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Simplifying the
Taxation of Trusts
The last issue of
The Wealth Counselor examined trusts and the asset
protection benefits provided to trust makers and their
beneficiaries through the utilization of ongoing trusts.
This issue of The Wealth Counselor addresses related and
important questions about the taxation of trusts, which are
important to all wealth planning professionals.
Trusts are Separate Taxpayers
All trusts are separate taxpayers. Unless disregarded under
the exception for trusts discussed below, each trust has its
own tax year and tax accounting method. Trusts also receive
income and pay expenses. Net income is taxed either to the
trust or to the beneficiaries, depending upon the trust
terms, local law and, in the cases of complex trusts
(defined below), whether the trust distributed the income.
Planning Tip: If a trust permits accumulation
of income and the trust does not distribute it, the
trust pays tax on the income.
Planning Tip: If a trust distributes or is
deemed to have distributed the income to the
beneficiaries, the trust can deduct the amount of the
distribution and the beneficiaries must include it as
income.
A trust's distributable net income (DNI) determines the
amount of the distribution the trust can deduct, and the
amount the beneficiary must report as income. Thus, DNI acts
as a ceiling on the amount of the deduction a trust can take
for distributions to beneficiaries. DNI also acts as a
ceiling on the amount of the distribution that the
beneficiary must account for on his or her income tax
return.
Planning Tip: As a general rule, distributions
from a trust are first taken from DNI, then from
principal.
An explanation of the DNI calculation is beyond the scope of
this newsletter. However, it is important to note that this
is an area where the client's wealth planning team must work
together to ensure that the income taxation flows as the
client desires. For example, as a general rule, capital
gains will be subject to taxation at the trust level except
in the year the trust terminates. However, if the client so
desires and if it is permissible under state law, the lawyer
can draft the trust agreement so that it defines trust
income to include capital gains, thereby passing the capital
gains tax liability to the beneficiary.
Planning Tip: It is critical that the client's
wealth planning team work together to ensure that trust
income will be subject to taxation as the client
desires.
Simple vs. Complex Trusts
The Internal Revenue Code defines a simple trust
as a trust that:
- By its terms must distribute all of its income
(meaning fiduciary accounting income) currently;
- Makes no principal distributions; and
- Makes no distributions to charity.
The regulations to
the Internal Revenue Code define a complex trust
as a trust that is not a simple trust; in other words, a
trust that:
- Is allowed by its terms to accumulate income;
- Makes discretionary distributions of income or
mandatory or discretionary distributions of principal;
or
- Makes distributions to charity.
Grantor
Trusts
The Internal Revenue Code defines a grantor trust
as a trust in which the trust maker has one or more of the
powers specifically described in Sections 673 to 677. A
trust can also be a grantor trust as to a beneficiary where
the beneficiary has one or more of these same powers if the
beneficiary also has or had the power over the trust
principal described in Section 678. To the extent a trust is
a grantor trust, it functions as a conduit; in other words,
all of the income, deductions, credits, etc., flow through
to the trust maker or beneficiary and are subject to tax on
their own personal tax return, regardless of whether the
trustee makes distributions from the trust. The general
rules governing the income taxation of trusts and their
beneficiaries do not apply to grantor trusts due to
application of these rules.
Planning Tip: Revocable trusts are grantor
trusts as to their trust maker(s) and thus a revocable
trust's income and deductions flow through to its trust
maker(s).
Planning Tip: Grantor trusts are powerful
planning tools because of the fact that the trust is the
same as the grantor for income tax purposes. Thus, a
sale by a grantor to a grantor trust does not trigger
income tax.
It is now clear that with a grantor trust, the grantor's
payment of the trust income tax does not constitute a gift
to the trust beneficiaries. Thus, for those clients who are
willing to pay this tax, grantor trusts are also excellent
vehicles to leverage gifts to beneficiaries.
Planning Tip: By paying the income tax of a
grantor trust, the grantor is in essence making an
additional contribution to the trust, but one that is
not subject to gift tax.
Grantor Trusts and Life Insurance
Grantor trusts also can be very useful in the context of
transfers of life insurance. When transferring life
insurance (for example, from the insured to avoid estate tax
inclusion or to a "new" irrevocable life insurance trust),
consider selling the policy for full and adequate
consideration to a trust that is a grantor trust as to the
insured. As long as the sale is for the policy's full fair
market value, such a transfer will avoid the three-year
estate tax inclusion rule, and it will not invoke the
transfer-for value rules.
Planning Tip: A sale of life insurance to a
grantor trust for full and adequate consideration avoids
both the three-year estate inclusion rule for transfers
of ownership and the transfer-for value rule.
Compressed Income Tax Brackets for Trusts
A frequent objection to the accumulation of trust income is
the fact that trusts pay federal income tax according to a
compressed rate schedule. In other words, trusts pay the
maximum federal income tax rate of 35% at only approximately
$10,500 of income per year in 2007, compared to
approximately $350,000 for single taxpayers, heads of
household, or those married filing jointly.
On its face, it appears that it may be costly from an income
tax perspective to accumulate trust income. However, the
critical questions are, what type of income is it and, if
interest or rent income, will accumulation result in
additional tax? In other words, what are the relative tax
rates of the beneficiaries?
Planning Tip: The compressed tax rates for
trusts only apply to accumulated interest and
rent income. Trusts pay the same rates as
individuals for capital gains and dividend income. Thus,
careful investment of trust assets can reduce or
eliminate the impact of compressed tax rates.
Planning Tip: If the trust beneficiaries are
already in the maximum federal income tax bracket,
accumulation of interest income will not cause
additional tax. In fact, with these beneficiaries,
accumulation of trust income may actually reduce their
overall income tax by not phasing out deductions and
credits.
Planning Tip: If the trust beneficiaries are
not in the maximum federal income tax bracket, what are
their relative tax brackets? The tax impact of income
accumulation is the difference in the tax rates, likely
an additional 7% or less, not the full 35%.
Furthermore, trust makers can give a trustee the ability not
only to distribute directly to a beneficiary (which is not
good for asset protection), but also the discretion to make
distributions on behalf of a beneficiary such as to pay
rent, medical expenses, tuition, credit card bills, etc.
Planning Tip: Distributions on behalf of a
beneficiary are distributions to the beneficiary for tax
purposes and will be subject to tax at the beneficiary's
rates. Such distributions are also good for asset
protection because the trustee does not make them
directly to the beneficiary. Thus, to the extent the
trustee is able to "distribute" to pay for these needs
directly, trust income will be taxed at the
beneficiary's income tax rate.
Conclusion
A working knowledge of the taxation of trust income is
important for the client's entire wealth planning team. By
working together, the team can often minimize the overall
tax impact and help ensure that our plan meets the client's
unique planning objectives.
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