Author: David Joulfaian
Source: Social Science Research Network
Link: Full article
Households can reduce taxes by transferring taxable income generating assets from high income family members to those in lower tax brackets. Parents, for instance, may exploit di􏰁erences in the marginal tax rates that they face and those that apply to their children. But under progressive taxation, the marginal tax rates may converge upon transferring large sums from high to low income members as the income of the recipient is pushed into higher tax brackets, thereby limiting the tax arbitrage bene􏰂ts of intergenerational transfers. As an alternative, and under a more e􏰁ective form of income splitting, high income family members may create trusts for the bene􏰂t of other family members, and divide the transferred assets among a large number of trusts so as to subject the income from each trust to the lowest possible tax bracket. The Tax Reform Act of 1986 modi􏰂ed the treatment of trusts such that the maximum individual tax rate became applicable at very low levels of trust taxable income thereby erasing much of the bene􏰂ts of transferring income through this vehicle. This paper provides an overview of the tax treatment of income received by individuals and that of trusts, and provides evidence on how changes in di􏰁erential tax rates introduced in 1986 altered the use of trusts as means to splitting income and sheltering it from taxation.