By: Martin M. Shenkman, CPA, MBA, PFS, AEP, JD | Income tax planning for trusts has been profoundly affected by the dramatic changes the American Taxpayer Relief Act of 2012 (“ATRA”) has had on the tax system. Income tax rates are higher. The federal estate tax, which had been an issue for many clients, now affects only a super-wealthy few. These changes have significant impact on how every practitioner completing a Form 1041, or even a 1040 for clients receiving K-1s from trusts should plan. Even if your clients face a state estate tax, the cost is significantly less than the combined state and federal estate tax that they had once faced. Trusts are subjected to an income tax regime very similar to that faced by individuals, but with a special deduction for distributions of distributable net income (“DNI”). Another hallmark of trust taxation is that trust income is subject to a compressed tax rate structure so that the maximum trust income tax bracket is reached at only about $12,000 of income. The Medicare Surtax which became effective in 2013 has added to the compressed income tax burden that trusts face. The following checklist will help you in the process:
√ General Trust Planning Tips to Reduce the Surtax
Planning for the Medicare Surtax under IRC Sec. 1411 has been the “talk of the town” since it first became effective in 2013. Practitioners planning for and preparing Trust Forms 1041 must be especially alert for planning opportunities to reduce the Surtax. This is especially important if the beneficiaries might sue trustees if the trust incurs Surtax that could have been avoided.
- Reduce trust income below the threshold amount if the trust is close to the level at which the Surtax applies. This is most simply accomplished by making distributions to beneficiaries that push income out of the trust to the beneficiary via the distributable net income (“DNI”) deduction to the trust.
- Trustee fees can be used to adjust how much NII is distributed. In regular income tax world trustee fees can generally be allocated against just certain types of income included in DNI (such as interest income) if that is more highly taxed and reported that way on the K-1. Specially allocating trustee fees will also impact the amount of NII that is deemed to be distributed. If you can do this in the income tax world it should affect the NII Surtax world in a similar manner. Note that in the regular income tax world some portion of expenses must be allocated to non-taxable income, e.g. muni-bonds, and lose the deduction to that extent. After making the trustee fee allocation for general income tax purposes and determining how much of each type of income is distributed under the regular DNI rules, a deduction for trustee fees is then allowed in determining the amount of undistributed NII that is subject to the Surtax, but the trustee fees must be allocated proportionately among NII and non-NII items.
Many clients and trustees will not be comfortable simply distributing funds to beneficiaries to save income tax. Consider the use of LLCs and FLPs to hold trust distributions to provide some measure of control. Flow through entities can pass income to “beneficiaries” without the need for actual distributions like a trust.
- Common advice is to convert NII to non-NII, but trustees have a fiduciary duty to invest trust assets. Investments must conform to the Prudent Investment Act unless the legal documents permit variation, but even variation must be undertaken with caution.
- Make interest tax exempt by investing in municipal bonds and move investment assets into life insurance which is protected by a tax favored envelope, but again, being mindful of the Prudent Investor Act.
√ Grantor Charitable Lead Trust
Unlike their more popular cousins, charitable remainder trusts (“CRTs”); charitable lead trusts (“CLTs”) are taxable. Practitioners should be alert for a fundamental change in the tax status of many newly formed CLTs. With higher income tax rates and substantial recent appreciation in the stock market there should be increasing interest in the use of grantor charitable lead trusts (“CLTs”). CLTs, while generally structured as non-grantor trusts, can be structured as a grantor trust so that the donor may benefit from a current income tax charitable contribution deduction. The deduction would be the present value of the qualified annuity or unitrust interest to be paid to the charitable beneficiary. IRC Sec. 170(f)(2)(B). In the remaining years of the CLT the grantor will be taxed on all of the income of the CLT. Thus, the value of the current contribution deduction must outweigh the income taxes that will be due in those future years.
A CLT can be characterized as a grantor trust to achieve this result in the following ways:
- A reversionary interest with value greater than 5% of the value of the trust assets at the time assets are transferred to the trust is held by the grantor’s spouse, the CLT will be characterized as a grantor trust. IRC Sec. 672(e).
- The grantor has a reversionary interest with value greater than 5% of the value of the trust assets at the time assets are transferred to the trust. IRC Sec. 673.
- The grantor retains a power to substitute assets, for assets of an equivalent value, in a non-fiduciary capacity. IRC Sec. 675(4)(C).
√ Use CRTs to Defer and Perhaps Avoid the Medicare Tax
CRTs, as tax-exempt trusts, are not subject to the Medicare tax. However, when the CRT makes distributions to current non-charitable beneficiaries, e.g. the client/grantor, some portion of a distribution may be characterized as NII and subject to the Medicare tax. While the CRT itself is exempt from income tax, the annuity or unitrust distributions made to individual beneficiaries are subject to regular income tax and Medicare tax. Under the final regulations, net investment income is classified and distributed using the four existing classes into which CRT income must be divided under IRC Sec. 664. These classifications capture the historic categorization of income earned. Generally, the most costly categories of taxable income are deemed distributed first. NII would similarly be identified as a sub-component of each such class of income. The NII of the CRTs beneficiary attributable to the beneficiary’s annuity or unitrust distribution will be deemed to include an amount equal to the lesser of: (1) the total amount of distributions for the year and (2) the current and accumulated NII of the CRT. Prop. Reg. Sec. 1.1441-3(c)(2)(i). If there is more than one beneficiary the NII is apportioned among the beneficiaries based on their respective shares of the total annuity or unitrust amount paid by the trust for that year.
For example, if a client gifts appreciated property to a CRT which is subsequently sold by the CRT, there is no immediate imposition of regular income tax or Medicare tax under IRC Sec. 1411 tax on the capital gain which is NII. The full amount of the sale proceeds can be reinvested in the trust. The deferral of the recognition of NII by having made the gift to the CRT which sells the assets instead of the individual donor may effect not just a deferral but an avoidance of the Medicare tax. For example, if the gain were realized in one year by the client much of the gain could be subject to the Medicare tax. It is possible for some clients that the spreading of that gain out over many years as part of the CRT tier system may result in the realization of that NII in sufficiently small quantities that the client’s MAGI remains under the threshold amount necessary to trigger the Medicare tax in future years. This same result may reduce the bracket in which income is realized as well.
√ Divorce Considerations
Most clients remain concerned as to whether trust assets are reachable in a divorce. Whether a trust is reachable in a divorce proceeding will depend on state law, as well as on a number of trust characteristics. A “discretionary” trust gives the trustee the power to determine if, when, and how much to distribute from the trust. This can be more difficult to reach through in a divorce. If, on the other hand, a trust is deemed a “support” trust, which directs the trustee to make distributions to support the beneficiary, it may be reachable. A common support standard is Health Education Maintenance and Support, referred to by the acronym “HEMS.” Supports trusts may have to rely on a spendthrift provision for any protection from claimants. Thus, a support trust might be easier to reach in a matrimonial action. While these generalities provide useful constructs, reality is much more complex because many trusts are actually a blend of the two principals, and all of this is compounded by the differences in state law, and how the trust is administered. A court might be influenced to see a trust that makes those regular distributions of trust income as somehow being more readily available, than a trust that has not made distributions. Practitioners rendering tax planning advice that suggests distributions should be mindful of these important ancillary consequences.
√ State Tax Compliance
State income tax planning for trusts will remain a critical component of planning and as the importance of estate tax planning wanes, state tax considerations will become relatively more important. Planning the initial situs of a trust, which state laws will govern, and which state or states can tax trust income, could have a material impact on the economic effect of the trust. If a trust is formed in a less than optimal jurisdiction, it may be possible to use the process of decanting (merging or transferring an existing trust into a new trust with more desirable provisions), or other techniques, to modify existing trusts to achieve better results.
Practitioners must bear in mind that as they recommend distributions from trusts to flow out DNI to lower bracket beneficiaries, those beneficiaries may be liable for state income tax on the distributions that could exceed the income tax that the trust might pay. For example, the trust may be based in a state that does not assess income tax on the trust. A distribution may reduce the trust’s federal income tax burden, but it could subject the beneficiaries to a high incremental state income tax.
Where a trust is administered may have important implications to the application (or avoidance) of state income taxation. In a recent case a New Jersey resident created a testamentary trust. In 2006 the sole trustee resided in New York and the trust was administered outside New Jersey. The trustee filed and paid New Jersey tax on S corporation income attributable to income from New Jersey, but not on S corporation income attributable to non-New Jersey sources. The fact that the tax return showed a New Jersey address was not deemed significant by the Court. The court held that since the trust was not administered in New Jersey, the Trustee was a New York resident and therefore could only be taxed on New Jersey source income. Residuary Trust A. v. Director, 27 NJ Tax 68 (2013). Thus, in guiding clients as to state income tax compliance and tax planning practitioners need to consider not only where the trust is administered, but the potential for changing that place of administration to improve state income tax consequences.
√ Multiple Fiduciaries
The increasing complexities of trusts using various fiduciaries will complicate these decisions and planning to avoid state income tax. Some trusts may have an institutional general trustee, an individual co-trustee, a trust investment adviser, a trust protector, a person authorized to make loans for less than adequate security, the grantor or another person the right to swap assets (see below), or other mechanisms to achieve grantor trust status. A trust protector may hold broad powers to modify the terms or operations of the trust. Practitioners should be cautious in determining tax status and other filing positions to ascertain whether one or more of these fiduciaries (or “quasi-fiduciaries”) has taken actions that might affect the tax status or other attributes of the trust.
√ Swap Powers
An approach to ensure that clients die with the lowest-basis assets is to include a swap power in trust agreements. The swap power causes the trust to be a grantor trust and permits the holder, typically but not always, the grantor, to swap trust assets for assets of equivalent value, e.g., cash. If a client has made transfers to a grantor trust, he or she may be able to exchange or swap cash for appreciated assets held in the trust, thereby bringing those assets into their estate for a step-up. To make this swap power viable, consider drafting standby purchase instruments. Also endeavor to have lines of credit and other cash resources secured well in advance. This power, while interesting in theory, creates a number of practical issues. How can it be exercised? While one commentator quipped in humor that clients should be called weekly to assure that they are still well enough to exercise the power, when should it be exercised? At minimum, annual planning meetings should address this power.
√ Irrevocable Trusts Generally
Existing irrevocable trusts should be reviewed to ascertain what, if any, purpose they serve, or can be made to serve, in the new tax environment. Practitioners should not merely prepare returns for trusts because they were prepared in prior years without ascertaining whether the trust is still viable and if viable, still appropriate. If the trust no longer serves optimal planning purposes it may be feasible to merge (decant) the trust into a new trust better crafted to meet current circumstances. This can provide an efficient mechanism to salvage the trust purpose. Decanting can be accomplished in one of three ways:
- Pursuant to the terms of the trust, if the governing instrument permits a transfer of trust assets to the new trust.
- Under state statute. A growing number of states permit decanting pursuant to state statute.
- Under state common law.
Decanting may enable a trustee to extend the term of an existing trust, although generation skipping transfer tax issues must be addressed; correct scrivener errors; add a spendthrift provision to protect trust corpus from potential claims of a beneficiary’s creditors; change trustee provisions; change governing law and situs to a state that is more favorable to achieving trust objectives; convert a non-grantor trust to a grantor trust, or vice versa; or qualify a trust as a special needs trust under applicable state law if the successor trust lacked these provisions.
Caution must be exercised in decanting a trust that is GST exempt or grandfathered to avoid tainting that benefit.
√ Irrevocable Life Insurance Trusts (“ILITs”)
Many ILITs were created to hold life insurance to pay an estate tax that may no longer be relevant to the client. Repurposing existing ILITs if the insurance is no longer needed for its initial purpose, or if the trust no longer optimally serves the client’s purposes, may be productive. For, example, a trust owning insurance might be modified by any of the following approaches:
- The insurance may be cashed in and the proceeds distributed to current beneficiaries and the trust terminated.
- The insurance may be retained and the trust modified or decanted to better meet current needs.
- Many ILITs simply hold life insurance and a nominal bank account, but the trust provisions may permit a much more robust trust that can serve as a spousal lifetime access trust to receive and hold additional gifts in order to save state estate taxes or for other purposes.
√ 663(b) 65-Day Election
Under this election, an amount paid or credited to a beneficiary within the first 65 days of a tax year can be treated as if paid or credited during the estate or trust’s prior tax year. This election might facilitate shifting income to a lower bracket taxpayer, shifting income to avoid an underpayment of estimated taxes, or facilitating taking advantage of a net operating loss. The election is made by checking the required box on Form 1041 for the estate or trust. Treas. Reg. Sec. 1.663(b)-2(a). This election is generally only applicable to complex trusts. This is because simple trusts are required to distribute income annually and should generally not have the result necessary to make an election. In light of the new Medicare tax on passive net investment income of estates (and trusts) the fiduciary may wish to use flexibility in the governing instrument as to distributions, and the varying tax brackets of the estate and the various beneficiaries to make a distribution within 65 days of the close of the tax year to reduce the estate’s Medicare tax on net investment income (“NII”).
Martin M. Shenkman, CPA, MBA, PFS, JD is a regular tax expert source in The Wall Street Journal, Fortune, Money and The New York Times.