The good news regarding trusts and taxation is that gifts and inheritances are not considered income for income tax purposes. This means that gifts to trusts and distributions of principal from trusts to beneficiaries are not subject to income tax.
There are two types of transfer taxes that can be relevant to trusts: the gift tax and the estate tax. Both taxes used to be key elements in the estate plans for many millions of clients, but a series of changes to the law starting in the late 1990s and culminating in 2012, have made these taxes irrelevant for the vast 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 million of otherwise taxable transfers were not subject to transfer tax. This amount was also indexed for inflation, meaning that the number rises every year. In 2018, the exemption amount is expected to be approximately $5.6 million. Moreover, the unused exemption of a deceased person is “ported” over to his or her surviving spouse. In effect, married couples therefore have more than $11 million in lifetime exemption.
While this makes transfer tax irrelevant for most people, people involved in elder law work should be familiar with the rules to be able to work on the estate plans of wealthy clients. To the extent that it is applied, the transfer tax rates are high: up to 40% on the federal level plus additional tax on the state level in some states.
Gift tax, which is applied at the time of a gift transfer, and estate tax, which is applied at death, are different sides of the same coin. They operate together. They apply at the same rate and the lifetime exclusion amount we discussed earlier is one exclusion amount that applies to both taxes. If a person uses $3 million of his gift tax exemption during lifetime, that amount is deducted from his estate tax exemption amount.
Note on Pending Tax Legislation
As of early December, 2017, the House and Senate have each passed different versions of tax reform that could seriously affect the transfer taxes discussed in this module. The tax reform bill passed by the House would double the exemption amount 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 the exemption amount. Whether the bill will pass and, if so, which version, is unclear. Moreover, even if the estate tax is amended or repealed, that can be undone by future legislation, especially if Democrats re-take Congress and/or the Presidency. The underlying principles covered in this presentation are unlikely to change much (except if the estate tax is repealed) and so this material is still worth knowing, though with the understanding that the exemption amount is very much in flux.
So, let’s start with gift tax. The first thing to note is that not all gifts are taxable. Gifts to spouses who are United States citizens are not taxable at all. Gifts to charity (assuming they are given to tax-exempt charitable organizations) are not taxable. Moreover, the first $15,000 in gifts per year per recipient are not subject to gift tax. This is known as the “annual exclusion,” and like the lifetime transfer tax exemption, it is subject to inflation adjustments and increases once every few years, in increments of $1000. The $15,000 annual exclusion amount is as of 2018.
Gifts not subject to any exclusion or exemption are deducted from the giver’s lifetime transfer tax exclusion amount (the $5.6 million). It is only once this amount has been exhausted that gifts (or inheritances) are subject to transfer tax.
For wealthy people whose assets are sufficient to bring them within the realm of transfer tax relevance, trusts can be excellent tools to minimize transfer tax.
Gift Tax Annual Exclusion
First, trusts can be used to take advantage of the annual exclusion. While grantors with many descendents understandably are reluctant to give cash gifts to minor beneficiaries, they are much more amenable to gifting assets to family trusts or trusts that will hold assets for the long-term benefit of beneficiaries.
Let’s assume, for example, that an elderly and wealthy couple have 40 beneficiaries, including children, grandchildren and great-grandchildren. The couple can gift up to $30,000, free of any transfer tax consequences, to each beneficiary each year. (The IRS even allows this to be done by a single spouse who can take advantage of the combined annual exclusion amounts of both spouses as long as the other spouse consents – a technique known as “gift-splitting.”) With 40 beneficiaries at $30,000 each, the couple can distribute up to $1.2 million per year without using a dime of their lifetime exclusion amounts.
While clients would almost certainly balk at the prospect of writing $30,000 checks to each of the 40 beneficiaries, many of whom may be children, setting up a massive family trust to hold these gifts is a ready and viable alternative. The trust can be set up with their descendants as the trust beneficiaries. For example, it may provide the trust funds can be used for the health, education, maintenance and support of trust beneficiaries in the trustee’s discretion, and that the trust funds will be distributed to the client’s children, in equal shares, after the clients’ deaths. This arrangement allows the client to write a single $1.2 million check once per year to the trust and to take advantage of the annual gift tax exclusions available for all the descendants.
“Crummey” Rights of Withdrawal
There is one wrinkle that requires an additional legal maneuver, however. Technically, the annual exclusion of $15,000 per year per beneficiary is only available when the gift is of a present interest. A gift to a trust, because it does not vest in the beneficiary immediately, is normally considered a gift of a future interest. Some enterprising California attorneys in the 1960s got around this problem by giving each beneficiary the technical right to her share of 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 to withdraw his or her $30,000 at any time within, say, 30 days after the clients make the annual contribution. This has the effect of making the gift a “present interest” rather than a future interest, thus making it eligible for the gift tax annual exclusion.
While the IRS originally called this withdrawal power a sham and refused to recognize the maneuver’s validity, the Ninth Circuit Court of Appeals allowed it in the famous case of Crummey v. Commissioner back in 1969. Other courts followed suit, and the IRS eventually conceded the validity of the tactic. Because of the name of the famous case that confirmed it, these rights of withdrawal are sometimes referred to as “Crummey” withdrawal powers. For the tactic to be guaranteed to work, the trustee should notify each beneficiary of his or her withdrawal power immediately after the gift and ideally, each beneficiary should countersign an acknowledgment that she has been notified of the right of withdrawal, though a parent may sign for a minor beneficiary.
Estate Tax and the Gross Taxable Estate
For a trust device to work to minimize transfer taxes, the trust assets must be considered outside of the “taxable estate” of the grantor. In defining the “gross taxable estate” for estate tax purposes, the Internal Revenue Code is quite broad on what is considered the assets of a deceased person. While the gross estate rules are complex, we will focus only on their relevance to trusts.
If the grantor of a trust retains certain rights over trust assets, they are considered part of his taxable estate, meaning that the trust assets would be subject to estate tax (thereby nullifying any possible transfer tax benefits of the trust).
First, under section 2036 of the Internal Revenue Code, if the grantor retains the use or enjoyment of property for the rest of her life, that property is part of her taxable estate. If the trust allows the grantor the right to income from the trust, that is considered use or enjoyment of the trust. Similarly, if the trust contains a house and the grantor lives there, that is use or enjoyment of the property, whether or not the trust specifically gives the grantor the right to live there. Thus, in transfer tax planning trusts, the grantor should be given no access or rights to enjoy the trust assets or, at least, any such rights should be scheduled to end at a defined time. Note, however, that if there is a term after which the grantor’s interest in the trust expires, the grantor must survive past this term or the assets are part of his taxable estate.
Section 2038 also brings back into the grantor’s taxable estate any property over which she retained the power to “alter, amend, revoke, or terminate.” So, an estate tax planning trust must not give the grantor the power to do any of those things to the trust assets. In effect, the grantor must completely give up control over the trust assets.
Income Taxation of Trusts
Like individuals, when trusts make money by interests, dividends, capital gains or any other manner, they must pay federal and state income tax. Unfortunately, the income tax bracket thresholds for trusts are very low, meaning that their effective tax 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 federal level alone. By comparison, individuals must be making well over $400,000 in income to reach the 39.6% tax bracket.
Trusts can reduce their taxable income by distributing their income to beneficiaries. When a trust does distribute income to beneficiaries, the trust can take a deduction for the amount distributed. The beneficiary who receives that income will pay income tax on that amount on his or her own appropriate tax level. For example, 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 distributed to beneficiary Tom, who is in the 25% tax bracket, this would increase his income tax by $5,000. This is a tax savings of over $1,000 for the family.
When trustees are given the discretion to hold or distribute income, it gives them the flexibility to decide on distributions on a year by year basis. Trustees can also work with accountants and other tax experts to determine the best way to handle income in a given year. Trustees, with the advice and tax professionals, can even allocate distributions as income or principal depending on what’s best for the family.
Let’s say, for example that the trust with total assets of $400,000 earned $20,000 in ordinary income in 2017 and distributed $20,000 to Tom and $20,000 to Jane for their living expenses during that year. Let’s also assume that Jane’s income puts her in the 28% tax bracket while Tom’s income puts them in the 25% tax bracket. If the trust were to pay income tax on the $20,000 in income, it would pay over $6,000 in federal income tax. If Tom pays the federal income tax, it would amount to $5,000. If Jane pays the federal income tax, it would amount to $5,600.
In this case, the trustee can allocate the entire $20,000 distribution to Tom as income and the entire $20,000 distributions to Jane as principle. The amount distributed to Jane is therefore not taxable at all and Tom would be responsible for the full income tax payment. This saves the family money over-all. The trust can then distribute $5,000 of principal to Tom to compensate him for the income tax that he paid.
To ensure that people don’t set up sham trust arrangements to move income around and avoid income tax, since the 1970s, the Internal Revenue Code provides that trusts over which the grantor retains certain elements of control are to be treated as the grantor’s assets for income tax purposes. Trusts that are so treated are known as “grantor trusts.” The rules for determining what trusts are considered grantor trusts, set forth in sections 671-679 of the Internal Revenue Code, are complicated. For our purposes, we can sum it up in that most powers over the trust’s distributions or administrative controls over the trust assets that are retained by the grantor cause trusts to be considered grantor trusts. A notable exception is that powers that can only be exercised with the consent of an “adverse party” (which usually just means any trust beneficiary, because the exercise of control over trust assets could decrease the continuing availability of trust assets) will not cause a trust to be considered a grantor trust.
The “adverse party” exception allows great flexibility to practitioners in determining whether to use grantor trusts or non-grantor trusts. For example, a grantor in a low tax bracket might want the trust to be considered a grantor trust since she is paying a lower tax rate than with the trust, whereas a high-income client may want a non-grantor trust for the converse reason.
Real Estate Considerations
There are three more tax considerations that must be kept in 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 pay capital gains tax on that profit. The cost basis is typically the amount for which it was purchased plus certain improvements made to the property.
- Step-up in cost basis
If property is gifted, the recipient takes the cost basis of the donor. So, for example, if Jim purchased a house in 1975 for $50,000 and sells 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 she sells 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 the property as a gift. This is known as a “carryover” cost basis. On the other hand, if a person dies while owning property, the cost basis in the hands of the heir becomes the date of death value. So, if Jim dies in 2018 when the house 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 of death 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 real estate to one’s children. However, it is possible to gift the appreciated real estate to a trust and maintain the step-up in cost basis. That is because, if the 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, if instead of gifting the property to Lisa outright, John placed the property into a trust for Lisa’s eventual benefit but that was considered part of his taxable estate, 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 taxable estate through the rules of section 2036 or 2038 that we discussed earlier. For example, we might give John the right to live in the house for the rest of his life or the right to change beneficiaries upon his death. Either would cause the 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 cost basis.
- Section 121 Exemption
The second consideration also involves capital gains tax. While selling a house at a profit typically requires the realization of the capital gain, Section 121 of the Internal Revenue Code allows a capital gains exemption of up to $250,000 for an individual or $500,000 for a married couple if the home was his (or their) personal residence. So, if married couple, Adam and Eve, purchased their personal residence in 1970 for $40,000 and sell it in 2019 for $540,000, they will not have to pay a dime in capital gains tax. If they gift the home to their children and the home is sold, they lose this exemption because the home is no longer the personal residence of the owners.
Instead, Adam and Eve can transfer the home to a trust for the eventual benefit of their children. Because the Internal Revenue Code considers assets in a “grantor trust” to be the grantors’ for income tax purposes and because capital gains tax is a type of income tax, a home in a grantor trust where the grantors are the occupiers of the residence, does receive the benefit of the Section 121 exemption. Therefore, where the home is appreciated real estate and the purchasers are living in the home, it is important to ensure that the trust to which they gift it is considered a grantor trust. Careful reading of Sections 674 and 675 of the Internal Revenue Code 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 reacquire trust assets by substituting other property of equivalent value, which makes the trust a grantor trust under Section 675(4).
- Property Tax Exemptions
Many state property tax programs allow for property tax relief for owner occupied residences, and many provide additional benefits for seniors who reside in their own homes. A common feature to these programs requires that the house be the primary residence of the owner. By gifting the family home to children or other heirs, a person can lose eligibility for this benefit.
A reliable way to keep this benefit is to gift the assets to a trust, but ensure that the trust and the deed by which the house is transferred to the trust states that the grantor retains a “life estate,” or at least the right to live in the house for the rest of his or her life. This can allow the trust object is to be accomplished while maintaining the owner-occupied property tax exemption.