Estate planning has two components: the organizational (writing documents and securing funding) and the operational (what happens next as life goes on). Much emphasis is put on the organizational component of estate planning; unfortunately not enough emphasis is placed on the operational component of estate planning. That's especially true in the case of irrevocable trusts, which are trusts that cannot be modified or terminated without the beneficiary's consent.
Irrevocable trusts, which can be set up as grantor trusts or nongrantor trusts, can be used to remove assets from a taxable estate. If created correctly, grantor trusts are disregarded for income tax purposes (i.e., the settlor is taxed on the trust's income), but not for estate or gift tax purposes (i.e., the trust is considered the owner of the transferred assets). Nongrantor irrevocable trusts are trusts for all purposes: income, estate, and gift tax.
Sometimes, advisers and their clients take a "set it and forget it" stance toward irrevocable trusts. They may assume that the trust "worked": It removed one or more assets from the client's taxable estate, and now, until the surviving spouse dies or the trust terminates, all that has to be done is file the appropriate income tax returns (Form 1040, U.S. Individual Income Tax Return, for grantor trusts; Form 1041, U.S. Income Tax Return for Estate and Trusts, for others) and accompanying Schedules K-1. Then, years or even decades may pass before anyone takes a second look at the trust and considers whether it contains the right assets or whether a change should be made to its investments.
But the establishment of a trust should be viewed as a beginning point, not an ending point, if the trust is going to continue for any length of time. Even though the trust is irrevocable, its assets do not have to be. Nonetheless, if the trust is a grantor trust, client-grantors should be aware that selling assets can have income tax consequences for them.
CPAs, their clients, and other advisers should review funded irrevocable trusts for these points:
Strategic investments. Most irrevocable trusts have bypassed gift and estate tax (and maybe also generation-skipping transfer tax). CPAs should review the assets in the trust to determine whether the assets are invested for the greatest leverage. In other words, once assets are in an irrevocable trust, they will bypass estate taxation until they are distributed out to the beneficiary (and therefore included in the beneficiary's taxable estate). Since the assets are not included in the grantor's or grantor's spouse's taxable estate, how can they be best invested to maximize the effect of bypassing the taxable estate? If an asset is in an irrevocable trust, it is out of the grantor's taxable estate; so to obtain leverage, invest in assets that you think will appreciate so it is not just the assets themselves that are removed from the estate but also any appreciation. Are they the right assets for the client's family at this time?
Financing, loan, and personal financial statement issues. If it is important that a trust asset be available for a loan, it may make sense to review all of the assets and determine whether a switch in investments should be made. That's because most lenders will not lend to an asset held in a trust, as they believe it is difficult to foreclose on a trust asset. Moreover, an asset in an irrevocable trust will not be on a beneficiary's financial statement for lending purposes, so a change may need to be made if a beneficiary wants an asset to appear on his or her statement.
Income and net investment income tax consequences. Assuming the irrevocable trust is not a grantor trust, the trust income is taxed to the trust or to the beneficiaries who receive trust income distributions. The trustee and advisers should review the terms of the trust and who the permissible income distributees are. The beneficiaries' income tax brackets can play a role in trust distributions, as, if all the beneficiaries are in a high income tax bracket, there may not be a significant income tax benefit to distributing trust income to them. If the income tax beneficiaries are in lower income tax brackets, it may make sense to distribute the income to them and have it taxed directly to them, not to the trust.
To help fund the Patient Protection and Affordable Care Act, P.L. 111-14, a 3.8% net investment income tax took effect in 2013. The tax is imposed on individuals, trusts, and estates on nonbusiness income from interest, dividends, annuities, royalties, rents, and capital gains above certain thresholds. For the 2016 tax year, the threshold for trusts is $12,400. If a nongrantor trust has net investment income, the 3.8% tax may be applied to the lesser of the amount of the trust's undistributed net investment income or the amount of its AGI in excess of $12,400.
For grantor trusts, the net investment income tax applies not at the trust level, but instead at the grantor level.
There are several ways for a trust to minimize the net investment income tax. The trust could invest in tax-exempt income. The trustee could allocate indirect expenses to undistributed net investment income. All or a portion of trustee fees could be allocated to capital gain that is not distributed by the trust, resulting in a reduction in undistributed investment income subject to the net investment income tax. Or the trustee could make discretionary distributions of net investment income to the beneficiary, and, depending on the beneficiary's income tax bracket, that distribution would reduce or eliminate the net investment income tax for the trust.
The possibility of selling other assets to the irrevocable trust. Sometimes a client can remove significant appreciation from his or her estate by selling assets held outside the irrevocable trust to the trust. This practice freezes the value of the asset being sold to the trust at the sale price (assuming the sale price is fair market value). Although the client would have to pay capital gains tax on the sale, this tactic may be worthwhile depending on the value of the appreciation removed.
Whether any assets need to be protected by the trust's spendthrift clause. Most irrevocable trusts contain a spendthrift clause, which means that the assets in the trust are not available to a beneficiary's creditors until they are distributed to the beneficiary. Advisers should determine whether a client holds any assets that should be placed out of reach of a beneficiary's creditors (e.g., because the family has created a plan to invest for the common good of all family members and wishes to protect each other from any beneficiary lawsuit, business debt, etc.). In such an instance, an asset may be better positioned in an irrevocable trust even if the trust has to buy it at fair market value to protect it.
Liability of the assets in the trust. If the trust owns several pieces of property and one or more of them have potential problems, such as hazardous waste, high tenant use, or attractive nuisance qualities, then it may make sense to split those assets into different entities. For example, the trust could be bifurcated into different trusts so that the liabilities of each property stand on their own. (In that instance, however, advisers should exercise caution if there are known existing creditors, as bifurcation may not be possible under a state's fraudulent conveyance laws.)
The preparation of the annual income tax return for an irrevocable trust is a good time for an adviser to ask questions about the assets in the trust and how they relate to the client's overall estate plan. That way, the adviser can engage the client and the team in an approach that is not just organizationally, but also operationally, sound.
Patricia M. Annino, J.D., LL.M., a nationally recognized authority on estate planning and taxation, chairs the Estate Planning practice at Prince Lobel Tye LLP. To comment on this article, contact Chris Baysden, senior manager of newsletters at the AICPA.