2018 National Conference on Special Needs Planning and Special Needs Trusts Taxation of Third Party SNT s I. Richard Gershon 10/17/2018

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1 2018 National Conference on Special Needs Planning and Special Needs Trusts Taxation of Third Party SNT s I. Richard Gershon 10/17/2018 Professor of Law University of Mississippi (Ole Miss) School of Law

2 A GREAT RESOURCE! irs publication on income taxation of trusts and estates The IRS s freely available publications are written for the general public. They tend to be well written and relatively approachable. Since I can t possible cover all there is to know in an hour, I recommend the following IRS publication: pdf/i1041.pdf

3 WHY DO WE TAX TRUSTS? Trust income basics 26 U.S. Code 102 Gifts and inheritances (a) General rule Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance. [Emphasis supplied.]

4 INCOME FROM PROPERTY IS TAXABLE But: (b) Income Subsection (a) shall not exclude from gross income (1) the income from any property referred to in subsection (a); or (2) where the gift, bequest, devise, or inheritance is of income from property, the amount of such income. [Again, emphasis supplied.]

5 TEXT The whole reason we have subchapter j the taxation of trusts and trust beneficiaries: IRC 102 (b) FLUSH (I will explain that!) Where, under the terms of the gift, bequest, devise, or inheritance, the payment, crediting, or distribution thereof is to be made at intervals, then, to the extent that it is paid or credited or to be distributed out of income from property, it shall be treated for purposes of paragraph (2) as a gift, bequest, devise, or inheritance of income from property. Any amount included in the gross income of a beneficiary under subchapter J shall be treated for purposes of paragraph (2) as a gift, bequest, devise, or inheritance of income from property.

7 A Marvelous Example Example: In 2017, Matt Murdock gave Jessica Jones an apartment building worth $2 million. The gift was made out of a detached and disinterested generosity, and was thus the value of the property was excluded from gross income under 102(a). (see, Commissioner v. Duberstein, 363 U.S. 278 (1960)). In 2018, Jessica collected $80,000 in rent from the apartments. That $80,000 will be included in Jessica s gross income under 102(b) because it represents income from property. If not for 102(b), it could be argued that the rent was also a gift, since it was generated by property given to Jessica. If that were the case, income from property would never be taxed again, once the property was transferred by gift or inheritance.

8 Assuming The Trust is not a Grantor Trust First Party, self settled SNT s are not treated as separate entities for Federal Income Tax purposes. Instead, the grantor is treated as owning the assets, and is taxed directly on income earned by the trust. 26 U.S.C. Subpart E ( ). Accordingly, income and deductions of the trust are reported on the settlor s 1040 for the taxable year. This presentation is focused on Third Party, Non Grantor Trusts.

9 THE BOTTOM LINE IF THERE IS INCOME TO DISTRIBUTE, THEN THE DISTRIBUTION WILL BE INCOME DISTRIBUTION OF CORPUS IS A NON TAXABLE GIFT DISTRIBUTION OF INCOME IS TAXABLE IF THE TRUSTEE CAN DISTRIBUTE EITHER INCOME OR CORPUS (DISCRETIONARY TRUST) THEN THE DISTRIBUTION IS TREATED AS A DISTRIBUTION OF INCOME TO THE EXTENT THERE IS INCOME TO DISTRIBUTE. IN OTHER WORDS, TAXABLE DISTRIBUTIONS COME BEFORE NON TAXABLE DISTRIBUTIONS.

10 Simple v Complex Trusts

11 TYPES OF TRUSTS simple trusts If a trust is a simple trust, the trust is required to distribute all of its income every tax year to a non charitable beneficiary. Example: Kirk establishes a trust that is required to pay Sulu all net trust income each year. The corpus of the trust will pass to Spock at Sulu s death. The trustee has no discretion regarding distributions from the trust (although the trustee will typically have discretion over trust investments). All trust income will be distributed every year. Live long and prosper, Sulu.

12 TYPES OF TRUSTS Complex Trust In a complex trust, the trustee will have discretion over distributions of income and corpus. This could even include the discretion not to make distributions in a given year, or to make distributions to a charity. Example: Hans Solo establishes trust naming Princess Leia as the trustee. The terms of the trust state that Leia shall distribute as much trust income or principal as she deems in her sole discretion necessary provide support for Luke. The force is strong in Princess Leia!

13 TYPES OF TRUSTS Why does it matter if a trust is simple or complex? Because a trustee is required to distribute all income at least annually from a simple trust, the trust itself will not be taxed. IRC Section 661(a) allows for a deduction of all income required to be paid during the taxable year. Accordingly, the trust will have a deduction equal to its income.* The beneficiary, on the other hand, will be taxed on the income distributed. The trust in this case is a "pass through entity." *The amount of the deduction cannot exceed Distributable Net Income (a term I promise to explain!).

14 WHY DOES IT MATTER? Complex Trusts are, well, Complex! Because a trustee in a complex trust can make distributions of income, corpus, or neither in any given year, it is possible that the trust will not distribute all of its income in that taxable year. While the trust will still get a deduction under IRC Section 661(b) for any income it distributes. The trust will be taxed, however on any income it retains for the year.

15 A FURTHER COMPLICATION not complex enough for you? A complex trust is a taxable entity (unless it actually distributes all of its income). The beneficiary will actually be taxed on all income distributed to that beneficiary during the taxable year. BUT, What if the trustee decides to make only a distribution out of corpus, even though there was income to distribute that year?

16 HOW IS THE DISTRIBUTION TAXED? Example Distribution from a complex trust Bubba is the trustee of a trust providing that Bubba has discretion to distribute income, corpus, both (or neither) for the benefit of Cyrus. The trust consists of stocks, bonds, and rental real estate (the corpus) worth $1million. During the current year, the trust earns $50K in dividends, $10K in bond interest, and $45K in rentals from the rental property (income). If Bubba makes no distributions this year, the trust will have income of $105K, that it will have to report on its 1041 (this will be the trust s gross income).

17 A DISTRIBUTION OF INCOME On the other hand If in the scenario above, Bubba instead distributes all of the annual income to Cyrus, the trust will be entitled to a deduction equal to the income distribution, and Cyrus will report the $105K. Similarly, if the trust distributes $60K of income to Cyrus, then the trust will retain $45K of income that it must report while Cyrus will include the $60K distribution on his return.

18 A DISTRIBUTION OF CORPUS What if Bubba retained the income, and gave Cyrus stock, instead? If Bubba, gave Cyrus $75K worth of stock, rather than giving him income from the trust that year, what would happen? Subchapter J of the Internal Revenue Code provides that the distribution of stock to Cyrus will be treated as a distribution of income under IRC section 662. In other words, if Cyrus could get either corpus or income, the distribution will be considered an income distribution to the extent there was income to distribute, even though Cyrus actually received corpus.

19 ONE OTHER COMPLEXITY Class of beneficiary If the trust provides that Cyrus in the above scenario can only receive distributions of corpus, on the other hand (and some other beneficiaries are the income beneficiaries), then the distribution to Cyrus will not be taxable to him, and it will not reduce the trust s distributable income for the year. THE TRUST INSTRUMENT ALWAYS CONTROLS, AND YOU MUST BE SURE TO KNOW THE TERMS OF THE TRUST, IN ORDER TO KNOW THE INCOME TAX CONSEQUENCES TO THE TRUST AND THE BENEFICIARIES.

20 SOME IMPORTANT TRUST TAX TERMS AND CONCEPTS Distributable Net Income v. Trust Accounting Income The definition of income for trust purposes differs from the Internal Revenue Code definition of Income. For example, tax exempt municipal bond interest is income for trust accounting purposes, but it is not considered part of the trust s taxable income for tax purposes. Similarly, capital gain income is typically considered an increase in value attributable to corpus, and will not be income for trust purposes, even though it can be considered income for tax purposes.

21 IMPORTANT TAX TERMS Distributable Net Income (DNI) Form 1041, Schedule B is used to calculate the DNI. Lines 1 8 on form 1041, Schedule B calculates the trust accounting income (TAI) which will include tax exempt interest, and other items allocable to the income beneficiary, but not necessarily taxable.

22 FILING REQUIREMENTS 1041 basics You generally must file Form 1041 if are a trustee for a domestic trust, and that trust has gross income of $600 or more for the year. You must also file a K 1 for any beneficiary receiving a distribution in the taxable year. Let s examine the 1041 included in your materials. (Don t do this while driving or operating heavy material some drowsiness is assured. Don t tax an drive.)

Third-Party Special Needs Trusts: Asset Protection Benefits and Tax Burdens

Third-Party Special Needs Trusts: Asset Protection Benefits and Tax Burdens Presented by I. Richard Gershon University of Mississippi School of Law I. What is a Third-Party Special Needs Trust? A. Difference