• Typically a trust is an independent entity that is taxed separately from the settlor. Because trust income is taxed at higher rates than individual income, the settlor may intentionally create a defect in the trust terms so that the trust’s income will be taxable to the grantor. This is achieved by violating the grantor-trust rules of IRC §§ 671–677 in a way that does not affect the completeness of the gift under IRC §§ 2035–2042. A violation renders the trust “defective” because the settlor must recognize the income even if the settlor does not actually receive it. The attribution of tax liability and payment of taxes on trust income do not give the grantor an ownership in the trust, which remains separate from the settlor’s estate and is not subject to estate taxes.
defective trust
A trust that is treated, for income-tax purposes, as if it were the same entity as the grantor, but for estate-tax purposes is treated as an entity separate from the grantor.
