Monthly Archives: July 2021

Occasionally, those who aren’t Estate Planning attorneys will attempt to do their own Estate Planning. They think they can find a document online or use a friend’s document and can figure it out. Unfortunately, there are many pitfalls one could run across.

Let’s look at three of these pitfalls which one must sidestep.

Bill and Mary had a house worth $500,000, an IRA worth $500,000, and investments of $500,000. They have three children, Aaron, Betty, and Charlie. At the death of the survivor of Bill and Mary, they want to leave the house to Aaron, the retirement plan to Betty, and the investments to Charlie.

The first problem with this plan, even assuming they draw up documents which accomplish this distribution pattern, they may not have considered the downsides. Bill and Mary’s plan didn’t anticipate that they might sell the house, which they did. The specific bequest of the house to Aaron lapsed. They added the proceeds from the house to the investment account. Since their plan left the investment account to Charlie, those assets went to him instead of Aaron.

There’s a second problem with this plan, even assuming they draw up documents which accomplish the plan. They’ve not considered the income tax implications. While the three assets are the same value currently, the house and the investments get a step-up in basis at death. In other words, when the beneficiary receives the assets, they won’t owe income tax on them. However, the IRA is “Income in Respect of a Decedent” or “IRD,” which is an exception to the step-up rules. Assuming Betty has a marginal state and federal income tax rate of 40%, $200,000 of the IRA would be lost to income taxes. It might have been better to leave the IRA to Charlie who is in a lower tax bracket or spread the tax consequences over all three of them. After taxes, Betty would end up with $300,000, while each of her brothers would end up with $500,000.

There’s a third problem with this plan, even assuming they draw up documents which accomplish it. They’ve not considered fluctuations in the values of the various assets. Let’s say they die ten years after they draft the plan and the assets are then worth $3 million. But, their children won’t each get $1 million. In fact, one of the children might get far less than the others. How is that possible? The house bequeathed to Aaron could be in a neighborhood of decreasing property values. Its value declined to $100,000. Bill and Mary continued to contribute to the IRA designated to Betty and it was worth $1 million at the death of the survivor of Bill and Mary. The investments bequeathed to Charlie did quite well and were worth $1.9 million by the death of the survivor. Thus, Aaron would get the house worth $100,000. Betty would get the IRA worth $1 million (but subject to income taxation of $400,000). Charlie would get the investments worth $1.9 million. Thus, Charlie would get more than triple the after-tax value of his sister and 19 times the value of the bequest to his brother.

Estate Planning is about far more than documents. It’s also about the knowledge and experience of the attorney who drafts the plan.

Often, there is confusion regarding how a trust or a subtrust may report income and the TIN which should be used. Treasury regulations spell this out quite clearly. Treasury Regulation 1.671-4 is the relevant section.

A “nongrantor” trust is a trust which is not substantially owned by anyone pursuant to the provisions of section 671 and following. A nongrantor trust should obtain and use its own TIN. The trustee of the trust should provide the TIN of the trust and the address of the trust to banks and other institutions at which it has assets.

The income of the trust gets reported on the trust’s own tax return, Form 1041. The trust would receive a distribution deduction for distributions which carry out Distributable Net Income (“DNI”). These distributions to the beneficiary which carry out DNI then get taxed on the beneficiary’s tax return. The trustee would provide a Form K-1 to the beneficiary advising the beneficiary of the amount of income which the beneficiary must report on their tax return.

Let’s look at a quick example.

Mary set up an irrevocable trust. The trust contains nothing that would deem Mary or any other person as the substantial owner under Sections 671 and following. In other words, the trust is a nongrantor trust. The trust had $50,000 of income in the year. The trust made $20,000 of distributions to the beneficiary of the trust, Ben (Mary’s son). Those distributions were of cash and carry out DNI. Mary’s sister, Alice, is the trustee of the nongrantor trust. Alice will file a Form 1041 for the trust and report the $50,000 of income and a distribution deduction of $20,000. She’ll also provide Ben with a K-1 for the distribution of $20,000 to him. Ben will include the $20,000 of income from the K-1 on his tax return for the year.

Grantor trusts and nongrantor trusts each have their place in Estate Planning. Remember, whether a trust is a grantor trust or a nongrantor is not indicative of whether it is included in the taxable estate of the grantor for estate tax purposes, only income tax purposes.

Often, there is confusion regarding how a trust or a subtrust may report income and the TIN which should be used. Treasury regulations spell this out quite clearly. Treasury Regulation 1.671-4 is the relevant section.

Section 1.671-4(b)(2) provides that if a trust is treated as owned by one grantor or one other person, the trustee must either A) Furnish the name and TIN of the grantor or other person treated as the owner of the trust and the address of the trust to all payors for the taxable year, or B) Furnish the TIN of the trust and address of the trust. Of course, the latter method would also be used if the trust is a nongrantor trust.

A grantor of a trust is spelled out in Sections 671 to 677. For example, the power to revoke is listed as a power making a trust owned by the grantor under section 676. Under Section 678 someone other than the grantor may be treated as the owner of the trust for income tax purposes. Under Section 678, someone other than the grantor would be treated as the owner of the trust if they had the power to vest the corpus or income of the trust in themselves (i.e. a general power of appointment), or if they previously had such a power and they retained other powers under sections 671 to 677. There is an exception if the original grantor still is considered the owner of the trust. (Of course, upon the grantor’s death, the grantor is no longer considered the owner of the trust.)

Let’s look at two quick examples.

Example 1: Mary has a revocable trust. The trustee of Mary’s trust (who might be her or might be someone else) wants to use Mary’s TIN (which is her social security number). This is appropriate because Mary has the power to revoke the trust and is the owner pursuant to section 676. If the trustee preferred, they could choose to use a separate TIN for the trust.

Example 2: Upon Mary’s death, her trust sets up a subtrust for John. Under the subtrust, John has a right to withdraw the assets and income from the trust. This type of trust is commonly referred to as an “Access Trust” or a “Divorce Protection Trust.” Since John has a right of withdrawal and Mary is dead, John is considered the owner pursuant to Section 678 of the Code. The trustee of John’s subtrust may use John’s TIN (which is his social security number) as the TIN for the trust. If the trustee preferred, they could use a separate TIN for the trust.

If the trustee chooses to use the substantial owner’s TIN, the income would go directly to the substantial owner’s tax return and there’d be no need for a separate tax return for the trust. If the substantial owner isn’t the trustee, the trustee would need to provide the substantial owner a statement showing all items of income and deduction and other information which might be necessary for the substantial owner to take into account in computing their taxable income.

A grantor trust is “substantially owned” by someone under Code Sections 671 and following a common power which causes a trust to be a grantor trust is the retention of the power to revoke the trust under Section 676. A revocable trust is income taxed to the grantor and it’s also included in the estate of the grantor for estate tax purposes. However, a trust need not be included in the taxable estate of the grantor to be a grantor trust. A trust could be called what is known commonly, though confusingly, as an “intentionally defective” grantor trust. In reality, there’s nothing at all “defective” about such a trust. It’s excluded from the estate for estate tax purposes, but, taxed to the grantor for income tax purposes.

For example, if the grantor retains the power to substitute other assets of an equivalent value for the assets of a trust, it’s a grantor trust, pursuant to Section 675(4)(C).

A grantor trust can offer many advantages. First among those is simplicity from an income tax perspective. A grantor trust does not need to file its own income tax return but can report the income on the grantor’s taxpayer identification number. Second, the income from the trust is taxed to the grantor, whether or not it is distributed to the grantor. This may sound like a flaw, but it’s a huge advantage if the grantor is trying to remove value from their taxable estate. It allows the assets in the trust to grow tax-free because the grantor is paying the taxes on the income of the trust. It’s important to note that the payment of taxes by the grantor is not considered a gift by the grantor, but rather the grantor’s own legal obligation.

Let’s look at a quick example. Mary set up a trust and contributed $1,000,000 to the trust. The trust has $50,000 in taxable income and no distributions in the year. The $50,000 of taxable income is taxed on Mary’s income tax return. Mary pays the tax which she owes on the $50,000 of income, which comes to $20,000. Mary pays the taxing authorities the $20,000 from her own funds, not diminishing the trust’s assets. When Mary pays the $20,000, she is not making an additional gift to the trust.

A grantor trust allows assets to grow tax-free, much like a Roth IRA. This increased compounding power is a very powerful advantage for a grantor trust. The next article in the series will examine the tax reporting of trusts. In other words, what tax identification number and address does the trustee provide to the bank or brokerage company?