Archive for the ‘irrevocable trust’ Tag

New Tax Impacts for Trusts with Capital Gains – Part III

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.

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New Tax Impacts for Trusts with Capital Gains – Part II

Originally published in the Cedar Street Times

November 15, 2013

Two weeks ago I laid the groundwork of some of the basics on revocable and irrevocable trusts in order to start discussing new implications due to law changes in 2013.  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.

In early 2013 new laws were passed that increased the personal income tax rates from 35 percent to 39.6 percent on people in the highest tax bracket ($400,000 filing single or $450,000 married filing joint).  It also raised the capital gains rate to 20 percent for these same people (up from 15 percent).  In addition, a new 3.8 percent Medicare surtax is assessed on net investment income (think interest, dividends, capital gains, among others) for people making over $200,000 single or $250,000 filing joint.  Most people do not make $450,000 or even $250,000 a year, so this seems innocuous to many.

However, many people making less than these thresholds do have irrevocable trusts – most commonly after a spouse has passed away.  The problem with irrevocable trusts is that the thresholds to be impacted are so much lower.  Once your trust has just $11,950 (2013) of income, you have hit the top bracket and will be subject to the 39.6 percent income tax rate, 20 percent capital gains rate, and the 3.8 percent Medicare surcharge!  One stock sale could easily put you in the top bracket!  This effectively means an 8.8 percent tax increase on capital gains and 4.6 percent to 8.4 percent increase on other types of income.  That is a big hit every year, and will be something new to battle.

If you can avoid having the income taxed to the trust, and instead have it distributed out and taxed to the beneficiaries, you can probably save a chunk of taxes since it will be taxed at the lower rates on the beneficiary tax returns – assuming your individual beneficiaries are not in the top tax bracket!

Whether or not you have discretion or are required to distribute income to beneficiaries is defined in your trust document.  Even the very definition of “income” itself, for trust accounting purposes, is governed by your trust document primarily and the state’s principal and income act, secondarily.  The proper allocation of income and expenses to trust accounting income or principal is very important to beneficiaries (whether they realize it or not), since trust accounting income generally goes to one beneficiary, and the principal often goes to a different beneficiary down the road…so it determines the amount the beneficiaries receive.  Many common irrevocable trusts are written to require the distribution of trust accounting income each year to the current beneficiaries with rights to dip into principal as needed to maintain an ascertainable standard of living.  Upon death, the remaining principal goes to the remainder beneficiaries.

The California Uniform Principal and Income Act does not define capital gains as income, but as a principal transaction – basically an asset changing form – for instance from real estate to cash.  I hardly ever see trusts that even mention capital gains, much less defining it as a part of income.  In the absence of trust language, the principal and income act governs, therefore many trusts in California are not permitted to distribute capital gains to the beneficiaries.

It is amazing to me how many trust tax returns I have seen over the years that violate this – often because the preparer does not really understand trust taxation rules.  I have even run into cases where the prior preparer has never even asked for the trust document, and thus relies on the default settings in their tax software in conjunction with “the way we’ve always done it” to govern!  This would be analogous to creating a detailed shopping list and asking your neighbors to go shopping for you; in lieu of taking your list, they go on the internet and print out a list of common things people buy, and then supplement it with things they have bought for other neighbors in the past! Chances are pretty good; you will not get what you need!  Enforcement of correct trust income tax preparation comes much more often by threats of lawsuit against the trustee than by IRS audit. Keep in mind the remainder beneficiary’s attorney would be happy to sue the trustee for shorting his client’s share by not following the terms of the trust.

In two weeks we will conclude our discussion.

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.

New Tax Impacts for Trusts with Capital Gains – Part I

Originally published in the Cedar Street Times

November 1, 2013

In order to discuss the new challenge trustees have regarding capital gains, let us first review some basics regarding revocable and irrevocable trusts.

A revocable living trust is a trust created during your lifetime that spells out what you want to happen with, and who you want to control, your assets if you become incapacitated or pass away.  This is the most common type of trust, and many people set these up because it has many advantages over just having a will upon death: the chief reasons are that it provides more control, has more tax advantages, it is more private, it is faster, and it is less expensive than the default court process called probate.

I would say the one major drawback of a trust administration process compared to probate is that you do not have the standardized court oversight and genuine closure that you have with the probate process.  If there are difficult problems with trust administration, it often stems from that fact that most people appoint one of the recipients of their assets (beneficiaries) as the person responsible for carrying out the trust terms (the trustee).

Money does strange things to people, and I have witnessed it lead to families ripped apart when the non-trustee siblings start questioning the integrity of the sibling appointed as trustee.  Generally, beneficiaries want their money yesterday!  And they do not understand that it still takes a good bit of time, effort, and expense to handle everything.  That said, I would still choose to have a trust 98 percent of the time, instead of just a will.  If there are concerns about the solidarity of the beneficiaries, a corporate trustee could always be a solution.

Another characteristic of a revocable living trust is that it can be changed or even scrapped at anytime while you are alive – hence the name “revocable.”  As a result of this control feature, of being able to terminate the trust and retain the assets, the trust is disregarded as a separate taxpaying entity, and you just report all the eligible income and expenses of the trust on your personal 1040.  Everything gets reported under your Social Security Number instead of having a separate taxpayer identification number.

Now let us turn the tables and speak about irrevocable trusts.  These are trusts that generally cannot be changed once they are created.  (Of course, nothing is set in stone, and well drafted trusts with trust protector language can assist in making changes, or if all the beneficiaries agree and the court approves a petition, changes or even revocation of an irrevocable trust are possible!)

An example of  an irrevocable trust would be your revocable living trust after you pass away.  At that point, your wishes regarding the disposition of your assets are irrevocable – locked-in as you specified – and the trustee must carry out your wishes.  Often a revocable living trust will contain provisions to set up other trusts.  For married couples, it has been very common to create an irrevocable trust called a bypass trust, (aka credit shelter trust, ‘B’ Trust, etc.).

Prior to some new “permanent” laws passed in January ($5 million indexed-for-inflation estate tax exemption with portability), it was important for estate inheritance tax reasons for many people to create bypass trusts. For most people estate inheritance tax will not be a concern now, but bypass trusts, or similar types of trusts, can still be important for controlling where the deceased spouse’s assets end-up, especially in blended family situations with children from prior marriages.  In other words, dad doesn’t want mom to disinherit the children he had from a prior marriage once he dies!

Another type of common irrevocable trust is a gifting trust.  These are commonly created by a parent or a grandparent to permanently move assets out of their estate and into a trust for the benefit (or future benefit) of a child or grandchild with certain stipulations and protections governing the assets in the trust.  We saw a lot of these set up in 2012 due to the uncertainty of the estate tax laws and the possibility of missing an opportunity to save estate inheritance tax down the road.

Due to the fact that you have relinquished a lot of control with an irrevocable trust, and it will no longer be included in your estate, the taxing authorities view this trust as a separate tax paying entity.  This means it has its own tax return each year and gets its own taxpayer identification number.

In two weeks we will begin discussing the new tax rate changes and their impacts on trusts.

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.

Sale of a Residence After Death – Part II

Originally published in the Cedar Street Times

April 5, 2013

Two weeks ago we discussed the sale of a personal residence after someone passes away when held as joint tenants or community property.  We also discussed the concept of a cost basis step up (or down) to the current fair market value at death as it relates to joint tenancy, community property, and tenancy in common.  If you missed this article you can find it on my website at www.tlongcpa.com/blog.  This week we are going to discuss what happens when a sole owner or tenant in common passes away and the house or fractional interest in a house goes to their trust or estate.

Often children are tasked with figuring out what to do with mom or dad’s house after the second spouse passes.  Names like executor, executrix, and trustee get thrown around and sometimes you get to know your accountant and attorney better than if you had gone on a fishing trip together!  After death, the house typically become part of the estate if there was no trust in place, and if there was, then it becomes part of an irrevocable trust that has the task of winding up affairs and distributing the assets to the beneficiaries (or trusts for the beneficiaries).

If the surviving spouse held the house as a sole owner or in his or her revocable trust before death, the house receives a full step-up (or down) in basis to the current fair market value at death.  If the house is distributed outright to a beneficiary (or beneficiaries) and then the beneficiary immediately sells the home, you often will have a loss due to the real estate commissions and other sales expenses (or perhaps even a market decline between date of death and the sale as we saw so often over the past five years).  This loss, however, will generally be a nondeductible personal loss unless you first convert it to a rental property, and then sell it later.

If, however, it is decided the house needs to be sold while it is still in the estate or trust in order to pay debts or to distribute the proceeds to various beneficiaries, you may have a case to take a deductible loss on the sale of the property (which would offset other taxable income in the estate or trust, or perhaps flow through to the beneficiaries reducing their personal taxes).  Fair warning, the IRS and the courts disagree on this issue!

The IRS has taken the position that even a trust or estate cannot take a loss unless it is a rental property or converted to a rental property and then sold.  However, this conflicts with some of the instructions they provide regarding capital assets held by trusts and estates. The courts, on the other hand, have held that a trust or estate does not hold personal assets, and thus is allowed to take a loss on the sale of what used to be the decedent’s personal residence as long as no beneficiaries live in the property in the interim.  There are other issues to consider here, but in the right circumstances, strategic planning could create some large tax savings.

If a tenant in common passes away, his or her ownership percentage receives a step in basis to the current fair market value and the interest flows through to the estate or trust.  Similar results would occur as those just discussed for sole owners.  It is less common to find someone holding a personal residence as a tenant in common, especially with unrelated people.  It also comes with other, more complicated issues, since fractionalizing ownership in a house diminishes the value – basically, who wants to buy a house with other people you don’t know?  In all cases after someone passes away, date-of-death appraisals are requisite, and you may need specialized appraisers for fractional interest properties.

This really just scratches the surface of the issues you can encounter, and it is always best to find a CPA and attorney team that is equipped to handle these issues appropriately.

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.