12. Types, Features, and Taxation of Trusts

Question 1

Trust

Legal Arrangement

Answer 1

Involves three parties

1. Grantor - transfers the principal, or corpus, into the trust
2. Trustee - holds the legal title to assets and has a fiduciary duty to safeguard the trust and distribute per docs
3. Beneficiary - person or persons who benefit
4. One person can be two, or all three

Question 2

Types of Trust Interests

Answer 2

1. Income interest
2. Remainder
   
   1. Vested remainder is not forfeitable
   2. Contingent remainder depends
3. Reversion - Grantor receives principal upon termination

Question 3

Trust Duration

Answer 3

1. Terms dictate length of the trust life
2. Rule against perpetuities (some states do not have a rule against perpetuities)
   
   1. Prevents trusts from having an infinite life.
   2. Aims to prevent the transferor of property from controlling the disposi-tion of the property for an unreasonably long period after making the transfer.
   3. Generally states that an interest cannot last longer than 21 years or 21 years and nine months after the death of the youngest person who was named in the instrument creating the interest, and who was alive on the date the inter-est was created.

Question 4

Date Trust is Created

Answer 4

Different for revocable and irrevo-cable trusts.

1. Irrevocable trust created on the date the trust is created.
2. Revocable trust created on the date in which the trust becomes irrevocable (usually at the DOD of the settlor).

Question 5

Perpetuities Savings Clause

Answer 5

To avoid application of the rule against perpetuities, most trusts and wills contain a perpetuities savings clause requiring that the trust terminate no later than the outer limits of the rule (21 years)

Question 6

Charitable Trusts and Perpetuities

Answer 6

Charitable trusts are exempt from the rule against perpetuities.

Question 7

Reasons for Creating a Trust

Answer 7

1. To avoid probate
2. To avoid or reduce transfer and/or income taxes
3. Asset management for an individual who is the grantor and the beneficiary in the case he becomes incapacitated
4. Asset management for beneficiaries who are not grantors (grantor may not have confidence in the beneficiaries’ abilities to invest assets)
5. To make a charitable contribution while retaining an income interest in the gifted property

Question 8

Inter vivos (living trust)

Answer 8

1. Created during the grantor’s life
2. Property transferred to the trust before grantor’s death avoids probate
3. Gift tax applies if assets are transferred to irrevocable living trust during grantor’s life

Question 9

Testamentary Trust

Answer 9

A testamentary trust is a type of trust that becomes effective at death.

1. Created within a will
2. Becomes effective at the testator’s death
3. Irrevocable at the time of the testator’s death
4. Not subject to gift tax because transfers to trust occur at death

Question 10

Testamentary Trusts and Probate

Answer 10

Because assets are transferred to the trust through the testator’s will, they are subject to probate when the testator dies.

1. May cause delays in the creation of the trust
2. Assets will be subject to public scrutiny

Question 11

Testamentary Trust Elements

Answer 11

Testamentary trusts must contain the same elements of a living trust.

1. Beneficiaries can be determined
2. Testator must have intended to create the trust
3. Trustee manages property after the trust is created
4. Trustee holds legal title to the property after the trust is create

Question 12

Testamentary Trust Advantages

Answer 12

1. Will can be modified to remove the trust any time before death
2. Can provide flexibility in income and corpus distributions that would not be possible with a direct bequest by will
3. Can contain POA provisions, allowing one or more beneficiaries (holders) to control trust property to some extent
4. Trust assets can be managed by a professional trustee, rather than beneficiaries
5. Can provide life income and security to beneficiaries after the testator’s deat

Question 13

Testamentary Trust Disadvantages

Answer 13

1. Assets that fund the trust pass through the will first, and are subject to probate.
2. There is no income tax savings during the testator’s lifetime.
   
   1. Because assets are owned by testator during her lifetime, income from the assets will be taxed to the testator.
3. Assets will be included in the testator’s gross estate for estate tax purposes upon death.
4. Depending on the provisions of the trust, the beneficiary may have no control over when the trust corpus is received.
5. Trust may be associated with large costs, such as annual trustee fees

Question 14

Trust Characteristics

Permanency

Answer 14

1. Revocable: Able to be rescinded or amended by the grantor (grantor trusts)
2. Irrevocable: A trust in which the grantor has given up all control over the property; the trust cannot be changed by the grantor

Question 15

Trust Characteristics

Funding

Answer 15

Funded: Has property placed in it, and there is a principal or corpus amount

Unfunded: Legally ready to receive property but has not yet done so

Question 16

Trust Characteristics

Income Payout Requirements

Question 17

Types of Trusts

Living Trust

Answer 17

1. Grantor creates an inter vivos trust that is funded with part or all of the grantor’s property.
2. This property does not pass through probate at death; thus, the transfer is accomplished with a minimum of publicity, expense, and delays
3. Revocable living trust—This is revocable during the grantor’s life and becomes irrevocable at grantor’s death.
   
   1. Includable in gross estate for estate tax purposes.
   2. There is no gift tax at time of creation because there is not a completed gift.
4. Irrevocable living trust—The grantor places property into a trust that he cannot rescind or amend.
   
   1. Transfers constitute completed gifts; thus, gift tax may apply at the time the trust is created.
   2. It has income and estate tax benefits (freeze value of estate assets). “Freezing” an estate asset means the appreciation after the act that “freezes” the asset for estate tax purposes is not in the person’s estate.

Question 18

Types of Trusts

Grantor Trusts

Answer 18

IRC SS 671–677 state that if a trust is a grantor trust,

• Grantor is treated as the owner of the assets
• Consequently, all the income, deductions, and credits of the trust are attributable to the grantor.

A trust is a grantor trust if the grantor retains the following:

1. A reversionary interest in the corpus or income of the trust
2. The power to control the beneficial enjoyment of the property or income (withdraw funds or change beneficiaries)
3. Certain administrative powers, such as borrowing
4. Power to revoke a portion of the trust
5. Income for the benefit of the grantor, such as purchasing life insurance on the grantor or paying for support obligations of the grantor

Question 19

Types of Trusts

Special Needs Trusts

Answer 19

Established by clients with a dependent who is receiving government assistance such as Supplemental Security Income (SSI) or Medicaid.

The trust pays for the beneficiary’s needs that are not covered by assistance.

Question 20

Types of Trusts

Pourover Trusts

Answer 20

Assets are poured from another source (e.g., a will, IRA, or insurance contract) into the trust. It may be revocable or irrevocable

Question 21

Types of Trusts

Dynasty Trusts

Answer 21

1. Passes a life insurance policy to grandchildren
2. Avoids generation-skipping transfer tax (GSTT)
3. Transfers substantial wealth

Question 22

Types of Trusts

Totten Trust

Answer 22

Similar to POD/TOD

1. This is a trust created by a New York statute.
2. When an individual opens an account in trust for another, it is not a completed transfer. The income is taxed to the grantor until the trust is made irrevocable.

Question 23

Types of Trusts

Health and Education Exclustion Trust (HEET)

Answer 23

1. Created to pay education and medical expenses of grandchildren or other skip beneficiaries free of gift tax and GSTT.
2. Payments are considered qualified transfers if made directly to educational institutions or medical providers.

Question 24

Special Trust Provisions

Answer 24

1. Sprinkling (spray)—the power to direct income at the discretion of the trustee for the benefit of the beneficiary (trustee can choose when and how much to distribute to the beneficiary)
2. Beneficiary power to withdraw to limited extent
3. Crummey power—limited power to withdraw (usually 30–60 days)
4. Special or limited POA [e.g., the holder’s power to invade the principal for the health, education, maintenance, or support (HEMS) of the income beneficiary]
5. General powers of appointment (e.g., the holder’s power to appoint income or corpus to himself, his creditors, his estate, or the creditors of his estate

Question 25

Overview of Trust and Estate Income Tax Calculation

Answer 25

1. Trusts are generally treated as separate taxable entities. Grantor trusts are not recognized for tax purposes.
2. A simple trust
   
   1. Required to distribute all of its income currently (each year)
   2. No charitable beneficiaries
   3. Does not distribute any corpus
3. A complex trust is any trust that cannot be classified as a simple trust.
4. An estate is created when a decedent dies.
   
   1. The estate consists of the probate assets.
   2. The estate holds and protects the assets, collects income from those assets, and satisfies obligations of the estate until all the assets are distributed.
5. Estates and trusts are subject to the same rate schedule, a very highly progressive structure.
6. Fiduciaries file Form 1041 on or before the 15th day of the fourth month after the close of the tax year. Grantor trusts may also file a Form 1041

Question 26

Calculating the Trust Income Tax

Answer 26

1. Similar to calculating tax for individuals
   
   1. Gross income – deductions = taxable income
   2. Deductions include a distribution deduction
   3. Deductions include an exemption:
      
      1. Exemption for most simple trusts is $300
      2. Exemption for most complex trusts is $100
2. Fiduciaries may be subject to AltMin

Question 27

How Trust Income is Taxed

Answer 27

1. The beneficiary is taxed on an amount equal to the distribution deduction.
2. The trust is not taxed on this amount because the trust gets a deduction for it.
3. The distribution deduction is the lesser of distributable net income (DNI) or the amount actually distributed to the beneficiaries.
4. Income distributed maintains its character (ordinary, tax exempt, capital)

Question 28

Distributable Net Income (DNI)

Answer 28

1. Equals maximum distribution deduction
2. Equals maximum amount on which beneficiaries can be taxed
3. DNI—similar to fiduciary accounting income
   
   1. Includes most normal income and expense items
   2. Excludes items relating to corpus such as capital gains, stock splits, and depreciation of business assets