increases and $200,000 ($250,000 for joint return filers) for the 3.8% tax. These new rules heighten the importance of drafting trusts to minimize

Transcription

1 Seq: 1 Color: 0c: Format: rls$prod:journal.fmtfree lead 100D*points, Next 120D, Vjust JC2:1 TAX ON TRUSTS DRAFTING TIPS THAT MINIMIZE THE INCOME TAX ON TRUSTS PART 2 Trust distribution provisions balance the tax-saving potential of increased distributions with the nontax concern of controlling payouts to beneficiaries. JAMES G. BLASE, ATTORNEY JAMES G. BLASE, CPA, LL.M., practices with the law firm of Blase & Associates, LLC in St. Louis, Missouri, and is an Adjunct Professor of Estate Planning at St. Louis University School of Law. He is a frequent lecturer and author on a wide variety of estate planning topics. Mr. Blase would like to thank his associate Ryan G. Polley, who provided valuable assistance in the preparation and editing of this article. Recent legislative changes have increased the top income tax rate to 39.6% (from 35%) and the rate on long-term capital gain and qualified dividends to 20% (from 15%). Furthermore, certain net investment income is subject to an additional tax of 3.8%. The income threshold for these new tax burdens is a modest amount of about $12,000 ($11,950 in 2013) for trusts. While the same tax rates apply to individuals, the thresholds for them are much higher $400,000 ($450,000 for joint return filers) for the tax rate 1 See Blase, Drafting Tips That Minimize the Income Tax on Trusts Part 1, 40 ETPL xx (July 2013). increases and $200,000 ($250,000 for joint return filers) for the 3.8% tax. These new rules heighten the importance of drafting trusts to minimize taxes. This two-part article explores principal drafting areas to achieve a less punitive minimum income tax (MIT) approach for trust instruments. The first installment, in the July 2013 issue of Estate Planning, 1 examined ways to minimize the effects of the general disparity in income tax brackets between trusts and individuals and to minimize the effects of the 3.8% tax increase on net investment income and the 5% surtax on capital gains and qualified dividends. The discussion that follows explores issues such as permitting distributions in excess of the 5% limitation of Section 2514(e)(2), minimizing income taxes and maximizing deferral for qualified retirement plan benefits and nonqualified annuities payable to trusts, and maximizing the income tax basis step-up at a beneficiary s death during the trust term. Planning area #3 The third planning area involves making distributions in excess of the 5% limitation of Section 2514(e)(2). Bearing in mind the Section 2514(e)(2) 5% limitation on the income that may be withdrawable by the beneficiary under Section 678, the estate planner may also wish to consider including optional clauses in the trust document to permit the actual distribution of additional taxable amounts (including, especially, capital gains) if necessary and desirable to avoid the tax on net investment income as well as the additional 5% capital gains tax imposed 2 Sections 61 and 662. on trust capital gains that may not be imposed on individuals. In order to accomplish this dual objective, the drafting attorney must comply with the requirements of Reg (b)-1 for characterizing capital gains as part of distributable net income. At the outset, a strategy for minimizing the need to distribute trust capital gains to the beneficiary is to avoid large one-time capital gains, and instead spread the gains out over a period of years, so as to keep the combination of the gains and the other net investment income below the $200,000 or $250,000 (as applicable) net investment threshold level for individuals, and so that as much trust income as possible can fall within the Section 2514(e) 5% limitation. This would avoid the necessity of making outright trust distributions that may later be subject to estate taxes at the death of the beneficiary, as well as to the rights of creditors or a divorced spouse of the beneficiary. Requirements to treat capital gains as part of distributable net income. The Code does not present a deduction problem for distributions of IRA and qualified retirement plan receipts to trust beneficiaries, even though a substantial portion of the same may be characterized as principal for trust accounting purposes under the UPIA. This is because the receipts comprise a part of the trust s distributable net income which, if actually distributed, are deductible by the trust and taxed to the trust s beneficiaries. 2 If, however, the trust also possesses tax-exempt income, the latter will also be considered distributed to the beneficiary pursuant to Section 662(b), and therefore 1

2 Seq: 2 Color: 0c: Format: rls$prod:journal.fmtfree lead 48D*points, Next 120D, Vjust JCE1:1 in order to tax any of the excess (i.e., over the 5% limitation and over the $12,000 top tax bracket level) IRA and qualified retirement plan benefits to the beneficiary, the trustee also needs to distribute the trust s tax-exempt income and other items of distributable net income not already subject to the beneficiary s Section 678 power of withdrawal. Obtaining a Section 661 distribution deduction for capital gains of the trust presents an additional set of issues. In order to distribute capital gains to the trust beneficiary, the capital gains must first be considered part of the trust s distributable net income. The regulations establish alternatives for recognizing capital gains as part of distributable net income by providing that an allocation to income of all or a part of the gains from the sale or exchange of trust assets will generally be respected if the allocation is made either pursuant to the terms of the governing instrument and applicable local law, or pursuant to a reasonable and impartial exercise of a discretionary power granted to the fiduciary by applicable local law or by the governing instrument, if not prohibited by applicable local law. 3 Allocations pursuant to terms of governing instrument and local law. The Uniform Principal and Income Act ( the Act ) unequivocally recognizes the allocation of capital gains to income, and therefore to distributable net income, if the allocation is required under the terms of the trust instrument. 4 As long as the trust instrument does not require that all income be distributed currently to the beneficiary or beneficiaries (which would potentially overfund trust distributions), this technique for characterizing capital gains as trust accounting income is generally a successful strategy. Because the trustee is not required to distribute the capital gains to the beneficiary or beneficiaries, the trustee is able to monitor the situation to make the most prudent decisions possible, including, for example, situations where the beneficiary is likely to be subject to federal estate tax, where the beneficiary turns out to be a spendthrift or otherwise unfit to receive the additional distributions, or where the beneficiary has special needs. Allocations pursuant to impartial exercise of a discretionary power. The second method recognized by the IRS for characterizing capital gains as part of distributable net income is for allocations made pursuant to a reasonable and impartial exercise of a discretionary power granted to the fiduciary by applicable local law or by the governing instrument, if not prohibited by applicable local law. 5 Proceeding under this second alternative is a little more tricky than proceeding under the first avenue, at least if a trust is required to distribute all of its income currently to the beneficiary. Although UPIA section 103(b) permits a discretionary allocation of capital gains to income if the terms of the trust clearly manifest an intention that the fiduciary shall or may favor one or more of the beneficiaries, Reg 1.643(b)-1 recognizes a discretionary allocation of capital gains to income, for distributable net income purposes, only if the allocation is also reasonable and impartial. For a trust that is required to distribute all of its income currently, the hurdle in the regulations appears to require that no more than a reasonable portion of the capital gains be allocated to income. What is a reasonable portion obviously depends on all of the facts and circumstances, but generally it can be thought that the trustee may not completely favor the income beneficiary at the expense of the remaindermen of the trust. For a trust that is not required to distribute all of its income currently, however, an allocation of capital gains to trust accounting income should obviously not be viewed as partial towards any beneficiary, for purposes of Reg (b)-1; nor should it be regarded as favoring one or more beneficiaries, for purposes of UPIA section 103(b). The allocation should therefore be respected for distributable net income purposes, pursuant to Reg (b)-1, and a discretionary distribution of the capital gains in excess of the 5% Section 2514(e)(3) limitation should be respected for purposes of Sections 661 and 662. The sample drafting language in Exhibit 1 takes a combination approach of the two allocation methods described above. It automatically allocates all capital gains to income in the case of trusts that are not required to distribute all of their income currently, and then leaves it to the drafting attorney to determine whether inserting the Section 678 power of withdrawal over capital gains is appropriate in a given situation. For trusts that are required to distribute all of their income currently, the allocation between income and principal is to be made by the trustee, but with the added requirement that all of such allocations must be reasonable and impartial. Drafting comment. When analyzing the sample drafting language in Exhibit 1, consider the following point: The principal reason this sample language does not automatically allocate all capital gains to in- 3 Reg (b)-1. 4 UPIA section 103(a)(1). 5 Reg (b)-1. 2 Estate Planning

3 Seq: 3 Color: 0c: Format: rls$prod:journal.fmtfree lead 70D*points, Next 120D, Vjust JCE1:1 come with respect to a trust that is required to distribute all income currently, is because many grantors will not wish to automatically distribute significant capital gains to the trust beneficiary, if one of the primary purposes of the trust is to protect the beneficiary s interest in the trust corpus. If the potential consequences have been fully explained to the client, this sample language may of course be modified accordingly. Authorizing independent trustee to make full or partial distributions. To the extent capital gains will or may be allocated to trust accounting income in a manner that will also be recognized as distributable net income under the Code and regulations, the other desired trust clause involves the ability of an independent trustee to make full or partial distributions of income and principal to the beneficiary, in order to carry out these capital gains to the beneficiary for income tax purposes. The sample drafting language in Exhibit 2 provides one way for doing this. Drafting comments. When analyzing the sample drafting language in Exhibit 2, consider the following points: 1 This form should specifically exclude any trust that the client does not want to be terminated under any circumstances, including, for example, a special needs trust or a trust for a second spouse with remainder to the client s children from a previous marriage. 2 The preference here is definitely to use an independent trustee when allowing for unlimited distribution decisions, in order to avoid potential adverse transfer tax issues and to avoid unwanted income tax results. Using an independent trustee also helps ward off attacks by creditors and an ex-spouse. 3 The preference is also to prohibit full or partial distributions when the beneficiary is under a specified age (in Exhibit 2, age 35). Younger beneficiaries may not be sufficiently mature and experienced to comprehend fully the risks that large distributions present with respect to divorce, potential creditor attack, etc. 4 The sample language references current Section 672(c), and this use of the word current is intentional. Although the IRS has ruled that the power to substitute an independent trustee using the current Section 672(c) language does not create an estate tax issue, if the wording of Section 672(c) is ever changed by Congress in the future, the revised language may not be respected by the IRS for transfer tax avoidance purposes. An independent trustee distribution authority clause can also turn out to be invaluable in other settings. For example, assume that a married couple decided to divide their home between their two revocable trusts in order to reduce estate taxes and attain a fractional interest estate tax discount for the value of their home at the surviving spouse s death (i.e., through the use of a bypass trust). This may be an excellent strategy if the surviving spouse s estate will be subject to federal estate tax. If, however, the surviving spouse s estate is unlikely to be subject to estate tax, the strategy may actually be self-defeating. As discussed, below, the couple s heirs will lose full income tax basis stepup. Further, if the surviving spouse ends up selling the principal residence, the $250,000 exclusion will be available for only the portion of the residence that the surviving spouse owns or is deemed to own (i.e., under a revocable trust). Permitting an independent trustee or co-trustee to encroach on the principal of the bypass trust and distribute the one-half interest in the principal residence to the surviving spouse will result in a full income tax basis step-up on the residence at the surviving spouse s death. It will also qualify the sale of the principal residence fully for the $250,000 capital gains exclusion. Planning area #4 The fourth element of the MIT approach to trust drafting involves planning to maximize income tax deferral for distributions from IRAs, qualified retirement plans, and nonqualified annuities payable to trusts. 6 This special planning is then combined with the Section 678 withdrawal power concepts already discussed, in order to minimize income taxes on the deferred payments but without forcing unnecessary outright distributions of the payments to the beneficiary. Recent private letter rulings issued by the IRS 7 have created concern among estate planning attorneys regarding the best way to draft trusts that are intended as potential receptacles of IRA or other qualified plan benefits (hereinafter sometimes referred to as retirement benefits ) on the death of the account owner or participant. This concern stems from the fact that, unless the trust is properly drafted, the payment of the retirement benefits cannot be stretched out over the lifetime of the trust beneficiary, because the IRS views all contin- 6 See also Blase and Sharamitaro, Consider the MAT, 149 Tr. & Est. 38 (February 2010). 7 See Ltr. Ruls , , and Earlier letter rulings on a similar subject matter, but which were not applying the final IRS regulations, do not appear to be relevant to the instant discussion. 3

4 Seq: 4 Color: 0c: Format: rls$prod:journal.fmtfree lead 43D*points, Next 240D, Vjust JCE1:1 gent takers (e.g., heirs at law) and potential appointees of the trust corpus as beneficiaries of the trust for purposes of determining the designated beneficiary with the shortest life expectancy. Conduit trust. An often-used estate planning technique to ensure the maximum possible income tax deferral for retirement benefits is the conduit trust described in the final regulations under Section 401(a)(9). 8 As its name implies, the conduit trust technique requires that each annual required minimum distribution payment to the trust be distributed directly to the beneficiary upon receipt by the trustee. The conduit trust technique, however, presents numerous problematic issues for most estate planning clients. Among those problems are the following: 1 Forcing annual conduit trust payments onto a minor beneficiary. 2 Forcing annual conduit trust payment onto a younger (even though not a minor) beneficiary. 3 Forcing annual conduit trust payments onto a beneficiary who is older but a spendthrift. 4 Forcing annual conduit trust payments onto a special needs child. 5 Forcing annual payments onto a surviving spouse from a second marriage, when the desire is that the trust corpus pass to the descendants of the first spouse to die at the surviving spouse s death (which would normally be the case when a trust is used). 6 Subjecting conduit trust payments to potential creditors of the beneficiary. 7 Subjecting conduit trust payments to the potential rights of a divorced spouse of the beneficiary. 8 Subjecting conduit trust payments, compounded over the lifetime of the beneficiary, to estate tax at the beneficiary s death as well as at the subsequent deaths of the beneficiary s descendants. The practicing estate planner, who has for years taken pride in the ability to provide protection against all of the above potential issues, now finds himself or herself looking for a better alternative to the conduit trust approach to qualifying retirement benefits for the maximum potential income tax deferral. Regardless of whether one agrees that the expansive approach to determining beneficiaries of a trust (other than a conduit trust) taken by the IRS in its recent private letter rulings is supported by the final regulations themselves, the fact is that these private letter rulings nevertheless exist, and estate planners therefore need to address them without hampering the clients other legitimate estate planning objectives. Assuming the above-outlined drawbacks associated with conduit trusts are adequately explained, very few clients who own interests in substantial qualified retirement plan benefits or IRAs will be enamored by the possibility of establishing a conduit trust that ensures maximum deferral of income taxes on qualified plan and IRA benefits after their deaths. Clients typically want the principal advantage of the conduit trusts (i.e., the ability for their beneficiaries to defer income tax on the retirement plan and IRA benefits), but they do not want any of the numerous disadvantages associated with those trusts. Client complaints concerning the conduit trust approach may become increasingly loud if anything resembling the President s Fiscal Year 2014 Revenue Proposals relative to post-death minimum required distributions are eventually passed. These proposals generally shorten the post-death deferral period to a limit of only five years. Trust modifications. One potential solution to the various estate planning concerns associated with a conduit trust would be to use a standard trust, with the following modifications: 1 The trust should include a Share A and a Share B, Share A being the trust s right to receive the benefits under all qualified retirement plans and IRAs, including Roth IRAs as well as certain nonqualified annuities, and including the reinvested proceeds therefrom, and Share B being all other trust assets. 2 Permissible testamentary appointees under Share A may include only descendants of the primary current beneficiary of the trust parents in the same or younger generation as the primary current beneficiary of the trust. 3 If desired, permissible appointees under Share A may also include a surviving spouse of the primary current beneficiary of the trust who is no more than a designated number of years older than the primary current beneficiary of the trust. 4 All potential remaindermen of Share A (including contingent remaindermen) in the event of the death of the primary current beneficiary before the trust has terminated, who are older than the oldest descendant of the grantor of the trust at the time of the grantor s death, and all non-individual remaindermen, should be deemed to be deceased or not in existence for purposes of construing the remaindermen provisions (including 8 See Reg (a)(9)-5, Example 2. 4 Estate Planning

5 Seq: 5 Color: 0c: Format: rls$prod:journal.fmtfree lead 75D*points, Next 120D, Vjust JC1:1 contingent provisions) that would otherwise apply. 5 In order to ensure that contingent takers of the client s retirement benefits are as closely related to the grantor as possible, if application of the rule in paragraph 4, immediately above, results in all otherwise then-living descendants of the grantor s parents being deemed to be deceased, then the youngest living remainderman who is a descendant of the grantor s parents should not be deemed to be deceased. 6 Remaindermen (including contingent remaindermen) who were deemed to be deceased or not in existence for purposes of construing Share A, (i.e., pursuant to paragraphs 4 and 5, immediately above, receive a priority distribution of Share B assets until they have received an amount sufficient to make them whole with respect to what they would have received from Share A had they not been deemed to be deceased or not in existence. 7 Priority distribution provisions analogous to those described in paragraph 6, immediately above, also need to be included if otherwise permissible appointees (e.g., a spouse of the beneficiary or charity) were eliminated by reason of paragraphs 2 and 3, above. 8 To avoid a potential escheat situation, if the sole contingent taker under the trust document is a charity or charities, heirs-at-law must be added to prepare for the contingency that one or more charities are not (or are deemed not) in existence. 9 If desired, an additional equitable adjustment to the Share B priority distributions described in paragraphs 6 and 7, above, can be 9 See Regs (a)(9)-4, Q& A-5(b)(3) and (c), and Reg (a)(9)-8, Q&A-11 (last sentence). made for the fact that the priority takers may receive their priority shares at a different income tax cost than the takers under Share A. 10 If separate GST-exempt and non-gst-exempt trusts are a possibility, an exception to the above rules needs to be included that would give the beneficiary of the non-gst-exempt trust a power of withdrawal, exercisable only with the consent of a disinterested trustee. This should cause inclusion in the beneficiary s gross estate under Section 2041, without affecting the status of the trust as a designated beneficiary. References to the see-through trust concept in the regulations specify that not all beneficiaries of the trust are see-through beneficiaries, but rather only the beneficiaries of the portion of the trust with respect to the trust s interest in the employee s benefit. 9 The beneficiaries of Share B therefore need not be considered for MRD planning purposes. Two-share approach. Notwithstanding the general guidelines outlined above, in a particular situation a client may wish to ensure that certain contingent takers take fully under both Share A and Share B, even though they may be older than the client s oldest children, so that including them as permissible contingent takers will cut down on the maximum income tax deferral period available. In certain situations, the twoshare approach may not be necessary or even advisable: 1 Prior to 2010, where a company retirement plan did not permit payout other than on a lump-sum (or five-year maximum) basis and also did not permit the required lump-sum payment to be made to an inherited IRA. 2 When the client has little in the way of qualified plan and IRA benefits, the two-share approach may not be worthwhile. (Of course, the word little is a subjective term.) 3 When a married owner or participant is already beyond the required beginning date. Because, as discussed above, the deceased account owner s or participant s life expectancy may be used to calculate the post-death distributions in this situation, and because the surviving spouse is normally roughly the same age as the deceased owner or participant, there will likely be little to gain from the two-share approach. 4 The two-share approach would also not be necessary when (a) no outright remainderman of the trust would be a non-individual or an individual older than the participant s or account owner s oldest living descendant at the time of his or her death, and (b) neither any individual other than a descendant of the participant or account owner nor any nonindividual would be a permissible appointee of all or a portion of the trust assets. A much simpler trust form involving only one share may be all that is required when a client has numerous children and grandchildren. In this situation the oldest beneficiary issue can be easily addressed by providing in the contingent gift clause that all heirs-at-law older than the participant s or account owner s oldest living descendant at the time of his or her death are deemed to be deceased. Note, however, when a client wishes to bestow on the trust beneficiaries a limited testamentary power to ap- 5

6 Seq: 6 Color: 0c: Format: rls$prod:journal.fmtfree lead 20D*points, Next 120D, Vjust JE1:1 point to potentially older individuals (including a surviving spouse) or charity, the full two-share approach would still be required. Adhering to the above general guidelines, drafting attorneys may of course choose to draft the trust in any manner they deem best. Exhibit 3 represents just one attorney s attempt at an additional trust clause intended to avoid the numerous estate planning problems associated with a conduit trust. This language is not intended as a separate standalone trust, but rather as additional trust administration language applicable to each trust established under the trust document. Drafting comments. When analyzing the sample drafting language in Exhibit 3, consider the following points: 1 The sample language would obviously not be necessary if the IRA, etc. payments are outright to the beneficiaries, rather than in trust, which for adult beneficiaries would typically be the recommended approach if each beneficiary s share of the IRAs, etc. is insubstantial. Separate shares are also eliminated for smaller trusts, of under $100,000 of IRA, etc. benefits, in Exhibit 3. 2 A beneficiary s ability to appoint trust assets of Share A to a surviving spouse is limited to a surviving spouse who is no more than five years older than the beneficiary, in order to place an age ceiling on the oldest beneficiary of the trust for designated beneficiary determination purposes. If the surviving spouse is more than five years older than the trust beneficiary, Share B assets are used to provide a priority distribution for the surviving spouse in light of the surviving spouse s exclusion as a permissible taker under Share A. 3 Similarly, if contingent takers older than the trust beneficiary are eliminated as beneficiaries of Share A because they are older than the beneficiary, Share B assets are used to provided a priority distribution for the older contingent takers who are excluded from sharing in Share A. Planning area #5 The fifth planning area involves maximizing the income tax basis step-up at the beneficiary s death during the trust term. One direct consequence of having trust assets excluded from the beneficiary s gross estate for federal estate tax purposes, including the estate of a surviving spouse under a bypass trust and the estate of a beneficiary of a trust that is exempt from the generation-skipping transfer tax, is that the trust assets will not receive a Section 1014 income tax basis adjustment at the surviving spouse or beneficiary s death. Normally the benefit of saving 40% or more in federal and state transfer taxes makes this tradeoff well worth the planning effort. With the advent of the $5.25 million federal estate tax exemption, however, the overall tax results when a trust beneficiary dies need to be reexamined. The vast majority of decedents today and in the future will no longer be subject to the federal estate tax, assuming the federal estate tax exemption remains at or above its current $5.25 million level. This is especially the case if trusts established for their benefit by third parties are structured using the MIT approach to avoid unnecessary additions of trust income and principal (including capital gains) to their gross estates at death. Estate planners should, therefore, consider including conditional testamentary general powers of appointment in their trust documents, in an effort to achieve a Section 1014 income tax basis adjustment (hopefully a basis step-up) when the trust beneficiary dies. Exhibit 4 contains a sample provision that could be added to a generation-skipping transfer tax-exempt lifetime trust for a child. Drafting comments. When analyzing the sample drafting language in Exhibit 4, consider the following points: 1 One of the conditions of the testamentary general power of appointment is that the beneficiary not have a surviving spouse. This is in order to preserve the couple s spousal portability election. If the beneficiary is married, an independent trustee has the ability to add testamentary general power of appointment language. 2 The sample language seeks to achieve the greatest income tax basis step-up available by first selecting trust assets having the greatest built-in appreciation, and therefore capital gain. 3 A trust that is not exempt from the federal generation-skipping transfer tax normally includes a testamentary general power of appointment even if the result would be the imposition of federal estate taxes at the beneficiary s death, except where a taxable termination does not occur by reason of the beneficiary s death. One of the reasons for this is the ability to attain the same Section 1014 income tax basis adjustment, but the other reason is that generating federal estate taxes instead of federal generation-skipping transfer taxes entitles the trust remaindermen to the potential application of the credit for tax on prior transfers pursuant to Section The sample language in Exhibit 4 should be coupled with the abovediscussed ability of an independent trustee or co-trustee to make distri- 6 Estate Planning

7 Seq: 7 Color: 0c: Format: rls$prod:journal.fmtfree lead 58D*points, Next 120D, Vjust JCE1:1 butions in full or partial termination of the trust, thus allowing trustees to terminate completely trusts that are no longer deemed necessary (e.g., because divorce protection, creditor protection, and estate tax protection are no longer issues), thereby saving on ongoing administration costs and allowing for full income tax basis step-up on the former trust assets at the beneficiary s death. Another potential significant benefit of the power to make distributions in full or partial trust termination of a trust is the intentional elimination of fractional interest discounts that serve to reduce the estate tax value of trust assets, and therefore also potentially serve to lower the Section 1014 income tax basis adjustment. Finally, distributions in full or partial termination of a trust owning an interest in a couple s principal residence may allow the full amount of any capital gain on the sale of the entire residence (and not just a portion of the gain) to be eligible for the $250,000 exclusion for sales of a principal residence by an unmarried individual. Additional drafting considerations Estate planners should also bear in mind the following additional planning considerations when drafting trust documents. 10 See Section 671, to the effect that the portion of the trust not subject to the grantor trust rules is taxed under subparts A through D of Subchapter J. 11 If the trustee making the designation of cotrustee is also the withdrawal power holder, Use of the MIT approach in special needs situations. On the surface, use of the MIT approach when drafting trust instruments would seem to be an unwise choice when dealing with a special needs beneficiary or in any other situation where the client does not want the beneficiary to be able to independently access the trust income (e.g., spendthrift child situations and some second-marriage situations). However, one of the major benefits of the Section 678 sole power of withdrawal approach is that the primary beneficiary of the trust does not necessarily need to be the same person who possesses the sole power of withdrawal under Section 678. Thus, for example, one or more siblings of a special needs child could be given the Section 678 sole power of withdrawal over the trust income. It would even be possible to give the Section 678 power to a sibling who, for one reason or another, will be in the lowest income tax bracket among the siblings. Of course the sibling would then be able to withdraw income sufficient to pay his or her income taxes attributable to the Section 678 power, or an independent trustee could be given the power to reimburse the sibling for his or her taxes attributable to the power. If the power holder should abuse the power to the detriment of the special needs child, the independent trustee could exercise the trustee s power to suspend the sibling s Section 678 power for the following year and even transfer that power to another sibling or siblings. If the special needs beneficiary does have regular supplemental needs, it will normally be preferable to have that level of income taxed to the beneficiary, at his or her likely lower income tax bracket. The trust could be drafted to provide for this possibility by allowing the beneficiary or the beneficiary s legal representative to suspend the power holder s right of withdrawal, in whole or in part, for one or more the IRS may attempt to argue that the trustee has, in effect, made a gift of the entire present value of his or her withdrawal right, calculated over the shorter of the beneficiary s or trustee s life expectancy, at least if the cotrustee actually exercises the suspension succeeding trust years. Thus, for example, if during 2013 the beneficiary or the beneficiary s legal representative determines that the beneficiary s estimated supplemental needs for 2014 are approximately $10,000, the beneficiary or the beneficiary s legal representative could suspend the power holder s withdrawal rights for 2014, to this extent thus causing the $10,000 to be deductible by the trust under Section 661 and taxable to the beneficiary under Section The beneficiary s right (including the exercise of the right) to suspend the power holder s right of withdrawal should not create adverse estate and gift tax consequences for the beneficiary of the special needs trust, because by definition the beneficiary has no legal rights in the trust, and would not be the transferor for Section 2036 or 2038 purposes. If the beneficiary s legal representative also happens to be the withdrawal power holder, the legal representative s suspension power would obviously be an illusory one. In this situation the above forms allow a trustee having no beneficial interest in the trust to suspend the withdrawal power, in whole or in part, for one or more succeeding trust years. In cases where there may be no such impartial trustee then serving, the trust form should allow the then serving trustee or trustees to designate an additional co-trustee having no beneficial interest in the trust, to serve in this capacity. 11 Options available for existing irrevocable trusts. A complete discussion of the subject is beyond the scope of this article, but existing ir- power. The trustee s counter arguments include: (1) there is zero assurance he or she would even be the trustee the rest of his or her life (e.g., he or she could become incapacitated the next day, at which time the successor trustee could suspend the withdrawal 7

8 Seq: 8 Color: 0c: Format: rls$prod:journal.fmtfree lead 94D*points, Next 120D, Vjust JCE1:1 revocable trusts, whether established before or after the client s death, may be revised under certain circumstances to include one or more of the above-outlined MIT approaches to trust drafting. Some of the available avenues for revision include judicial and nonjudicial revisions authorized by state statute, revisions by a trust protector pursuant to a grant of authority in the trust instrument establishing the irrevocable trust, and the use of an available state decanting statute to establish a largely parallel trust with MIT approach provisions. Caution should be the rule before proceeding under any of these lines for revising an existing irrevocable trust instrument, however, in order to avoid inadvertent adverse estate, gift, or generation-skipping transfer tax consequences, and in order to ensure that the generation-skipping transfer tax grandfathered status of a trust is not destroyed by an impermissible trust modification. 12 Need to anticipate future tax legislation. With the seemingly endless attempts by Congress and the IRS to impose additional taxes on trusts, it is also important today to include some form of trust protector language in a trust document. The language needs to be carefully crafted to avoid any inadvertent adverse estate, gift, or generation-skipping transfers taxes. One attempt at some sample language is in Exhibit 5. Conclusion The severely compressed federal income brackets for estates and trusts have not served their original purpose, and the situation is only getting worse. Congress should repeal these compressed estate and trust income tax brackets and return to the original system of taxing trusts and estates like individuals, while retaining the existing multiple trust rule in order to prevent abuses of the system. While we wait for Congress to pass this long overdue reform legislation, it is incumbent on estate planners to assist their clients in creating a fairer income tax system for their heirs, through avenues that are permitted under existing law, and which do not require unnecessary outright distributions of income and principal to the trust beneficiary in order to minimize income taxes. The MIT approach to trust drafting discussed in this article addresses some of the techniques available to help clients. Estate planners should explore other planning options as well. The Uniform Principal and Income Act recognizes the allocation of capital gains to income if the allocation is required under the trust instrument. The practicing estate planner now must look for a better alternative to the conduit trust approach to qualifying retirement benefits for the maximum tax deferral. The sample language would obviously not be necessary if the IRA, etc. payments are made outright to the beneficiaries, rather than in trust. Consider including conditional testamentary general powers of appointment in their trust documents to achieve a Section 1014 income tax basis adjustment. With the Section 678 sole power of withdrawal approach, the primary beneficiary of the trust need not be the same person who possesses the sole power of withdrawal. Exhibit 1 Sample Drafting Language for Allocating Income and Principal The trustee shall have the power to determine what is principal and what is accounting income of the trust estate; PROVIDED, HOWEVER, that: (a) in the case of securities purchased at a discount, the entire subsequent sale price or maturity value shall be credited to principal; (b) in the case of securities purchased at a premium, the premium shall be charged against principal without amortizing the same; (c) dividends on shares of stock payable in the stock of any class of the corporation declaring or authorizing the same shall be treated as principal, except that any such dividends paid in lieu of periodic cash dividends or in lieu of recoupment of dividends defaulted or accumulated while the shares of stock are held in the trust estate shall be income; (d) rents, royalties and cash dividends received from wasting assets (including, without limitation, cash dividends paid by oil, coal, lumber, or mining companies), power); (2) he or she has no control over the actions of the co-trustee, including the cotrustee s decisions regarding trust investments, so at best there would be only an annual gift protected by Section 2514(e), since the co-trustee could restore the trustee s withdrawal right each year; (3) assuming he or she is found to have control over the co-trustee s actions, then how can there also be a gift of any more than a one year s 5% withdrawal right (i.e., more than an annual release protected by Section 2514(e)), because the trustee would presumably also retain the ability to persuade the co-trustee to restore his or her withdrawal right each year; and (4) how would the gift be valued if there is no way of knowing what the withdrawable income will be each year (i.e., would the trustee s annual withdrawal rights over his or her lifetime equal 1%, 5%, or somewhere in between?). 12 See Reg (b)(4). 8 Estate Planning

9 Seq: 9 Color: 0c: Format: rls$prod:journal.fmtfree lead 70D*points, Next 120D, Vjust JC1:1 extraordinary cash dividends other than liquidating dividends, and dividends payable in the stock of a corporation other than the corporation declaring or authorizing the same shall be income; (e) the proceeds of the sale of unproductive or underproductive property, liquidating dividends, and rights to subscribe to stock or bonds shall be principal; and (f) all other capital gains and losses shall (I) if the trust does not require that all income be distributed currently to any beneficiary or beneficiaries, be automatically allocated to income, and (II) if the trust requires that all income be distributed currently to one or more beneficiaries, be allocated between income and principal by the trustee, in the trustee s sole discretion, provided that such allocation must be made by the trustee in a reasonable and impartial manner. Exhibit 2 Sample Drafting Language for Full or Partial Trust Terminations The trustee(s) of any trust hereunder, other than (i) the grantor s wife, (ii) the primary current beneficiary of the trust, (iii) the spouse of the primary current beneficiary of the trust, (iv) any descendant of the grantor or of the grantor s wife, (v) any descendant of the primary current beneficiary of the trust, and (vi) any other person or entity related or subordinate, within the meaning of current Section 672(c) of the Internal Revenue Code, to the grantor s wife (substituting the grantor s wife for the grantor in said Section), to the primary current beneficiary of the trust (substituting the primary current beneficiary of the trust for the grantor in said Section) or to any descendant of the primary current beneficiary of the trust (substituting descendant of the primary current beneficiary of the trust for the grantor in said Section), may, in such trustee s or trustees sole discretion, terminate the trust, in whole or in part (including, in such trustee s or trustees sole discretion, for the purpose of paying the primary current beneficiary s income taxes attributable to any income of the trust, including capital gains), and distribute all or any portion of the remaining principal and accumulated and undistributed income of the trust (other than principal and accumulated and undistributed income of the trust which is then withdrawable by any individual) to or for the benefit of the primary current beneficiary of the trust and/or, except in the case of the trusts under ARTICLES and hereof, any descendant or descendants of the primary current beneficiary of the trust, in equal or unequal portions; PROVIDED, HOWEVER, the preceding provisions of this subsection shall not apply if the primary current beneficiary of the trust is less than thirty-five (35) years of age, and PROVIDED FURTHER, HOWEVER, the power to terminate the trust, in whole or in part, under this subsection shall not apply to the extent the power or its exercise or nonexercise would (a) cause any portion of the income or principal of the trust to be includable in the estate of any person (other than the person or persons who receive(s) the trust assets as a result of the full or partial termination of the trust) for federal or state estate tax or inheritance tax purposes, (b) cause imposition of the federal generation-skipping transfer tax or any other transfer tax, or (c) cause any person to make a taxable gift for federal or state gift tax purposes. The trustee shall have broad discretionary power pursuant to this subsection, but in exercising said discretion, the trustee shall focus primarily on the needs and general welfare of the primary current beneficiary of the trust, and secondarily on the needs and general welfare of the descendants of the primary current beneficiary of the trust. [May need to change from descendants to relevant remaindermen. ] Exhibit 3 Sample Drafting Language to Avoid Problems of a Conduit Trust Separate Accounting for Retirement Assets Except as otherwise provided in paragraph 4, below, if (i) any retirement assets (as defined in ARTICLE, below) shall become payable to any trust hereunder as a result of the grantor s death, whether immediately or over time, and (ii) assuming the below-described Share A/B arrangement is established, the aggregate present fair market value (as of the date of the grantor s death, and as determined for federal estate tax purposes, if the federal estate tax is in existence at the time of the grantor s death, otherwise as determined by the trustee, in the trustee s sole discretion) of all of said retirement assets (as so defined) payable to all trusts hereunder that are to be established as a result of the grantor s death, divided by the total number of said trusts, shall exceed One Hundred Thousand Dollars ($100,000), the trustee shall set aside and maintain as a separate share (hereinafter referred to as Share A ) from the remainder of the assets of each trust established hereunder (hereinafter referred to as Share B ), said trust s 9

10 Seq: 10 Color: 0c: Format: rls$prod:journal.fmtfree lead 70D points, Next 120D, Vjust J2:1 right to receive all retirement assets (as so defined), together with the proceeds from the same, and with respect to any such separate shares created hereunder, the following rules shall apply notwithstanding any other provision of this instrument to the contrary: 1 No testamentary power of appointment in Share A may be exercised in favor of the primary current beneficiary of the trust s surviving spouse (other than a surviving spouse who is no more than five (5) years older than the primary current beneficiary of the trust), any creditor of the primary current beneficiary of the trust s estate, the primary current beneficiary s estate, or any charitable organization. If, as a result of the application of the immediately preceding sentence, an otherwise permissible appointee or appointees in Share A has or have been eliminated, and if there is a percentage ceiling on the proportion of the original trust that the primary current beneficiary of the trust may appoint to said appointee or appointees, then said percentage ceiling shall be raised over the remaining principal and accumulated income of Share B to the extent necessary to allow the primary current beneficiary of the trust to exercise his or her testamentary power of appointment over Share B in favor of said appointee or appointees who or which were eliminated as a permissible appointee or appointees in Share A, to the full extent of the ceiling over the original trust, recognizing that it may not be possible to fully achieve the percentage ceiling over the original trust. 2 For purposes of construing the provisions of the CONTINGENT REMAINDER INTERESTS under ARTI- CLE hereof, which will potentially apply at the termination of Share A, all potential heirs-at-law of the grantor and of the grantor s wife who are older than the oldest living descendant of the grantor at the time of the grantor s death (assuming all such descendants were alive at the termination of the trust) shall be deemed to be deceased, and all non-individual potential takers shall be deemed to be not then in existence; PROVIDED, HOWEVER, if one or more descendants of the grantor s parents or of the grantor s wife s parents are living at the time of the grantor s death, and if the application of the foregoing provisions of this paragraph 2 shall result in all such descendants who are also living at the time of the termination of the trust being deemed to be deceased, then the youngest such descendant of the grantor s parents or of the grantor s wife s parents who is living at the time of the grantor s death, as well as at the time of the termination of the trust, shall not be deemed to be deceased pursuant to the foregoing provisions of this paragraph 2, but all other heirs-at-law of the grantor and of the grantor s wife shall be deemed to be deceased. If, as a result of the application of the immediately preceding sentence, an individual or individuals and/or a non-individual or non-individuals who and/or which would have otherwise received a portion of Share A as a contingent taker or takers under ARTICLE hereof is or are deemed to be deceased or otherwise not then in existence, only these individual(s) and/or non-individual(s) (other than any ancestors of the individual takers in Share A pursuant to the immediately preceding sentence, who shall be deemed to be deceased) shall be deemed to be then living and/or designated for purposes of determining contingent takers of Share B under said ARTICLE hereof, until such time as said individual(s) and/or non-individual(s) receive the same share(s) in Share B which they would have received in Share A had they not have been deemed to be deceased or not then in existence pursuant to the application of the immediately preceding sentence, after which point the provisions of said ARTICLE hereof shall apply normally to the balance of Share B. 3 If the trust has an inclusion ratio, as defined in Section 2642(a) of the Internal Revenue Code or in any successor section thereto, of other than zero, and if, assuming the primary current beneficiary of the trust died immediately, a taxable termination as defined in Section 2612(a) of the Internal Revenue Code or in any successor section thereto, would occur, then the primary current beneficiary of the trust shall have the power to withdraw all of the income and principal of Share A of the trust, but only with the consent of the then acting trustee or co-trustees of the trust (other than the primary current beneficiary of the trust or any institution in which the primary current beneficiary of the trust owns any interest) who and/or which is/are not adverse to the exercise by the primary current beneficiary of the trust of the aforesaid power of withdrawal (within the meaning of Internal Revenue Code Section 2041(b)(1)(C)(ii), or any successor section thereto, and Section (c)(2) of the Treasury Regulations, or any successor section(s) thereto), or if all of the then acting trustees (other than the primary current beneficiary of the trust or any institution in which the primary current beneficiary of the trust owns any interest) are adverse to said exercise, then only with the consent of a nonadverse individual or institution (other than the primary current beneficiary of the trust or any institution in which the primary current beneficiary of the trust owns any interest) designated by the then acting trustee or co-trustees of the trust (other than the primary current beneficiary of the trust or any institution in which the primary current beneficiary of the trust owns any interest), or, if no such nonad- 10 Estate Planning