Trusts: Simple to Complex

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1 Trusts: Simple to Complex Stetson Pre Conference: Tax Intensive October 18, 2017 Robert B. Fleming FLEMING & CURTI, P.L.C. Tucson, Arizona 1. Is my trust simple, or complex? This is a fun question to start with. All of your clients insist that they want a simple will do they want a simple trust, too? Or is a complex trust, well, better? Understanding the difference between simple and complex trusts is wonderfully easy. Note that there is no inherent benefit to one or the other category. Start with IRC 642. That section spells out the personal exemption deduction for trusts and estates. In 642(2), it provides the general rule, and two exceptions: a trust gets a presumptive $100 deduction ( 642(b)(A)), but a trust which, under its governing instrument, is required to distribute all of its income currently, shall be allowed a deduction of $300 ( 642(b)(B)), and a qualified disability trust gets the same personal exemption as an individual is entitled to claim (in 2017, that is $4,050; unlike the trust personal exemption, this one is keyed to inflation) Note that the only requirement listed here is that all income must be distributed currently. The IRS definition of a simple trust, however, goes one step further. It indicates that a simple trust must not distribute amounts allocated to the corpus of the trust. (Cf: IRS Form 1041 instructions, available online, at An otherwise simple trust that does in fact distribute principal (corpus) is not a simple trust in that tax year though it may be a simple trust in years before and after the principal distribution. Now look at IRC 651. It describes a trust that provides that all of its income is required to be distributed currently (IRC 651(a)(1)). Such a trust gets an income tax deduction for the amount of income which is required to be distributed. The amount of the deduction, incidentally, is limited to the distributable net income (DNI) of the trust (IRC 651(b)). Fleming Trusts: Simple to Complex Page 1

2 DNI is an amount calculated on the trust s form 1041, Schedule B. After adjusted total income is calculated, DNI deducts capital gains and makes a few other, lesssignificant, adjustments. In other words, a trust that distributes capital gains is effectively precluded from being treated as a simple trust. So what is the significance of being characterized as a simple or complex trust? Really, just the $200 difference in the personal exemption a tax difference that will usually be insignificant. That is especially true since any trust which qualifies as a simple trust (and therefore gets the slightly larger personal exemption) will only have tax liability for its capital gains, anyway the entire DNI distribution will be deducted from income on the Is my trust a grantor trust? There is terrific uncertainty and misunderstanding about grantor trusts. A little background explanation helps make the topic understandable. Trusts are separate taxpaying entities. They have their own taxpayer identification numbers, and they file separate returns. Unless, that is, they are grantor trusts. One problem is that the tax code itself does not use the term grantor trust. Instead, it refers to circumstances in which a grantor will be treated as a substantial owner of the trust. The conventional use of grantor trust is just that a convention to describe the circumstance in which a trust is treated as owned by the grantor (or, in rare circumstances, someone other than a grantor). The grantor of a trust is treated as a substantial owner when one of the tests of IRC is met. It helps to appreciate that the logic of the grantor trust rules was originally the opposite of the usual current thinking: the rules were written to cause treatment as a grantor trust when the grantor did not seek such treatment. Today, the grantor trust rules are usually viewed as comfortable mechanisms to make sure that a trust is characterized as a grantor trust, rather than rules to be avoided. This is true for a combination of two relatively-recent tax developments: the so-called Kiddie Tax, which made shifting income tax consequences to one s lower-tax-level children difficult-to-impossible, and the much more rapid compression of the tax brackets for trusts. As a consequence, grantor trust treatment is usually preferable to non-grantor trust status. One other point should be observed: there is a disconnect among estate tax, gift tax and income tax treatment of transfers to trusts. Consequently, there are circumstances in which planners seek to capitalize on that difference, allowing income to be taxed to the grantor, a stepped-up basis for income tax purposes, and still effect a completed transfer for estate tax purposes. Fleming Trusts: Simple to Complex Page 2

3 Who is a grantor? According to 26 CFR (e)(1), a grantor includes any person to the extent that such person either creates a trust, or directly or indirectly makes a gratuitous transfer of property to a trust. It s not quite correct, but usually the grantor is the person putting his or her own money in the trust. One last concept we need: the notion of a non-adverse party. Actually, IRC 672(a) first defines an adverse party as one who himself or herself has a beneficial interest in the trust property so that, for instance, an exercise of trustee discretion will reduce trust assets that would otherwise flow partly to the adverse party. A non-adverse party, then, is anyone who is not an adverse party. So, how does a trust get characterized as a grantor trust? By including one of the provisions in IRC Looking at the range of choices by IRC section number, here are some of the most common methods: 676. Power to revoke. If the grantor has the power to revoke the trust and revest title to trust assets in the grantor, then the trust will be treated as owned by the grantor Power to control beneficial enjoyment. If the grantor has the authority to decide who will receive trust principal or income, or if that authority is held by a non-adverse party, then the trust income will be taxable to the grantor Income for benefit of grantor. Even if 674 does not apply, if the grantor or the grantor s spouse is entitled to receive income (or may receive income without the intervention of an adverse party) then the grantor will be treated as owner of the trust Administrative powers. This IRC section is the most fun. It provides an interconnected set of powers which will cause the grantor to be owned as trust owner. One that is often used when the planner wishes to complete a gift for estate/gift tax purposes but continue to have the trust s income treated as taxable to the grantor: 675(4)(C), a power to reacquire the trust corpus by substituting other property of an equivalent value (without the approval or consent of any fiduciary) Reversionary interests. If the grantor will receive trust principal or income at some future time, he or she will be treated as the owner of the trust. Two important rules qualify this basic statement: (1) the reversionary interest only causes grantor trust treatment if it is exceeds 5% of the value of the trust, and (2) for purposes of calculating the 5% threshold, any discretion held by the trustee to make distributions to (or for the benefit of) the grantor will be treated as if it has been fully exercised. Is your trust a grantor trust? If the grantor has any substantial likelihood of receiving benefits from the trust, or retains the ability select who will receive trust principal or income, then it is likely that it will be a grantor trust. Fleming Trusts: Simple to Complex Page 3

4 3. Is my (self settled) special needs trust a grantor trust? Yes. Why? Because, regardless of the application of other rules, the trustee almost certainly has the power to distribute at least 5% of the trust principal for the benefit of the grantor. IRC 673 therefore mandates treatment of the grantor as a substantial owner. You might be uncertain about whether the (disabled) beneficiary of a self-settled special needs trust is actually a grantor at all. You should not be. As described above, the tax code treatment of a grantor includes someone who directly or indirectly makes a transfer into a trust. Though the terms grantor and settlor (or trustor or, less elegantly, trust-maker ) are distinct, the tax term grantor includes the person whose assets were transferred into trust by a surrogate such as a court, guardian or parent. 42 U.S.C. 1396p(d)(4)(A) complicates the picture somewhat by mandating that the self-settled special needs trust must be established by a court, guardian or parent. This unfortunate language requires us to distinguish among the establishor, the settlor and the grantor of a given trust. Each term is defined by a different body of law or practice, but the original owner of the transferred asset is the grantor for income tax purposes. You might argue that 673 is less clear than described here. After all, it speaks of a reversionary interest rather than a right to reacquire property or control its beneficial enjoyment. But even a more restrictive reading of the reversionary interest phrase will run up against the reality that a right to receive so much as 5% of income will cause the trust s income to be taxable to the grantor. 4. Is my special needs trust a Qualified Disability Trust? IRC 642(b)(2)(C), adopted as part of the Victims of Terrorism Tax Relief Act of 2001, allows for favorable income tax treatment for qualified disability trusts. Such trusts are permitted to claim a personal exemption of the same amount as individuals which, in 2017, could mean eliminating taxation of the first $4,050 of income. Remember (from #1 above): a non-grantor trust can be categorized as either simple or complex. The difference is essentially whether the trust is required by its governing instrument to distribute all of its income to the beneficiary annually if it is, then the trust is simple. Generally, special needs trusts will not include such a requirement, and so will be complex. A complex trust is entitled to claim a $100 personal exemption on its federal income tax return. By contrast (but irrelevantly, for our purposes) a simple trust receives a $300 personal exemption. But a qualified disability trust gets an exemption of $4,050 (in 2017) a significant benefit. Fleming Trusts: Simple to Complex Page 4

5 So what makes a trust a qualified disability trust? First, it has to file a substantive tax return and the self-settled special needs trust does not (because it is a grantor trust). Assuming it does, however, the rest of the requirements are pretty straightforward: all of the trust s beneficiaries must be disabled within the meaning of Social Security rules. Receipt of Supplemental Security Income or Social Security Disability benefits qualifies the beneficiary. Disability eligibility should permit such treatment even for individuals who have insufficient quarters of coverage to qualify for SSDI benefits and excess resources preventing receipt of SSI benefits though the mechanism for establishing that disability is less than clear. Is your special needs trust a qualified disability trust? Not if it s a self-settled special needs trust, but if it is a third-party special needs trust it probably will. Want more details? Look for an article on the Special Needs Alliance website at 5. Does my trust need an EIN? As an aside, this one is our favorite tax question. It s also the question most-often asked at seminars, on our website, and in after-session conversations. Some trusts must have a separate taxpayer identification number (which, for trusts, is called an Employer Identification Number, or EIN). Other trusts may choose to have an EIN. What makes the difference? A trust is presumptively a separate taxpaying entity, must have an EIN and must file a separate (fiduciary) income tax return a Non-grantor trusts all fit into this category though it is important to note that even though the beneficiary of a trust may not be treated as a substantial owner (a grantor ), the original grantor may still be treated as the substantial owner. Assuming, though, that the trust does not have a living grantor for tax purposes, 26 CFR (a)(1)(ii)(C) mandates that Any person other than an individual 9such as corporations, partnerships, nonprofit associations, trusts, estates and similar nonindividual persons) that is required to furnish a taxpayer identifying number must use an employer identification number. (emphasis added) There is a different treatment, however, for grantor trusts. 26 CFR (a)(2) spells out a step-wise analysis for trusts treated as owned by one or more persons pursuant to sections 671 through 678 (e.g.: grantor trusts): 1. The general rule: unless a later exception applies, a grantor trust must have an EIN (26 CFR (a)(2)(i)(A)). 2. If the grantor trust is wholly owned by one grantor, then it need not obtain an EIN provided that some minimum rules are met (and they are easy to meet) (26 CFR (a)(2)(i)(B)). Banks, brokerage houses, accountants and others seem to almost universally believe that the distinction between requiring an EIN and not requiring one is Fleming Trusts: Simple to Complex Page 5

6 based on the trust s revocability, or the fact that the grantor is not the trustee. They are wrong. The difference is one of choice by the trustee. If the trustee decides to follow the option provided by the CFR above, then no EIN is required. What does the trustee have to do? He/she/it must choose to look at the provisions of 26 CFR (b)(2)(i)(A), and Furnish the name and taxpayer identification number (TIN) of the grantor or other person treated as the owner of the trust, and the address of the trust, to all payors during the taxable year, and comply with the additional requirements described in paragraph (b)(2)(ii) of this section. Those additional requirements? Give the grantor information about trust income and expenditures. As an aside, the use-the-grantor s-ssn option is only available if there is a single grantor for the trust, but a married couple are treated as a single grantor for these purposes. 6. Do I need to file a fiduciary income tax return (a 1041)? Maybe. If you have an EIN for the trust, you should file a fiduciary income tax return. If the trust is not a grantor trust, then the 1041 should claim income and deductions as a separate taxpayer. If the trust is a grantor trust but has an EIN, then the tax return should not provide any income or deduction information. It is not, after all, a separate taxpayer. Think of the return as simply allowing someone at the IRS to check the box indicating that the EIN has been accounted for sort of like a bedcheck at summer camp. The grantor trust with an EIN will file a return that indicates that it is a grantor trust, and that the trustee has complied with the requirements of 26 CFR (b)(2)(i)(A). Many professionals include a grantor trust letter as part of the filing, but that is only to establish compliance with the regulations. A grantor trust may not claim separate deductions or exemptions (it is, after all, not even a separate taxpayer), and so a substantive return may not be filed. If the grantor trust does not have an EIN, then there is no filing at all. The trustee simply gives the beneficiary sufficient information to prepare his or her own individual income tax return, as required by 26 CFR (b)(2). 7. What about the pooled special needs trust I administer (or participate in)? A self-settled pooled trust is a Grantor trust though the very nature of it being pooled confuses the question somewhat. It needs an EIN. May need (and could have) an EIN for each subtrust. Each separate grantor trust files a non-substantive 1041, though it might have some income and deductions. Can you identify why? A pooled trust that accumulates non-grantor trusts is a different animal but an easier one to describe for tax purposes. The larger trust will have an EIN and file a Each sub-trust might have its own EIN, but distributions to beneficiaries will Fleming Trusts: Simple to Complex Page 6

7 carry out DNI just as a third-party complex trust always does. The most interesting question: is there a circumstance in which a non-grantor pooled trust distributes DNI assigned to one sub-trust to the beneficiaries of one or more other sub-trusts? 8. Can a trust be a designated beneficiary for an IRA / 401(k) / qualified retirement plan? Yes. 26 CFR 1.401(a)(9)-4 (Determination of the designated beneficiary ) is organized in a Q&A format. Question and answer #5 spell out four requirements for treatment of the trust s beneficiaries as the designated beneficiary(ies) : 1. The trust must be valid under state law (though there is an exception for trusts that would be valid but for lack of corpus, permitting dry trusts as beneficiaries). 2. The trust must be irrevocable or become irrevocable because of the death of the plan participant. 3. The beneficiaries must be identifiable from the trust instrument. 4. The plan administrator must be provided documentation as spelled out in the regulations (basically a copy of the trust and a list of trust beneficiaries). Though the CFR provision only spells out those four requirements, Natalie Choate ( Life and Death Planning for Retirement Benefits ) adds the de-facto requirement that: 5. All trust beneficiaries must themselves be individuals (or the value of designated beneficiary treatment will have been lost). Keep in mind that this only describes when a trust may be named as beneficiary. Quite another analysis must be employed to determine whether a trust should be so named. 9. Can I name a trust as beneficiary of my IRA / 401(k) / qualified retirement plan? Yes. In order to understand the problem implicit in this question, it is important to distinguish between two kinds of trusts which might be designated beneficiaries. Both kinds of trusts can be grouped together under the heading of see-through trusts, but they are different and they have different effects, particularly on minimum-distribution calculations. The two kinds of trusts: 1. The conduit trust. In this trust, the trustee is compelled to distribute all funds received as distributions from IRAs and qualified plans to the beneficiary in the same year indeed, more-or-less immediately. Because this Fleming Trusts: Simple to Complex Page 7

8 trust is essentially ignored for RMD (required minimum distribution) purposes, the income beneficiary is the governing life for the life expectancy calculation which determines the amount of the RMD. Interestingly, this is true even after the death of the income beneficiary, so the remainder beneficiaries can be older, can fail to qualify as designated beneficiaries, or whatever. Once the RMD calculation methodology is set, it does not change. 2. The accumulation trust (not, incidentally, an IRS term). In this type of trust, the trustee, though still required to receive RMDs each year, is authorized to hold some or all of the RMD amounts in the trust for the benefit of income and remainder beneficiaries. Because the IRA/qualified plan now benefits all trust beneficiaries, the RMD calculation is made on the basis of the oldest possible trust beneficiary. An accumulation trust can create problems with calculation of the governing life expectancy, and even with whether the trust will qualify as a designated beneficiary at all. But one important rule to keep in mind: you don t have to calculate the life expectancy of every conceivable beneficiary, just the now-living person or persons who will receive the remaining trust outright (after the death of at least the current income beneficiary and perhaps other, later, deaths). 10. Are there downsides to naming a trust as beneficiary of an IRA / 401(k) / qualified plan? Of course there are. There are several some practical and some tax/legal: 1. The owner of the qualified plan will face relentless pressure for the rest of their life to change the beneficiary designation. Investment houses will insist that it is not permissible (they ll be wrong, but persistent). Financial advisors and tax preparers will question the designation, and many of them will assert that it was a mistake. Clients need to be armed with the (correct) information necessary to resist the proposed changes over time. And here s one we ve been seeing a lot lately: the client s broker might change employment, and not be permitted to take all the account information with them. The new account through the new clearing house will likely get set up incorrectly, and no one will even think to talk to the lawyer who prepared the plan and even the accountant does not change, she might not think to ask about the titling and beneficiary designations. 2. Upon the plan participant s death, the experience of a successor trustee will be highly variable from one entity to another. Some will insist that the plan must be distributed immediately. Others might insist that it can be maintained, but only as a single trust with no divisions into separate shares. The federal rules actually countenance the division via the so-called separate accounts rule provided that the division is accomplished by the beneficiary finalization date (September 30 of the year after the year of the participant s death): Fleming Trusts: Simple to Complex Page 8

9 (2) If the employee's benefit in a defined contribution plan is divided into separate accounts and the beneficiaries with respect to one separate account differ from the beneficiaries with respect to the other separate accounts of the employee under the plan, for years subsequent to the calendar year containing the date as of which the separate accounts were established, or date of death if later, such separate account under the plan is not aggregated with the other separate accounts under the plan in order to determine whether the distributions from such separate account under the plan satisfy section 401(a)(9). Instead, the rules in section 401(a)(9) separately apply to such separate account under the plan. Reg (a)(9)-8, A-2(a)(2) 3. Though that same section of the Regs. appears to allow separate calculation of distribution periods for the separate accounts, in practice different entities might insist on distributions at the quickest rate (the oldest separate account-holder). Oddly, the division into separate accounts can be completed as late as the end of the calendar year after the year of death in order to permit the applicable distribution period calculation based on each separate account: However, the applicable distribution period for each such separate account is determined disregarding the other beneficiaries of the employee's benefit only if the separate account is established on a date no later than the last day of the year following the calendar year of the employee's death. 11. Will naming a trust as beneficiary of my IRA / 401(k) / qualified plan provide any valuable creditor protection? Yes. After the Supreme Court s surprising ruling in Clark v. Rameker, 134 S.Ct (2014), it became clear that inherited IRAs are not protected from creditors under federal law. That means, at a minimum, that they might be subject to the claims of the trustee in a bankruptcy proceeding. Arizona is one of a handful of states that provides additional protection, including of inherited IRAs (see A.R.S (B)). Unfortunately, beneficiaries cannot be relied upon to remain in states with favorable creditor or bankruptcy protections, and the benefits of Arizona law could be lost. One safe way to protect the inherited IRA is for the participant to leave it to a trust which will generally be sheltered from the beneficiary s creditors regardless of state law (as an aside, it is also possible to have the creditor protection values set by choice-of-law provisions in a trust an option not available for an individual beneficiary). Fleming Trusts: Simple to Complex Page 9

10 12. Can the beneficiary of my IRA / 401(k) / qualified plan be an accumulation trust? Yes. The conduit trust is easy. The accumulation trust is a little more complicated. Naming a trust as beneficiary of the IRA or qualified plan will have two kinds of effects: it will require a determination of whether the trust qualifies as a designated beneficiary, and if so it will determine whose life expectancy is used for purposes of calculating minimum distributions. If the trust is a see-through trust (and the trust s tested beneficiaries themselves qualify as designated beneficiaries), then the trust qualifies as a designated beneficiary even though it might have an effect (negative or positive) on the minimum distribution rules. If the see-through trust is a conduit trust, then the conduit beneficiary is the measuring life for minimum distribution purposes and for designated beneficiary testing. In other words, if the trust includes mandatory distribution of all minimum distributions to John Doe, then it does not matter that the remainder beneficiary of the trust is a charity, or a non-qualified trust, or any other entity. Once the measuring life is established, subsequent events do not modify the calculations; upon John Doe s death, the minimum distributions are not recalculated for the remainder beneficiary s life expectancy. If the see-through trust is an accumulation trust, then both the designated beneficiary testing and the measuring life calculation require determining who will receive distribution of trust principal after the death of the initial income beneficiary. In other words, if the trustee was not required to distribute all minimum distribution amounts to John Doe, then the account custodian would have to consider the remainder beneficiaries but not indefinitely. So if upon John Doe s death the trust continues distributing RMDs to his wife Jane, who is two years older than John, her life expectancy will be used and the designated beneficiary status will be met if upon her death the trust distributes outright to a younger person. Now imagine that the trust provides that all RMDs must be distributed to John for life, then to Jane (two years older than John). Upon the death of both John and Jane the trust terminates and distributes outright to Jenny, the daughter of John and Jane (who is, obviously, younger than both John and Jane). If Jenny is not living at the time of the death of both John and Jane, then the trust distributes to ABC Charity. Jenny is alive at the time of the IRA owner s death. In these facts, Jane (the oldest of the three counted beneficiaries) sets the RMD calculations; the fact that a charity could possibly end up with the IRA does not change the determination of designated beneficiary status. Those rules seem complicated, but a few moments consideration will likely bring them into focus. Naming an accumulation trust as beneficiary of an IRA or qualified plan is not that complicated, and should not be frightening. That does not mean that it should be a default position, however. Fleming Trusts: Simple to Complex Page 10

11 13. Can I, specifically, name a special needs trust as beneficiary of my IRA or qualified plan? Yes. Avoid making a charity remainder beneficiary (or at least make certain that the charity follows an outright distributee), and make sure you understand the rules. Expect lots of opposition from your banker, broker, accountant, financial planner and neighbors. Note that the rules about minimum distributions and the taxation of trust DNI are different. If actual distributions for the benefit of a beneficiary exceed the taxable income received (including the minimum distributions), the tax liability will flow out to the beneficiary along with those distributions. 14. What can be done when an IRA or qualified plan names a public benefits recipient as beneficiary? One helpful Private Letter Ruling suggests an outcome, though it is not without its difficulties: create a self-settled special needs trust and transfer the IRA or qualified plan to the trust. PLR involved a deceased IRA owner who had named his three sons as equal beneficiaries. Two sons had collected their shares (into, one hopes, separate rollover IRAs under the separate share rules). The third son was an SSI recipient who would risk both benefits loss and accelerated income taxes if he were to simply collect the IRA, liquidate it and place the proceeds into a selfsettled special needs trust. The decedent s ex-wife, mother of the son with disabilities, created a 42 USC 1396p(d)(4)(A) trust and sought to transfer the IRA intact to that trust. She requested a private letter ruling that such a transfer would not be deemed to be a liquidation of the IRA, and the IRS obliged. Fleming Trusts: Simple to Complex Page 11