- It may be more advantageous to permit trusts to make charitable contributions. But if that is done the contribution must be made from gross income of the trust to qualify for an unlimited charitable contribution deduction. Also, the IRS requires that the governing instrument permit contributions. If not, no deduction will be permitted. If a trust doesn’t have the requisite language, it cannot be amended (e.g., via a merger or decanting) to add that required verbiage. The IRS views the requirement as having to be in the original governing instrument, not a modified later version. All is not lost; however, it may be possible for a trust to contribute assets to a partnership that invests and pays charitable contributions. When the charitable deduction flows through from a partnership to the trust that owns an interest in that partnership the IRS seems to respect the deduction. So, going forward, charities will be more commonly named in trusts.
- Trusts that can be maintained as grantor trusts might be continued in that manner to avoid the harsh trust income tax surtax.
- Trusts that are characterized as non-grantor trusts that may then face the surtax should make a concerted effort to review their tax status before year end. Trusts should have the wealth adviser evaluate gains and income, the CPA for the trust evaluate the tax status of that, and the trustee to consider possible distributions (e.g., what is appropriate for the beneficiaries and what does the trust agreement permit). Then this data should be evaluated and distributions made before year end to shift income from the trust that may face maximum income tax rates and a surtax to the beneficiaries who may be in a lower graduated income tax bracket and not fact the surtax. The savings each year could be substantial (or not).
- When planning and drafting trusts, consider including a wider class of beneficiaries so that the trustee has more flexibility to distribute income to multiple beneficiaries that may be able to remain, even with trust distributions, in lower income tax brackets and avoid the new high surtax rates. Give trustees discretion to make distributions so that they have flexibility to better plan trust/beneficiary combined income tax results. Mandatory income distributions remain potentially problematic from a creditor protection perspective, but also may serve to limit income tax planning flexibility.
- Consider creating special withdrawal powers so that a beneficiary is deemed to be the owner of certain trust income so that the income earmarked will be taxed to the beneficiary and not to the trust.
- The transfer from the taxpayer to the spouse occurred one day before the spouse transferred the same assets to a trust for the benefit of the taxpayer’s children.
- Instruments were not dated and the Court was unsure when they were signed and should be deemed effective.
- The Operating Agreement was never amended to reflect that Mrs. Smaldino owned 41% of the Class B shares in the company.
- The partnership income tax return filed for that year did not reflect that Mrs. Smaldino owned any portion of the Class B shares in the company.
- Effectively, a trust might be use somewhat of a “kitchen sink” approach to planning and drafting.
- Consider including several provisions in the trust documents to permit you to modify or change the trusts or planning to provide flexibility in light or the uncertainty. Some of the provisions to practitioners may wish to incorporate:
- Decanting provision to permit the trustee to decant into a new trust (although some of the proposals may have restricted decanting and those might yet be enacted). This would supplement any state law rights to decant.
- Disclaimer provisions that might permit a person designated as a primary beneficiary to disclaim all assets transferred to the trust and that if such a disclaimer is executed that the assets would revert back to you as donor/settlor. In the typical application of a disclaimer, it would be treated as if the disclaimant predeceased you and the other trust beneficiaries would then take. So, this would be a somewhat novel application of the disclaimer mechanism. There is no law confirming that this will with certainty work, but if it does it could provide you with a mechanism to unwind the entire transaction. Some commentators suggest instead creating an initial trust that has only that one beneficiary, and later using powers of appointments to shift assets to a new trust. But will the limited time remaining before legislation is enacted permit that to be crafted?
- A provision permitting the trustee to disclaim. That too may raise issues that a disclaimer could be violative of the trustee’s fiduciary obligations to all of the beneficiaries.
- A provision for a named person to “turn-off” grantor trust status (i.e., convert the trust from a grantor trust for income tax purposes into a non-grantor or complex trust that pays its own taxes). The purpose of this would be to assure the ability to change the trust’s income tax status if that proved advantageous in light of the proposed harsh restrictions on grantor trusts. Even if those restrictions are not enacted this provision should not cause any detriment but hopefully would just preserve flexibility for future planning options. The person holding this power should act in a non-fiduciary capacity. If the person is acting in a fiduciary capacity their obligation to the beneficiaries might conflict with this power.
- Name a trust protector and authorize that person to change trustees, situs, governing law, administrative provisions, etc.
- Depending on the assets to be transferred to the trust and your feelings concerning those transfers it may be feasible and advisable to incorporate express language into the transfer documentation permitting the transfers to be rescinded. Recission of the transaction within the same tax year may obviate any income tax consequences of the transfer. The use of recission may be useful if some of the proposed changes are enacted in a manner that could have your transfers deemed to trigger adverse current income tax consequences. Again, these types of changes are not in the current version of the tax proposal but it is unclear what might yet be enacted.
- Give the power to the trustee to divide the trusts in the event that becomes useful, e.g., to take different actions to modify different portions of the trust differently.
- As discussed elsewhere, name a large class of beneficiaries, including charities and give the trustee flexibility to include capital gains in income and to have broad discretion to distribute income and perhaps principal out of the trust.
- Consider whether it make sense to include a power for a person, perhaps referred to as a “charitable designator” (which would make the trust under current law a grantor trust). This might provide further flexibility. Consider recommending to clients that they establish a donor advised fund and name that fund as a permissible beneficiary, so the client has a potential charitable donee even if they do not have a particular charity they want to benefit now.
- Other steps might be taken as well.
- Loan provision which authorizes someone you designate to loan trust funds to you without regard to whether you post adequate security (but may be required to pay adequate interest to avoid estate inclusion). While you might owe money to your trust the key is that it assures you access to trust assets and the cash flow you might need.
- Authorize the trust to purchase personal use assets, e.g., a vacation home, artwork, etc. That way, so long as you are married to the spouse you named as beneficiary, you may have use of these assets as a result of his spousal relationship.
- Charitable gifts should be permitted. If your client wishes to do this the trust could make donations that your client might otherwise have made themselves. The trust, however, cannot discharge any pledge or other obligation the grantor might have.
- Tax reimbursement clause that permits the trustee to reimburse your client for income taxes the grantor incurs on income earned inside the trust. While some of the tax proposals may have eliminated this mechanism, under present law and the current/latest tax proposal this has not be restricted.
What Estate Planning Should Be Done Now That Congress Might Not Change Anything?
This article was originally posted on the ABA Real Property, Trusts and Estates Law Section RPTE E-Report and can be accessed as here.
By: Martin M. Shenkman, Esq. and Joy Matak, JD, LLM
Changing Winds of Tax Legislation
For the better part of 2021, threats of significant tax changes have been swirling around the halls of Congress to impose capital gains tax on assets owned at death, when gifts were made, and every so many years for assets in trusts. At the same time, momentum began building for legislative proposals that would have reduced the lifetime exemption, destroyed valuation discounts for nonbusiness assets, and severely restricted the use of grantor trusts which had been the foundation of estate planning for decades. Congressional proposals whipped planning practitioners and their clients into such a frenzy these past several months, battening down the proverbial hatches in estate plans to protect their clients’ wealth while those favorable tools still existed, and before the reconciliation package could make its way through the legislative process and be enacted (assuming that date of enactment would be the effective date for many restrictions).
Then, like a hurricane that dies out at sea, the raging estate tax storm just stopped. Or did it? Perhaps by the time you are reading this article we will all know what the final legislation will be (or not).
When the President introduced his latest iteration of his Build Back Better framework on October 28, an eerie quiet descended upon the tax planning community as it appeared that none of the tax changes most feared by wealthy taxpayers would be included in the reconciliation package. The lifetime exemption was not reduced, there would be no deemed realization on death or gifting and thus no capital gains imposed on such transfers, and grantor trusts emerged unscathed in this latest round of proposed legislation.
While some wealthy taxpayers may be breathing a sigh of relief as this latest assault on estate tax planning appears to have fizzled out, it feels noteworthy to point out several things:
The lifetime exemption from gift and estate taxes was raised under a provision of the Tax Cuts and Jobs Act, which provision will sunset on December 31, 2025, if not extended. In other words, unless Congress can come together with the President, the lifetime exemption will be slashed automatically from over $12 million to around $6 million on January 1, 2026.
The legislation that would have neutered the effectiveness of grantor trusts in planning, proposed Sections 1062 and 2901, are already fully drafted. These are not theoretical concepts but rather specific legislative text that is sitting on the shelves in Congress, ready to be quickly dusted off and attached to future legislation as a possible revenue raiser.
There are things that the Executive branch can do to limit planning opportunities without an official Act of Congress. By way of example, Treasury can reintroduce the 2704(b) valuation discount regulations.
Significant uncertainty remains over what the outcome of any proposed tax legislation will actually be. While the latest “iteration” of the proposals appears to have few changes to the estate tax system, the situation still remains a “toss-up” as it is impossible to predict what changes might be made, or what restrictions added back to the tax proposal, as the plan winds its way through Congress. Nothing may change. Yes, after all the talk and planning panic, no estate tax changes may be enacted. It is also possible in upcoming negotiations some of the harshest proposals could still be enacted to pay for the spending program. Senator Sanders’ proposals, which are rather harsh in its impact on estate planning, is already in legislative format. That means it would take little time or effort to paste a provision into proposed legislation if needed to make the revenue numbers comparable to the spending figures. This uncertainty is one of several reasons why taxpayers should continue to plan. We just don’t know! One author just received an email from a well-known practitioner suggested that he heard that all the initial estate tax proposals were going to be reintroduced in the “backroom” negotiations.
For those in the midst of planning, or still contemplating planning, it is likely prudent to continue planning. Of course, planning should be done prudently and reasonably, considering the same factors that sound estate planning always entailed. Some of these will be reviewed in the following discussions in light of the current estate tax planning environment.
Special Income Tax Surcharges on High Income Taxpayers
The current proposal targets high income taxpayers.
Taxpayers who file as married filing jointly with adjusted gross income exceeding $10 million (or $5 million for taxpayers filing separately from their spouses) will face a surcharge of 5%. The surcharge increases to 8% when AGI exceeds $25 million (half that for married filing separate taxpayers).
As with most other income taxes, the threshold for trusts and estates is significantly lower. The 5% surcharge rate will hit nongrantor trusts with $200,000 of adjusted gross income and the 8% surcharge applies when the trust has adjusted gross income of $500,000.
For nongrantor trusts and estates, “adjusted gross income” is determined by taking several factors into account:
The Income Distribution Deduction. A non-grantor trust or estate pays tax on all income it earned but it receives a deduction for the income (distributed net income or “DNI”) distributed to beneficiaries. This is loosely based on the theory that trusts or estates pay tax on income earned but that distributions of income to beneficiaries carry that income out of the trust or estate to the recipient beneficiary. The logic of that is the “wherewithal to pay” concept. Since the beneficiary has received a distribution that beneficiary, not the trust, has the economic wherewithal to pay the income tax on that particular batch of income. Facing much higher surtaxes will result in several changes to non-grantor trusts.
Eligible expenses. IRC Section 67(g) eliminated all miscellaneous itemized deductions that are subject to the [2%] floor for individuals, non-grantor trusts and estates for tax years 2018 through 2025. However, IRC Section 67(e) permits a separate deduction for “costs which are paid or incurred in connection with the administration of [an] estate or trust and which would not have been incurred if the property were not held in such trust or estate.” Thus, trusts and estates are eligible to adjust gross income by expenses such as fiduciary commissions, preparation of fiduciary income tax returns, or obtaining legal advice relative to the administration of the trust or estate.
Charitable deduction. Though the President’s October 28 framework omitted consideration of charitable contribution deductions when calculating a trust or estate’s adjusted gross income for the purposes of assessing a 5% or 8% surcharge, an updated version of H.R. 5376 would allow trusts or estates to adjust gross income by chartable contribution deductions, if permitted under IRC Section 642(c). Charitable contributions can be a powerful tool for fiduciaries to reduce the adjusted gross income of a trust or estate, so long as the trust instrument adheres to the specific requirements of Section 642(c) by allowing distributions from gross income to charity.
The Surcharges Would Affect Many Trusts
Ultimately, even those clients who are not considering estate tax planning currently might wish to review their foundational documents. Testamentary trusts, e.g., credit shelter or family trust formed on the death of the first spouse, and estates not yet funded but governed by a will drafted prior to enactment of the proposals would be affected by them. It is not hard to imagine a scenario where property used to fund a trust for the benefit of a surviving spouse must be later sold for a gain in order to provide care and comfort for the spouse. The proposed income tax surcharges on non-grantor trusts and estates will require additional thought and care in structuring these transactions in order to mitigate the taxes and surcharges which, in some circumstances, could result in a tax due of over 48% of the income earned.
Finally, though grantor trusts are largely unscathed by the newest proposals, practitioners may wish to draft their trusts with an appreciation for the fact that grantor trust treatment only exists for so long as the trust is a grantor trust. That is, grantor trusts, whether already in place or being created, may someday be non-grantor trusts, whether on the death of the grantor or some other event. There is also always the risk that a future Congress reintroduces and passes the provisions undermining the use of grantor trusts.
Trust instruments can be drafted with an eye towards the current proposals to afford the flexibility fiduciaries might desire in addressing and mitigating the effects of any surcharges that a trust or estate might someday face.
Certain provisions a practitioner might which to consider:
Before any distributions are made the trustee will have to consider whether the beneficiaries face any claims or lawsuits that may result in an ex-spouse or creditor attaching the larger distributions that income tax changes might motivate. Also, the beneficiary’s personal income tax will have to be considered. The beneficiary may also be in the maximum income tax bracket so a distribution may have no salutary effects. Worse, if the trust has situs in a low or no tax state, e.g., Florida, but the beneficiary resides in a high tax state like California, the increase in state income taxation from a distribution may outweigh the federal income tax benefits.
Finally, if the trust is to have certain income, e.g., capital gains income, taxed to the current beneficiaries rather than being taxed to the trust, either the trust instrument will have to permit that income to be taxed to the beneficiaries or the trustee may have to take certain actions to achieve that result. It may be feasible to decant the trust into a new trust with different provisions if that becomes necessary.
These provisions will have a wide ranging and unexpected impact. They will become the proverbial “traps for the unwary” taxpayer. Someone with a small irrevocable trust they created for a grandchild, or on the death of a spouse, etc. could unexpectedly face a much higher income tax rate just from the sale of a security to raise cash for distributions.
While the application of the income tax surtax is perhaps less harsh then the massive grantor trust changes contained in other proposals, the application of income tax surtaxes at such low levels of trust income continue the theme that Congress seems to believe trusts are bad things really wealthy people use to evade taxes. The reality for most trusts is more moderate taxpayers are seeking to protect their family, now they may get caught by unexpected high tax rates.
Prudent Planning Should Continue
It still makes sense to get appropriate and comfortable planning completed. The lifetime exemption of $11.7 million in 2021 appears to be increasing in 2022 to $12.06 million, but there are still strong headwinds on the horizon forecasting significant reductions to the exemption amounts. Senator Sanders and several of his Congressional allies continue to tout a proposal to reduce the gift exemption from $11.7 million to a mere $1 million and drop the estate exemption to $3.5 million. President Biden’s proposal reducing all exemptions from $11.7 million to an inflation adjusted $5 million (which would mean about $6 million in 2022) had the support of all but two of the most conservative Congressional Democrats.
While there is no mention in the latest variation of the tax proposals to reduce the exemption, talks continue on the reconciliation package and it is far from clear what might eventually be enacted. Even if exemptions are not reduced in this round (and there is still no certainty of that), the exemption is scheduled under current law to be reduced by half in 2026 without any need for a law change to make that happen. So, planning to use exemption now before that change seems prudent regardless of the outcome of the current proposals.
Estate planning generally involves making gifts of assets in order to reduce the size of your taxable estate and remove assets that are likely to appreciate from your taxable estate so that, as a matter of current law, the appreciation can be transferred to your heirs without a transfer tax. However, prior to undertaking any substantial gifting plan, a prudent practitioner should confirm the client’s sources of income and ensure that planning does not disrupt the client’s current lifestyle or future comfort.
These are key points: any planning must be appropriate for the client, and comfortable to the client and the client’s family. Practitioners should endeavor to confirm that the client understands that things ought to be economically different for the client following transfer of the assets. If a transaction occurs but the client behaves as though they still own the assets transferred, for example, by using the income or continuing to enjoy the asset, the IRS may be able to challenge the gift successfully and essentially undo the plan to the taxpayer’s detriment. Even if SLATs, SPATs, DAPTs and other techniques are used to provide the client certain degrees of access to trust assets post transfer, those techniques cannot equate to the access and control the client has prior to transfers.
Your client should not pursue planning just because your bowling buddies all told you they have SLATs (or some other acronym). Your client should also not pursue planning just because your client’s estate planning confidant recommends it. If your client won’t sleep at night, the planning may not be right for them. So, planning has to make sense for your client’s circumstances and not disrupt the client’s lifestyle.
Despite this, in the current environment, get off the fence and make decisions as the time to do so may be short. Specific steps your client might evaluate with their advisers in these waning hours before we know the results of the legislative efforts are noted in the following discussion.
Time of the Essence
Not knowing what tax changes might be enacted, when they will be enacted, or when they will be effective if enacted, time remains of the essence to complete planning before a law change. Again, no one can predict what will happen so it may be best for your clients to complete planning if it has not already been finished. Bear in mind that some of the proposals used the date of enactment as the effective date for the new harsh rules proposed. There was even a rumor that the date of announcement of proposed legislation could be made the effective date to prevent taxpayers from completing last minute planning. So, the bottom line remains if your clients are going to plan, best complete it as quickly as possible, “just in case.”
Practitioners Should Endeavor to Avoid a Cavalier Approach
The recent tax court memorandum in the case of Louis Smaldino should be viewed as a cautionary tale for practitioners, particularly now that there are only a few precious weeks before year end.
Facts: Mr. Smaldino had six children from his prior marriage and he and his wife agreed that it would be better for their family dynamic if Mrs. Smaldino’s assets were not commingled with his children’s inheritance. Mr. Smaldino appears to have made substantial prior gifts and only had limited lifetime exemption left when he wanted to transfer a substantial part of his real estate portfolio to his children in the spring of 2013. His wife, on the other hand, does not appear to have made any lifetime gifts. So, Mr. Smaldino transferred 41% of the Class B shares in his real estate portfolio to Mrs. Smaldino and the next day, Mrs. Smaldino made a gift of the shares to a trust for Mr. Smaldino’s children.
Ruling: Ultimately, the Tax Court collapsed the transaction and concluded that it was Mr. Smaldino and not his wife who had actually made the gifts to the trust.
Factors in the Court’s Decision: As practitioners try to follow the crumbs left by the Tax Court in the Smaldino decision as they embark on year-end planning, practitioners may wish to consider the key findings by the Court in reaching its decision:
Lessons for Wary Practitioners: The Court evaluated the substantive and objective economic realities rather than the form of transactions in reaching its conclusion in Smaldino. In that case, Mrs. Smaldino never acted like an owner of the company; the record was void of any evidence that she had the benefits or burdens of ownership. Perhaps the decision would have been different if Mrs. Smaldino held onto her shares for some period of time before transferring them. Maybe the Court would have had a more difficult time in reaching its conclusion if Mrs. Smaldino held onto some of the shares, or if she sold them to the trust rather than gift them.
Practitioners should also ensure that instruments are properly executed and dated, particularly if their existence supports the transaction. Perhaps such instruments should be included with the timely filed gift tax return reporting the transactions.
According to the Tax Court memo, Mr. Smaldino was a certified public accountant, so it is possible that he filed the relevant income and gift tax returns. Certainly, the CPA needs to be aware of the planning so that appropriate tax filings and disclosures may be made, including, in this case, an allocation of taxable income to Mrs. Smaldino for the days’ worth of income that she would have earned by virtue of her ownership of 41% of the Class B shares. It might have been a better fact had Mrs. Smaldino received a distribution for her allocable share of income for the relevant year.
It seems prudent to create grantor trusts that may be respected even after the possible enactment of harsh laws restricting their use (in tax terminology those trusts are said to be “grandfathered”). If the very harsh restrictions that had been proposed to restrict or eliminate grantor trusts are not enacted, having such a trust in place might prove a useful component of your future planning.
Further, since there is no certainty that these changes may not be added back to final legislation taking the precaution to have these trusts in place now seems sensible. Weigh the possible benefits of having a grantor trust created, e.g., to purchase life insurance in the future, to use as part of asset protection planning, etc. versus the cost of creating it. If you have doubts you may be able to create a less costly trust more quickly if it is only going to be a standby. So, instead of creating a trust with an institutional trustee in a trust friendly jurisdiction (e.g., DE, AK, NV, etc.) create a trust in your home state naming a family member as trustee. The cost will be less but you might still secure many of the benefits of a grandfathered grantor trust should that become useful. In the future, if the trust is used in a meaningful manner, it can have the situs and governing law changed to a better jurisdiction (e.g., move the trust then from say California to Alaska).
Flexibility Is More Important Than Ever
Flexibility is vital to any planning given the significant uncertainty. Practitioners may wish to incorporate options to modify and tailor an irrevocable trust and plan for whatever should eventually occur with tax legislation in Washington. And whatever is the outcome of the current tax legislative process, there may again be significant changes after the 2022 or 2024 elections.
Integrating flexibility is vital.
It is advisable for most taxpayers to structure the trust or trusts they create in a manner that permits access to trust assets after the transfers but which does not undermine the tax goals (removing assets from your estate) or asset protection goals (making it difficult for creditors to reach the assets). While those goals are somewhat contradictory all may to some degree be accomplished. A number of steps might be considered to do this. These can be grouped into two categories. The first is the general structure of the trust or trusts you select.
DAPT – A Domestic Asset Protection Trust is a self-settled trust that you could create of which you are also a beneficiary. Under the laws of 19 different states, you could make a gift to such a trust, be a beneficiary in the discretion of an independent trustee (perhaps, or preferably, an institutional trustee), yet the assets arguably are outside your estate and unreachable by your creditors. Because of the perceived risk according to some commentators of DAPTs (especially if you live in a state that does not permit such trusts), it may be preferable to use one of the approaches below.
Hybrid DAPT – This is a trust for the benefit of your spouse/partner and/or descendants initially. So, it appears initially no different than the SLAT below. However, you would grant a person (or committee if you prefer) the power to add as beneficiaries any persons from a class consisting of your grandparent’s descendants, which obviously includes you. So, you could be added back as a beneficiary in the future should you need that mode of access to the trust. The theory behind this concept is that you are never a beneficiary of the trust until added back so whatever incremental risk exists for a DAPT is arguably not as great in the context of a hybrid-DAPT.
SPAT – This is a trust for the benefit of your spouse/partner and/or descendants initially. So, it appears initially no different than the SLAT below. However, you would grant a person (or committee if you prefer) the power to direct the trustee to pay over trust principal or income to you (or a class of people that includes you). That person expressly would not have the power to add anyone as a beneficiary (including you), so that the trust should never be characterized as a self-settled trust. Since principal could be appointed to you should you need access to the trust, the SPAT can provide greater protection than the mere SLAT below. The theory behind this concept is that you are never a beneficiary of the trust and cannot be added as a beneficiary so whatever incremental risk exists for a DAPT is arguably not as great in the context of a SPAT. Bear in mind that there is very little relevant law on the above concepts.
SLAT – Spousal Lifetime Access Trust (and it doesn’t have to be a spouse, it could be a sibling or anyone else). This is a trust for the benefit of your spouse/partner and descendants. This should have less risk than the preceding three trusts, but also less access.
Note that there is no means to weigh the relative risk of each of the options. Also, how well the trust is administered will be critical to achieving any of the above objectives.
Additional trust access provisions (used in any grantor trust structure).
Plans Should Make Sense Regardless of Tax Laws
Planning should make sense regardless of what happens with the tax laws since there may be no material changes to the estate tax yet there is still a possibility of significant change. If, without tax motives/benefits, you might not do the planning then you might reconsider whether anything should be done. However, to the extent that the assets moved into trust safeguard the exemption that is scheduled to decline by half in 2026, then planning now may be sensible regardless of the outcome of current legislative proposals. Planning may enhance asset protection (from claims, creditors, etc.) so thus may be beneficial in all events regardless of tax law changes.
* Martin M. Shenkman, Esq. is an attorney in New York City and author of 42 books and more than 1200 articles. He is active in the ABA.
Joy Matak, JD, LLM leads Sax, LLP’s Trust and Estate Practice. Joy has more than 20 years of diversified experience as a wealth transfer strategist.
 Smaldino v. IRS, T.C. Memo 2021-127.
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