Travis H. Long, CPA, Inc. Blog

Originally published in the Cedar Street Times

November 29, 2013

During the past two columns I laid the groundwork of some of the basics on revocable and irrevocable trusts, I discussed the new tax rates that affect many trusts, and I discussed the distinction between income and principal transaction and their relations to capital gains.

In a short summary of the past two articles, revocable trusts such as the common revocable living trust most people use for estate planning is disregarded for tax purposes as separate from the owner – in other words all of the income generated by its assets gets reported on your personal 1040 tax return.  Irrevocable trusts, such as a bypass trust commonly used in estate planning, or a gifting trust, are treated as separate tax paying entities, get their own taxpayer identification number, and file their own tax returns.  There are commonly two types of beneficiaries of irrevocable trusts: 1) current beneficiaries – who often receive the trust accounting income (and principal to an extent if needed) during their lifetime, and 2) remainder beneficiaries – who receive the principal upon the death of the current beneficiary.

The trust document has the power to define what type of revenues get classified to trust accounting income or principal, thus determining which beneficiary ultimately receives the money.  If the trust document does not define how a particular revenue is to be treated, as is often the case with capital gains, then the state’s principal and income act governs.  In California this means capital gains are considered a principal transaction and would not go to the current beneficiary. Federal tax rates on the highest income bracket earners have effectively risen by up to 8.8% on capital gains and 4.6% to 8.4% on other types of income. For irrevocable trusts, the highest bracket sets in at only $11,950 of income, so taxation to the trust is not generally desirable!

Picking up from that point in the last article, we can now discuss how that affects taxation.  If trust accounting income is supposed to go to the current beneficiary, then for tax purposes that income will be “pushed out” of the trust and reported on the tax returns of the current beneficiary instead of the trust.  To the extent that revenues are considered principal transactions, and are therefore slated for the remainder beneficiaries down the road, the trust pays the taxes instead.  Capital gains used to be taxed at the same rate whether the income was pushed out to the current beneficiary, or taxed in the trust.  Now, with the potential 8.8% additional tax on capital gains taxed to the trust, it matters a lot!

If there is a genuine concern that the remainder beneficiary should ultimately receive the money from gains due to appreciation, then the 8.8% additional tax would be worth it.  For many grantors that set up trusts, however, a big concern is minimizing the tax impact, and they would rather structure the trust to distribute the gains to the current beneficiary to save taxes.  This would be especially true when there is a close relation between the current beneficiary and the remainder beneficiary, such as a parent and a child, and even more so if there is a presumption that the parent will eventually give the money to the child anyway either during life or upon death.

If you are in the process of setting up a trust, I think this subject is an essential conversation that should be had between you, your attorney, and your tax professional.  The attorney can draft language to allow the trustee the power to allocate the gains on sales to trust accounting income.  It is worth mentioning that the underlying Treasury Regulation 1.643(a)-3 examples and Private Letter Ruling 200617004 place heavy emphasis on consistency by the trustee.  In other words, you cannot flip back and forth each year between allocating capital gains to income or principal; you pick a method and stick with it. I think there will be resistance from some attorneys out of habit, or rote concern for the remainder beneficiaries in considering something like this.  It is true, it may not always be the right choice, but I think given the changed landscape, it could be right for many people.

If you already have a trust, but have no explicit language in the trust document allowing for capital gains allocation to income, Treasury Regulation 1.643(a)-3 provides some leeway to do so anyway if done consistently.  But it is questionable whether you can begin treating capital gains as income if you have not been doing so in the past.  Perhaps a one-time change with a signed statement by the trustee of the intent from that point going forward would add credence.  Another approach would be to amend the trust document providing the power to allocate capital gains to income from that point forward.  If the grantor is still alive and consents to the change along with all of the beneficiaries, amending the “irrevocable trust” should not generally be a problem.  If the grantor is not living, but all the beneficiaries agree, you may be able to successfully petition the court.

Of course you do all this, and the tax rates could just change again.

Please keep in mind there are many other rules and exceptions surrounding the ideas discussed in this article which I have not space to mention.  Consulting with qualified professionals regarding your specific situation is always your best course of action.

Prior articles are republished on my website at www.tlongcpa.com/blog.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.