Module6: Tax Issues and Trusts
TransferTaxes
Thegood news regarding trusts and taxation is that gifts and inheritances are notconsidered income for income tax purposes. This means that gifts to trusts anddistributions of principal from trusts to beneficiaries are not subject toincome tax.
Thereare two types of transfer taxes that can be relevant to trusts: the gift taxand the estate tax. Both taxes used to be key elements in the estate plans formany millions of clients, but a series of changes to the law starting in thelate 1990s and culminating in 2012, have made these taxes irrelevant for thevast majority of Americans. As of 2013, the 2012 law gave each taxpayer up to$5 million in lifetime transfer tax exclusion, meaning that the first $5 millionof otherwise taxable transfers were not subject to transfer tax. This amountwas also indexed for inflation, meaning that the number rises every year. In2018, the exemption amount is expected to be approximately $5.6 million.Moreover, the unused exemption of a deceased person is “ported” over to his orher surviving spouse. In effect, married couples therefore have more than $11million in lifetime exemption.
Whilethis makes transfer tax irrelevant for most people, people involved in elderlaw work should be familiar with the rules to be able to work on the estateplans of wealthy clients. To the extent that it is applied, the transfer taxrates are high: up to 40% on the federal level plus additional tax on the statelevel in some states.
Gifttax, which is applied at the time of a gift transfer, and estate tax, which isapplied at death, are different sides of the same coin. They operate together.They apply at the same rate and the lifetime exclusion amount we discussedearlier is one exclusion amount that applies to both taxes. If a person uses $3million of his gift tax exemption during lifetime, that amount is deducted fromhis estate tax exemption amount.
Noteon Pending Tax Legislation
As ofearly December, 2017, the House and Senate have each passed different versionsof tax reform that could seriously affect the transfer taxes discussed in thismodule. The tax reform bill passed by the House would double the exemptionamount immediately and phase out the estate tax over the next several years,while the Senate version would leave the estate tax in effect, but double theexemption amount. Whether the bill will pass and, if so, which version, isunclear. Moreover, even if the estate tax is amended or repealed, that can beundone by future legislation, especially if Democrats re-take Congress and/orthe Presidency. The underlying principles covered in this presentation areunlikely to change much (except if the estate tax is repealed) and so thismaterial is still worth knowing, though with the understanding that theexemption amount is very much in flux.
GiftTax
So,let’s start with gift tax. The first thing to note is that not all gifts aretaxable. Gifts to spouses who are United States citizens are not taxable atall. Gifts to charity (assuming they are given to tax-exempt charitableorganizations) are not taxable. Moreover, the first $15,000 in gifts per yearper recipient are not subject to gift tax. This is known as the “annualexclusion,” and like the lifetime transfer tax exemption, it is subject toinflation adjustments and increases once every few years, in increments of$1000. The $15,000 annual exclusion amount is as of 2018.
Giftsnot subject to any exclusion or exemption are deducted from the giver’slifetime transfer tax exclusion amount (the $5.6 million). It is only once thisamount has been exhausted that gifts (or inheritances) are subject to transfertax.
Forwealthy people whose assets are sufficient to bring them within the realm oftransfer tax relevance, trusts can be excellent tools to minimize transfer tax.
GiftTax Annual Exclusion
First,trusts can be used to take advantage of the annual exclusion. While grantorswith many descendents understandably are reluctant to give cash gifts to minorbeneficiaries, they are much more amenable to gifting assets to family trustsor trusts that will hold assets for the long-term benefit of beneficiaries.
Let’sassume, for example, that an elderly and wealthy couple have 40 beneficiaries,including children, grandchildren and great-grandchildren. The couple can giftup to $30,000, free of any transfer tax consequences, to each beneficiary eachyear. (The IRS even allows this to be done by a single spouse who can takeadvantage of the combined annual exclusion amounts of both spouses as long asthe other spouse consents - a technique known as “gift-splitting.”) With 40beneficiaries at $30,000 each, the couple can distribute up to $1.2 million peryear without using a dime of their lifetime exclusion amounts.
Whileclients would almost certainly balk at the prospect of writing $30,000 checksto each of the 40 beneficiaries, many of whom may be children, setting up amassive family trust to hold these gifts is a ready and viable alternative. Thetrust can be set up with their descendants as the trust beneficiaries. Forexample, it may provide the trust funds can be used for the health, education,maintenance and support of trust beneficiaries in the trustee’s discretion, andthat the trust funds will be distributed to the client’s children, in equalshares, after the clients’ deaths. This arrangement allows the client to writea single $1.2 million check once per year to the trust and to take advantage ofthe annual gift tax exclusions available for all the descendants.
“Crummey”Rights of Withdrawal
Thereis one wrinkle that requires an additional legal maneuver, however.Technically, the annual exclusion of $15,000 per year per beneficiary is onlyavailable when the gift is of a present interest. A gift to a trust, because itdoes not vest in the beneficiary immediately, is normally considered a gift ofa future interest. Some enterprising California attorneys in the 1960s gotaround this problem by giving each beneficiary the technical right to her shareof any contribution for a limited time after the contribution. In our example,this would mean a provision that any of the 40 beneficiaries have the right towithdraw his or her $30,000 at any time within, say, 30 days after the clientsmake the annual contribution. This has the effect of making the gift a “presentinterest” rather than a future interest, thus making it eligible for the gifttax annual exclusion.
Whilethe IRS originally called this withdrawal power a sham and refused to recognizethe maneuver’s validity, the Ninth Circuit Court of Appeals allowed it in thefamous case of Crummey v. Commissioner back in 1969. Other courtsfollowed suit, and the IRS eventually conceded the validity of the tactic.Because of the name of the famous case that confirmed it, these rights ofwithdrawal are sometimes referred to as “Crummey” withdrawal powers. For thetactic to be guaranteed to work, the trustee should notify each beneficiary ofhis or her withdrawal power immediately after the gift and ideally, eachbeneficiary should countersign an acknowledgment that she has been notified ofthe right of withdrawal, though a parent may sign for a minor beneficiary.
EstateTax and the Gross Taxable Estate
For atrust device to work to minimize transfer taxes, the trust assets must beconsidered outside of the “taxable estate” of the grantor. In defining the“gross taxable estate” for estate tax purposes, the Internal Revenue Code isquite broad on what is considered the assets of a deceased person. While thegross estate rules are complex, we will focus only on their relevance totrusts.
If thegrantor of a trust retains certain rights over trust assets, they areconsidered part of his taxable estate, meaning that the trust assets would besubject to estate tax (thereby nullifying any possible transfer tax benefits ofthe trust).
First,under section 2036 of the Internal Revenue Code, if the grantor retains the useor enjoyment of property for the rest of her life, that property is part of hertaxable estate. If the trust allows the grantor the right to income from thetrust, that is considered use or enjoyment of the trust. Similarly, if thetrust contains a house and the grantor lives there, that is use or enjoyment ofthe property, whether or not the trust specifically gives the grantor the rightto live there. Thus, in transfer tax planning trusts, the grantor should begiven no access or rights to enjoy the trust assets or, at least, any suchrights should be scheduled to end at a defined time. Note, however, that ifthere is a term after which the grantor’s interest in the trust expires, thegrantor must survive past this term or the assets are part of his taxableestate.
Section2038 also brings back into the grantor’s taxable estate any property over whichshe retained the power to “alter, amend, revoke, or terminate.” So, an estatetax planning trust must not give the grantor the power to do any of thosethings to the trust assets. In effect, the grantor must completely give upcontrol over the trust assets.
IncomeTaxation of Trusts
Like individuals,when trusts make money by interests, dividends, capital gains or any othermanner, they must pay federal and state income tax. Unfortunately, the incometax bracket thresholds for trusts are very low, meaning that their effectivetax rates are much higher than those for individuals. As of 2017, for example,any income above $12,500 per year is taxed at a rate of 39.6% on the federallevel alone. By comparison, individuals must be making well over $400,000 inincome to reach the 39.6% tax bracket.
Trustscan reduce their taxable income by distributing their income to beneficiaries.When a trust does distribute income to beneficiaries, the trust can take adeduction for the amount distributed. The beneficiary who receives that incomewill pay income tax on that amount on his or her own appropriate tax level. Forexample, a trust that earned $20,000 in income in 2017 would pay well over$6,000 in federal income tax. On the other hand, if the $20,000 was distributedto beneficiary Tom, who is in the 25% tax bracket, this would increase hisincome tax by $5,000. This is a tax savings of over $1,000 for the family.
Whentrustees are given the discretion to hold or distribute income, it gives themthe flexibility to decide on distributions on a year by year basis. Trusteescan also work with accountants and other tax experts to determine the best wayto handle income in a given year. Trustees, with the advice and taxprofessionals, can even allocate distributions as income or principal dependingon what’s best for the family.
Let’ssay, for example that the trust with total assets of $400,000 earned $20,000 inordinary income in 2017 and distributed $20,000 to Tom and $20,000 to Jane fortheir living expenses during that year. Let’s also assume that Jane’s incomeputs her in the 28% tax bracket while Tom’s income puts them in the 25% taxbracket. If the trust were to pay income tax on the $20,000 in income, it wouldpay over $6,000 in federal income tax. If Tom pays the federal income tax, itwould amount to $5,000. If Jane pays the federal income tax, it would amount to$5,600.
Inthis case, the trustee can allocate the entire $20,000 distribution to Tom asincome and the entire $20,000 distributions to Jane as principle. The amountdistributed to Jane is therefore not taxable at all and Tom would beresponsible for the full income tax payment. This saves the family moneyover-all. The trust can then distribute $5,000 of principal to Tom tocompensate him for the income tax that he paid.
GrantorTrusts
To ensure that people don’t set up sham trustarrangements to move income around and avoid income tax, since the 1970s, theInternal Revenue Code provides that trusts over which the grantor retainscertain elements of control are to be treated as the grantor’s assets forincome tax purposes. Trusts that are so treated are known as “grantor trusts.”The rules for determining what trusts are considered grantor trusts, set forthin sections 671-679 of the Internal Revenue Code, are complicated. For ourpurposes, we can sum it up in that most powers over the trust’s distributionsor administrative controls over the trust assets that are retained by thegrantor cause trusts to be considered grantor trusts. A notable exception isthat powers that can only be exercised with the consent of an “adverse party”(which usually just means any trust beneficiary, because the exercise ofcontrol over trust assets could decrease the continuing availability of trustassets) will not cause a trust to be considered a grantor trust.
The “adverse party” exception allows great flexibility topractitioners in determining whether to use grantor trusts or non-grantortrusts. For example, a grantor in a low tax bracket might want the trust to beconsidered a grantor trust since she is paying a lower tax rate than with thetrust, whereas a high-income client may want a non-grantor trust for theconverse reason.
RealEstate Considerations
There are three more tax considerations that must be keptin mind when dealing with real estate. The first two involve capital gains tax.When property is sold for more money than its “cost basis,” the seller must paycapital gains tax on that profit. The cost basis is typically the amount forwhich it was purchased plus certain improvements made to the property.
A.Step-up in cost basis
If property is gifted, the recipient takes the cost basisof the donor. So, for example, if Jim purchased a house in 1975 for $50,000 andsells it in 2018 for $500,000, he’s achieved a taxable capital gain of$450,000. If he gives the house as a gift to his daughter Lisa in 2018 and shesells it in 2019 for $500,000, she has also achieved a taxable capital gain of$450,000. Her cost basis was the same as her father’s because she received theproperty as a gift. This is known as a “carryover” cost basis. On the otherhand, if a person dies while owning property, the cost basis in the hands ofthe heir becomes the date of death value. So, if Jim dies in 2018 when thehouse is worth $500,000 and Jane, his heir, sells the property in 2019 for$500,000, she need not report any capital gain. Her cost basis is the date ofdeath value of the house, or $500,000. Since the sale price was also $500,000,there is no capital gain. This is known as a “step-up” in cost basis.
This is an excellent reason NOT to gift appreciated realestate to one’s children. However, it is possible to gift the appreciated realestate to a trust and maintain the step-up in cost basis. That is because, ifthe property is considered part of the taxable estate of the deceased donor,the property still gets the benefit of the step-up in cost basis. So, ifinstead of gifting the property to Lisa outright, John placed the property intoa trust for Lisa’s eventual benefit but that was considered part of his taxableestate, and then died in 2018, Lisa’s cost basis in the property would be$500,000. We can ensure that the trust is considered part of John’s taxableestate through the rules of section 2036 or 2038 that we discussed earlier. Forexample, we might give John the right to live in the house for the rest of hislife or the right to change beneficiaries upon his death. Either would causethe house to be considered part of his taxable estate for estate tax purposes.Therefore, it would also suffice to ensure the benefit of the step-up in costbasis.
B.Section 121 Exemption
The secondconsideration also involves capital gains tax. While selling a house at aprofit typically requires the realization of the capital gain, Section 121 ofthe Internal Revenue Code allows a capital gains exemption of up to $250,000for an individual or $500,000 for a married couple if the home was his (ortheir) personal residence. So, if married couple, Adam and Eve, purchased theirpersonal residence in 1970 for $40,000 and sell it in 2019 for $540,000, theywill not have to pay a dime in capital gains tax. If they gift the home totheir children and the home is sold, they lose this exemption because the homeis no longer the personal residence of the owners.
Instead, Adam and Eve can transfer the home to a trustfor the eventual benefit of their children. Because the Internal Revenue Codeconsiders assets in a “grantor trust” to be the grantors’ for income taxpurposes and because capital gains tax is a type of income tax, a home in agrantor trust where the grantors are the occupiers of the residence, doesreceive the benefit of the Section 121 exemption. Therefore, where the home isappreciated real estate and the purchasers are living in the home, it isimportant to ensure that the trust to which they gift it is considered agrantor trust. Careful reading of Sections 674 and 675 of the Internal RevenueCode can suggest manners in which to ensure that the trust is a grantor trust.One frequently used option is to give the grantor the authority to reacquiretrust assets by substituting other property of equivalent value, which makesthe trust a grantor trust under Section 675(4).
C.Property Tax Exemptions
Many state property taxprograms allow for property tax relief for owner occupied residences, and manyprovide additional benefits for seniors who reside in their own homes. A commonfeature to these programs requires that the house be the primary residence ofthe owner. By gifting the family home to children or other heirs, a person canlose eligibility for this benefit.
A reliable way to keep this benefit is to gift the assetsto a trust, but ensure that the trust and the deed by which the house istransferred to the trust states that the grantor retains a “life estate,” or atleast the right to live in the house for the rest of his or her life. This can allowthe trust object is to be accomplished while maintaining the owner-occupiedproperty tax exemption.
