2017 National Conference on Special Needs Planning and Special Needs Trusts. Saving Income Taxes with Qualified Disability Trusts Bradley J.

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1 2017 National Conference on Special Needs Planning and Special Needs Trusts Saving Income Taxes with Qualified Disability Trusts Bradley J. Frigon Law Offices of Bradley J. Frigon 6500 S. Quebec St. Suite 330 Englewood, CO

2 Introduction The Victims of Terrorism Tax Relief Act of 2001 amended the I.R.C. provision on trust income tax exemptions. Starting with tax year 2002, a "qualified disability trust," (QDT) whether taxed as a simple or complex trust, can claim in lieu of the $100 or $300 exemption, an exemption in the amount that a single individual taxpayer can claim, i.e., $4050 in 2017.

3 Code Section Review I.R.C. 642(c) provides as follows: (c) Disability trusts (i) In general. A qualified disability trust shall be allowed a deduction equal to the exemption amount under section 151(d), determined (I) 68(b)(1)(C), and by treating such trust as an individual described in section (II) by applying section 67(e) (without the reference to section 642(b)) for purposes of determining the adjusted gross income of the trust.

4 Code Section Review (ii). Qualified disability trust. For purposes of clause (I), the term qualified disability trust means any trust if: (I) such trust is a disability trust described in subsection (c)(2)(b)(iv) of section 1917 of the Social Security Act (42 U.S.C. 1396p), and (II) all of the beneficiaries of the trust as of the close of the taxable year are determined by the Commissioner of Social Security to have been disabled (within the meaning of section 1614(a)(3) of the Social Security Act, 42 U.S.C. 1382c(a)(3)) for some portion of such year.

5 QDT Code Section IRC Section 151 provides as follows: (d) EXEMPTION AMOUNT. For purposes of this section (1) IN GENERAL. Except as otherwise provided in this subsection, the term exemption amount means $2,000.

6 QDT Code Section (cont). IRC Section 67(e) provides as follows: (e) DETERMINATION OF ADJUSTED GROSS INCOME IN CASE OF ESTATES AND TRUSTS. For purposes of this section, the adjusted gross income of an estate or trust shall be computed in the same manner as in the case of an individual.

7 QDT Code Section (cont). IRC Section 642(b)(2)(A) In general, except as otherwise provided in this paragraph, a trust shall be allowed a deduction of $100. IRC Section 642(b)(2)(B) Trusts Distributing Income Currently, a trust which, under its governing instrument, is required to distribute all of its income currently shall be allowed a deduction of $300.

8 QDT Code Section (cont). 4. Subsection (c)(2)(b)(iv) of section 1917 of the Social Security Act (42 U.S.C. 1396p) provides as follows: (B) the assets (i) were transferred to the individual s spouse or to another for the sole benefit of the individual s spouse, (ii) were transferred from the individual s spouse to another for the sole benefit of the individual s spouse,

9 QDT Code Section (cont). (iii) were transferred to, or to a trust (including a trust described in subsection (d)(4)) established solely for the benefit of, the individual s child described in subparagraph (A)(ii)(II), or (iv) were transferred to a trust (including a trust described in subsection (d)(4)) established solely for the benefit of an individual under 65 years of age who is disabled (as defined in section 1614(a)(3));

10 QDT Code Section (cont). Section 1614(a)(3) of the Social Security Act, 42 U.S.C. 1382c(a)(3)) provides as follows: (3)(A) Except as provided in subparagraph (C), an individual shall be considered to be disabled for purposes of this title if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or which has lasted or can be expected to last for a continuous period of not less than twelve months.

11 Qualified Disability Statutory Requirements Not all SNTs will qualify as a QDT even if the trust is taxed as a simple or complex trust. The statutory requirements for a trust to receive an increase exemption as a qualified disability trust (QDT) can be broken down as follows:

12 Qualified Disability Statutory Requirements (cont.) The trust must meet the statutory requirements of 42 U.S.C. 1396p(c)(2)(B)(iv). (i) (ii) (iii) (iv) It must be irrevocable; It must be for the sole benefit of the disabled beneficiary; The beneficiary must be under the age of 65; and The beneficiary must be disabled as defined for purposes of the Supplemental Security Income (SSI) and Social Security Disability Income (SSDI) programs.

13 Qualified Disability Statutory Requirements (cont.) The trust must be taxed as a simple or complex trust under I.R.C. 652 or 662. Since a grantor trust is not a separate taxpayer, it will not qualify as a QDT. The Commissioner of the Social Security Administration (SSA) must determine that the beneficiary is disabled for some portion of the year by the close of the taxable year. In other words, there must be an actual determination from SSA that the beneficiary is disabled. This may require the beneficiary to receive SSI or SSDI benefits which can be a potential problem for a beneficiary who has a disability but is ineligible to receive benefits due to work or other financial issues such as parental deeming.

14 Qualified Disability Statutory Requirements (cont.) A narrow reading of I.R.C. 642(b)(2)(c) would exclude all third party SNTs from qualifying as a QDT. Section 1917 of the Social Security Act references 42 U.S.C. 1396p "Liens, adjustments and recoveries, and transfers of assets." Subsection (c)(2)(b)(iv) states there is no penalty for a transfer of assets if those assets: (iv) were transferred to a trust (including a trust described in subsection (d)(4)(a) of this section) established solely for the benefit of an individual under 65 years of age who is disabled (as defined in section 1382c (a)(3) of this title).

15 Qualified Disability Statutory Requirements (cont.) For a third party SNT to receive the QDT exemption, subsection (c)(2)(b)(iv) must be read to include all special needs trusts not just trusts described under (d)(4)(a). A more reasonable interpretation of I.R.C. 642(b)(2)(c) would include a third party SNT as a QDT provided the special needs beneficiary is receiving SSI or SSDI benefits and the trust was funded prior to the beneficiary turning 65. There are no reported cases or rulings on this point.

16 Tax Terms and Primer If a trust is not a grantor trust for income tax purposes, then a trust is classified as a simple trust or complex trust. This classification is made on a year by year basis at the beginning of the tax year based upon what distributions or accumulations a trust makes. A trust that does not qualify as a simple trust is a complex trust.

17 Tax Terms and Primer (cont.) The requirements for a trust to be classified as a simple trust are found in I.R.C. 651(a) and are as follows: 1. The terms of the trust require that all income be distributed currently; 2. Thetermsofthetrustmustnotprovideforanyamountstobe paid, permanently set aside, or used for the taxable year for charitable purposes; 3. The trust must not actually distribute any amounts during the year other than the income required to be distributed currently;

18 Tax Terms and Primer (cont.) A trust is a complex trust (and not a simple trust): 1. For any year in which income is required to be accumulated; 2. For any year in which the trustee has the discretion to accumulate or distribute income, even if the trustee actually distributes all of its income for that year; 3. For any year in which principal is distributed; and 4. For any year in which a charitable contribution is made.

19 Tax Terms and Primer (cont.) A grantor trust is not treated as a separate taxpayer for federal income tax purposes. The income from a grantortrustistaxedtothegrantoror,sometimes,to another person because he or she holds some interest in or control over the trust s assets. If the grantor or another person is treated as the owner of any portion of trust assets, then the trust is ignored for income tax purposes and the income, deductions, and credits attributable to that portion of the trust assets are taxed to the grantor.

20 Tax Terms and Primer (cont.) The standard deduction for single taxpayers and married couples filing separately is $6,350 in 2017, up from $6,300 in 2016; for married couples filing jointly, the standard deduction is $12,700, up $100 from the prior year; and for heads of households, the standard deduction is $9,350 for 2017, up from $9,300. The numbers look like this:

21 Tax Terms and Primer (cont.) Filing Status Standard Deduction Amount Single $6,350 Married Filing Jointly & Surviving $12,700 Spouse Married Filing Separately $6,350 Head of Household $9,350

22 Tax Terms and Primer (cont.) For 2017, the additional standard deduction amount for the aged or the blind is $1,250. The additional standard deduction amount is increased to $1,550 if the individual is also unmarried and not a surviving spouse.

23 Tax Terms and Primer (cont.) For those taxpayers who itemize their deductions, the Pease limitations, named after former Rep. Don Pease (D OH) may cap or phase out certain deductions for high income taxpayers. The Pease thresholds for 2017 are:

24 Tax Terms and Primer (cont.) Filing Status PEP Threshold Begins PEP Threshold Ends Individual $261,500 $384,000 Married Filing Jointly $313,800 $436,300 Head of Household $287,650 $410,150 Married Filing Separately $156,900 $218,150

25 Tax Terms and Primer (cont.) The personal exemption amount for 2017 is $4,050, the same as However, the exemption is subject to a phase out that begins with adjusted gross incomes of $261,500 ($313,800 for married couples filing jointly). It phases out completely at $384,000 ($436,300 for married couples filing jointly). The Phaseouts apply as follows:

26 Tax Terms and Primer (cont.) Filing Status PEP Threshold Begins PEP Threshold Ends Individual $261,500 $384,000 Married Filing Jointly $313,800 $436,300 Head of Household $287,650 $410,150 Married Filing Separately $156,900 $218,150

27 Tax Benefits of a Qualified Disability Trust Under what circumstances is it be desirable to qualify as a disability trust? The negative is compressed tax brackets for trusts. When a trust pay taxes (rather than passing through DNI to beneficiaries) the trust will almost always pay at higher rates than individuals with the same income. This is true because of the dollar amountsofincomerequiredtotriggereachstepuptoa higher tax bracket.

28 Tax Benefits of a Qualified Disability Trust (cont.) For 2017, a trust's taxable income in excess of $12,500 is taxed at the highest income tax rate (39.6%), while an individual's taxable income must exceed $418,400 (unmarried taxpayers) or $470,700 (married taxpayers filing jointly) to be subject to the same rate.

29 Tax Benefits of a Qualified Disability Trust (cont.) Individual Taxpayers If Taxable Income is Between: The Tax Due is: $0 $9,325 10% of taxable income $9,326 $37,950 $ % of the amount over $9,325 $37,951 $91,900 $5, % of the amount over $37,950 $91,901 $191,650 $18, % of the amount over $91,900 $191,651 $416,700 $46, % of the amount over $191,650 $416,701 $418,400 $120, % of the amount over $416,700 $418,401 + $121, % of the amount over $418,400

30 Tax Benefits of a Qualified Disability Trust (cont.) Married Individuals Filing Joint Returns and Surviving Spouses If Taxable Income is Between: The Tax Due is: $0 $18,650 10% of taxable income $18,651 $75,900 $1, % of the amount over $18,650 $75,901 $153,100 $10, % of the amount over $75,900 $153,101 $233,350 $29, % of the amount over $153,100 $233,351 $416,700 $52, % of the amount over $233,350 $416,701 $470,700 $112, % of the amount over $416,700 $470,701 + $131, % of the amount over $470,700

31 Tax Benefits of a Qualified Disability Trust (cont.) Federal Income Tax Rates for Trusts and Estates 2016 Tax Year If Taxable Income is Between: Tax Due Is: $0 $2, % $2,550 $5, % of excess of $2,550 $5,950 $9,049 $1, % of excess of $5,950 $9,050 $12,399 $2, % of excess of $9,050 $12,400 + $3, % of excess of $12,400

32 Tax Benefits of a Qualified Disability Trust (cont.) Federal Income Tax Rates for Trusts and Estates 2017 Tax Year Taxable Income: Tax Due Is: $0 $2, % $2,550 $5, % of excess of $2,550 $6,000 $9,149 $1, % of excess of $6,000 $9,150 12,499 $2, % of excess of $9,150 $12,500 + $3, of excess of $12,500

33 Tax Benefits of a Qualified Disability Trust (cont.) Beginning in 2013, a 3.8% surtax applied to the lesser of (1) net investment income or (2) modified adjusted gross income in excess of the following thresholds (without adjustment for inflation): Single $200,000, Married Filing Jointly $250,000, Married Filing Separately $125,000. The 3.8% Medicare surtax applies to a trust or estate when the lesser of (1) undistributed net investment income or (2) the excess of adjusted gross income is over $12,500.

34 Capital Gains Rate There are three long term capital gain rates and qualified dividends, 0% 15%, and 20% (28% applies to collectables). The capital gain and qualified dividend brackets are as follows: The application of the special rates for capital gain and qualified dividends become more complex when a tax payer has ordinary income that is added to increase overall taxable income which will create different tax brackets for each type of income.

35 Capital Gains Rate (cont.) Example: Married couple, $50,000 of wages and $25,000 long term capital gain and $25,000 of qualified dividends. Their expenses that are eligible to be itemized deductions under Schedule A do not exceed their standard deduction and personal exemption. Tax is calculated as follows:

36 Capital Gains Rate (cont.) Standard deduction $12,700 Personal Exemption $ 8,100 Total $20,800 Ordinary Income $50,000 Less Deductions $20,800 Total $29,200 The $50,000 of long term gain and qualified dividends go on top of the $29,200 income. Total income is $79,200.

37 Capital Gains Rate (cont.) Ordinary income fills up the first tax bracket of $18,650 and $10,550 of the second tax bracket. From there the long term capital gain rate starts. In this example the next $44,700 is taxed at 0% and $3,300 is taxed at 15% rate.

38 Capital Gains Rate (cont.) Single filers: Income Tax Bracket Short term capital Long term capital gains gains rate rate Up to $9,325 10% 10% 0% $9,326 to $37,950 15% 15% 0% $37,951 to $91,900 25% 25% 15% $91,901 to $191,650 28% 28% 15% $191,651 to $416,700 33% 33% 15% $416,701 to $418,400 35% 35% 15% $418,401 and over 39.6% 39.6% 20%

39 Kiddie Tax There are some positive aspects concerning treatment as a qualified disability trust that might outweigh the negatives to trust taxation. A qualified disability trust receives a full personal exemption, rather than being limited to the $300 deduction and, in an increasing number of cases involving kiddie tax liability. In at least some cases it might be preferable (if possible) to treat the trust as a qualified disability trust, secure its personal exemption, and pay taxes at the more highly compressed rate.

40 Kiddie Tax (cont.) The Tax Increase Prevention and Reconciliation Act of 2005, which was signed into law on May 17, 2006, provide that the kiddie tax applies until a child reaches age eighteen. For 2017, the threshold for the kiddie tax meaning the amount of unearned net income that a child can take home without paying any federal income tax is $1,050. All unearned income in excess of $2,100 is taxed at the parent s tax rate.

41 Kiddie Tax (cont.) The kiddie tax generally applies to the unearned income of a child, regardless of the source of the property generating the income or when the property was transferred to the child. Accordingly, when parents, grandparents, and friends gift income producing assets, combined with the child's own unearned income, the gifted assets that generate income may be subject to the kiddie tax.

42 Kiddie Tax (cont.) Because a trust generally is a taxpaying entity, the kiddie tax applies to a child beneficiary of the trust only to the extent of taxable distributions from the trust to the childbeneficiary (under 652(a) or 662(a)) during the taxable year. The income from property in a UGMA or UTMA custodianship also is subject to the kiddie tax.

43 Kiddie Tax (cont.) The kiddie tax applies to unearned income for children under the age of 19 and college students under the age of 24. For purposes of the kiddie tax, unearned income is defined as income that is not attributable to earned income as defined in 911(d)(2). In general, under 911(d)(2), earned income, is defined to include wages, salaries, professional fees, and other amounts received for personal services rendered. Earned income to a child is not subject to the kiddie tax.

44 Kiddie Tax (cont.) Earned income, for kiddie tax purposes, also includes any amounts included in the child's income under 652 and 662 during a taxable year if the child is a beneficiary of a 642(b)(2)(C)(ii) qualified disability trust. Clearly, passive investment income (e.g., interest, dividends, mineral royalties, etc., including passive investment income on invested earned income) is subject to the kiddie tax. Social Security and pension benefits paid to the child also are included in unearned income.

45 Kiddie Tax (cont.) An exception to the application of the kiddie tax was added for distributions from a QDT as defined in 642(b)(2)(C)(ii). Specifically, for purposes of the kiddie tax rules, any amount included in the income of such child under 652 and 662 during a taxable year shall be considered earned income of such child for such taxable year. Section 652 references a trust where all the income is required to be distributed (a simple trust). Section 662 references a trust that may accumulate or distribute income (a complex trust). Section 652 and 662 do not apply to a grantor trust.

46 Kiddie Tax (cont.) To take it another step, is unearned income from the child s own assets subject to the Kiddie tax? The Kiddie tax was designed to stop parents from shifting income to their children by transferring assets to the child and then having the income earned from the transferred asset taxed at the child s rate. A first party SNT is funded with the child s assets not the parent s assets. As a result, there is no income tax motivation for the transaction. Nonetheless, the regulations state that the Kiddie tax is imposed on all unearned income regardless of its source.

47 Kiddie Tax (cont.) Reg. 1.1(i) 1T, provides as follows: Will a child be subject to tax under section 1(i) on net unearned income that is attributable to gifts from persons other than the child's parents or attributable to assets resulting from the child's earned income? Yes. The tax imposed by section 1(i) applies to all net unearned income of the child, regardless of the source of the assets that produced such income. Thus, the rules of section 1(i) apply to income attributable to gifts not only from the parents but also from any other source, such as the child's grandparents. Section 1(i) also applies to unearned income derived with respect to assets resulting from earned income of the child, such as interest earned on bank deposits.

48 EXAMPLE 1: Case Comparison In 2017, the taxable income of a third party SNT is $30,000. The $30,000 of taxable income is from interest and dividends. Beneficiary A is the sole beneficiary of the trust and has no other personal income or deductions. The trust has fiduciary fees and legal costs of $5,000. The Trust is a separate taxable entity and the beneficiary is not the owner of any portion of Trust under I.R.C The trust is a complex trust and no distributions were made to or for the benefit of the beneficiary in Trustee and legal expenses to the trust are not subject to the 2% floor under I.R.C. 67.

49 Case Comparison (cont.) The total tax liability for the Trust is calculated as follows: Taxable Income for Trust Taxable Income $30, Qualified Dividends $47, Deductions $ 5, Gross Income $72, Less Exemption $ Taxable Income $71, Trust Tax Liability $20, Medicare Surtax 3.8% $ 1, Total Federal Tax For Trust $21, Beneficiary Tax Liability 0.00

50 Case Comparison (cont.) EXAMPLE 2: Same facts as Example 1, except that the trust distributes $50,000 to the beneficiary and the trust is a complex trust and qualifies as a QDT. The trust may deduct the $5,000 in administrative charges, the $50,000 distribution to the beneficiary, and claim an increased QDT exemption in the amount of $4,050. The beneficiary must include in income the $50,000 distribution. The beneficiary will then apply against the trust distribution his own $4,050 personal exemption and $6,350 standard deduction.

51 Case Comparison (cont.) EXAMPLE 2: Taxable Income for Trust Qualified Dividends $47, Taxable Income $30, Deductions $ 5, Distribution Deduction $50, QDT Exemption $ 4, Trust taxable Income $17, Trust Tax Liability $ 4, Medicare Surtax 3.8% $ Total Federal Tax for Trust $ 5,441.00

52 Case Comparison (cont.) EXAMPLE 2: Taxable Income for Beneficiary Taxable Income $50, Deductions $ 0.00 Less Standard Deduction $ 6, Less Personal Exemption $ 4, Gross Income $39, Total Tax Liability for Beneficiary $1, Combined tax liability of Beneficiary and Trust $7,151.00

53 Case Comparison (cont.) As illustrated in these examples the tax savings can be dramatically different for the trust and beneficiary with the same amount of income. Example 1, trust tax due is $21, Example 2, combined tax due for trust and beneficiary is $7, When a trust qualifies as a QDT, and makes partial distributions for the benefit of the beneficiary, tax savings will be achieved by utilizing the increased QDT exemption for the trust along with the standard deduction and personal exemption of the beneficiary.

54 Case Comparison (cont.) If a trust is at the 39.6% tax bracket, the increased $4,050 exemption will save $1, of tax, and $ of increased tax due to the addition of the Medicare surtax. For a total tax savings of $1,

55 65 Day Rule 663(B) Election for Trusts With respect to discretionary distributions, whether of income or principal, the year of payment by trust will generally be the year of deduction and will set the year for determining inclusion of the payment. But, if, within the first 65 days of the tax year of a trust an amount is properly paid or credited, and if the fiduciary makes a proper election, the distribution is treatedashavingbeenmadeonthelastdayofthe preceding tax year.

56 65 Day Rule 663(B) Election for Trusts (cont.) While the distribution must be made within 65 days of the new year, the election must be made no later than the deadline for filing the fiduciary income tax return for the tax year for which the distribution is treated as made, plus extensions. Because trusts must use the calendar year, the election deadline for trusts is April 15, plus any extensions. An election becomes irrevocable after the last day for making it.

57 MAGI Calculation MAGI is intended to create a uniform nationwide system to calculate income. MAGI is based upon the taxable income of the individual or individuals filing a joint return. The starting point for calculating MAGI is adjusted gross income (AGI). AGI is calculated by adding income on Lines 7 through 21 on Form 1040, which is then combined on Line 22 as total income. From total incomecertainabovethelinedeductionsonlines23 through 35 (e.g., trade and business deductions, losses from sale of property, and alimony payments) are subtracted to reach AGI which is reported on Line 37 of Form 1040.