Hayes, vice president, Wilmington Trust Co., Wilmington, Del., warned that "many people are reacting emotionally" to the Treasury Department's plan on the basis of incomplete information. The philosophy underlying Treasury's proposal is a substantial departure from the past in the direction of the free market, and he noted that if portions of the plan were to be adopted piecemeal, particularly with respect to income taxation of trusts, it would "really create a lot of problems with respect to the allocation of principal and interest. …