Estate Planning & Administration

Since the compression of trust and estate income tax brackets in 1986¹, conventional wisdom has dictated that income is better taxed in the hands of grantors or beneficiaries, rather than being taxed within a trust (or estate). For example, in tax year 2000, $20,000 of trust income results in a federal income tax of $6,942 if the income is taxable to the trust (assuming no deductions or exemptions). If that income was instead taxable to a single trust beneficiary who has no other income (and no deductions or exemptions), it would generate a federal income tax of only $3,000. Even if the grantor's or the beneficiary's income is subject to tax at the top income tax rate brackets, the aggregate income tax payable will still usually be no more than if that same income had been taxed within the trust. Thus, tax advisors have been struggling since TRA ‘86 to draft documents and otherwise find ways to minimize trust taxable income.²

Obviously, the best alternative would generally be to have trust income taxed to the grantor.³ Given the donative intent evidenced by the underlying transfer, the grantor should be happy to further enrich the trust beneficiaries by paying the tax on their trust's income. Under present law,⁴ the payment of income taxes by the grantor of a grantor trust should not result in a further gift to the trust or its beneficiaries, so grantor trust status may effectively benefit the trust beneficiaries without a gift tax consequence.

Unfortunately, grantor trust status may not always be available.⁵ Therefore, assuming the trust allows for discretionary - rather than mandatory - payments of income, the question will be whether income should be taxable to the trust, or to the beneficiaries. Despite the obvious income tax advantages that stem from the generally lower income tax rate brackets of trust beneficiaries, the decision as to who is the more cost-effective taxpayer (trust or beneficiary) should also take into account the gift and estate tax consequences of distributing versus accumulating income.

The top effective federal income tax rate bracket is 39.6%. In contrast, the top federal estate and gift tax rate, and the generation-skipping tax rate, is 55%. Given these relatively higher transfer tax rates, the trustee should consider whether the shorter-term income tax savings which might result from making distributions to beneficiaries is really cost-effective if additional transfer taxes are incurred as a result.

The comparison of the income tax versus transfer tax benefits can be very clearly illustrated by the two most common transfer tax "shelter" trusts: (1) the unified credit (bypass) trust which is typically established for the benefit of the surviving spouse and/or issue at the death of the first spouse, and (2) the generation-skipping exemption trust. Both of these trusts are designed so that no further transfer taxes are levied on trust assets either while they are in the trust or when they are distributed to the beneficiaries. If the assets in these trusts are instead distributed to a trust beneficiary prior to the termination of the trust according to its terms, and those assets are subsequently given away by that beneficiary or included in that beneficiary's estate, unnecessary transfer taxes may be incurred.

Illustrative Examples

Consider the situation of a pre-1998 fully funded ($600,000) bypass trust which generates income at the rate of 8% a year. Assume that the surviving (widow) spouse has an estate of her own consisting of $3 million (also generating income at 8%), that she survives her husband by 15 years, and that she has annual after-tax expenses of $150,000. In this situation, the advantage of accumulating income as opposed to distributing it to the widow (assuming no appreciation of underlying principal) is shown in Exhibit 1.⁶ As the exhibit demonstrates, the next generation has $351,777.07 of additional wealth if income is accumulated in the credit shelter trust rather than being distributed to the surviving spouse.

Exhibit 1

Suppose the income of this credit shelter trust is instead distributed annually to the couple's two children, each of whom has $100,000 of other annual taxable income. If the children accumulate those distributions - after-tax - until their mother's death, the overall benefits are even greater, as shown in Exhibit 2.

Exhibit 2

The above examples and Exhibits 1 and 2 illustrate the premise that, if the purpose of the trust is to minimize or avoid transfer taxes that would otherwise be incurred by a beneficiary or his or her estate, distributions to that beneficiary that pass trust income to that beneficiary are not cost-effective from an overall tax perspective. This result occurs because the transfer taxes subsequently imposed on the distributed funds exceed the income tax savings that result from having trust income bear less income tax (even after taking into account the time value of that earlier income tax savings). In contrast, the examples suggest that the greatest savings occur if income distributions are instead made to ultimate trust beneficiaries (i.e., those individuals who would be expected to receive trust assets upon trust termination).

This premise can also be illustrated in the case of a $1 million generation-skipping trust for a child for life, with the remainder outright to the child's issue. Assume that the child has other assets of $3 million, that all assets generate income at 8% (no appreciation of principal), that the child's after-tax expenses are $150,000 annually, and that the trust exists until the child's death 30 years later. In this case, the results shown in Exhibit 3 occur after application of federal taxes. Again, Exhibit 3 demonstrates that accumulation results in significantly more wealth (an additional $1,759,327.16) passing to the next generation (the child's children).

Exhibit 3

If the income of the above-described trust is instead distributed on an annual basis to the child's two children (who have no other taxable income), the benefits are significantly greater yet, as presented in Exhibit 4. Thus, if income is distributed currently to the next generation (child's children), exhibits 3 and 4 show an additional $3,246,093.09 of wealth passing to that generation when compared to the situation where income is instead distributed currently to the child.

Exhibit 4

None of the above illustrations take into account state income taxes. But given the ability of a nonresident grantor/testator to create a trust with a tax situs in a no-income tax jurisdiction, state income tax consequences at the beneficiary level would be yet another factor favoring accumulation.

Conclusion

Clearly, the examples above are based upon a narrow set of facts. They have nevertheless been constructed to illustrate the basic concept that the benefits of a lower income tax rate may be more than offset by a resulting increase in the transfer taxes ultimately paid on those distributions of trust income. Of course, the most tax-advantaged distributions may conflict with certain practical objectives of the trust and the practical objectives of the testator/grantor's estate plan, generally. Nevertheless, the trustee of any trust that provides for the discretionary accumulation of income should consider the relative advantages and disadvantages of accumulation versus distribution. This analysis should include both transfer tax and income tax ramifications. In particular, a desire for short-term income tax savings should not, per se, take precedence over the often ultimately larger transfer tax benefits of foregoing those savings.

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¹ The Tax Reform Act of 1986, Section 101, Pub. L. No. 99-514.

² This article discusses the income tax consequences to trusts (rather than estates) since most of the favorable alternative tax planning (generation skipping and spousal "bypass" trust planning) relates only to trusts. Nevertheless, a part of the article's premise (that distributions to individuals should take into account not only overall income tax savings but also the resulting potential accumulation of such distributions in the hands of the individual and the gift or estate tax consequences of those accumulations) may also hold true in the case of certain distributions from estates.

³ The grantor trust rules are set forth in IRC Sections 671-679.

⁴ The IRS has, nevertheless, vacillated on this issue. See Ltr. Rul. 9543049, which deleted a portion of Ltr. Rul. 9444033. The deleted portion of Ltr. Rul 9444033 implied that the payment of income taxes by a grantor of a grantor trust constituted a gift to the remaindermen of the trust.

⁵ Many types of powers that cause a trust to be a grantor trust (e.g., trusts where the grantor retained a reversion (Section 673), a power to control beneficial enjoyment (Section 674), a power to revoke (Section 676), or a power to receive income (Section 677)) would cause the trust to be included in the grantor's estate. The power of the grantor, in a nonfiduciary capacity, to replace trust assets with assets of similar value (Section 675(4)(C)), is generally considered a "safe" power for estate tax purposes (see Ltr. Rul. 9227013), but it may not be sufficient - in the IRS' view - to create a grantor trust. For example, in Ltr. Ruls. 9604015, 9437023, and 9413045, the IRS refused to rule on the effect of a Section 675(4)(C) power. Practitioners should expect that "intentional" grantor trusts will be very closely scrutinized by the IRS, since they do have income tax benefits (as well as indirect gift and estate tax benefits).

⁶ All estate tax calculations in this article assume a full phase-in of the unified federal estate and gift tax credit equivalent to $1 million since all deaths are hypothesized after the date of that full phase-in (2006).